external debt: causes of debt

11.1 Balance of Payments – Full Accounts

Definition (AO1): The Balance of Payments (BOP) records all economic transactions between residents and non‑residents over a given period, expressed in a single currency (usually the domestic currency).

• Current account – trade in goods & services, primary income (interest, dividends, wages) and secondary income (transfers, remittances, aid).
• Capital account – transfers of non‑produced, non‑financial assets (e.g., debt forgiveness, migrants’ transfers of assets) and the acquisition/disposal of non‑produced, non‑financial assets.
• Financial account –
  • Direct investment (FDI)
  • Portfolio investment (equity & debt)
  • Other investment (loans, currency deposits)
  • Changes in official reserve assets

In equilibrium the sum of the three accounts (plus the statistical discrepancy) equals zero. A surplus in one account is offset by a deficit in another.

Illustrative BOP diagram (AO2)

11.2 Exchange‑Rate Measurement

Nominal exchange rate (AO1): The price of one unit of foreign currency in terms of domestic currency (e.g., 1 USD = 0.75 GBP).

Real exchange rate (AO1):

\[ RER = \frac{E \times P^{*}}{P} \] where \(E\) = nominal exchange rate (domestic currency per unit foreign currency), \(P^{*}\) = foreign price level, \(P\) = domestic price level.

Interpretation: The real exchange rate measures the relative price of domestic goods to foreign goods. An increase in the real exchange rate indicates a loss of competitiveness.

Exchange‑rate regimes (AO2)

• Fixed (or pegged) – domestic currency is tied to another currency or a basket at a set rate; central bank intervenes with reserves and may adjust interest rates.
• Managed (or “dirty‑float”) – the rate is market‑determined but the central bank intervenes occasionally to smooth volatility.
• Floating – the rate is set by supply and demand in the foreign‑exchange market; intervention is rare.

11.3 Development Indicators & Characteristics of Economies

Key development indicators (AO1)

Indicator	What it measures	Typical source
Human Development Index (HDI)	Composite of life expectancy, education (mean & expected years), and GNI per capita	UNDP Human Development Report
Multidimensional Poverty Index (MPI)	Deprivations in health, education and standard of living	OPHI (Oxford‑Poverty & Human Development Initiative)
Gini coefficient	Income or wealth inequality (0 = perfect equality, 1 = perfect inequality)	World Bank, national statistics offices
MEW (Mean Years of Schooling)	Average years of education for adults aged 25+	UNESCO Institute for Statistics

Typical characteristics of economies (AO1)

Income group	Key economic features	Common external‑sector issues
Low‑income economies	High dependence on primary commodities, low productivity, limited industrial base	Large current‑account deficits, high external‑debt‑to‑GDP ratios, vulnerability to commodity‑price shocks
Middle‑income economies	Diversifying exports, growing manufacturing sector, increasing FDI inflows	Capital‑account volatility, exchange‑rate pressures, need for debt‑sustainability management
High‑income economies	Advanced services sector, high domestic savings, strong institutional frameworks	Large capital inflows, potential “Dutch disease”, managing external imbalances through fiscal policy

11.4 International Aid (AO2)

Definition (AO1): Transfers of resources from resident (donor) to non‑resident (recipient) entities that do not require repayment. In Cambridge terminology this is usually called Official Development Assistance (ODA) together with humanitarian and private‑sector aid.

Aid type	Source	Typical purpose	Key examples
Official Development Assistance (ODA)	Governments & multilateral institutions (World Bank, IMF, regional development banks)	Infrastructure, health, education, capacity‑building	UK’s Foreign, Commonwealth & Development Office grants; World Bank project loans
Humanitarian aid	Governments, NGOs, UN agencies	Emergency relief after natural disasters or conflict	UN‑OCHA cash transfers after the 2010 Haiti earthquake
Private‑sector aid	Philanthropic foundations, multinational corporations	Technology transfer, training, CSR projects	Bill & Melinda Gates Foundation health programmes in sub‑Saharan Africa

Macro‑economic effects (AO2)

• Positive: raises national income, improves health/education, can stimulate private investment (the “aid‑effect”).
• Negative: may create aid‑dependence, crowd out domestic saving, distort fiscal incentives, and in some cases lead to “Dutch disease” if large inflows appreciate the real exchange rate.

11.5 Multinational Companies (MNCs) (AO2)

Definition (AO1): Enterprises that own or control production facilities in more than one country. Their activities are distinguished from portfolio investment, which is purely financial.

Aspect	Key points
Types of foreign investment	• Foreign Direct Investment (FDI) – ownership ≥10 % of voting power. • Portfolio investment – equity/debt holdings <10 %.
Benefits to host economies	• Technology transfer and skills development. • Employment creation. • Access to export markets and global value chains. • Potential increase in tax revenue.
Potential costs	• Profit repatriation reduces national income. • Possible crowding‑out of domestic firms. • Pressure on labour standards and environment. • “Race to the bottom” in tax incentives.
Policy issues for governments	• Designing tax incentives that attract FDI without excessive revenue loss. • Regulating labour and environmental standards. • Managing exchange‑rate effects of large capital inflows.

11.6 External Debt (AO2)

Types of external debt (AO1)

• Official vs. commercial: Loans from governments or multilateral institutions (official) versus private banks, bond markets (commercial).
• Concessional vs. non‑concessional: Concessional debt carries a grant element ≥25 % (e.g., low‑interest World Bank loans); non‑concessional debt is market‑rate.
• Short‑term vs. long‑term: Short‑term ≤12 months; long‑term >12 months.
• Sovereign bonds: Issued in foreign currency, usually USD or EUR.

Causes of external‑debt accumulation (AO2)

• Current‑account deficits: Persistent gaps between imports (including capital goods) and export earnings.
• Fiscal deficits financed abroad: Domestic saving insufficient to fund government spending.
• External shocks: Sudden falls in commodity prices, spikes in global interest rates, or adverse exchange‑rate movements.
• Structural weaknesses: Low productivity, poor infrastructure, limited export diversification.
• Currency mismatches: Debt denominated in foreign currency while revenues are in the domestic currency.
• Debt‑financed growth strategies: Deliberate borrowing to fund large‑scale investment projects under the assumption that future growth will offset the debt.

Key debt‑sustainability indicators (AO2)

Indicator	Formula	Interpretation
External‑debt‑to‑GDP ratio	\(\displaystyle \frac{\text{Total external debt}}{\text{Nominal GDP}}\times 100\)	Higher ratios signal greater vulnerability to external shocks.
Debt‑service‑to‑Exports ratio	\(\displaystyle \frac{\text{Principal + interest repayments}}{\text{Total exports}}\times 100\)	Shows the proportion of export earnings needed to meet debt obligations.
Debt‑service‑to‑Revenue ratio	\(\displaystyle \frac{\text{Debt service payments}}{\text{Government revenue}}\times 100\)	Indicates fiscal pressure from external debt.

Debt‑sustainability framework (Cambridge core formula) (AO2)

\[ \frac{Debt_{t}}{GDP_{t}} \;=\; \frac{Debt_{t-1}}{GDP_{t-1}}\;(1+r-g)\;-\;\frac{Primary\ Deficit_{t}}{GDP_{t}} \]

• \(r\) = average interest rate on external debt.
• \(g\) = real GDP growth rate.
• Primary Deficit = fiscal deficit excluding interest payments.

If \(r > g\) and the primary deficit remains positive, the debt‑to‑GDP ratio will tend to rise, indicating a potential sustainability problem.

Debt‑relief mechanisms (AO2)

• HIPC Initiative (Heavily Indebted Poor Countries): Conditional debt forgiveness after meeting macro‑economic criteria.
• Debt‑for‑nature swaps: Creditors cancel debt in exchange for local environmental projects.
• Restructuring & refinancing: Extending maturities, reducing interest rates, or converting debt into concessional terms.

11.7 Synthesis – Policy Implications (AO3)

1. Use aid and FDI strategically to build productive capacity, reduce reliance on external borrowing, and diversify exports.
2. Strengthen domestic financial markets to mobilise internal savings, thereby limiting fiscal deficits financed abroad.
3. Adopt prudent fiscal rules (e.g., debt‑brake, primary‑balance targets) to keep the primary deficit low.
4. Match the currency composition of external debt with the currency of revenue streams to avoid exchange‑rate‑induced debt spikes.
5. Maintain an exchange‑rate regime that supports external‑balance stability while preserving monetary‑policy independence.
6. Prepare contingency mechanisms (sovereign‑wealth funds, reserve buffers, debt‑relief negotiations) to absorb external shocks.

Suggested flowchart (AO2)