Nafziger Economic Development (4th ed)

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TABLE 15-1. Mexico’s International Balance of Payments, 2001 ($ billion)

Figures are rounded off to the nearest billion U.S. dollars.

Source: International Monetary Fund 2002a:574–578.

World Bank estimates that foreign capital as a share of LDC total capital formation was 10–20 percent in the 1960s and 1970s, although this share declined to 8–12 percent in the 1980s, 1990s, and first decade of the 21st century (World Bank 1984i:226–227, 1988i:230–231, 1994i:178–179, 2003h:16, 220, 332).

But when a country imports capital, domestic saving declines. Two economists who have noticed this relationship argue that using foreign capital makes a country less thrifty. They suggest that foreign capital distorts the composition of capital, frustrates indigenous entrepreneurship, and inhibits institutional reform (Griffin and Enos 1970:313–327).

Their explanation is wrong. A careful look shows that an increase in capital inflow associated with a decrease in domestic saving occurs because of the way economists define these aggregates. From Equation 15-8,

where S is saving, I is investment, and F is capital imports. Investment does not rise because the increase in capital formation from the capital inflow is counterbalanced by the negative foreign investment, or an increase in foreign claims on the country.

Two Gaps

Hollis Chenery and Alan Strout (1966:679–733), in a model based on empirical evidence from 50 LDCs from 1957 to 1962, identify three development stages in which growth proceeds at the highest rate permitted by the most limiting factors. These factors are (1) the skill limit (see Chapter 11 on inability to absorb additional capital), (2) the savings gap (investment minus savings), and (3) the foreign exchange gap (imports minus exports).

In stage 1, foreign skills and technology reduce the skill limit. The authors, however, focus on stage 2, investment-limited growth, and stage 3, trade-limited growth – both stages in which foreign aid and capital can reduce the gap that limits accelerated growth.

But why differentiate between the two gaps, as Equations 15-7 and 15-8 imply that the actual savings gap is always equal to the actual foreign exchange gap? The answer is that gap analysis does not focus on actual shortages but, rather, on discrepancies in plans between savers and investors, and exporters and importers. Planned saving depends on income and income distribution, but planned investment is determined by the expected rates of return to capital. Export plans depend on international prices and foreign incomes, but import plans are determined by international prices, domestic income, and income distribution. Given the independence of decisions, it is not surprising that the excess of planned investment over saving might differ from the amount that planned imports exceed exports.

Chenery and Strout’s evidence indicates that at early development stages, growth is likely to be investment limited. If planned investment minus planned saving is greater than planned imports minus planned exports at a given GNP, then all the investment will not be realized. Actual investment equals actual saving plus foreign borrowing at a lower level of GNP than would have been realized if there had been a small savings gap. The required foreign assistance equals the larger of the two gaps, the savings gap. This import of capital will remove the limitation that investment places on growth.

If, by contrast, the foreign exchange gap is larger than the savings gap, imports will fall, reducing the foreign capital and inputs available for the development effort. In this case, growth is trade limited. Capital imports equal to the foreign exchange gap will remove the limitation that trade places on growth.

In reality, foreign borrowing reduces both the savings and foreign exchange gaps by equal amounts. A machine acquired by international transfer represents both an import for which no foreign exchange needs to be expended and an investment good that does not have to be offset by domestic saving.

The Chenery–Strout three-stage approach only approximates reality in the many LDCs, where the three limitations often coexist or interact with one another. In fact, limits may vary from one sector to another. One sector may be limited by a savings gap, another by a foreign exchange gap, and a third by a skill constraint.

Furthermore, the two-gap analysis, which focuses on an aggregate approach, does not look at specific needs that foreign funds can meet. Moreover, the emphasis on external development limitations diverts attention from technology or on internal

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economic factors that are often important constraints on growth. Nevertheless, the Chenery–Strout three-stage and two-gap approaches, even though stereotypical, can be useful tools in analyzing foreign capital requirements in a number of different LDCs (Meier 1976:333–344; Kindleberger and Herrick 1977:296–298; Meier 1980:331–334).

Stages in the Balance of Payments

As we have said, foreign loans enable a country to spend more than it produces, invest more than it saves, and import more than it exports. But eventually the borrowing country must service the foreign debt. Debt service refers to the interest plus repayment of principal due in a given year. Sometimes a country can arrange debt relief, convert debt into equity, or postpone payment by rescheduling the debt or borrowing in excess of the debt due for the year (see Chapter 16). Despite potential economic sanctions and credit restraints, a country may, in rare instances, repudiate its debts or simply default as Argentina in 2001–03 or sub-Saharan Africa did on more than half its scheduled debt in 1990 (Nafziger 1993:17).

Paying back the loan requires a country to produce more than it spends, save more than it invests, and export more than it imports. Doing this need not be onerous, however. In fact, it is typical for a newly industrializing country to encounter a growing debt. The United States, from the Revolutionary War until after the Civil War, was a young and growing debtor nation, borrowing from England and France to finance an import surplus for domestic investments, such as railroads and canals. However, the United States proceeded to a subsequent stage, mature debtor nation, 1874 to 1914, when the economy’s increased capacity facilitated the export surplus to service the foreign debt. Similarly, contemporary industrializing countries effectively using capital inflows from abroad should usually be able to pay back loans with increased output and productivity. (See the last section of this chapter, which analyzes the present-day United States, the world’s largest international debtor, whose debts do not fit into this balance of payments stages theory.)

Sources of Financing the Deficit: Aid, Remittances, Foreign Investment, and Loans

Exports minus imports of goods and services equal the international balance on goods, services, and income. Aid, remittances, loans, and investment from abroad finance a LDC’s balance on goods and services deficit.

Both oil-importing developed and developing countries had a deficit in 1974, mainly as a result of the quadrupling of oil prices over four months in 1973 and 1974. However, from 1975 through 1980, when the DCs had surpluses, the oil-importing LDCs had deficits. These deficits continually increased over this period (except for 1976 and 1977), and middle-income LDCs had higher deficits, partly because oil comprised a larger proportion of their total imports than was the case in low-income countries. Middle-income countries’ larger deficit was financed disproportionately by

FIGURE 15-1. Total Resource Flowsa to Developing Countriesb by Type of Flow, 1990–2002 (billions of dollars). Source: UNCTAD 2003d:4.

aDefined as net liability transactions or original maturity of greater than one year.

bThe World Bank’s classification of developing countries is different from that of UNCTAD. Central and Eastern Europe is

included in the former classification. c Preliminary.

commercial loans, with low-income countries receiving primarily aid (World Bank 1981i:4–63).

From 1981 to 1999, LDCs had a deficit every year. The deficit increased during the recessions in the United States and in other DCs, 1981–82, but fell from 1983 to 1990; in the 1990s, the deficit increased again through 1993. From mid-1998 to 2003, as borrowers chose or were required by creditors to pay down debts (World Bank 2003e:8), total resources to finance deficits of LDCs fell (Figure 15-1) and they ran surpluses. Oil-exporting countries had surpluses, 1980 to 1986, but these balances shifted to deficits from 1987 to 1995 (except 1990), as real oil prices virtually collapsed (Figure 13-1).

The major sources of financing, loans at bankers’ standards, declined during most of the 1980s (table in Nafziger 2006b), as commercial banks became more cautious with loan writeoffs, write-downs, and asset sales by several highly indebted LDCs. Low-income countries received fewer foreign capital resources, as their primary source, aid, as a percentage of GNP declined in the major donor group, the Organization for Economic Cooperation and Development (OECD). However, loans at bankers’ standards, primarily to East Asia, Southeast Asia, Latin America, the Middle East, and Eastern Europe, increased during the early 1990s and the early years of the 21st century.

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CONCESSIONAL AID

Aid, or official development assistance (ODA), includes development grants or loans (with maturities of more than one year) to LDCs at concessional financial terms by official agencies. Military assistance is not considered part of official aid, but technical cooperation is.

The grant element of aid. Economists distinguish concessional loans, which have at least a 25-percent grant element, from loans at bankers’ standards. In 2001, the average grant component of the bilateral aid (given directly by one country to another) member countries of the OECD gave to developing countries was 93.8 percent. Of the $51.4 billion the OECD contributed, $41.0 billion was outright grants. In addition, loans totaling $10.4 billion had a grant component of 69 percent, or $7.2 billion. (The grant element of the loan depends on how much the interest rate is below an assumed commercial rate of 10 percent, the length of the grace period in which interest charges or repayments of principal is not required, how long the repayment period is, and the extent to which repayment is in local, inconvertible currency.)

Calculating the grant component of OECD aid or ODA to developing countries in 2001 is fairly simple. Adding the product of $41.0 billion multiplied by 1.00 (the grant component of gifts) to the product of $10.4 billion multiplied by 0.69 (the grant component of loans) equals $48.2 billion, the total grant element of aid (grants plus loans). Divide $48.2 billion by $51.4 billion (total aid) to equal 0.938, the grant component of aid to developing countries (OECD 2003b).

OECD aid. During the 1980s, OECD countries contributed four-fifths of the world’s bilateral (and almost three-fifths of all) official development assistance to LDCs. However, in the early 1990s, after the collapse of centralized socialism and a decade or so of falling surpluses in the Organization of Petroleum Exporting Countries, the OECD contributed 98 percent of all aid (with OPEC providing 2 percent).4 The OECD aid increased from $6.9 billion in 1970 to $8.9 billion in 1973 to $13.6 billion in 1975 to $26.8 billion in 1980, but declined to $25.9 billion in 1981 and to $21.8 billion in 1985, before increasing to $47.1 billion in 1988 and $60.8 billion in 1992, but declined to $56.0 billion in 1993 and $51.4 billion in 2001. As a percentage of GNP, it dropped from 0.34 percent of GNP in 1970 to a post-1960s low of 0.30 percent of GNP in 1973. In 1975, this figure increased to 0.33 percent and in 1980 to 0.37 percent before declining to 0.35 percent in 1985, but rebounding to 0.39 percent in 1986, but fell to 0.34 percent in 1988 and 0.33 percent during all three years, 1990–92, before declining to 0.30 percent in 1993 and 0.22 percent in 2001. The most recent figures cited are less than half of the 0.70 percent target the OECD accepted in the 1990s for LDCs and a fraction of the 0.20 percent for

4 During peak years in the 1970s and early 1980s, OPEC countries contributed one-fourth and the socialist countries of the Soviet Union and Eastern Europe one-seventh of world ODA. In 1993, China, South Korea, Taiwan, Turkey, Egypt, India, Israel, and a growing number of other countries provided ODA. However, countries outside OPEC and the high-income OECD provided only a small fraction of 1 percent of global ODA in 1993 (OECD 1995:107; Nafziger 1990:357–58).

FIGURE 15-2. Aid Flows, 2001.a Note: DAC Members have progressively introduced the new System of National Accounts that replaced gross national product (GNP) with gross national income (GNI). As GNI has generally been higher than GNP, ODA/GNI ratios are slightly lower than previously reported ODA/GNP ratios.

a Aid refers to net ODA. 2001 data are provisional. Source: OECD 2002b:1.

least-developed countries.5 In 2001, only Denmark, Norway, Sweden, the Netherlands, and Luxembourg exceeded the target for LDCs (see Figure 15-2).

Although annual U.S. foreign aid (ODA) in the 1960s, 1970s, and 1980s was larger than that of any other country, from 1993 to 2000, Japan gave more foreign aid than any other country (Figure 15-3), before relinquishing the lead to the United States again in 2001 (not shown). As a percentage of GNI (0.11 percent), foreign aid in the United States ranked last among OECD members. The U.S. citizens spent more on participant sporting activities and supplies in a year than their government spends annually on foreign aid. Furthermore, aid as a percentage of GNP in the United States declined steadily with 0.50 percent in 1965, 0.32 percent in 1970,

5In 1961, U.S. President John F. Kennedy proposed that the 1960s be the First Decade of Development. Although he pledged that the United States would devote 1 percent of its GNP to the effort, the U.S. share has never exceeded half that share (Piel 1995:13–22).

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FIGURE 15-3. G-7 Aid to Developing Countries (millions of US$, 1960–2000). Note: At 2000 prices and exchange rates. Source: OECD 2002b:3.

0.26 percent in 1975, 0.27 percent in 1980, 0.24 percent in 1985, 0.21 percent in 1988, 0.20 percent in 1991, 0.15 percent in 1993, and 0.11 in 2001. During the same period, other OECD countries maintained an aid to GNP percentage in excess of 0.40 percent before falling to 0.39 percent in 1992 and 0.38 percent in 1993 and 0.30 percent in 2003. The real value of U.S. aid dropped from the 1960s to the 1970s, then leveled out in the 1980s, but fell again in the 1990s. In the rest of the OECD countries, real aid increased continually from the 1960s before dropping slightly in the 1990s (Overseas Development Council 1982; OECD 1995; OECD 2002b).

Why give aid? Development assistance is under renewed attack. Traditional critics view it as too softhearted to be hardheaded. Some leftists see aid as imperialist support for repressive LDC regimes, rather than as a way of spurring economic development for the masses. Critics of all persuasions charge that aid is ineffective: It does not do what it sets out to do.

Let us examine this issue more carefully. Foreign aid’s purpose is usually to promote the nation’s self-interest. Economic aid, like military assistance, can be used for strategic purposes – to strengthen LDC allies, to shore up the donor’s defense installations,

to improve donor access to strategic materials, and to keep LDC allies from changing sides in the international political struggle. Assistance can be motivated by political or ideological concerns – to support a military ally; influence behavior in international forums (see below on U.S. support for IMF lending); to strengthen cultural ties; or to propagate democracy, capitalism, or Islam. (A political and strategic motivation – to promote democracy and private enterprise and minimize Soviet influence in the third world – was important in congressional approval of President Harry Truman’s call in 1949 for U.S. “Point Four” economic assistance to LDCs.) Furthermore, aid supports economic interests by facilitating private investment abroad, improving access to vital materials, expanding demand for domestic industry, and subsidizing or tying exports.

Tied aid, as it prevents the recipient country from using funds outside the donor country, is worth less than its face value. In some instances, aid may be tied to importing capital-intensive equipment, which may reduce employment in the recipient country. Tied aid was 19.2 percent of OECD aid in 2000 but 75.7 percent of U.S. aid in 1996, the last year of report (OECD 1995:29; OECD 2002b:5).6

Some aid – emergency relief, food aid, assistance for refugees, and grants to leastdeveloped countries – is given for humanitarian reasons. Most OECD countries have a small constituency of interest groups, legislators, and bureaucrats pressing for aid for reasons of social justice. For example, some of the support for Point Four and subsequent aid came from humanitarian groups in the United States.

It is difficult to separate humanitarian motives from the self-interested pursuit of maintaining a stable, global political system. DCs have an interest in pursuing a world order that promotes capitalist development and global integration and avoids war (especially a nuclear holocaust), acute world population pressures, widespread hunger, resource depletion, environmental degradation, and financial collapse. Economic aid is one aspect of this drama.

Many of the major aid recipients of the United States represent countries that the United States considers important strategic interests (see Table 15-2). In 1994, the U.S. Agency for International Development (1994, summarized in Population and Development Review 1994b:483–487) tried to identify strategic, humanitarian, and economic interests in United States aid. Long-term objectives of aid included encouraging broad-based economic growth, promoting peace, building democracy, promoting U.S. prosperity through trade, protecting the environment, providing humanitarian assistance, aiding postcrisis transition in the former socialist countries, stabilizing world population growth, and protecting human health. AIDs and other epidemic diseases, and drugs, such as cocaine, marijuana, and heroin, reflect threats to the quality of life in DCs, as well as LDCs. In 2004, USAID emphasized “promoting democracy and good governance,” including strengthening the rule of law and respect for human

6Joel Waldfogel, “Deadweight Loss of Chistmas [Giving]” (1993:1328–1336), argues that much of the gift from a giver to a recipient, like tied aid, is likely to represent deadweight loss. The recipient, who receives a gift worth $1,000, is most likely to be worse off than with an unfettered choice of spending with an equal amount of cash. The journalist Ross Gittins (2003) considers Waldfogel’s effort as part of the foolishness of economists, more in keeping with the spirit of Scrooge.

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TABLE 15-2. US Top 10 Recipients of Aid

(millions of US$, 2000)

Note: Aid refers to gross bilateral official development assistance (ODA) and official aid (OA).

Source: OECD 2002b:5.

rights, promoting competitive elections, supporting a politically active civil society, and facilitating more transparent and accountable governance.

Major motives for Japanese aid are international responsibility as a major world economic power, export promotion, resource acquisition, overall economic security, bilateral influence, and recipient political stability. Japan’s aid programs are biased toward Asia – Indonesia, China, Philippines, Thailand, India, Pakistan, Bangladesh, South Korea, Malaysia, Vietnam, Sri Lanka, and Nepal – and a smattering of Latin and African countries (see Figure 15-4 for top recipients of foreign aid by OECD countries). A low proportion of Japan’s aid goes to least-developed countries, which are primarily in Africa. Japan’s aid also focuses on loans, so the grant element of aid is low.

FIGURE 15-4. OECD Top 10 Recipients of Foreign Aid (millions of US$, 2000). Note: Aid refers to gross ODA and OA. Source: OECD 2002b:2.

Despite Japan’s leadership in aid expenditures, aid programs in Japan are understaffed, politically muddled, and administratively complex. The programs are fragmented into competing ministries that are excessively centralized, yet no ministry has total oversight of the program (Rix 1993; OECD 1995).

Japan’s historical memory of rapid economic growth through using strong internal leadership and control to learn and adapt from the West has shaped Japan’s foreign aid programs. A strong emphasis by Japan, which attributes its economic success to self direction, is to promote self-reliance among its aid recipients. The Keidanren, Japan’s Federation of Economic Organizations, the main business grouping in Japan and a major contributor to Japan’s aid philosophy, argues that Japan’s aid “is based on the belief that the developing countries themselves should play the leading role in their economic development and that Japan’s [overseas development assistance] is designed to complement their self-help efforts to end poverty” (Rix 1993:38–39).

Still, we cannot take the Keidanren’s and aid officials’ stress on recipient selfreliance totally at face value, as some of Japan’s foreign economic policies in Asia foster dependence, as Chapter 17’s discussion on the Asian borderless economy indicates. Indeed, we generally need to be skeptical of DCs’ stated goals: critics doubt that U.S. aid and foreign policy promote peace, human rights, and democracy.

Aid to enhance global public goods. Global public goods provide an especially strong argument for foreign aid. As pointed out in Chapter 13, the atmosphere and biosphere are global public goods, because nations cannot exclude other nations from the benefits of their conservation or from the costs of their degradation. In addition, family-planning programs (Chapter 8) and programs that further long-run economic sustainability and global peace and security also have global public goods components.

The effectiveness of aid. How effective has aid been? In some instances, aid has exceeded an LDC’s capacity to absorb it. Moreover, aid can delay self-reliance, postpone essential internal reform, or support internal interests opposed to income distribution. Specifically, food aid can undercut prices for local food producers.

William Easterly (2001b), when a World Bank economist, contended that billions of dollars in DC government, World Bank, and IMF aid had been squandered on poorly designed programs. Lending based on an LDC’s meeting conditions of economic reform and good governance, instead, contributed to widespread zero percapita growth and a failure to adjust. Governing elites of recipient governments, with an emphasis on power rather than development, “were afraid to invest in the masses that might demand their share of power.” By contrast, according to Easterly, lenders had incentives to continue to lend or aid to maintain the aid bureaucracy and to support political allies, even when recipients’ corruption and poor governance “destroyed any hope of economic growth.” For Easterly (2001b), the initiative to forgive debts, a form of aid, supported by Bono, the Dalai Lama, Pope John Paul II, and George W. Bush, to highly indebted poor countries (HIPCs) is “pouring good money after bad. If government mismanaged the original loans, will they manage