International Economics

Why do developing countries need external (outside) finance?

• To fund development projects (roads, electricity, ..)

• Fund human capital accumulation (education, health)

• Fund government deficits.

• Fund current account deficits

• Poverty alleviation (personal consumption)

Sources of External Finance

1. Debt Finance

2. Remittances from abroad

3. Foreign Aid

4. Foreign Direct Investment

What is debt finance, and why is it not an option for most developing countries?

• Debt finance includes government bonds and treasury bills.

• People may not purchase government bonds/treasury bills for fear that the government may refuse to honor the bonds, and there is no recourse if that occurs.

Remittances

Money sent from abroad from individuals (usually families) for private use (education, consumption, hospital bills)

Types of Foreign Aid

1. Private Aid (mostly international NGOs)

2. Bilateral Aid (Aid from one country to another)

3. Multilateral Aid (World Bank and IMF)

Official Foreign Aid

Official foreign aid refers to development assistance, such as medical, disaster relief, and economic aid aimed at alleviating poverty and improving the welfare of the citizens in the recipient country.

Official Aid comes from two sources:

• Bilateral Aid: Aid from one country (usually developed) to another (typically less developed).

• Multilateral Aid: Aid from a Multilateral Agency, such as the World Bank and International Monetary.

Official Aid takes three forms:

➢ Grants: Loans with no repayment requirement (free money).

➢ Concessional Loans: Carry no interest and offer a long repayment period (10-40 years).

➢ Technical Assistance: Includes expert personnel, e.g., engineers, professional advice, etc.

Development Assistance Committee (DAC)

a group of OECD countries that coordinates and harmonizes the aid policies of its member states.

DAC Members

Australia, Austria, Belgium, Canada, Denmark, the European Union, Finland, France, Germany, Greece, Ireland, Italy, Japan, South Korea, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States

Official Development Assistance (ODA)

Government aid that promotes developing countries' economic development and welfare.

ODA funding

A long-standing United Nations target is for developed countries to devote at least 0.7% of their gross national income (GNI) to ODA

Who makes decisions at the IMF?

The IMF has 184 members. Decisions are made by

Ø Executive Board, representing the IMF’s 184 members

Ø A Managing Director (European)

Ø 3 Deputy Managing Directors

Where does the IMF get its money?

ØMember countries pay a subscription fee, referred to as a “quota”

ØA country’s quota depends on the country’s GDP; richer countries pay more.

ØU.S. is the largest contributor, quota = 17.6 % ($35 billion)

How does the IMF serve its members?

ØMonitors Economic and Financial developments and policies of member countries.

ØLends to countries to countries that have (temporary) Balance of Payment problems.

ØProvides Technical Assistance---i.e., training to governments and central bank officials on how to keep good financial records, etc..

  Idea: Countries in a Balance of Payment crisis may need foreign loans to prevent drastic reduction in consumption.

What are the key features of IMF lending?

ØIMF lending is conditional on policies: the borrowing country must adopt certain policies in order to receive the loans.

ØIMF lending is short-term: Typical IMF loan has to re-paid within 3-7 years.

ØIMF loans charge market interest rates (i.e., interest rates are close to the rates charged by private banks).

What is the main objective of the World Bank?

To alleviate poverty and promote sustainable growth in poor countries.

How is the World Bank Financed?

It obtains its funds from two sources:

•-- -member dues

•--- borrows from financial markets.

Who makes decisions at the World Bank?

Ø Board of Governors, representing the World Bank’s 184 members.

Ø President of the World Bank (An American).

Ø 24 Executive Directors

How does the World Bank serve its member countries?

ØProvides loans to help countries to develop—development loans

ØProvides policy advise, e.g. free trade, structural adjustment policies.

ØFunds specific projects, e.g., HIV prevention, build infrastructure

What are the key features of World Bank lending?

Ø Lending is conditional on policies: the borrowing country must adopt certain policies in order to receive the loans.

Ø World Bank lending is long-term: Typical loans have a 30 year repayment period.

Ø Loans charge below market interest rates (i.e., interest rates are very low). For example, some loans are interest free.

Ø Only poor countries are eligible to borrow from the World Bank.

Foreign Aid from the World Bank takes 3 forms

ØGrants: Loans with no repayment requirement (free money).

ØConcessional Loans: Carry no interest and offers a much longer grace period (10-40 years).

ØTechnical Assistance: Includes expert personnel, e.g., engineers, etc

Foreign Direct Investment

FDI refers to investments by multinational corporations in foreign countries, such as GM setting up a plant in Mexico.

Advantages of FDI

Ø No future debt service.

Ø Transfer of technology.

Ø Helps  balance of payments and generates foreign exchange.

Ø Generates tax revenue---very important for poor countries.

Ø Pays higher wages.

Ø Employment creation.

Ø Technology transfer.

Ø Trains domestic managers & technicians.

Ø Provides contacts with overseas banks, markets, & supply sources.

Disadvantage of FDI

•Technological dependence.

•Unsuitable technology.

•Diversion of local skills from domestic entrepreneurship & innovation.

•Tax incentives to attract FDI leads to market distortion.

•Foreign firms may evade taxes.

•Foreign firms have advantages over domestic firms (economies of scale, access to markets, etc), making domestic firms less competitive.

•Increases cost of operation for domestic firms---by paying higher wages.

•Can lead to unemployment in case of mergers or acquisitions.

•Can create income inequality.