Academic journal article The Lahore Journal of Economics

Implications of Public External Debt for Social Spending: A Case Study of Selected Asian Developing Countries

Academic journal article The Lahore Journal of Economics

Implications of Public External Debt for Social Spending: A Case Study of Selected Asian Developing Countries

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Access to financial assistance is important to individuals, business organizations, and governments. The "three-gap model" explains why developing countries facing fiscal and balance-of-payments problems often resort to foreign aid.1 Different variants of this model are frequently used by donor agencies in country analyses to define the relative need for and ability of the government concerned to use foreign aid effectively (Islamov, 2001). However, continued reliance on foreign borrowing is not costless.2 Servicing accumulated foreign debt absorbs a significant fraction of the meager resources generated through exports and remittances. This, in turn, creates the need for further borrowing and widens the fiscal deficit. Data from developing countries reveal that cutting down on current (nondevelopment) expenditure is seldom feasible. The final outcome is straightforward: debt servicing adversely affects ongoing development projects and allocations for social sectors such as health and education.

External borrowing is considered important for developing countries because it increases their access to foreign resources in order to finance imports (equipment and material) meant for development projects. The practice of borrowing may be useful in the short run, but it has important long-run consequences: resources have to be generated first through exports and then used to pay back and service the outstanding debt.

All this depends on the careful and efficient use of the borrowed funds. It is not possible for the central bank to print the hard currency (foreign exchange) needed to repay external debt, and so external borrowing is often associated with vulnerability and debt crises (Rais & Anwar, 2012). The case of domestic public borrowing is somewhat different. The government can easily raise fresh loans to repay mature bonds. The resources are then simply transferred from one hand (taxpayers) to the other (bond holders) in the case of domestic debt servicing.

Many developing countries' government liabilities have increased due to rising interest payments, price hikes of oil imports, and unfavorable conditions in the international markets for their primary exports. As a result, they are caught in a vicious circle of deficit and debt: the increasing budget and trade deficits lead to more borrowing while debt accumulation over time causes the fiscal deficit to widen further. Their current expenditure has also risen over time due to overspending, and this behavior is also motivated by the availability of foreign aid and easy borrowing (Shonchoy, 2010).

Post-1980s, most low-income developing countries have relied on external borrowing to finance development programs in infrastructure, construction, power generation, and the social sector. Development of these sectors is important to raise people's living standards. The impact of external debt on social sector spending is a controversial issue. Mahdavi (2004), for example, emphasizes spending cuts and higher revenues, and suggests distributing the total cuts appropriately among the various categories of public spending in order to reduce the fiscal deficit.

However, a reduction in current spending by the government is often difficult, given the adverse effect on welfare and employment, which can exacerbate public discontent and political instability. If, however, the funds released from cuts in current spending are applied carefully to enhance productivity, then this strategy may be effective for economic growth in the long run. This holds particularly for those developing countries where the public sector is the main provider of employment and the major source of investment in infrastructure and fixed capital formation.

High stakes of debt lead to greater servicing liability. Increasing dependence on foreign borrowing is reflected in commonly used indicators such as the ratio of outstanding debt to GDP and the ratio of debt servicing to export earnings. …

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