GOOD DEBT MANAGEMENT PAYS
(Article Reference: Document No.3, January 1993)

EXTERNAL DEBT, PUBLIC FINANCE, AND THE BALANCE OF PAYMENTS
by Jocelyn Horne[1]

Introduction
This paper addresses the basic linkages between macroeconomic policies, in particular, fiscal policy, and a country's external debt situation. The key macroeconomic issue is how to formulate an overall strategy that addresses the problem of external debt yet contains macroeconomic stabilization policies that will allow for sustainable growth. This task is difficult because of the policy trade-offs involved, as discussed below. In general, demand-management policies alone are inadequate and will need support from a wide range of structural reforms, especially in the fiscal area.

Abstracting from issues related to debt relief, the macroeconomic adjustment programs for dealing with external debt fall into two main groups as discussed below; it is assumed that the objective is to achieve external sustainability, defined broadly as the stabilization of external debt in terms of GDP at some appropriate level, and to restore credit-worthiness.

The first group of policies focuses on the numerator in reducing the stock of net claims on the debtor country by effecting a net transfer of real resources through an improvement in the trade balance. The most reliable strategy for achieving this is by making substantial cuts in domestic absorption. This normally entails a tighter fiscal policy supported by monetary restraint with possible real exchange rate depreciation to improve competitiveness. These policies have to be supported by supply-side measures to address issues relating to structural reform. These are the so-called "orthodox" policies that have been followed by many debtor countries with and without assistance from international agencies.

The second group of policies acts on the denominator by increasing output growth to slow down the dynamic process of debt feeding on itself. There are various strategies in this regard, usually involving substantial increases in domestic spending, sometimes with an emphasis on the distributional aspects of inflation with price/exchange rate controls. These are the so-called "heterodox" policies followed by some Latin-American countries in the mid-1980s. The focus of this paper is on the first group but it is apparent that in following either path, there are costs and tradeoffs involved and, it would appear, a somewhat conflicting role for fiscal policy.

The central problem for a debtor country is that if it follows the first route and implements restrictive macroeconomic policies to generate a trade surplus, it may stabilize external debt at the cost of future growth, thereby undermining the initial benefits of the debt reduction. It is necessary to examine policies that can minimize the costs, policies that attempt to manage the currency composition of external debt, and the role of exchange rate policy. Finally it is necessary to ask how the role of fiscal policy can be strengthened.

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Ms. Jocelyn Horne - Ms. Horne has held various teaching positions in her home country and in the United Kingdom from 1976 to 1984. Now a senior economist at the International Monetary Fund (IMF), Ms. Horne is responsible for the formulation of fiscal stabilization programmes for Kenya and Uganda and conducts policy-oriented research on fiscal and macro-economic issues relating to both developing and industrial countries. Ms. Horne is the author of several papers on international and public finance in particular.

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[1] Senior Economist, Fiscal Affairs Department, International Monetary Fund, May 14, 1992. The views expressed are personal and do not reflect any official position of the IMF.

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