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Uses of Capital Flows and Development Needs

Historically, North-South capital flows (both aid flows and commercial loans) have helped to fill two financial gaps:

 they finance the current account balance of payments deficit - that is, the gap between imports and exports - by providing an inflow of foreign exchange to the economy as a whole; and
 where money is lent to the public sector, capital flows finance the budget deficit - that is, the gap between the government's spending and its income from taxes, etc., - along with domestic borrowing.
As principal payments fall due on the debts incurred by governments during the surge of commercial lending in the 1990s, the growth of borrowing from private sources (net of repayments) has slowed down considerably, and has not been sufficient to off-set the dramatic decline in official financing since 1993. The overall effect is a decline in finance (net of repayments) to governments. This reduction is much more dramatic if interest payments are considered, as the shift of debt from official to commercial sources has increased its average cost6. This represents a major reduction in the external resources available to governments.
For many low-income countries, a particularly important aspect of the financial constraint facing governments is the limited availability of resources to finance recurrent spending (that is, non-investment spending, eg., on salaries, maintenance, drugs and other consumables in the health sector, teaching and learning materials in education, etc.). Most grants and official loans are tied to particular investments, which themselves often increase the need for recurrent spending (for running costs and maintenance), leaving recurrent spending to be financed by tax revenues and borrowing from other (ie., commercial and domestic) sources.
In most low-income countries, especially in Sub-Saharan Africa, government revenues are limited by low incomes and large subsistence and informal sectors (which limit the tax base) and weak administrative capacity (which impairs the ability to collect taxes). An additional problem is that many countries with particularly low revenues rely heavily on taxes on imports and exports, and on corporate taxes, which are typically reduced under IMF and World Bank adjustment programmes (Woodward, 1996, pp55-57).
Access to foreign commercial borrowing for most of these countries is also limited; and the potential for domestic borrowing is restricted in most cases because of low savings rates. Borrowing to finance recurrent spending is in any case a dangerous strategy: unlike investment, recurrent spending does not generate profits which can be used to pay the interest. The dangers of borrowing to finance consumption are clearly demonstrated by the Latin American debt crisis in the 1980s.

A better case can be made for borrowing to finance recurrent spending on health and education, as this is, in effect, an investment in human capital (that is, in the future productivity of the work-force). However, the returns on this investment are indirect and slow to materialise, making commercial and domestic borrowing (which bears high interest rates and is generally relatively short-term) inappropriate. Over the long term, borrowing to finance recurrent spending makes the situation worse, because interest payments on the borrowing will come out of future recurrent budgets.
In middle-income countries, recurrent spending constraints are generally not so tight; and there may be greater scope for governments to borrow locally to make up for the reduction in flows to the public sector from abroad. However, local borrowing is generally much more expensive, because interest rates tend to be much higher than those on foreign commercial borrowing. This strategy can therefore impose very substantial costs on the public finances over the longer term. Perhaps the best-known example of this phenomenon is Brazil, where interest payments on domestic debt amount to some 5% of GDP, putting considerable pressure on non-interest government spending7.
The decline in the level of investable resources available to governments may be partly compensated for by the process of privatisation which, by shifting the ownership of industries such as power generation and telecommunications from the public to the private sector, implies that governments now have less need for investment resources.

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