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External Debt and the Developing World

by Kent E. Freeze, BYU sophomore and economics major


One of the main problems facing the developing world today is large and confining debt. A major obstacle to continued capital acquisition and future economic growth, debt burden is now one of the main concerns in international affairs. Many lesser-developed countries (LDCs) today simply cannot repay these debts, without the assistance of developed countries (DCs). This article looks into the status of the current debt crisis, and solutions to this crisis through trade barrier reduction, International Monetary Fund (IMF) assistance, debt restructuring, and debt forgiveness.

The Current Debt Crisis

The debt crisis is particularly acute in Sub-Saharan Africa. According to the World Bank classification, twenty-six of the thirty-three severely indebted, low-income countries are found in Sub-Saharan Africa.1 The external debt in these countries is approximately equal to their Gross National Income (GNI) (See Table 1, p. 46). According to E. Wayne Nafziger, a prominent development economist, “Sub-Saharan Africa’s high ratio of payment on debt to exports, without new foreign inflows or debt rescheduling, dampened new capital formation and external adjustment.”2 The extremely high ratio of external debt has effectively squeezed out capital inflow.

One of the main problems with external debt is how it directly damages capital inflow. According to Nafziger, “Net Capital Inflows = Imports – Exports = Private Investment – Private Saving + Budget Deficit.”3 Capital inflows are greater with higher imports, higher investment and a higher deficit. However, in order to pay off loans, just the opposite is true. It is necessary for LDCs to produce more than they spend, export more than they import, and save more than they invest. Debt payments come at the direct cost of foreign capital inflows.

In order to afford debt payments, many LDCs have found it necessary to restrict imports. As stated earlier, this will restrict capital construction in LDCs. Accordingly, net long-term resource flows to LDCs fell from 5.3 percent of GDP in 1997 to 3.1 percent in 2001.4 Also disturbing to LDCs is their high rate of capital flight—the amount of an investment that will return to the investing country. Many creditors are unwilling to loan funds if they know that a large portion of their investment will simply flow back to the investing country through capital flight. For example, during the period 1976–82, forty-two cents of every dollar loaned by foreign creditors left Nigeria through capital flight.5 The LDCs’ high degree of capital flight, coupled with debt-induced import restrictions, have kept their capital stock from much needed growth.

During the 1980s, the developed world quickly became alarmed as LDC debt skyrocketed. It was soon apparent that many LDCs simply had no way of repaying these loans. Fearing a wide-spread default, several major American banks devalued and began selling various LDC loans on the secondhand market at 40 to 70 percent discounts.6 The DCs, faced with the prospect of a domestic banking crisis, began debt negotiations with LDCs, resulting in the restructuring of LDCs commercial and multilateral debts. LDCs and DCs are both very involved in the problem of LDCs external debt. As a result, it is necessary for both developed and undeveloped worlds to work together to put a halt to ballooning LDC debt.

Resolving the Crisis

There is no simple answer to the current LDC debt crisis. A combination of increased trade liberalization, correct changes to the IMF, effective debt reconstruction through debt swapping programs, and appropriately forgiving LDC debt will ensure satisfactory recovery of LDCs from the burden of debt.

The Reduction of Trade Barriers

Historically, DCs have maintained higher tariffs in the agricultural and textile industries, both of which are essential parts of almost all LDC economies. These tariffs were not included in the original General Agreement on Tariffs and Trade (GATT) agreement following World War II and were only recently bound under the Uruguay Round of GATT. These tariff limits were intended to liberalize markets in a manner similar to GATT’s success in previous rounds for industrial goods, by setting new bindings from which future tariff reductions would be specified.7 Decreasing trade barriers will increase total welfare throughout the world—it is not a zero-sum game.

However, welfare changes often come at the cost of smaller segments of society. In hypothetically supposing the complete liberalization of agricultural trades, overall societal gains can come at a cost to producers or consumers (See Table 2). As a result, it has often been difficult to lower trade barriers, especially when faced with well organized producer organizations.

Significant progress has already been made in reducing trade barriers, but there is still much room for progress. While the developed world currently boasts a low, unweighted tariff rate around 5 percent, LDCs’ average tariff rate is much higher—at about 16 percent. The rate in Sub-Saharan Africa is even higher—at around 20 percent.8

LDCs feel forced to keep tariff rates high for two main reasons. First, high tariffs help to keep imports down and thus ensure a positive trade balance. When faced with high levels of foreign debt, LDCs will finance debt payments by a tariff-induced positive trade balance. Debt payments come at the cost of higher net welfare gain by trade liberalization. Second, many LDCs feel a need to protect infant industries that have the potential in the future to be competitive on the global marketplace.

To repay LDC external debt, it is imperative for LDCs to have increased access to foreign markets. This allows LDCs to earn foreign currency necessary for debt payment. However, in order to encourage capital inflow, LDCs need to increase foreign access to domestic markets. Therefore, LDCs and DCs must work together to continue encouraging the further reduction to trade barriers around the world.

International Monetary Fund Assistance Reform

For many of the poorest countries, little access is available to private funds. In the event of various economic crises, it has become necessary for the International Monetary Fund (IMF) to step in. However, in the 1990s, the IMF attracted a great deal of criticism regarding its usage of funds. According to Graham Bird, critics claimed that the IMF “reflects bargaining power rather than economic circumstances and that it is driven largely by the political self-interests of the fund’s major shareholders.”9 One of the greatest issues facing the IMF is that of conditionality—the attaching of various conditions on IMF assistance. Proponents for conditions claim that conditionality provides for a greater likelihood of repayment, however, studies have shown this is not always true.10 For example, the conditions for IMF assistance might be the elimination of trade barriers, monopolies, or tax distortions. These reforms are shown to increase total welfare in the long run. However, the short run effect of implementing these policies could lead to economic disaster.

LDCs seeking IMF assistance typically are already facing a financial crisis, one that could potentially become disastrous if the conditions for IMF assistance cause a negative short-run economic effect. Any serious economic shocks could erase any positive effects of IMF assistance.

This was dramatically shown in the experience of Kenya, which received a small IMF assistance program in 1993 on the condition that it open up its financial market system. Kenya resisted, complaining that the rapid liberalization would create chaos in the banking system. However, with no other financing options open, Kenya was forced to accept IMF assistance with the conditionality. The required reform resulted in fourteen banking failures within one year.11 David Glover and Diana Tussie stated that they were forced to “conclude that liberalizing in the hope of receiving credit has not been a particularly successful tactic.”12

Critics of IMF claim that it has further conditionalized its assistance by putting LDCs onto rigid timetables: countries are told what is to be accomplished in thirty, sixty, or ninety days. Sometimes, these agreements even include stipulations on which laws the country must pass in order to meet these requirements.13 The resulting loss of political sovereignty increases international animosity within LDCs. For the IMF to effectively distribute assistance to LDCs, it must do it in ways that pay better attention to the needs of these countries. When LDCs ask for IMF help, they are usually in a financial crisis, which leaves the LDCs very little leverage to debate with. The result is the wholesale adoption of IMF conditions with very little input on the part of the LDCs.

The IMF must listen to LDCs. The arrogance shown by the IMF in the past has made LDCs extremely wary of the IMF and not committed to IMF-imposed conditions. The result has been an ineffective IMF that fails to address the needs of LDCs. With increased input from LDCs, specialized assistance and intelligent, LDC-supported conditions can result. As a result, IMF assistance will be much more effective.


Another option is that of giving IMF assistance based upon selectivity instead of conditionality. This means that IMF funds are given to countries who are shown to have accomplished various reforms. Instead of forcing unpopular reform in LDCs, this system encourages rewards for self-imposed reform. There is economic evidence that selective aid can significantly promote economic growth and reduce poverty in LDCs.14

Debt Restructuring

In 2001, $25.6 billion worth of multilateral rescheduling agreements were reached with seventeen different countries. These restructuring agreements dealt mostly with Heavily Indebted Poor Countries.15 While restructuring has helped LDCs, by giving them a window of breathing space, it often simply delays the problem rather than solving it.

A fairly new form of loan restructuring entails swap arrangements. These arrangements often have the advantage of allowing external debt to be repaid in local currency. The most common form of swap arrangement is the debt-equity swap. These swaps “involve an investor exchanging at the debtor country’s central bank, the country’s debt purchased at discount in the secondary market for local currency, to be used in equity investment.”16 This effectively transforms the debt into local currency, which is much easier to repay, and gives LDCs a measure of relief. The debt- equity swap has the advantage of increasing investment in LDCs, while offering a path of debt repayment.

Other forms of swap arrangements are debt-for-nature and debt-for-aid swaps. Debt-for-nature swaps allow the foreign debt to be paid in the local currency, with some of these funds being used as an “environmental protection fund,” and the rest is used for other development projects. The debt-for-nature swap arrangement is attractive as it allows for debt relief, while aiding the country.

Debt-for-aid works in much the same way, with local currency payments being used instead for foreign aid projects. As opposed to raw foreign aid, which tends to breed dependence on the developed world, swap arrangements allow an effective means of economic growth while still repaying debts. As a result, swap arrangements have grown in popularity in recent years. Statistics from the World Bank indicate that “an estimated $4.2 billion of debt had been swapped for local currency claims by the end of December 2000.Of this, $2.2 billion was in the form of debt-for-equity swaps and $1.6 billion debt-for-nature and debt-for-aid swaps. Other debt arrangements accounted for the remaining $0.4 billion.”17 The continued and expanded use of swap arrangements will provide an effective reduction in the debt load of LDC countries.

Debt Forgiveness

In recent years, the movement for debt forgiveness has drawn much attention. A special interest group dedicated to debt forgiveness, Jubilee 2000, managed to attract significant support throughout the developed world for widespread debt forgiveness. As a result of their efforts, by the end of 2000, a total of twenty-four countries qualified for international debt relief.18 There is a good and simple reason for debt forgiveness: LDCs simply cannot grow without it! The proportion of exports devoted to external debt payment is much higher than they can currently bear (See Table 1, p. 46).


While wholesale forgiveness of all LDC debts is obviously unpractical, relatively small amounts of money can make large differences in LDCs standard of living. There is also a moral aspect involved regarding the repayment of unjust debts, especially debts incurred during the Cold War. Stiglitz, a former chief economist and senior vice president of the World Bank, argued:

When the IMF and the World Bank lent money to the Democratic Re-public of Congo’s notorious ruler Mobutu, they knew (or should have known) that most of the money would not go to help that country’s poor people but rather would be used to enrich Mobutu. It was money paid to ensure that this corrupt leader would keep his country aligned with the West. To many, it doesn’t seem fair for ordinary taxpayers in countries with corrupt governments to have to repay loans that were made to leaders who did not represent them.19

Debt forgiveness for these older and un-just loans seems especially appropriate.

Several proposals for debt forgiveness have been put forward. One idea is that of the creation of Special Drawing Rights (SDRs) by the IMF. SDRs are a kind of international money standard conceived in the 1960s as a replacement to the gold standard.

Currently, with many countries saving billions of dollars to protect against international market instability, some of this money has not been converted into aggregate demand. As a way of offsetting this loss in global aggregate demand, some have suggested the use of SDRs for the payment of LDC debts. As a result, debt accounts are paid, and aggregate demand remains high. Another suggestion is using global mineral resource revenues, such as sea bed minerals and fishing as a fund for LDC development assistance.20 Debt forgiveness has not been used enough by DCs and must be used more in the future. The debt relief afforded by such measures will go far in future growth and trade.


The developed world and LDCs need to coordinate effective plans for LDC debt reduction. A lower external debt ratio will allow LDCs to increase capital flows and lower barriers to international trade. Lower international trading barriers will allow the expansion of LDC capital inflows and make the repayment of loans more feasible. To effectively lower external debt, changes must be made within the IMF. Conditions tied to monetary assistance have often harmed LDCs by including unrealistic and sometimes economically damaging standards.

An economically smarter IMF that coordinates better with LDCs will more effectively adapt assistance to each country’s specific needs. Debt-swapping programs are an effective way of making debt payment more manageable and realistic, while lessening the harm to capital inflows.

Furthermore, the forgiveness of external debts by the creation of SDRs or using global mineral profits will go far in the fight against LDC debt. It is imperative that these measures are carried out with extensive consultation with LDCs. Without the support and understanding of LDCs, it will be impossible to effectively implement any of these measures. The cost of these reforms to rich countries is negligible and will ensure future growth in the developing world.

This paper received first place honors in the first annual Kennedy Center Essay Contest, which was held in conjunction with International Education Week, 17–21 November 2003.

1. World Bank. Global Development Finance: Financing the Poorest Countries Analysis and Summary Tables, Washington, D.C., 2002, p. 121.
2. Nafziger, E. Wayne. The Debt Crisis in Africa, Baltimore, The Johns Hopkins University Press, 1993, p. 8.
3. Ibid., p. 26.
4. World Bank. Summary, p. 32.
5. Nafziger, pp. 90–91.
6. Ibid., pp. 2–3.
7. Abbott, Philip C. and Philip L. Paarlberg. “Tariff Rate Quotas: Structural and Stability Impacts in Growing Markets,” Agricultural Economics , fall 1998, p. 257.
8. World Bank. Global Economic Prospects and the Developing Countries, Washington, D.C., p. 51.
9. Bird, Graham. The IMF and the Future, New York, Routledge, 2003, p. 224.
10. Stiglitz, Joseph E. Globalization and Its Discontents, New York, W.W. Norton & Co., 2002, p. 42.
11. Ibid., p. 32.
12. Glover, David and Diana Tussie, ed.The Developing Countries in World Trade, Boulder, CO, Lynne Rienner Publishers, Inc., 1993, p. 236.
13. Stiglitz, p. 43.
14. Ibid., p. 243.
15. World Bank, Summary, p. 153.
16. Nafziger, p. 189.
17. World Bank, Summary, p. 153.
18. Stiglitz, p. 243.
19. Ibid., p. 244.
20. Ibid., p. 243.