When does debt become a problem?Syllabus: Explain why the servicing of international debt causes balance of payments
problems and has an opportunity cost in terms of foregone spending on development objectives.
If a developing country borrows funds from international markets (long-term official concessional borrowing) and the funds are used for effective development projects there should be enough of an increase in GDP to pay the interest and borrowing back without a problem. This would promote economic growth and an upward growth cycle.
Foreign debt becomes a significant problem when:
- Scarce resources have to be devoted to interest / debt repayment
instead of meeting the needs of the people, many of whom already live
in a state of absolute poverty. This is a clear example of opportunity cost
(shown on a PPC) the currency paying off interest has the cost of
health, education and other public services not being provided
- The debt is so large that the rate at which the amount that has to be paid back grows more rapidly than inflows of foreign exchange with which to repay it - the debt increases automatically and restructuring (renegotiating the interest and conditions of repayment).
- The debt shifts from being long-term official concessional borrowing to short-term market rate borrowing from commercial banks (at higher interest rates).
- There is an external shock, such as an increase in the price of oil (or decrease as Venezuala and OPEC countries are now finding out - even Saudi Arabia has a growing budget deficit for the first time in living memory) or a hike in world interest rates, which increases the scale of any commercial debt the country faces.
- The country faces severe longer term balance of payments problems as the prices of primary commodities fall, causing the terms of trade to worsen.
- Capital flight causes local residents to move large sums of foreign exchange out of the country.
- The country experiences a loss of freedom to determine its national economic and social policies.
- Domestic resource allocation is distorted to gear production towards foreign currency earning areas instead of, for example, food production to meet basic needs, e.g. cash cropping.
- The seriousness of the debt problem necessitates the intervention of the IMF, which inevitably administers a 'heavy dose of medicine' (which often makes the patient sicker!) in the form of their structural adjustment programmes.