Developing Countries' Debt Problems and Growth Prospects ANNE O. KRUEGER*

I. Introduction

that the debt issue is far from resolved. And the reason is straightforward: it never was only a short-run problem of liquidity but instead reflected more serious long-run problems that would, under the best of circumstances, require sustained efforts over a substantial period of time. My theme will be that, for a number of heavily indebted countries, the "debt overhang," i.e., the debt-servicing obligations they now hold, has serious implications for their growth prospects. In particular, the effort to service the large volume of ou[standing debt places such a strain on their economies that the capacity to save and invest out of domestic resources is impaired. Without the debt overhang, investible resources would be there and, in any event, any excess of profitable investments over domestic saving could be financed through private capital flows to the developing countries. With the debt overhang, however, private capital flows may not be forthcoming. The longer-run solution depends on sufficiently rapid growth of developing countries' foreign exchange earnings that their debtservice ratios decline to more normal levels and economic growth swallows up the debt problem. For heavily indebted developing countries, growth prospects therefore depend largely on their adapting their economies to earning larger supplies of foreign exchange and on the degree to which foreign markets are open to them. To reach that conclusion requries a number of steps. A first step is to understand the factors which contributed to the debt crisis. Next, attention must turn to the measures taken to deal with the crisis. Thereafter, the meaning of the "debt overhang" and its implications can be addressed. A final section then assesses the prospects for developing countries' growth in that light.

The past five years have witnessed a large number of events in the international economy of unprecedented magnitude and importance. To name just a few: the worldwide recession of 1980-83 was deeper and longer than any since the Second World War; real primary commodity prices reached their lowest levels since the Great Depression; real interest rates attained unprecedented levels; the world's most important and presumably most stable currency appreciated 50 percent in five years in real terms; and the drop in the rate of inflation exceeded even the most optimistic expectations of policy makers and economists. In the midst of all this, the debt crisis of the developing countries increased anxieties and uncertainties about the international financial system. Partly because so many events were occurring simultaneously, and partly because initial focus was on the immediate liquidity problems of large borrowers, it was perhaps natural to assume that the debt crisis would be resolved as the worldwide recession abated. Initially, therefore, little attention was paid to the impact of the debt problem on the longerterm growth prospects of the developing countries. And, indeed, until the initial crisis phase was successfully passed, the longer term issues could not be addressed. Now, however, seems to be an appropriate time to examine the longer-term aspects of the debt problem. The upswing in the international economy began in 1983, and proceeded at a healthy pace through 1984. Even if there were no concerns as to the sustainability of the recovery, it is already apparent

*Vice President of Economics and Research,The World Bank. Invited Address at the Twentieth International Atlantic Economic Conference, August 29-September 1, Washington, D. C.

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KRUEGER: DEBT PROBLEMS AND GROWTH PROSPECTS

At the outset, I should point out that there are a large number of developing countries, and I am talking about only a limited group of them, i.e., those which had significant access to private international capital markets in the 1970's and were then unable to finance their debt-service obligations through normal mechanisms at some point after the 1979 oil price increase. There are a number of developing countries that are not included. Some (such as Korea, Colombia, and India) had access to private capital markets in the 1970's but have managed to maintain normal creditworthiness through the 1980-85 period. My analysis today does not apply to them. Another group of low-income developing countries, mostly in SubSaharan Africa, have severe debt problems, but those countries have not had as much access to the private capital markets as have the middle-income countries, and their debt is largely to official agencies. Moreover, the debt problems of SubSaharan Africa are an integral part of a much deeper set of economic difficulties which have resulted in declining standards of living in many countries since 1970. For that reason, although many of the conclusions also apply to SubSaharan Africa's prospects, I shall not focus on those countries. Rather, in my discussion, I shall concentrate on the middle-income countries which were enabled in the 1970's to borrow considerably on the private international capital market and which then, in the 1980's, at one time or another were subject to debt rescheduling. There are significant differences even among these middle-income, heavily indebted countries. Income levels vary widely. Some are very large economies and others much smaller. Some are oil exporters (such as Mexico) and others oil importers (such as Bolivia). Some are predominantly primary commodity exporters (the Philippines and Chile). Others have a large fraction of their exports in manufactures (such as Brazil). Some have an earlier history of debt rescheduling (such

9

as Turkey), while others had unblemished records of debt servicing until the current crisis (such as Costa Rica). For some, private capital flight (although perhaps indicative of deeper problems) was a major contributing factor to their difficulties (Venezuela is a case in point), while others seem to have had little private capital outflow (such as Brazil). Nonetheless, I shall couch my discussion in terms of a "typical middle-income developing country which rescheduled its debt," without qualifying every statement to take into account the enormous diversity.

II. Origins of the Debt Crisis The 1960's and early 1970's were an era of rapidly increasing hope and expectations for development. Not only did growth of most developing countries accelerate to rates previously not thought possible and several times historical levels, but some developing countries put on such spectacular performances as to change thinking about development altogether. Whereas growth rates of real G N P of 5, 6, and 7 percent had earlier been regarded as very high and sufficient to place a country in the high growth leagues, some of the star performers of the 1960's achieved real rates of growth in excess of l0 percent for sustained periods of a decade or more. The consequences for the international economy were several. First, the developing countries could no longer be regarded as premanently unimportant economically. As countries, such as Korea and Singapore, emerged as significant exporters on world markets, they also became important buyers of industrial goods from the rest of the world. Not only did their own performance command respect, but it demonstrated that other developing countries, too, have the potential to change their role in the international economy significantly. Irnports of manufactures from developing countries were no longer dismissed as "cheap, inferior quality, and undependable;" businessmen in developed countries instead began complaining about "unfair competition."

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As this happened during the 1960's and early 1970's, a second important lesson was learned: the same policies that led to successful export and growth performance resulted in a dramatic increase in the profitability of investment in those countries. This attracted significant inflows of private capital, including not only equity investments (which had earlier been largely directed toward investments in exportable raw materials or heavily protected import-competing industries) but also loans from foreign commercial banks. Already, by 1970, several developing countries had established themselves as creditworthy and had sizeable inflows of funds. As everyone knows, the era of spectacular growth of the international economy that had begun in 1945 ended with the commodity price boom of 1972-73 and the sharp rise in the oil price at the end of 1973. Those phenomena, while highly visible, were only the last in a series of events which cumulatively undermined the foundations for rapid growth in the industrialized countries. Before that, the Bretton Woods system of fixed exchange rates which had served the world so well for a generation had broken down, largely because individual countries did not wish to maintain monetary and fiscal policy combinations that were consistent with fixed and stable exchange rates. As inflationary pressures increased, divergences in inflation rates made continuation of the system infeasible. With hindsight, the fact that floating rates prevailed by the time of the oil price increase was probably essential to permit the industrial countries to absorb the change without more disturbance than actually took place. For my purposes here, however, the important fact about the oil price increase was that, initially, a significant group of oil-exporters temporarily incurred very large current account surpluses. Although some observers wondered how those surpluses could possibly be recycled, the international financial system demonstrated remarkable flexibility. While the OECD countries swung sharply into current account deficit initially, they

adjusted fairly rapidly, achieving about the same magnitude of current account balance by 1977 as had prevailed in the early 1970's. By contrast, the oil-importing developing countries initially increased their current account deficits and financed them by borrowing from the large commercial banks in the industrial countries. In effect, the commercial banks were acting as financial intermediaries between the oil exporting countries in current account surplus and the oil-importing developing countries. Some of the oil-importing, current-accountdeficit countries borrowed initially to finance their deficits as they bought time for their domestic producers and consumers to adjust to altered circumstances. Typically, they increased incentives for exporting, permitted the higher price of oil and other energy sources to reflect the changed international price, and adapted monetary and fiscal policies to restore macroeconomic balance. For those countries, current account deficits were already at more normal levels by 1976 or 1977, and further borrowing in the latter part of the 1970's was typically to finance productive investment. Some other developing countries, however, confronted with a suddenly increased oil import bill and hence a current account deficit, borrowed without altering their domestic policies sufficiently to bring about the necessary changes in the domestic economy. In many of these cases, current account deficits persisted or even worsened as fiscal imbalances were permitted to remain, inflation accelerated, and exhange rates were altered to reflect inflation differentials only with a lag and often not by the full amount of the differentials (when, indeed, the higher oil price would have warranted an exchange rate change in excess of the inflation differential). These deficits were covered by external borrowing. In some cases, debt-servicing obligations became so onerous that an individual country was confronted with the urgent necessity for policy reforms and debt rescheduling but, by and large, servicing the debt did

KRUEGER: DEBT PROBLEMS AND GROWTH PROSPECTS

not initially appear to be a major problem. There were several reasons for this. First, the oil price increase had set off a worldwide inflation. Although oil importing developing countries typically had inflation rates well in excess of the world rate, inflation in dollar terms was significantly higher than it had earlier been. Because lenders had not anticipated it, much of the debt incurred after 1973 (as well as before) was at fixed nominal rates of interest, usually below the rate of inflation. As a consequence, developing countries' export prices were rising sufficiently rapidly so that conventional measures of debt-service burdens (such as interest payments to exports) were not rising; indeed, the real value of developing countries' debt declined during the 1976-8 period, despite substantial net borrowing because of inflation. Secondly, the turbulence of 1972-73 did not entirely disappear in the later 1970's: commodity price booms for particular commodities (most notably coffee and cocoa) at various times permitted a significant easing of the debt burden and a simultaneous large increase in public investment programs. III. The Debt Crisis and Initial Response By 1979, therefore, the situation of various groups of developing countries differed dramatically. Some had adapted to the 1973 oil price increase and the turbulence of the 1970's and resumed rapid growth (indeed, some, such as Singapore, even exceeded their growth rate of the 1960's). Others had belatedly begun admustments but were only beginning to resume growth. And still others had hardly responded to the changes of the 1970's and had much heavier debt burdens than were in any event sustainable given their low growth rates. Finally, a sizeable group was incurring very large fiscal deficits and high rates of inflation, as they were unable to adjust their expenditures downward when their terms of trade deteriorated sharply as the commodity price boom that they had enjoyed ended. The 1979 oil price increase, therefore, oc-

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curred against a very different background than did the 1973 one. Some countries had still not adjusted to the 1973 changes, and they typically had higher levels of debt, higher rates of inflation, and lower rates of growth than had constituted the initial conditions when they were confronted with the 1973 oil price increase. Even then, had the industrial countries reacted as they did in 1973, the outcome might not have included a d e b t crisis, although it would surely have included a number of reschedulings. For, after 1973, the industrial countries typically reacted by treating the recession which followed the oil price increase as a decrease in demand, and applying the remedies that a p p e a r e d to have worked in earlier postwar recessions: expansionary monetary and fiscal policies. After 1973-74, much lower rates of growth of output and much higher rates of inflation than had been anticipated followed the developed countries' traditional Keynesian response to the oil price increase and resulting recession. By the time of the 1979 oil price increase, most industrial countries were concerned about their rates of domestic inflation, and adopted an anti-inflationary stance. The severe worldwide recession of 1980-83 ensued, and with it extraordinarily high real interest rates, low commodity prices, and the first reduction in the volume of world trade since the end of the Second World War. By 1982, developing countries were paying a nominal rate of interest of 14 percent for commercial loans. Their export prices that year declined by 5 percent, making a real interest rate of close to 20 percent for their variable interest rate debt; and their export earnings declined $16 billion in nominal terms. It is thus not surprising that many developing countries had major problems. For those already in debt and experiencing a continuing decline in their export prices and/or markets, there was no way to reduce current account deficits fast enough to avoid additional borrowing; the consequence was a further huge increase in debt and an even faster increase in

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debt-service obligations just when higher nominal and real interest rates made the existing burden of debt even more onerous than it had been. Debt service ratios were therefore rising because of larger debt, higher interest payments on it (both raising the numerator) and because of declining export earnings (reducing the denominator). Some of the consequences of these shifts are detailed in Tables 1 and 2. Table 1 gives the value of exports, imports, and current

account balances of non-oil exporting developing countries for selected years between 1974 and 1984. As can be seen, current account deficits remained at about $40 billion over the 1974-78 period, as developing countries continued to be net capital importers. However, oil-importing developing countries' exports rose by more than 50 percent over that same period, thus permitting a large increase in imports.

TABLE 1 NON-OIL DEVELOPING COUNTRIES' EXPORTS AND IMPORTS, 1974-84 (BILLIONS OF U.S. DOLLARS)

1974

1978

1980

1981

1982

1983

1984

Exports

126.8

194.7

320.7

329.7

315.8

323.8

353.5

Imports

167.4

245.3

405.9

431.7

389.0

370.4

380.4

Current Account Balance

-37.0

-42.3

-87.7

- 109. l

-82.2

-56.4

-50.0

Source: IMF, International Financial Statistics and Worm Economic' Outlook, various issues. Between 1978 and 1980, however, the oil price increase meant that import growth outpaced export growth, and the oil-importing developing countries' current account deficits doubled to almost $90 billion. In 1981, these countries' export earnings grew by only $10 billion, while imports jumped another $25 billion. Thus, the current account deficit of the oil importing developing countries reached $107 billion in 1981, reflecting both the impact of the recession on export earnings and the increased cost of imports resulting from worldwide inflation and the oil price increase. Table 2 gives some idea of the effects of this sequence of events for the debt of the developing countries. Although the analytical groups covered in Table 2 are not identical to those in Table 1, the aggregates are suffi-

ciently close so as to provide a reliable indicator of the significant changes. For all developing countries (oil exporting and oil importing), the debt burden increased enormously when judged by any indicator. For the middle income countries that export manufactures, the ratio of debt to exports stood at .773 in 1980, and rose to 1.09 by 1984; for all developing countries, it rose from .898 to 1.354. For individual countries, the situation was even more extreme. In Brazil, for example, the ratio of debt to GNP rose from .164 in 1980 to .291 by 1983; interest payments, which had accounted for 18 percent of export earnings and 1.7 percent of G N P in 1980, were 25.3 percent of export earnings and 2.2 percent of GNP by 1983. For Mexico, the

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KRUEGER: DEBT PROBLEMS AND GROWTH PROSPECTS

TABLE 2 SELECTED DEBT I N D I C A T O R S BY D E V E L O P I N G C O U N T R Y GROUPS, 1970-1984

1970

1974

1978

1980

1981

1982

1983

1984

All Developing Countries Ratio of Debt of GNP Ratio o f D e b t t o E x p o r t s Debt Service Ratio Ratio of Interest to GNP

.141 1,089 .147 .005

.154 .800 .118 .008

.210 1.131 .184 .011

.209 .898 .160 .016

.224 .968 .176 .019

.263 1.150 .205 .023

.313 1.308 .190 .023

.338 1.354 .197 .028

Middle-Income Manufacture Exports Ratio of Debt to GNP Ratio of Debt to Exports Debt Service Ratio Ratio of Interest to GNP

.162 .915 .151 .007

.180 .760 .137 .011

.221 .924 .177 .014

.228 .773 .161 .020

.247 .817 .171 .025

.279 .971 .193 .029

.344 1.052 .162 .029

.376 1.091 .160 .036

.214 1.110 .136 .008

.203 .887 .114 .009

.249 1.227 .209 .013

.297 1.207 .172 .019

.334 1.364 .208 .024

.402

.475

Other Middle-Income Imports Ratio of Debt to GNP Ratio of Debt to Exports Debt Service Ratio Ratio of Interest to GNP

.530 1.554 1.755 1.839 .227 . 2 3 1 .249 . 0 3 1 .033 .039

Source: World Bank, World Development Report 1985, Table 2.6. ratio of debt to GNP had stood at about 1.36 in 1980: it rose to 2.40 by 1983, and interest payments rose from an already-high 2 percent of GNP to 5 percent of GNP. An increase of 3 percentage points of GNP in interest paid is in any event sizeable; it is expecially sizeable when the government must somehow finance the interest payments domestically. The first large heavily indebted country to need assistance with its debt burden was Turkey. The significance of this lies in the fact that Turkey's situation was already unm a n a g e a b l e by late 1979. Early in 1980 (before the impact of the oil price increase had really been felt), the government embarked on a major reform effort, supported by the World Bank and the International Monetary Fund (1MF). In reality, Turkey

had attempted to continue growing after the first oil price increase by borrowing from abroad, failing to adjust its internal price of energy or to increase incentives for exports. The resulting fiscal deficit had placed strong inflationary pressures on the economy and, by the late 1970's, creditors were unwilling to extend further resources to Turkey until prospects for export growth were improved. When imports, therefore, had to be sharply curtailed, the growth rate slowed down and real GNP actually began declining. In an almost-crisis atmosphere, the reform program was undertaken. Turkish economic performance in the first half of the 1980's was significantly better than that of the last half of the 1970's, despite the worldwide recession. It was Mexico's situation, however, which really brought the debt situation to the

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world's attention. Largely because Mexico was an oil exporter, and therefore had been aided rather than harmed by the oil price increase of 1979, the announcement in the summer of 1982 that assistance was needed with debt-repayment obligations was startling. The efforts that then followed, led by the IMF, to put into place an economic reform program and simultaneously provide a rescheduling of existing obligations and sufficient additional money to make the prospective balance of payments manageable, were only the first of many such programs. When Brazil and Argentina followed in a short span of time, focus was squarely on the debt crisis. Thereafter, other debtors, many much less prominent, also undertook policy reform programs in the context of I M F agreements and sought assistance in managing their debt. In 1983 and 1984, more than $165 billion in outstanding debt was rescheduled. It is important to stress once again that each country's initial situation was different, as the contrast between Turkey, Mexico (an oil exporter), and Brazil vividly demonstrates. Nonetheless, it is useful to delineate the typical stages which have followed in a number of countries once a policy reform package (usually agreed upon with the IMF) and debt rescheduling had been negotiated. Typically, policy reforms have aimed at improving the current account of the balance of payments (in order to reduce the buildup of further debt) as a first step toward restoration of normal commercial borrowing relations. Policies adopted to reduce the current account deficit were essentially of two kinds: measures through which it was hoped that better domestic macroeconomic balance could be achieved and measures to increase incentives for earning foreign exchange while reducing those for spending it. In many cases, of course, the debt crisis arose precisely when countries could no longer obtain financing for their current account deficits. Hence, reducing prospective deficits was essential. To the extent that they

were often the result of excessive inflationary pressures, the policy response usually entailed reductions of expenditures and increases in revenues of the public sector. On the tradables-incentive side, realignment of the exchange rate, raising the price of tradables relative to nontradables has been a key ingredient. Even when these measures were taken, it was necessary that something be done to manage the debt-servicing obligations of the debtor country. Both debt to official creditors and that to private agencies was involved. Typically, consortia of private bankers were willing to negotiate one-year reschedulings of principal owed and, in addition, new money, once an I M F agreement had been reached on the reforms. Official debt was then rescheduled, and new credit extended, via the Paris Club. It is important to note that, in this phase, it was necessary that mechanisms be developed to raise needed new funds and to insure that banks rolled over principal payments coming due: otherwise, given the debt difficulties, each individual creditor had an incentive to demand repayment. In fact, it has been the smaller creditors who have typically been the most reluctant to reschedule and to extend new money. There can be no question but that private lending was "involuntary" in this stage: without cooperative arrangements, private creditors individually would have demanded repayment. Knowledge of the situation of individual countries suggests how impossible this would have been for individual countries. In addition, however, it would have been a macroeconomic impossibility. The leadership of the I M F was clearly essential to coordinate the necessary domestic policy changes with debt rescheduling, to arrange for sufficient new lending to permit debt-servicing obligations to be met, and simultaneously to allow a manageable balance of payments position. For the debtor country unable to fulfill its debt-servicing obligations without assistance, then, the first stage of the debt crisis followed the agreement on the reform package and

KRUEGER: DEBT PROBLEMS AND GROWTH PROSPECTS

debt rescheduling (with agreement on enough additional money to make the financing of the prospective current account deficit feasible). For most countries, this involved a sharp contraction of imports (induced by the higher relative price of importables, the lack of financing for them, and by the reduction in demand resulting from shifts in public sector finances). As can be seen in Table 1, 1982 witnessed a very sharp contraction of imports, from $436 billion to $390 billion for the developing countries as a group. Despite the fact that exports also declined by $16 billion, this permitted a decrease in their current account deficit of over $20 billion. 1983 saw a continuation of this pattern: export earnings remained almost constant (and still below their 1981 level) while imports shrank another $20 billion. Thus, the current account deficit was reduced by almost a third in two years, and that in spite of higher interest payments due because of larger external debt! For those countries which altered their policies sufficiently in 1982 and early 1983, the second phase of the return to normalcy began later in 1983, as their exports began growing enough to prevent further declines in domestic real output. The third phase came when foreign exchange earnings grew enough to permit modest increases in imports, thereby facilitating resumption of growth. In 1984, worldwide recovery and the effect of the policy packages already in place permitted a number of the heavily indebted developing countries to expand their exports significantly and even permitted some increase in imports and a moderate resumption of growth. Thus, after two years of negative per capita income growth, World Bank estimates are that 1984 witnessed real growth of developing countries' per capita incomes of over 2 percent. It must be noted that this was still below the rate achieved in the late 1960's and even the late 1970's, and also that growth was unevenly spread across countries and regions. Nonetheless, it marked a significant turna-

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round in many countries. By the end of 1984, another milestone was attained as the first countries entered what might be called the fourth phase of the resolution of the debt problem: the development of the multiyear rescheduling agreement (MYRA), first with Mexico and then with Venezuela. Under these agreements, the commercial banks, as a group, agreed to reschedule the principal repayments scheduled over the next six years into a longer and more manageable time frame. This, it was felt, would avoid the necessity for annual reschedulings as had earlier been undertaken, and provide countries with assurance that if they could maintain export growth and contain imports to reasonable levels, they would be able to manage their debt problems. T h u s , the M e x i c a n a n d V e n e z u e l a n MYRA's seem to most observers to represent the first cases of the fourth phase in the resolution of the debt problem. The first phase is the adjustment to the underlying crisis, with sharply curtailed imports and economic activity pursuant on debt rescheduling and macroeconomic policy changes. The second phase is that of export expansion but still with low levels of domestic economic activity. The third phase, then, is sufficient export expansion to permit both a gradual reduction in the debt-service ratio and a sufficient increase in imports to restore growth. The fourth phase is a realignment of the maturity structure of debt, with continuing export expansion and reduction in the debt service ratio. A fifth phase will presumably come when normal creditworthiness is restored and countries can once again access the private international capital market voluntarily. At present, some countries appear to be in each of the first three stages, and a few have entered the fourth. With that entry, a series of questions arise, and it is to them that I wish now to turn.

IV. The Debt Overhang and Growth Prospects Before the difficulties of the early 1980's,

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most observers regarded the entry of the developing countries into the private international capital markets as a healthy development. It had long been thought that, in a successful development program, the rate of return on additional investments would exceed that in more mature economies. In addition, capital flows to those countries would s i m u l t a n e o u s l y permit their more rapid growth and provide savers in developed countries with higher real rates of return than they could otherwise earn. At very low levels of development, it might be that most of these investments had long gestation periods and were in infrastructure, which might, therefore, require official or even concessional flows. But it was expected that, as countries achieved some degree of development, private capital flows could increasingly do the job. When investment was used for highly productive purposes, it would automatically be self-financing: the earnings on additional investment would more than cover additional debt-service obligations or profit repatriation. Under those circumstances, one would have expected the rapidly growing developing countries to increase their outstanding indebtedness (and also to experience rising inflows of other forms of capital) for a significant period of time. They would repay their debt, but in the same sense that a profitable business does, meeting repayment obligations and interest payments as they came due but borrowing more for new, worthwhile investments. To assess prospects for capital flows and growth in the future, therefore, a fundamental question is what went wrong in the latter part of the 1970's and early 1980's? The analysis in the preceeding section provides the basis for an assessment. In effect, the 1970's witnessed some healthy borrowing and some unhealthy borrowing. The latter might, in any event, have led to difficulties, but the worldwide events of 1979-83 exacerbated an already-difficult situation. The debt crisis can thus be viewed as the result of interaction

among four factors. First, borrowing was used in many instances to avoid macroeconomic adjustments in the 1970's and, hence, debt was built up without a sufficiently large increase in productivity to provide the automatic self-financing. Second, real interest rates were very much lower in the 1970's and hence, investments did not have to have the high real rates of return that currently prevail for debt servicing. Third, for oil importing developing countries, the oil price increase of 1979 resulted in large current account deficits and, hence, further borrowing, which increased already high levels of debt. Finally, the worldwide recession of 1980-83 resulted in sharper drops in export earnings and, hence, yet further debt built-up despite massive attempts at adjustment. And, while it is not relevant for present purposes, one should also mention that a policy mistake of some countries in the 1970's was to underestimate the advantages of private direct investmerit and the risks of borrowing abroad. The net result of these events, for the heavily indebted middle-income developing countries, was the inability to service their debt normally. As has been shown, the response of the international financial community permitted the maintainance of debt-servicing obligations through reschedulings arranged under the leadership of the I M F in the first phases of resolution. Through these arrangements, some countries are now in a position to hope for MYRA's, with sufficiently rapid growth of export earnings to lower their debt-service ratios and, ultimately, to permit the restoration of normal creditworthiness. At that point, it is to be hoped, the fifth phase of the resolution of the debt problem would have arrived, with normal growth and creditordebtor relations. If the analysis sketched at the beginning of this section is correct, i.e., that developing countries with sound economic policies should attract capital inflows for a substantial period

KRUEGER: DEBT PROBLEMS AND GROWTH PROSPECTS

of time during their development, one would expect that, when the fifth stage arrives, normal capital inflows would resume at a rate lower than the heydays of the 1970's, which would be about commensurate with the rate of growth of exports. To be sure, much depends on the evolution of the real rate of interest; should it be at levels that are very high by historical standards, it will be valid to ask how much additional borrowing is warranted. But, even if real interest rates return to their historic 3-4 percent range, more f u n d a m e n t a l questions remain as to whether countries can, in the fourth phase, manage to lower their debtservice ratios while simultaneously financing enough investment to permit the growth of export capacity required. The essential problem of the fourth phase is that there is a debt overhang. As already mentioned, interest payments on the debt constitute several percentage points of GNP in some of the large debtor countries. Prospective lenders may be concerned, and perhaps legitimately so, that even when there are profitable investment opportunities, earnings from those investments are, in effect, already partially mortgaged to service existing debt. That, in turn, implies that developing countries may need to reduce their debt (i.e., incur current account surpluses and become capital exporters) well before their state of development warrants it. Reducing the debt calls for additional domestic savings to finance repayment, instead of financing new productive capacity. There is a genuine basis for concern that the result may be a vicious circle: developing countries have realigned incentives and created productive investment opportunities, particularly in exportable activities, which, if undertaken, could gradually accelerate growth and permit the gradual lowering of the debtservice ratio. However, because of the debt overhang, they must increase public saving to service debt and cannot simultaneously increase, and must often lower, domestic investment. Consequently, their growth prospects

17

may be impaired in ways which then prevent reduction of the debt-service ratio and restoration of normal creditworthiness. Whenever export earnings are rising less rapidly than interest payments on the debt, that means that the debt-service ratio must be rising. Obviously, no country can permit such a situation to continue indefinitely, and creditors would normally be reluctant to continue lending were a country's debt-service ratio seen to be high and rising for a sustained period of time. On the other hand, most creditors may be willing to continue lending whenever they observe export earnings growing rapidly enough so that the debt-service ratio is constant or falling. Thus, in the long run, the resolution of the debt crisis for individual countries is to follow policies which permit sufficiently rapid growth of exports that the debt-service ratio falls to more normal levels from the abnormally high levels reached during the height of the worldwide recession. An important question is whether export growth can, by itself, provide sufficient impetus for resumed growth of real output in the indebted country. Typically, developing countries' production structures are specialized enough so that expansion of productive capacity, especially for exports, has a significant import content. When policies have been realigned to attract more resources into tradable-goods producing sectors, the normal expectation would be that once any existing idle capacity had been utilized, there would be profitable opportunities for additional investments to increase productive capacity. This normal response of an economy to realigned incentives would then entail additional investment, accompanied by imports of some types of capital goods in which the country had a comparative disadvantage. The significant question for a number of countries is whether a reasonable growth scenario is possible, even if political pressures for more rapid increases in living standards can be restrained and policies are sufficiently realigned as to provide adequate incentives

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for export growth. One can envisage several years of healthy export growth without much new investment, but sustained growth clearly requires capacity e x p a n s i o n and, hence, growth of imports. But growth of imports would require additional financing. Yet, because of the debt overhang, it is highly unlikely those flows will be forthcoming to some countries, regardless of how attractive investment in these countries' export industries may be. Over the medium term, therefore, the debt overhang may preclude the very expansion of exports that would permit a longer term resolution of the problem. To sum up the argument to this point, the debt problem is by no means resolved. Even in those countries in which policy reforms have been undertaken, the debt overhang means that voluntary lending has not been resumed. To date, compression of imports and utilization of previously idle capacity have permitted export growth. But sustained growth will require capacity expansion. In the absence of resumed voluntary capital flows, it is likely that there will be investment opportunities with high real rates of return in developing countries which cannot be undertaken as domestic savings are diverted to payment of debt service obligations and foreigners will not extend additional credit. Both from the viewpoint of those countries' growth prospects and from the viewpoint of their longer-run ability to service their debt, this represents a highly unsatisfactory situation.

V. Developing Countries' Growth Prospects The essential theme of this paper has been that the only long-run way out of the debt problem for developing countries is to achieve sufficiently high growth rates of exports that they can gradually reduce their debt-service ratios and, hence, restore normal creditworthiness. To this point, the paper has focussed on the problem of the debt overhang, and what the absence of sufficient capital flows in the medium-term may do to prevent the realization of sufficiently rapid growth. It has

been assumed: (1) that the indebted developing countries had realigned their policies sufficiently to attract producers into tradable goods production; and (2) that those countries that did induce an export supply response would indeed be able to export. Because of their potential importance, focus to this juncture was on the problems of capital flows, but an assessment of the growth prospects of developing countries requires some commentary on the other two assumptions. The easier one is indebted countries' policies: not all of them have as yet sufficiently realigned incentives but, as the data in Tables l and 2 demonstrated, there have been truly remarkable efforts in many countries. There is substantial basis for optimism that leaders will be willing to undertake additional measures as necessary. In part, that optimism can be based on behavior to date. In part, however, it must also be based on the realization that, in the absence of policy reforms on the part of the indebted countries, economic performance will continue to be unsatisfactory - - clearly an unsustainable situation. The more worrisome question is the willingness of the industrial countries to maintain access to markets for exports from developing countries (and each other). Protectionist pressures have, in recent years, increased significantly. In part, this was the result of the recession and its impact, and one can hope for some abatement on that score. In part, however, protectionist pressures arise in the United States - traditionally the world's leader in espousing free trade - because of the high purchasing-power-parity relation of the dollar with the currencies of the United States' major trading partners. Regardless of the reasons, protection, if intensified, could substantially diminish the chances of developing countries for resuming normal growth and creditworthiness. The reason is obvious. One has already seen that any hope of restoring creditworthiness must rest on rapid growth of the developing countries' exports: they must grow sufficiently in excess of the real interest rate to permit

KRUEGER: DEBT PROBLEMS AND GROWTH PROSPECTS

imports to grow and still achieve reduced debt-service ratios. With the present real rate of interest of around 5 percent, one would have to judge that a m i n i m u m rate of growth of exports of the developing countries for this result to occur would be, say, 8 percent. Such a growth rate is far above any realistic expectation as to the rate of growth of the industrial countries which might, on favorable assumptions, reach 3.5 percent. Historically, with liberal trade policies, the industrial countries' trade grew at about twice their rate of economic growth. Thus, a 7 percent rate of growth of trade might be consistent with the 3.5 percent OECD growth rate. Such a rate might also permit the developing countries to increase their share of world trade gradually and realize an 8 or 9 percent growth of exports without severe market disruption. If, however, the industrial countries restrict developing countries' exports, the outlook could be very different. For example, if protection resulted in a constant share of trade in GNP of the industrial countries, developing countries as a group can never lower their debt-service ratio; indeed, if the current 5

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percent real interest rate prevailed with 3.5 percent growth, the debt-service ratio would necessarily rise by about 1.5 percentage points per year! Obviously, such an outcome is entirely incompatible with the resumption of normal growth and creditworthiness on the part of the developing countries. One has to conclude, therefore, that there could be a gradual acceleration of growth of the heavily indebted developing countries, but that such an outcome will require three things: their domestic policy reforms; access to developed countries' markets and satisfactory growth rates of the developed countries; and mechanisms to permit capital flows of sufficient magnitude to permit expansion during the transition to normal creditworthiness. Domestic policy reforms are under way. On present estimates, the O E C D could achieve a 3.5 percent growth rate and, if protectionist pressures can be resisted, expansion of developing countries' trade seems feasible. Ensuring market access and devising mechanisms to smooth capital flows during the transition to normalcy appear to be the pressing policy problems.