CHAPTER SIX
FOREIGN AID, DEBT, FINANCIAL REFORM AND
DEVELOPMENT
➢ Foreign Aid
✓ Refers to international transfer of public funds in the form of loans
or grants either directly from one government to another (bilateral
assistance) or indirectly through the vehicle of a multilateral
assistance agency such as the World Bank.
✓ It is one of the major sources of foreign exchange in addition to export
earnings and private foreign direct and portfolio investment.
✓ Economists have defined foreign aid, therefore, as any flow of capital
to a developing country that meets two criteria:
A. Its objective should be non-commercial from the point of view of the
donor, and;
B. It should be characterized by concessional terms; that is, the
interest rate and repayment period for borrowed capital should be
softer (less stringent) than commercial terms.
✓ The concept of foreign aid that is now widely used and accepted,
therefore, is one that encompasses all official grants and concessional
loans, in currency or in kind, that are broadly aimed at transferring
resources from developed to less developed nations on development,
poverty, or income distribution grounds.
✓ Therefore, military aid is excluded from international economic
measurements of foreign-aid flows.
✓ The tradition of giving official foreign aid began with the so called
Marshal Plan (a plan by the secretary general of USA) which
aimed at rebuilding the economy of war-torn Europe after the WWII.
✓ And the success of Marshall plan in rebuilding the devastated
economy of Europe has motivated the developed western countries to
extend the disbursement of foreign aid to developing countries
(particularly in Africa) so as to help them attain their development
goal.
➢ Motivations for Foreign Aid
❖ We can broadly classify this motivation into two;
1. Economic Motivations
✓ The economic rationale which are advanced in the support of
foreign aid are the following:
A. Closing saving/foreign exchange-investment gap
✓ This motivation is deeply analyzed in the so called Two-Gap Model.
B. Fiscal Gap
✓ Foreign aid can also fill the fiscal gap which can be explained in
terms of the lack of sufficient government budget to undertake public
investment. This analysis is included in the so called Third-Gap
Model.
C) Technical Assistance
✓ Financial assistance needs to be supplemented by technical assistance
in the form of high-level worker transfers to ensure that aid funds are
used most efficiently to generate economic growth.
D. Tied Aid
2. Political Motivations
A) To contain the spread of communism and terrorism
B) To reduce the flow of refugees and other migrants
C) To strengthen the political regimes of developing countries whose
continued existence they perceived as being in their own national
security interests.
➢ Foreign Debt
✓ Foreign debt refers to the total private and public foreign debt owed
by a country.
✓ The accumulation of foreign debt is a common phenomenon of
developing countries at the stage of economic development where the
supply of domestic savings is low, current account payments deficits
are high, and imports of capital are needed to augment domestic
resources.
✓ Prior to the early 1970s, the external debt of developing countries was
relatively small and, the majority of creditors were foreign
governments and international financial institutions such as the IMF,
the World Bank, and regional development banks.
✓ However, during the late 1970s and early 1980s, commercial banks
began playing a large role in international lending by recycling
surplus Organization of the Petroleum Exporting Countries (OPEC)
“petrodollars” and issuing general-purpose loans to developing
countries to provide balance of payments support and expansion of
export sectors. For instance, over $350 billion was recycled from
OPEC countries between 1976 and 1982.
✓ Although foreign borrowing can be highly beneficial, providing the
resources necessary to promote economic growth and development,
when poorly managed, can be very costly.
✓ The main cost associated with the accumulation of a large external
debt is debt service. Debt service is the payment of accumulated
interest in addition to the principal.
✓ As the size of the debt grows or as interest rates rise, debt service
charges increase. This is because the debt service payment should be
made with foreign exchange, and export earnings (the main source
foreign exchange) in developing countries is very limited.
➢ Origins of the 1980s Debt Crisis
✓ The seeds of the 1980s debt crisis were sown in the 1974–1979
period, when there was a virtual explosion in international lending,
precipitated by the first major OPEC oil price increase.
✓ By 1974, most of developing have achieved a high economic growth
rate. As a result, they had begun importing heavily capital goods and
expand export aggressively through increased borrowing. On the
other hand, the economic growth rates of the industrialized countries
has went down as a result of the oil price and world wide recession.
✓ Countries with an excess of imports over lagging exports were
reluctant to approach official sources, such as the IMF, that might
subject them to painful policy adjustments.
✓ So the middle-income and newly industrializing developing countries
turned to commercial banks and other private lenders, which began
issuing general-purpose loans to provide balance of payments support.
✓ Commercial banks, holding the bulk of the OPEC surplus and facing a
low demand for capital from the slower-growing industrialized
countries, aggressively competed in lending to developing countries
on comparatively permissive and favorable terms.
✓ As a result of all these factors, the total external debt of developing
countries more than doubled from $180 billion in 1975 to $406 billion in
1979, increasing over 20% annually.
✓ More significant, an increasing portion of the debt was now on non-
concessional terms, involving shorter maturities and market rates of
interest, often variable rates.
✓ Despite the sizable increases in debt-servicing obligations, the ability
of most developing countries to meet their debt service payments
during the late 1970’s remain in danger.
✓ Unfortunately, this success growth in developing countries was short-
lived, and in fact, the surge in international ending that occurred in
1974–79 had laid the groundwork for all the problems that were to
come.
✓ Now developing countries faced an abrupt increase in oil prices that
added to oil import bills which adversely affected industrial imports.
✓ There was also a huge increase in interest rates caused by the
industrialized countries’ economic stabilization policies and a
decrease in export earnings for developing countries, resulting from a
combination of slowed growth in the more developed nations and a
precipitous decline of over 20% in primary commodity export prices.
✓ Finally, developing countries inherited from the previous period a
huge debt and debt service obligation.
➢ Private FDI and The Multinational Corporation (MNC)
✓ An MNC is most simply defined as a corporation or enterprise that
conducts and controls productive activities in more than one country.
These huge firms are mostly based in North America, Europe, and
Japan.
✓ MNCs and the resources they bring present a unique opportunity but
may pose serious problems for the many developing countries in
which they operate.
✓ The growth of private foreign direct investment (FDI) in the
developing world has been extremely rapid—though volatile in recent
decades.
✓ Yet, despite the overall ups and down global trend, FDI continues to
play an extremely important and indeed growing role in the
developing world—in 2012, inflows to developing countries were
about $700 billion, an extraordinary flow of resources.
✓ Indeed, 2012 represented a new milestone: For the first time in
history, developing countries received more than half of all global FDI
flows.
✓ According to UNCTAD estimates, in 2012, a little over two thirds of
the profits from FDI in developing countries were repatriated back to
investor countries; on the other hand, the remainder was retained,
much of that reinvested.
✓ Despite the extraordinary growth, FDI inflows to developing countries
have remained a small fraction of these countries’ total investment,
most of which is accounted for by domestic sources.
✓ Nevertheless, in recent years, FDI has become the largest source of
foreign funds flowing to developing countries.
✓ Globally, MNCs employ about 80 million workers in countries outside
their home base. Nonetheless, in most developing countries, MNCs
employ a relatively small fraction of the workforce, but the jobs tend
to be concentrated in the modern urban sector.
✓ Multinationals carry with them technologies of production, tastes and
styles of living, managerial philosophies, and diverse business
practices.
✓ MNCs have become, in effect, global factories searching for
opportunities anywhere in the world. Many MNCs have annual sales
volumes in excess of the GDP of the developing nations in which they
operate.
✓ Historically, multinational corporations, especially those operating in
developing nations, focused on extractive and primary industries,
mainly petroleum, nonfuel minerals.
✓ Recently, however, manufacturing operations and services (banks,
hotels, etc.) have occupied a dominant share of MNC production
activities.
➢ Some Fiscal Policies for Development /Financial Reforms/
1. Cutting government expenditure to achieve budgetary balance along
with increased taxation /both direct and direct/
2. Enhancing personal income taxes and property taxes
3. Improving corporate income taxes
✓ Generally, the governments of developing countries have to improve
their tax efficiency