consequences of debt

Relationship Between Countries at Different Levels of Development – Consequences of Debt (Cambridge 9708 – 11.5)

1. Why Countries Borrow

• Financing large‑scale infrastructure (roads, ports, power plants).
• Stabilising the economy during a downturn (counter‑cyclical fiscal policy).
• Covering current‑account deficits when export earnings are insufficient.
• Meeting short‑term liquidity needs or paying for emergencies (e.g., natural disasters).
• Political motives – funding popular programmes before elections.

2. Types of External Debt

• Official debt: Loans from foreign governments or multilateral institutions (World Bank, IMF, regional development banks).
• Commercial debt: Loans from private banks or bonds issued in international capital markets.
• Short‑term vs long‑term: Short‑term matures within 12 months; long‑term matures after one year.

3. International Aid – Forms, Reasons and Effects

• Official Development Assistance (ODA) – concessional loans and grants from donor governments.
• Multilateral aid – funding from institutions such as the World Bank, regional development banks, and the UN.
• Humanitarian aid – short‑term assistance after disasters or conflicts.

Why donors give aid

• Altruistic motives – poverty reduction, humanitarian concern.
• Strategic / political motives – securing influence, promoting trade or security interests.
• Economic motives – stabilising a trading partner, preventing regional spill‑overs of crises.

Typical macro‑economic effects

• Budget support can increase fiscal space, allowing higher spending on health, education or infrastructure.
• Concessional loans lower the debt‑service burden compared with market‑rate borrowing.
• Conditionality may require policy adjustments that affect growth and distribution.
• Debt‑relief programmes (e.g., HIPC) can improve debt sustainability but are usually tied to structural reforms.

4. Measuring the Debt Burden

The principal indicator used in the syllabus is the debt‑to‑GDP ratio:

$$\text{Debt‑to‑GDP Ratio}= \frac{\text{Total External Debt}}{\text{Nominal GDP}}\times 100\%$$

A high ratio signals greater vulnerability, especially for low‑income economies with limited fiscal capacity.

5. Debt‑Sustainability Framework (DSF)

5.1 Basic DSF Test

• Project the future debt‑to‑GDP ratio using the government’s fiscal plan.
• Compare the projected ratio with the threshold appropriate for the country’s income group.
• If the projected ratio stays below the threshold, debt is judged sustainable.

5.2 Key Diagnostic Variables

• Primary balance (PB) – fiscal balance excluding interest payments. A primary surplus is needed to stabilise or reduce debt.
• Interest‑growth differential (r − g). When the real interest rate on debt (r) exceeds the real GDP growth rate (g), debt tends to explode unless a primary surplus is generated.

5.3 Debt‑to‑GDP Thresholds (Indicative)

Income Group	Debt‑to‑GDP Threshold (%)	Typical Risk Indicators
Low‑income	30 – 40	High primary deficit, low foreign reserves, weak institutions
Lower‑middle‑income	40 – 50	Moderate primary deficit, limited fiscal space
Upper‑middle‑income	50 – 60	Higher fiscal capacity, diversified export base
High‑income	60 +	Strong institutions, deep capital markets

6. Consequences of High Debt Levels

6.1 Macroeconomic Consequences

• Debt‑service burden – A larger share of government revenue must be spent on interest and principal repayments, crowding‑out health, education and productive investment.
• Fiscal drag – To meet debt‑service obligations governments may raise taxes or cut spending, which can slow growth.
• Exchange‑rate pressure – Servicing foreign‑currency debt can force the sale of foreign reserves, leading to depreciation and imported‑inflation.
• Risk of default – Failure to meet obligations can trigger a sovereign debt crisis, loss of market access and sharply higher borrowing costs.

6.2 Development‑Specific Consequences

• Debt overhang – When investors expect that a large part of future earnings will be used to repay debt, they postpone or cancel investment, reducing potential growth.
• Crowding‑out of productive investment – Resources diverted to debt service limit the ability to finance human‑capital formation, technology adoption and infrastructure.
• Conditionality & loss of policy autonomy – Loans from the IMF or World Bank often come with structural‑adjustment conditions (e.g., fiscal consolidation, trade liberalisation) that restrict a country’s policy choices.
• Social impacts – Austerity measures can raise unemployment, increase inequality and undermine social stability.

7. Balance‑of‑Payments (BoP) Implications and Policy Tools (11.5.1)

External debt is both a symptom and a cause of BoP disequilibrium. A persistent current‑account deficit forces a country to borrow, which in turn creates future repayment obligations that can worsen the deficit.

7.1 Policy Instruments to Correct a BoP Disequilibrium

Policy Area	Tool	Typical Effect on the BoP
Fiscal	Contractionary budget (higher taxes, reduced public spending)	Reduces domestic demand for imports → improves current account.
Monetary	Higher policy interest rates	Attracts foreign capital → improves capital account; may also appreciate the currency, reducing export competitiveness.
Supply‑side	Improving productivity, removing bottlenecks	Increases export capacity and reduces import dependence.
Exchange‑rate	Devaluation (under flexible rates) or revaluation (under fixed rates)	Devaluation makes exports cheaper and imports more expensive → improves current account; revaluation has the opposite effect.
Capital‑account controls	Restrictions on short‑term capital inflows/outflows	Can stem rapid capital flight during a debt crisis, stabilising reserves.

7.2 Example

Country Y experienced a current‑account deficit of 5 % of GDP in 2022. The government introduced a modest fiscal consolidation (primary surplus of 1 % of GDP) and allowed a 7 % devaluation of its fixed exchange rate. Within two years the deficit fell to 1 % of GDP, easing debt‑service pressures.

8. Exchange‑Rate Effects (11.5.2)

• Nominal vs real exchange rate – Nominal rates are the market price of one currency in another; real rates adjust for price‑level differences and affect competitiveness.
• Fixed, pegged and managed float systems – Fixed regimes can provide stability but limit the ability to absorb external shocks; managed floats allow limited adjustments.
• Devaluation / revaluation – Devaluation improves export competitiveness but raises the local‑currency cost of foreign‑denominated debt.
• Marshall‑Lerner condition – A devaluation improves the trade balance only if the sum of the absolute values of the export and import demand elasticities exceeds 1.
• J‑curve effect – After an initial deterioration, the trade balance may improve as quantities adjust to the new exchange rate.

9. Development‑Specific Issues (11.5.3 & 11.5.4)

9.1 Key Living‑Standard and Inequality Indicators

• GDP per capita (PPP)
• Human Development Index (HDI)
• Multidimensional Poverty Index (MPI)
• Gini coefficient (income inequality)
• Mean Years of Schooling (MEW)

9.2 Kuznets Curve

The Kuznets curve hypothesises an inverted‑U relationship between income per capita and inequality: as an economy develops, inequality first rises (industrialisation) and then falls (broad‑based education and redistribution). High debt can shift the curve upward by limiting public investment in health and education.

9.3 Characteristics of Countries at Different Development Levels

Level	Population & Demography	Economic Structure	Income Distribution	Typical Debt Profile
Low‑income	High fertility, young age structure	Agriculture‑dominant, limited manufacturing	High inequality, large rural‑urban gap	Low external borrowing, high aid dependence; debt‑to‑GDP often > 30 %
Lower‑middle‑income	Rapid urbanisation, growing labour force	Mixed agriculture‑manufacturing‑services	Moderate inequality, emerging middle class	Rising commercial debt; debt‑to‑GDP 40‑50 %
Upper‑middle‑income	Slowing population growth, ageing trend begins	Service‑oriented, diversified exports	Lower inequality, stronger social safety nets	Higher debt capacity; debt‑to‑GDP 50‑60 %
High‑income	Stable or declining population, high labour productivity	Advanced services, high‑tech manufacturing	Low inequality, extensive welfare systems	Deep capital markets; debt‑to‑GDP often > 60 % without sustainability concerns

10. Relationship Between Countries (11.5.5)

• Foreign Direct Investment (FDI) – Can provide foreign‑exchange earnings and technology transfer, reducing the need for debt. However, excessive external debt can deter FDI because of perceived repayment risk.
• External‑debt burden – High debt levels in one country can affect creditors and neighbouring economies (e.g., contagion through banking links or trade).
• Globalisation – Integrated financial markets mean that shocks in major economies (interest‑rate hikes, recessions) quickly transmit to debt‑laden developing countries.
• Multinational corporations (MNCs) – Their profit repatriation can create current‑account deficits; at the same time, MNC‑led projects may be financed through external borrowing, adding to the host country’s debt stock.
• Aid and conditionality – Aid can be used to stabilise a country’s external position, but policy conditions may limit fiscal autonomy and affect long‑term growth.

11. Debt Traps and Vicious Cycles

1. Borrow to finance current‑account deficits → external debt rises.
2. Higher debt → larger interest payments → reduced fiscal space.
3. Reduced spending on growth‑enhancing projects → slower economic growth.
4. Slower growth → lower export earnings → need for further borrowing.

This cycle is especially dangerous for resource‑dependent economies where commodity‑price volatility amplifies debt volatility.

12. Policy Responses

• Debt restructuring – Negotiating longer maturities, lower interest rates or partial debt forgiveness.
• Fiscal consolidation – Improving tax collection, widening the tax base and cutting non‑productive spending to generate a primary surplus.
• Growth‑oriented strategies – Investing in sectors with high multiplier effects (education, renewable energy, high‑value manufacturing) to boost export earnings.
• Building foreign‑exchange reserves – Accumulating buffers to reduce reliance on short‑term borrowing and to defend the exchange rate.
• Improving governance – Strengthening institutions, enhancing transparency and ensuring that borrowed funds are used productively.
• BoP‑focused adjustments – Using exchange‑rate policy, capital‑account controls or supply‑side reforms to correct current‑account imbalances.

13. Illustrative Case Study (Brief)

Country X – Lower‑middle‑income

• 2000‑2010: Heavy borrowing for road and port projects; debt‑to‑GDP rose to 55 %.
• 2012‑2014: Global commodity‑price slump cut export earnings; primary deficit widened to 4 % of GDP.
• Debt service consumed 8 % of government revenue, forcing cuts in education and health.
• 2015: Negotiated a debt‑restructuring package (extended maturities, reduced interest rates). Combined with fiscal consolidation, the primary balance turned into a modest surplus, allowing a return to positive growth.

14. Summary

• External debt can finance development, but high debt‑to‑GDP ratios increase macro‑economic vulnerability.
• Debt sustainability hinges on the ability to generate a primary surplus and on the relationship between the real interest rate (r) and the real growth rate (g).
• Debt overhang, crowding‑out, conditionality, and exchange‑rate pressures are key development‑specific risks.
• Effective policy mixes debt‑management measures (restructuring, fiscal consolidation) with growth‑enhancing investment, BoP‑correcting tools, and good governance.
• Understanding the characteristics of countries at different development levels, the role of FDI and globalisation, and the relevant balance‑of‑payments policies is essential for exam success in Cambridge 9708 – 11.5.