The Role of International Credit in Contemporary Economies - Term Paper Example

International credit Credit refers to a borrowed amount of money or the potential of an entity (whether an individual or an economy) to loan money. In accounting terms of bank, it refers to positive cash entries. When money is exchanged across countries essentially for the use of one or more countries, we may call this international credit. In an open economy, different types of external assistance and foreign borrowing can play a role along with the associated problems of debt servicing. One may think of foreign assistance or international credit from different spheres: bilateral assistance from developed nation, multilateral help from the World Bank and also private foreign investments. The two major international credit institutions and their role: One of the major developments after the Second World War period was the internationalization or liberalization of the financial markets with United States of America on the front. The multinational corporations of USA spread their financial dealings and operation to different bases across nations. Simultaneously a large amount of funds were allocated for purchase of treasury bills of USA. The banks of USA have also spread their operations worldwide during the seventies. International operations contributed to around 20 percent of the total income of the American banks. International credit provides certain distinct benefits to the people of the borrowing nation. These funds obtained through international credit help in financing the projects of local firms and the government. International financial system offers different opportunities of diversification to an investor, which might not be locally available. However, when an economy joins the global financial markets, certain economic variables may be restricted as well as the effectiveness of certain basic economic and national policies. For instance the capital mobility across the world has automatically restricted the movements of domestic interest rates and also the control of money supply becomes so difficult under fixed exchange rates. Before economic transactions occur between the residents of different nations, certain arrangements are require making payments effective as well as bringing about the exchange or transaction successfully. The arrangements required need to address the political regimes, legal systems and the customary process of doing business in various countries. The basic of the international monetary system centers on the barter system prevalent in history. To make the exchange procedures convenient and easy to handle, a rage of monetary arrangements came into operation. These exchanges or transactions are supervised by international organizations like IMF and World Bank. The IMF (International Monetary Fund) and the World Bank came into existence on 27th December 1945 at the Bretton Woods conference after the conclusion of the Second World War as the allied nations contemplated some measures to bring about order in international relations. In the course of ensuring that, the IMF and World Bank imposed some conditionalities of reforms or structural adjustment policies, as they are popularly known. This was to improve the credit worthiness of the developing or less developed nations, often refered to as third world countries.these esentially concentrated on the macroeconomic policy of a nation.the origins of these policies. The origins of these policies can be traced back to the oil and debt crisis of late 1970s, the multiple economic depressions of the 1930s and 80s and stagflation. These called for a deeper and greater intervention in order to ensure overall well being of a nation. These policies implement free market mechanism, ensures internal changes like privatisation and deregulation along with external changes like reduction of trade barriers. Poverty reduction measures have also been stressed upon from the 1990s. Purpose of the International Monetary Fund The initial duty of the two institutions was to control the balance of payment problem and fill the deficit by supplying the dollar reserves required. However after the failure of the Bretton Woods regime in March 1973, the articles of IMF were amended to incorporate the freedom of choosing the exchange rate of a nation. The purpose of the international credit system is multifaceted: facilitating expansion and promoting a balanced growth of trade, ensuring stability of exchange rate, establishment of a multilateral payment system, to deal with balance of payment problems or disequilibria after ensuring certain safeguards or conditionality. The international monetary institutions ensure certain conditions before lending resources or funds. These conditions pertain to monetary, fiscal and exchange rate policies. The success of a project or the purpose for which loan is taken often depends on the infrastructure conditions of a nation, the ability to manage the macroeconomic conditions of the recipient country. The lending system incorporated programme based lending, a shift from project based lending because here a series of projects would be financed. When an institution lends credit to a country, there are certain underlying assumptions regarding the economy and the credit system as a whole. Domestic economic lapse of management is evident from balance of payment deficits; the best allocation of resources is possible under free market; when a restriction is removed, for instance if the economy tends to move towards free market system from the planning mechanism, then the economic agents, for example, the buyers and sellers will respond in a favorable manner or in a way which is supportive of economic growth; only the private sector is able to bring about efficient allocation of resources and a liberalized policy can solve these problems. The role of external debt is mainly reflected in evening out the deficit in the current account balance, which may be brought about by the capital inflows from these lending institutions. This enables the problem to be solved without any fall in the central Bank reserves. International reserves and the capital inflows may be seen as substitutes. The non-oil developing nations were able to meet their current account deficits due to their access to the international financial markets as well as increased their international reserves. The best test of the role of external debt or international credit may be illustrated by the oil shocks in1973, 1974 and again in1979 and 1980. The sudden price rise of oil brought about by the oil producing OPEC nations created high-pressure n the foreign reserves of the non-oil producing industrial nations and these deficits could not be met by other capital inflows or by increasing debts. In later years the countries preferred to increase debts to finance the current year deficits. Although current account deficits declined during 1976 to 1978 and the reserves were accumulated, indebtedness began to rise. The current account deficits were gradually increasingly financed by these lending agencies. During the 1980s, the focus was not merely on enjoying the borrowed funds but on improving the international relationships as well. Role of international credit to the emerging developing economies Historical evidence states that whenever trade place between developed and underdeveloped country the result is the movement of terms of trade against the economically weaker country. Initially it was believed that this is because normally a less developed country exports primary goods and raw materials. The demand for such goods is highly inelastic. On the other hand the demand for secondary and manufactured goods is highly elastic, which is exported by the developed nations. (Singer 1950) The business cycle fluctuation causes such a trend. Because in time of economic slump the price of the primary products and raw materials fall drastically which is not recovered in the boom period and vice versa for the manufactured ones. So in this type of trade it is found that during time the Less Developed Countries faced the problem of fall in terms of trade during the trading relationship. It was initially supposed that this type of inelastic nature of the demand for the exported commodities were responsible for secular decline in the terms of trade. Another important consequence is that the demand for such products are so inelastic that when there is a large fall in price of primary goods we find that export of primary goods rises but the rate of export rise is so small that the total export earning falls. Then to increase the earning the LDCs export more. That cause a fall in price farther due to excess supply. The export earning falls farther. This is known as export desperation. (Singer 1950) So the protectionist approach prescribed to strengthen the domestic industrial good producing sector through protecting them from foreign competition. Such policies were supposed to help the country to create sufficiently large market inside. In this way the primary and secondary goods producing sector would provide the linkage effects to each other. Again, if such a policy could be followed, the internal market of the country would not be affected by foreign disturbances. This was known as the policy of inward looking industrialization. The policymakers assumed that over time the primary goods exporting countries would be able to export manufacturing goods and would be free from the problem of declining terms of trade. But even decades after inward looking industrialization the LDC s continued to face the problem of falling terms of trade. So the economists had to shift their focus from the types of commodity traded to the type of country engaged in trading. They decided that when there is a developed (north) and underdeveloped (south) country trading relationship, the developed country always exploits the underdeveloped one. (Sarkar 1997; Molana, and Vines, 1989) External debts have a significant role to play in developing countries. Banks, speculators and other institutions that are at the forefront of transactions support the international monetary system but when the system fails or is disturbed, then the entire world economy is affected. The essence of this system may be explained and the cause of the developing or emerging economies may be established and explained by different theories, which lie at the base of this credit and lending system. It is believed that if a country specializes in that commodity in which it has advantage (i.e. better endowment of the factors of production) over the others and exchanges it for its required products, which may be better produced in other countries, then it is beneficial for both the countries (Law of comparative advantage). In this tune the global economic policy and the economic policy of any individual country has been formulated and since the last half of the 20th Century, LPG (Liberalization Privatization and Globalization) has been the hymn of the world. Generally the industrially advanced countries, which belong to, the OECD (Organization of Economic Cooperation and Development) group is in favor of globalization: to be more precise economic liberalization. (Trebilcock and Howse 2005) The theorists (liberals) who are in the favor of liberalization call the trade barriers as the distorting policies. The opposite argument (Protectionists) is led on the line that the free trade or economic liberalization is a new form of colonization to extract the surplus from the poor countries to the rich ones through the veil of trade. The evils of free trade got highlighted after the fall of South Korean Economy that implemented capital account liberalization, in order to ride the ladder of prosperity. South Korea ended up in nowhere as the foreign fund that had spurt a short term growth was soon withdrawn and lack of adequate capital registered long run stagnation or rather deceleration of the economy. The same was true for all the newly industrializing countries once known as roaring South Asian tigers that were reduced to paper tigers following the route of globalization. The Latin American giants like Argentina and Brazil experienced almost the same and their economy almost came at the verge of bankruptcy following a liberalized route. Yet, trade of commodities is not the only solution because there is no barter system an every transaction ultimately takes place under the veil of money. (Trebilcock and Howse 2005) thus it is not always possible to obtain a zero balance. It is this excess which, if negative needs to be evened out with the help of outflow of foreign reserves. This is where the depletion of foreign reserves comes into play and therefore international credit assumes an important role. In terms of national accounting, when investment exceeds domestic savings, the sum is equivalent to the import-export gap. Foreign capital inflows obviously reduces the productivity of capital and therefore raises the capital output ratio because there is often an inclination towards use of international credit for prestige projects, infrastructure projects and social-overhead capital. However we have no evidence as of now regarding the productivity issue and moreover studies of Papanek and Pesmazogolu suggests the contrary (foreign capital productivity is more then that of domestic resources. Forms of credit and motives of the lenders Credit to the developing nations may come in many different forms: grants, pure aids, loans, portfolio investment and off course Foreign Direct Investments through the multinationals. The donor nations and institutions provide aid, loans and investment to the recipient emerging nations for several reasons. If we study carefully, we may understand that foreign credit is necessary for current development but might bring about future dependence and weaken the domestic efforts to develop as well as create a distortion in the pattern of consumption and production. There might be outflow of profits and problems associated with servicing the debt. When financial assistance comes in from public bodies on terms of concession, we might identity three main motives, one or more of which is (are) probable. Firstly, one might help with a human face for the genuine cause of the poorer nations to help them come up on their feet. There might also be military, political and historical motives behind the grant of assistance. For instance, a large part of the network of American aid program is directed towards prevention of the spread of communism. Again, international credit or assistance might act in the favor of the donor countries in terms of accruing profits and raising their welfare apart form merely increasing the growth rate of the developing nations. Conditions or prerequisites for getting loans However, as mentioned before, these international lending institutions impose some conditions and even restrictions n administrative power of the government, which might be adverse to the countries’ needs. These policies or conditions in a nutshell may be listed as follows (assuming IMF and the World Bank to be representative of all the international credit institutions): Some important conditions are: Cutting social expenditures, also known as austerity, Focusing economic output on direct export and resource extraction, Devaluation of overvalued currencies, Trade liberalization, or lifting import and export restrictions, Increasing the stability of investment (by supplementing foreign direct investment with the opening of domestic stock markets), Balancing budgets and not overspending, Removing price controls and state subsidies, Privatization, or divestiture of all or part of state-owned enterprises, Enhancing the rights of foreign investors vis-a-vis national laws Improving governance and fighting corruption. Criticisms According to critics, the sovereignty of the nation is threatened due to implementation of such policies because the internal affairs of the economy are implicitly controlled externally (detrimental to democratic policies) and hence serves as the base for neo-colonisation. In any case Third World Debt is almost an universal fact as some of the 47 nation categorised as the poorest fo the world are already in a debt of $422 billion dollars by 2003. A common policy that the IMF encourages is privatization of public industries. This is aimed at increasing efficiency in these industries, increasing investment, and reducing public expenditure. Loss-making state firms are privatized to reduce government subsidies, and with the expectation that the private sector will be able to provide more effective and efficient role in management. Profit-making firms are sold off to bring down the state payroll and convert assets into available funds that can be allocated to current expenditure. The criticisms are based on the fact that that public units have a wider social welfare role as a cause of functioning (subsidising electricity for the poor) in contrast to which privatisation have a narrower objective and endangers jobs and wages of workers. The reform policies aim at encouraging trade for achieving he essential objective of balancing the balance of payments. The long term trade benefits (optimising comparative advantage) incorporate devaluation of currency and reduction in tariffs and provision of subsidies. However, devaluation makes imports more expensive, thus bringing about inflationary pressures on industries dependant on imports of raw materials.also, exports become price inelastic and hence a contraction of the econpomy may be required to restore balance. Continued debt service also becomes difficult by the government. This again contradicts the key policy of reducing budget deficit. According to the critics, the policies act as a cause behind the economic stagnation that is common in borrowing nations. These policies lay stress on balanced budget maintenance that brings about austerity programs aiming at promotion of education health social safety net facilities.these schemes require constant supply of funds as cuts in funds of such programs, once implemented would be detrimental to long term growth of economies. From the very time of implementation of the structural reforms the gap between global economies have increased steadily. Critics often point at the neoliberal ideas related to corporations (including MNCs) that mainly aim at cost reduction and profit maximisation – a direct impact on wages in comparison to volume of work, especially for unskilled section. Simultaneously this implies a rise in living standards of the profit makers. Thus raising the differences between developed and less developed nations. As the protrade policies crete an environment conducive to serve western needs, the environment is pulluted constantly due to great amount of discharge into the air and surrounding water bodies thus creating an hazardous environment. Similarly the agricultural reforms advocates the use of pesticides and fertilisers in large amounts, thus leading to contamination of river waters and endangering aquatic life. As far as MNCs are concerned even they have been accused of widening the rural urban wage gap further, but it involves not only a transfer of funds but also that of expertise, techniques and products. Conclusion: Although the main focus still remains on balancing of external debts and trade deficit management, the reasons for the debts have changed to some extent as the lending institutions now engaged themselves in benevolent acts of aiding a country in times of natural disasters and economic mis management. The SAPs’ emphasis on poverty reduction have attempted to render greater support the Millennium Development Goals (MDG). As a result of the introduction of PRSPs in 2002, a less rigid and more creative approach to policy creation has been adopted by the IMF and World Bank. 1. Baran, P. (1957) The Political Economy of Growth. New York: Monthly Review Press 2. Findlay, R.(1980) “The Terms of Trade and Equilibrium Growth in World Economy” American Economic Review 70 (June): 291-309 3. Frank, A.G. (1967). Capitalism and Underdevelopment in Latin America. New York: Monthly Review Press. 4. Molana, H.H. and Vines, D.A. (1989) “North South Growth and Terms of Trade: A Model on Kaldorian Lines”, Economic Journal 99 (June): 443-53 5. Sarkar, P. (1986) “The Singer Prebisch Hypothesis: A Statistical Evaluation”. Cambridge Journal of Economics 10 (December 1986): 355-71 6. Sarkar, P. (1986b) “Patterns of Trade and Movements of International Terms of Trade Between The Developing and Developed Market Economies, 1950-1980,” Economic Bulletin for Asia and the Pacific, 3: 1-16 7. Sarkar, P. “Growth and Terms of Trade: A North South Macroeconomic Framework” Journal of Macroeconomics, 19 (1997): 117-33 8. Sapsford, David and ren-Chen, John. “Endogenous Technological Progress and North-South Terms of Trade: Modeling on The Ideas of Prebisch Singer on The Lines of Kalecki-Kaldor”, Development Economics and Policy, London: Macmillan (1998): 249-59 9. Singer, Hans. “The Distribution of Gains between Investing and Borrowing Countries” American Economic Review 40 (1950): 473-85 Read More