•                     a positive net balance on goods and non-factor services trade,

•                     foreign exchange reserves generated by past current account surpluses,

•                     multilateral or bilateral public development assistance 

•                     net private capital inflows

•                     foreign debt forgiveness.

            In the early postwar period the latter two options were not relevant since the Bretton Woods System frowned on private capital flows and kept them to a minimum in the form of short-term trade credits. Countries were encouraged to have hedge financial profiles, with balanced external payments positions and reserves sufficient to act as a margin of safety against fluctuations in earnings. When the cushion of official reserves was not sufficient to meet payments and keep exchange rates from speculative attack, reserves could be supplemented by official lending by multilateral institutions such as the IMF. The majority of such lending was to industrialised countries with balance of payments difficulties caused by internal or external shocks that turned what could be classified as a “hedge” financing profile into a “speculative” profile in which they could not meet payment for current goods and services at the existing fixed exchange rate. In exchange for temporary bridge financing from the IMF, the country agreed to adopt tight monetary and fiscal policies designed to reduce income sufficiently to bring about a fall in imports relative to exports (that were supposed to rise but usually also fell, but by less) in order to produce a reverse flow of resources in the form of a current account surplus that could be used to repay the official lending and replenish reserves. It is clear that such a system carried a deflationary bias since all countries could not have hedge financing profiles unless there was an external source of liquid reserves via a lender of last resort.

            The basic philosophy behind this approach was that a commitment to a fixed exchange rate was identical to the commitment to pay in a timely fashion included in any financial contract so that devaluation was equivalent to a partial default on debt service to non-resident holders of domestic assets. The system was organised on the presumption that on average, over time, countries applying appropriate monetary and fiscal policies to preserve price stability would have a balanced external position and would always be able eventually to meet their financial commitments in terms of foreign currency at their declared par rate. Bretton Woods was a system organised for a world of more or less similar industrialised countries living in a world where “hedge finance” predominated as the norm with individual countries occasionally falling into speculative mode due to an unforeseen internal (excessive wage increases relative to productivity) or external shock (loss of a protected export market), which could be countered or offset by changes in internal (domestic absorption) policies. While the adjustments were implemented the payment shortfalls were met by official lending. It was only in the extreme case of fundamental disequilibrium that exchange adjustments (expenditure switching) were contemplated as a complement to internal adjustment policies.[20] Thus the accumulated stocks of external sovereign debt of most countries remained very low and the majority of international capital flows involved direct investments, for example by American companies setting up operations in Europe before the creation of the common external tariff of the European Economic Community and in Latin American countries, primarily in the areas of natural resource extraction.[21]

            However, after the collapse of convertibility of the dollar in 1971 and of fixed exchange rates in 1973, which is normally considered the end of the Bretton Woods System, default on domestic currency denominated external commitments became acceptable in the form of flexible exchange rates. Thus, this form of default risk which had been born by the multilateral financial system and by national governments in the form of the cost of reserve balances was shifted to the individual lender.  As a result foreign loans tended to be dominated in the currency of the lender. It also brought to an end the role of the IMF as sole provider of international liquidity and with fixed exchange rates no longer the lynchpin of the system, freer international capital flows became increasingly important, first in providing adjustment finance, but more importantly in making it possible to reap the efficiency gains thought to accrue from allowing the market to allocate capital internationally on the basis of highest returns. As already noted, it had long been taught that developing countries provided higher returns because their low domestic savings had prevented them from fully exploiting investment opportunities while developed countries with excess savings faced diminishing returns. Thus overall returns would be increased if free international capital flows allowed developed country savers to access the higher returns available in developing countries, allowing them to borrow to increase their savings and accelerate their investment and growth performance.

    Whether or not the presumption that risk-adjusted returns in developing countries are superior to developed countries is correct, the rise in lending to developing countries in Latin America as petrodollars were recycled, followed by the sharp reversal of US interest rates and the appreciation of the dollar, quickly converted what had been speculative financial profiles of these countries into Ponzi profiles. The initial remedy, which for the developing countries involved was to produce current account surpluses to meet the debt service, and the distressing return of negative net resource transfers, required such substantial declines in income as to produce what came to be called the “lost decade” of growth in Latin America and the risk of political instability. A solution was eventually found in the Brady Plan, which given the rejection of default as a solution accepted the natural response to a Ponzi financing profile, viz. to borrow more to meet outstanding financial commitments. The over-indebted Latin American countries sought to create conditions in which they could attract the additional borrowing required to meet debt service, in particular by finally burying the Bretton Woods preference for official capital flows and opening their capital accounts. The decision was supported by the belief in the increased efficiency that would result from free international capital markets. But, this implied prolonging the implicit Ponzi financial profile. Such a strategy to allow developed country lenders and developing country borrowers to emerge from the crisis was simply to prolong what was on Minsky’s definition “financial fragility” for its success depended on the willingness of lenders to continue to lend. However, the rapid return of financial inflows to developing countries in the beginning of the 1990s noted above hid the inherent fragility and in many circles a new view of development strategy became dominant and deregulated open competitive internal markets and free international capital flows were seen as the necessary and sufficient conditions for a successful development strategy.

4. Policy to stabilise external financing      

Hedge financing profiles for developing countries  

            From the perspective of Minsky’s balance sheet approach financial fragility may be reduced by measures that ensure that firms maintain hedge financing profiles by financial management that insures that exogenous changes in cash commitments are matched by changes in cash inflows to meet them. By analogy, the way to achieve a more stable international financial system is to ensure that developing countries stay as close as possible to hedge financing profiles. This means ensuring that net export earnings are always sufficient to cover their debt servicing needs in every future period. Since net export earnings for developing countries are generally highly volatile due to reliance on a small number of export commodities with highly variable demand and prices, this might involve calculation of the volatility of net exports over a period of time and then limiting borrowing to the amount that generates debt service equal to average net export earnings less a cushion of safety represented by two standard deviations. Reserves could be held to cover all or part of the two standard deviation cushion of safety over debt service.[22]  There is, however, one major difficulty with this approach to stability – stability precludes countries from utilizing net external capital inflows to finance their development! 

5. External Flows as a Sustainable Source of Development Finance

            It is possible to see the difficulties involved in providing hedging mechanisms to produce stability in positive net financial flows from developed to developing countries by reference to the analysis of a similar problem raised in the slightly different context of the appropriate policy for post-war economic recovery in a developed country. At that time development issues per se where not the focus of attention. The majority of what were to become developing countries were not yet independent nations. The major problem of development financing was reconstruction of the devastated productive capacity of the European economies. The major policy concern was the possibility that even those countries that had emerged with their productive capacity intact would return to the pre-war conditions of depression with the returning military combatants joining another army – the reserve army of the unemployed. However the idea of using a Keynesian policy of debt financed public investment was not well received and economists sought other alternatives.[23]

            The US had emerged from the war with a substantial commercial trading surplus as the major supplier for the Allied armies, and a current account surplus due to its position as the major source of war finance. Keynes’s theory of aggregate demand suggested that net exports provided an alternative source of demand enhancement and alternative proposals to ensure post-war recovery involved the possibility of avoiding debt-financing of government expenditure by relying on a permanent trade surplus.[24] Discussion quickly turned to a problem similar to that raised in objection to debt finance in the form of the accumulation of interest on the foreign lending that would be required to support a permanent commercial surplus. Maintaining a constant trade surplus (or trade surplus as a share of income) would require capital outflows in the form of foreign lending of an equivalent amount (or share of income), given reserves and exchange rates. But, the foreign lending would soon generate return flows of interest and profits remittances which would create a surplus on the factor services balance of the current account. In the absence of any change in the amount of capital outflows the trade surplus would have to shrink to accommodate the increased factor services balance. Alternatively, foreign lending would have to rise each year by an amount sufficient to cover the increasing earnings from interest and profits. In the former case the trade balance and the impact on demand would disappear, in the latter an ever-increasing capital outflow would be required.

            Domar, recognising the similarity with his earlier argument on the sustainability of debt-financed public investment, provided the answer that again turned on the interest rate. As long as capital outflows increased at a rate that was equal to the rate of interest received from the outstanding loans to the rest of the world, the inflows created on factor service account by the interest and profit payments would just be offset so there would be no net impact on the trade balance. On the other hand, if interest rates were higher than the rate of increase in foreign lending the policy would become self-defeating and the trade balance eventually become negative to offset the rising net capital service inflows. Eventually the continually rising factor service flows would turn the trade balance negative.

            At the time the discussion was not concerned with the impact of the US policy on the rest of the world – the idea was to find a way to full employment that did not require domestic borrowing. Foreign lending seemed clearly favourable to domestic borrowing on both political and economic grounds. Few recognised that this policy was precisely what would be required if the developed world were to provide the finance for the developing world – positive net resource flows from developed to developing countries -- that has been the basis of development policy in the post-war period. Reversing Domar’s analysis allows analysis of this problem, but now from the point of view of a developing country as the recipient of the foreign lending.

            Foreign capital is required to finance the excess of imports of necessary consumption goods and capital goods over exports required for the development plan – these are the positive net resource flows encouraged by policy. A development strategy based on external financing implies a trade deficit balanced by foreign capital inflows. But, the obverse of the argument for a developed country says that the deficit on goods trade will soon generate debt service payment outflows that cause the current account deficit to increase unless the trade deficit is reduced to accommodate a fixed level of capital inflows. Alternatively, capital inflows would have to rise to accommodate the rising current account deficit caused by the increased payments on capital factor services account for any given goods account deficit. Following Domar’s argument for developed countries, it is only possible to maintain a development strategy based on net imports financed by foreign capital inflows if the interest rates on the foreign borrowing are equal to the rate of increase of foreign borrowing.  If interest rates are higher than the rate of increase of inflows, just as in the case of a developed country seeking to preserve full employment through a permanent trade surplus,[25] the policy will eventually and automatically become self-reversing as the current account becomes dominated by interest and profit remittances that exceed capital inflows.[26]

            It is important to note that increased exports will do little to eliminate this problem. For example, in the case of a fixed level of capital inflows a rise in exports to offset the rising debt service will reduce the net trade deficit and thus the net resource inflow available to finance development. The same will be true if exports rise to meet the excess of capital remittances over increasing capital inflows, for this will also lead to a reduced deficit on goods account.

            With respect to the stability of the financial system, it is interesting to note that the Domar conditions for a sustained long-term development strategy based on external financing, on sustained positive net resource transfers are the precise equivalent of the conditions required for a successful Ponzi financing scheme.  As long as the rate of increase in inflows from new investors in a pyramid or Ponzi scheme is equal or greater than the rate of interest paid to existing investors in the scheme there is no difficulty in maintaining the scheme. However, no such scheme in history has ever been successful – they are bound to fail, eventually by the increasing size of the net debt stock of the operator of the scheme. The historical conditions in which developing countries have been able to benefit from such conditions have been extremely rare – aside from the early 1970s[27] and the early 1990s – and certainly do not prevail in current private international market conditions where risk premium alone are several multiples of domestic growth rates.

            In actual practice it is highly likely that capital inflows will start to fall off as the current account deficit increases beyond some threshold level, currently considered to be around 4 per cent of GDP[28] and quickly create crisis conditions in which official support is necessary in the form of an official financing. The resolution of the crisis caused by the breakdown of the Ponzi financing scheme is the generation of a negative flow of real resources that is sufficient to generate the external surpluses necessary to resume debt servicing on its private debt and to repay the official lending.

            Just as a permanent current account surplus financed by a permanent increase in foreign lending at interest rates higher than the rate of interest on the lending did not provide the US with a permanent full employment policy, external financing cannot provide developing countries with a permanent development strategy unless the rate of increase of export earnings is equal to the rate of interest on the outstanding debt.[29] However, when the foreign borrowing is not used for expenditures that create net foreign exchange earnings (it makes little difference if this is domestic infrastructure investment, or purchase of basic or luxury consumption goods, or military equipment) it means that the country’s development planning is subject to maintaining the steady rate of increase in capital inflows and becomes hostage to international financial markets. Any external event, which causes inflows to change, will create domestic instability and require domestic adjustments to reduce dependence on external resources, usually leading to financial crisis through failure to meet financial commitments. At the same time, in order to make foreign lenders confident in the country’s ability to meet foreign commitments, policies that enhance the short-term ability to pay, such as building up foreign exchange reserves or reducing external dependence by reducing domestic growth to produce a stronger export performance and fiscal balance will be implemented. But, these policies are also self-defeating, since they either reduce the capital inflows that can be maintained on a permanent basis, or reduce the growth of per capita incomes.  External financing as a permanent source of development financing is thus a two-edged sword that must be managed judiciously if it is to contribute to development rather than becoming a source of persistent financial instability and crisis.

            It is important to note the relation between a policy of development from without based on external financing and the debt problem. Just as Domar’s original analysis was designed to find the conditions under which the ratio of debt to national income would stabilise, the analysis of external lending was designed to find the conditions under which the ratio of the current account to national income would stabilise. However, as noted, the stability of the ratio means an ever increasing absolute amount. The ever-rising absolute amount of foreign lending translates into an ever-rising amount of external debt for developing countries whether interest rates are equal or below the rate of increase in inflows. Thus the fact that such policies represent a de facto “ponzi” financing scheme which creates financial fragility that produces crises and/or reverse resources flows which damage growth is then just a different way of explaining the fact that large external debt burdens tend to have a negative impact on developing country growth.[30]

            In the early post-war period when official external financing occurred at low interest rates, the Domar condition was probably met[31] and external financing was a viable long-term strategy and the stress on increasing the flow of official assistance and public funds was appropriate. When the majority of financing shifted to private markets in the early 1970s at negative interest rates with rising flows the strategy was also viable. However, when international interest rates and dollar exchange rates reversed in the late 1970s, the policy was no longer sustainable and financial crises became prevalent.

6. The Implications of External Flows as a Ponzi Financing Scheme for Development Policy

            The implications of the argument concerning the sustainability of external flows should be interpreted carefully. There are three possible general cases.

Case 1 Rate of Interest on Foreign Borrowing Exceeds Rate of Increase of Capital Inflows:

Domar’s argument is made on a comparison of unchanged rates of change over time. On this basis it is possible to conclude that whenever the assumed constant servicing rate on foreign borrowing over time is above the prevailing and assumed constant rate of increase of inflows the borrowing country will experience continually rising external debt stocks and an eventual crisis and reversal of net resource flows that may lock the economy into a low-level debt trap. A sustained development policy based on external capital is not viable in these conditions.

Case 2 Rate of Increase of Capital Inflows Equal or Greater than Rate of Interest on Foreign Borrowing:

On the other hand, even if the Domar sustainability condition is met and the assumed constant servicing rate is equal or below the assumed constant rate of increase in capital inflows, it will still be true that external debt stocks will rise continuously and the borrowing economy will be subject to increasing financial fragility and financial crisis since a small internal or external shock that causes an increase in its net goods account deficit through either a falloff in export volumes or prices, or an increase in export volumes or prices. Or a reduction in the rate of increase in capital inflows or an increase in the rate of interest on foreign loans will cause reversion to Case1

Case 3 Rate of Increase in Capital Inflows and Interest Rates Vary Over Time:

Indeed, the normal case is for both the rate of debt servicing and the rate of capital inflow to be highly variable. Capital surges can bring about sharp increases in inflows that increase the rate of increase in inflows above the servicing rate, but that bring about bunching of repayments in the future and create large accumulation of non-repatriated profits that can be rapidly reversed when capital flows fall off to rates below the servicing rate and aggravating the reversal of resource flows. These fluctuations will be aggravated if the tenor of lending is particularly short term, as this will increase the variability of both the rate of increase of inflows and the variability of the rate of interest.

For Case 1 it is clear that the problem lies with the disparity between the rate of interest and the rate of increase of capital inflows and can be remedied by action to reduce the former or increase the latter. It is interesting that the period of greatest success of external financing occurred when international capital flows were intermediated by the multilateral financial institutions at preferential interest rates and long maturity or through grants-in-aid. However, the international financial system and the reform of its architecture seem to have consistently moved away from this framework to restore a system of private financial flows at market rates which are generally believed to have caused the international system breakdown the repetition of which these institutions were created to prevent.

For Case 2, where strategy is sustainable the basic problem is to implement a policy of transition which allows the use of the positive resource flows to create domestic productive capacity that allows the borrower to grow at its maximum potential rate without pushing the economy into financial crisis. In order for a development policy based on external flows to be successful, the external resources would have to be dedicated to the creation of a competitive industrial sector[32] to increase manufactured goods exports, allowing increased total imports for a given rate of capital inflow and eventually allowing exports to shift to covering debt service, allowing the rate of capital inflows to decline pari passu until the current account went into deficit, external debt was fully repaid and the country became a capital exporter with reverse capital flows.  However, with free international capital markets a smooth transition of this nature is unlikely since success makes the country a more attractive and a less risky investment destination so there will be a tendency for flows to increase, making some sort of controls necessary. The goal is to reach an end state in which net export surpluses of goods and services are sufficient to repay foreign borrowing. This policy must thus have as components a policy of export promotion, as well as a policy of controlling the rate of increase of foreign borrowing and ensuring that the tenor of the borrowing is the same as the length of the development plan. Thus policies to increase the maturity and repayment structure of the lending may be as important as policies to ensure low interest rates.

            The alternatives would be for foreign investors to automatically reinvest interest and dividends[33], or to avoid the use of fixed interest rate instruments. Domar suggests that “The simplest and most obvious remedy lies not in abstaining from foreign investment which the world needs badly, but in reducing the interest rate on public lending to a minimum consistent with the preservation of international dignity; surely we don’t need the interest as income” (Domar, op.cit., p. 133). In his Report to the First UNCTAD Conference Prebisch suggests the creation of a fund to provide “compensatory finance” which would be in the form of non-interest-bearing grants in amounts calculated to compensate countries for their terms of trade losses. [34]

Another alternative, given by Ohlin, is to recognise that deregulated open competitive internal markets and sustained international capital inflows are neither necessary nor sufficient conditions for a successful development strategy. He notes that there is “sometimes an indignant presumption that there should always be a net transfer to developing countries in order to help them to import more than they exported. Behind this presumption there is the old idea that countries in the course of their development should be capital importers until they mature and become capital exporters. This, however, does not mean that they should receive positive net transfers, borrowing more than they pay in interest and dividends. ... If export performance and the returns on the use of foreign resources are adequate, foreign debts and investments can be serviced without the aid of new loans.”[35]

For Case 3, which is in fact a simple extension of Case 2 to real world conditions, the policy must be to try to maintain the Domar sustainability conditions of Case 2. For sharp surges in inflows this may require controls on inflows or an attempt to restructure repayment profiles to eliminate bunching. For sharp reversals in flows some sort of developing country lender of last resort would be required in order to smooth the rate of increase of inflows over time. The Conditional Credit Line of the IMF went some way towards meeting this goal, but its conditions were not conducive to use and it has been abandoned.  Given the increased reliance on external financing and private financing, the importance of international liquidity to smooth over volatility has become increasingly important at precisely the time when these institutions willingness and ability to provide such liquidity has been sharply reduced and what is provided is now provided at market rates and additional conditionality. In most financial systems the discount window of the central bank was not only a source of liquidity to institutions in liquidity difficulty but at rates that were clearly below market since there was no market borrowing available. As a result, fluctuations in inflows have increasingly been transformed from liquidity to solvency problems. The shift from multilateral lending to private lending has thus reduced liquidity, increased interest rates on both normal flows and distress borrowing flows, and thus increased the financial fragility associated with international borrowing.

The present analysis also suggests that the Bagheot principle that last resort lending should be at penal interest rates to encourage domestic solutions should not be extended to the case of countries experiencing volatility in external flows since it defeats the purpose of development based on external finance by pushing a country back towards Case 1.

For declines in export volumes and prices, there are well-known remedies that have been discussed since the United Nations Conference on Trade and Employment in Havana and the first United Nations Conference on Trade and Development, including developed country policies to ensure full employment of their economies, commodity price stabilization schemes, import targets for developing countries, non-reciprocal trade concession, preferences for developing country exports, regional preferences among developing countries, and compensatory finance to offset losses in the purchasing power of exports due to declines in the terms of trade. For increasing import volumes, some control on the direction of the net resource inflows to ensure the positive transition mentioned for Case 2 is achieved may be required, while compensatory finance covers the losses due to rising import prices.

            The Sovereign Debt Restructuring Mechanism (SDRM) arrangements currently under discussion, and the collective action clause (CAC) stipulations that have been included in several recent sovereign bond issues subject to New York legal adjudication, provide for resolution when lenders have decided that a Ponzi scheme cannot be continued, but the point of creating a financial environment in support of development should be to create mechanisms that shield against a country from having a “Ponzi” profile create financial crisis. This will require that countries have some control over the amount of capital that enters the country and its tenor and performance conditions, as well as recognising that a development strategy built solely on foreign lending is a Ponzi scheme that cannot succeed on a long-term basis any more than full employment in the post-war US could be built on continuous capital outflows and export surpluses.