Debt Management Together And Macroeconomic Policies Finance Essay - Free Essay Example

Sample details Pages: 11 Words: 3373 Downloads: 7 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? Debt management together with macroeconomic policies are two key elements which could be used to determine a countries ability to sustain external debt. This paper seeks to highlight the aspects of external debt and how OECS countries could use debt management as a means to create a stable economic environment. Every country in the world engages in some form of external borrowing as they seek to increase consumption and productivity. Countries borrow for various reasons and also engage in different types of borrowing. With borrowing comes market risk which is arises as a result of foreign exchange risk and commodity price fluctuations. There is not instrument to measure such risk but hedging could be used as a means to control and reduce risk (Jayaraman Laub, 2009). Don’t waste time! Our writers will create an original "Debt Management Together And Macroeconomic Policies Finance Essay" essay for you Create order International, regional as well as domestic institutions are those who make funds available so that the government could sustain a large current account. Institutions such as the IMF and World Bank have sought to help countries manage debts with the use of structural adjustment policies which have been proven to be both detrimental and effective. The country analysis will show that over the years the external debt of various OECS countries had increase significantly because of natural disasters and poor implementation of debt management strategies (Rowden, 2001). This paper also seeds to provide recommendations that are very essential for effective debt management. Countries before implementing should assess their current position and decide which strategy works best in what situation. Introduction External debt servicing is a problem that has plagued OECS countries for the past few years. The factors that contribute to the inability to service external debt are numerous. In some instances problems arise as a result of a countrys inability to control and use borrowed funds efficiently. Problems may also arise due to the fact that the return on investments is insufficient to make debt repayments. The use of inadequate debt management policies has lead to growth of external debt which increases the countries possibility of default. However, some problems (such as the US financial crisis that affected nearly the entire world) are beyond the control of the borrowing countries (Economic Commission for Latin America and the Caribbean, 2010). OECS countries in recent times have faced high unexpected growth in the repayment of external debt. The fluctuation in exchange rate, trade policies (such as tariffs), and terms of trade have lead to a trade imbalance which is where imports exceeds exports. The ability of the commercial institutions to finance government expenditures had reduced as a result of the current financial crisis. Therefore, in order to sustain the huge current account governments have to seek financing externally. Generally countries that experience problems with debt- servicing resort to debt rescheduling which results in a further increase of cost. Establishing credit worthiness in the international market is not as easy as tarnishing it. Therefore, countries need to manage external debt effectively with the use of practical macroeconomic policies (Loser, 2004). This paper seeks to highlight the main aspects of external debt and the ways in which OECS countries could engage in effective debt management practices. External Debt External debt otherwise known as foreign borrowing could be defined as debt owing to creditors outside the country which forms part of a countrys total debt. The debtors of the OCES range from corporations, governments and also private households while the creditors range from governments, commercial banks and international lending institutions, like the International Monetary Fund (IMF) and the World Bank (Rowden, 2001). Foreign borrowing is important because provides a country with the ability to increase consumption and investments beyond the limits of its current domestic production. It also provides the ability to fund capital formation not only by collecting domestic savings but also by tapping into the surplus saving of other countries with low interest rates (Klein, 1997). Countries engage in foreign borrowing for reasons such as: import financing; economic problems; commodity price variations; increase production; and vulnerability. Countries such as Grenada which suffers from a significant trade deficit would normally seek to borrow from financial institutions to finance imports. Also, foreign debt could arise as a result of major economic shocks. For example, if the Eastern Caribbean Central Bank (ECCB) increases interest rates then automatically the interest rate on any external debt that any Eastern Caribbean country would increase. This would lead to reduce availability of money in circulation, hence giving rise to an increase in the value of local currencies. Exports would decrease because it is now more costly, forcing the country to borrow to cover its imports. In addition, in the event of a serious shock in commodity prices such as oil, a countrys economy could end up in a helpless position in which the country would have to borrow to import less costly good or use the option of subsidizing the cost of the now expensive goods. Countries also borrow to increase production to enhance economic growth. Once the debt is injected into the productive sectors, the debt could be easily repaid and as a result could lead to trade surplus. In addition, countries borrow in order to obtain security. Countries such as Syria and Israel are both indebted to the US and Russia respectively. Most of these countries debt goes into obtaining military supplies to protect their countries instead of to their productive sectors (Loser, 2004). OECS governments engage in various types of debts, all of which has to be paid either now or sometime in the future. They include: export credits (loan intended to finance purchase of goods and contractual services); international bank loans; issuing of bonds; foreign direct investments; grants (contributions made by generous private non-government organizations such as Food and Agricultural Organization (FAO)); and equity investments (includes offering of stock outside youre a country) (Klein, 1997). In order to service long- term and short-term external debt governments of the OECS generally implement policies (such as increase taxes). A high tax rate reduces FDI who normally enjoy tax breaks from low tax countries. A reduction in FDI would reduce government revenue and spending because FDI contributes significantly to a government current account (Abel, Bernanke, Croushore, 2010). Locally businesses would now seek to save more and invest less while consumers who patronize theses business would consume less and also save more. A reduction in income means that governments, business and private individuals are not able to invest in the financial markets. This could also lead to reduce economic activity which would push governments to borrow more externally to stimulate economic growth (Abel, Bernanke, Croushore, 2010) . International Lenders OECS countries borrow externally from international institutions such as the IMF, the World Bank and other commercial banks round the world. Emphasis will be place on the IMF and the World Bank. These two institutions were created in order to help with capital and currency shortages. OECS countries turn to the IMF to obtain short term loans to finance difficulties with balance of payment while finances form the World Bank are used for development (infrastructural development such as building of water dams). To guarantee that debts are serviced, the IMF and the World Bank have implemented polices for structural adjustments that must be adhered to in order for member countries to obtain finances (Third World Traveller, n.d). Do the policies for structural adjustment of the IMF and the World Bank help the OECS in any way? The answer to this question is no. These policies have crippled the agricultural sector, cause environmental destruction and also increase poverty among the OECS countries. Jamaica is a typical example that could be used as references when the effects of the policies of the IMF and the World Bank are discussed. The detriments may not be visible to countries such as ST. Lucia and Grenada but it does exist and if the level of external debts keeps rising, then it will become visible enough to actually feel the effects (Rowden, 2001). The various policies implemented by the IMF and the effects on developing countries could be found in Appendix 1. Risk Foreign exchange, interest rate, commodity price and market price are all types of risks if attention is not paid to could cause a government to plunge more into debt. As the number of currencies used in international trade increases; sensitivity to cross-currency exchange risk also increases when servicing of debt in terms of dollars. For borrowing countries, exchange rate risk has become a major problem as currencies fluctuate against each other. An increase in exchange rate risk would mean that the debt amount would also increase (Moffett, Stonehill, Eiteman, Fundamentals fo Multinational Finance, 2009). The majority of floating interest rate debt especially from commercial banks has abruptly exposed countries to huge movements in money market rates and balance of payment (BOP) shocks, which contributes significantly to the debt management problems of a country. With the increase in reliance on commercial banks as a source of financing, the possibility exists that interest rates will increase (Moffett, Stonehill, Eiteman, Fundamentals of Multinational Finance, 2009). In recent times, volatility for developing countries that rely on exports of commodity as a main source for foreign exchange earnings has increased as the price of commodity increases. The volatility of commodity price has been a common cause of instability in developing countries. Market based price risk arises as a result of the fluctuation of exchange rates, interest rates and commodity price. Instruments used to manage market based risk causes the price risk to shift to the dealers and further consumers externally. There is no instrument used to control the volatility of interest rate, exchange rate and commodity price. However, hedging could be used against adverse fluctuations that are unanticipated (Moffett, Stonehill, Eiteman, Fundamentals of Multinational Finance, 2009). Debt management Before attempting to seek financial assistance the countries of the OECS need to seek answers to the following questions. How much to borrow? The amount of debt that a country accumulates is basic policy decision which is determined by the level of judgment and skills of the individuals making it. In order to determine the amount to borrow the OECS countries need to take the following two factors (which are determined by economic management) into consideration. First, the country needs to know the amount of capital that its economy could absorb. Secondly, in order to avoid problems with external payment, the amount of debts that can be serviced needs to be taken into account (Klein, 1997). Is borrowing in excess? Most of the OECS countries excessive borrowing is as a result of poor and inappropriate fiscal policies. The many tax breaks which are often given to foreign investors result in not only reduction in government revenue but also becoming a magnet for inappropriate Foreign Direct Investment (FDI). Reduction in revenue, results in a weak tax base which generally causes inflation which together makes it harder to generate revenue and increase returns on FDIs. This is because of poor allocation of resources, the tendency to export reduces, and little factor utilization. Governments would now seek to borrow externally to invest in the public sectors such as tourism and agriculture (Klein, 1997). Inflation combined with inappropriate fiscal policies and trade policies that are highly protective could lead to the exchange rate being overvalued, which would increase the overall demand of borrowing externally (Klein, 1997). Debt Monitoring The OECS countries need to engage in better debt monitoring practices in other to have a better understanding of the amount of debt received and how it is disbursed. The following are useful ways of monitoring a countries debt. Firstly the general accounting principles of the World Bank needs to be applicable in all of the OECS countries especially when preparing loan report for finances borrowed from the World Bank. Secondly the debt accounts need to reflect the governments budgetary balance with external borrowing. Also the debt account should be reconciled with the interest payments shown in the current expenditure of the government. Thirdly, all debts paid throughout the state need to be managed by a special unit in the Ministry of Finance (Greenidge, Drakes, Craigwell, 2010). The disbursement of the finances must be kept up to date and prepared by each sector. Fourthly, all accounting records must be computerized and backed up on a daily basis. This would enable quick access to any record and in the case of emergency (hurricane) the data which has been backed up and safely stored could be retrieved. Fifthly, the central bank and the government has to have close collaboration in order to monitor debt payments and from time to time reconcile their individual accounts to detect and correct discrepancies. Although the treasury maintains the consolidate accounts (income and expenditure) of the country, its records must also be reconciled with the other sectors (Greenidge, Drakes, Craigwell, 2010). Debt Management Institutions The institution used to manage debt could be found within the administrative structure of a government. Statistical, control and external financing units are the three groups needed to manage debt. They work together to ensure that information gathered on the countrys total debt is timely and accurate to determine whether the country is capable of absorbing more external debt and identify the appropriate types of borrowing (Klein, 1997). Country Debt Analysis Grenadas external debt increased by approximately 67.3 percent from the year 2004 to 2009 although record from previous years revealed that the rate of growth slowed down. This was mainly as a result of government seeking alternative finance sources that was cheaper. After the passage of hurricane Ivan, external debt increased significantly compared to the years 2001-2003. In 2005 47.2 percent the public debt was restructured causing Grenada to save millions in interest payments. In 2006 90 percent of Grenada debt service to the Paris Club was rescheduled upon the Paris Club agreement. In April of 2006 Grenadas arrangement under the Poverty Reduction and Growth Fund (PRGF) was approved by the IMF. Grenada got additional debt relief from the Paris Club in 2009 (Ministry of Finance, 2010). As a result of lending from the World bank and the IMF Grenadas external debt increased in 2009 by roughly 7.3 percent which was an increase of 1.2 percent from 2008 which was a result of the disbursement for finances from preceding loan. Grenadas external debt increased by approximately 4.4 percent reflecting the sum of EC$ 1.35 billion because of the public investment Programme (PSIP) (expansions of the public sector such as repair done to schools and infrastructural development for the preparation of Cricket World Cup in 2007). Interest payment made on external debt increased slightly from EC$ 21,830,823 in 2007 to EC$ 27,294,405 in 2009 and have already made payments of approximately EC$ 13,086,627 for the first quarter of this year. Total interest payments increase by 29.1 percent as the interest payments for the Paris Club rescheduling was outstanding (Ministry of Finance, 2010). St. Lucia The external non-guaranteed debt decrease by 14.3 percent and 62.9 percent respectively, at the close of 2009. As a result of keeping with the debt management strategies the foreign exchange risk faced by the central government external debt was minimal. A total of 76.2 percent of the central government external debt faced no foreign currency risk because more than half of the 76.2 percent were US dollars denominated while the remainder was in Easter Caribbean and Barbados dollars. However debt was contracted in Euros and British pound sterling in the amount of $50.1 million (Ministry of Finance, 2010). In addition to borrowing from regional development institutions St. Lucia also borrowed $28.9 million from the Exogenous Shock Facility of the IMF. The concessionary interest on multi-lateral loans increased by 14.2 percent, of which, 68.4 percent was accounted for by the central government external debt. 23.1 percent of the debt contracted by the central government external debt was funded by the World Bank and the IMF. External debt is expected to increase significantly as the government intends to seek funds to aid with the reconstruction of infrastructure which was damaged as a result of the passage of hurricane Tomas (Ministry of Finance, 2010). Conclusion The purpose of debt management policies is to resist macroeconomic and balance of payments instability, while attaining maximum benefits from external borrowing. In order to service debt on new borrowings countries must ensure that the level of productivity as well as export increases. Countries that are greatly indebted are prone to severe macroeconomic shocks which would lead to severe cuts in consumption and investments. Growth is the one of the most important factors that determines creditworthiness, but a country must take into consideration those investments that are either successfully or poorly done decides whether growth will take place. It is better to not borrow at all than to invest and borrow badly (Sachs, 2001) . The cost of external borrowing is not only as a result of interest rates, but with each loan, the borrower is hard-pressed closer to its ceiling point, which is actually an additional cost to real interest charges. They also need to take into consideration all the risk which could be managed through hedging (Sidaoui, 2000). Therefore those responsible for macroeconomic policies such as the Finance Ministry within a country should pay specific attention to the relationship involving foreign borrowing, investments and growth. They must ensure that the projection for assessment is practical as it relates to the effects of any investment on the public and private sector. Also, a countries ability to repay their debt must be assessed before making any further borrowings (Sidaoui, 2000). Recommendations Before any government engages in any form of external borrowing they must first take into consideration the following: ensure that they have a plan as to how the funds received will be repaid and the implications of acquiring such debt on the implementation of future fiscal and monetary policies. OECS countries should seek to implement macroeconomic policies that are practical which would help to control inappropriate and excessive borrowing. Also, the effects of external volatility would decrease whereas reserves would increase. Stringent measures should be taken to ensure that finances received from external sources be used efficiently and invested in areas that have the potential to grow and increase revenue and foreign currency which could be used to service external debt. The procedures for debt monitoring (for example preparation of account by each sector) and the follow up must be transparent. In order to avoid the implementation of tough adjustment policies, OCES countries need to secure some form of financing that they could depend on in the event of a short-term financial crisis. OECS members should strive to create an environment that is conducive in order to encourage more long term investments by developing their financial system. A developed financial system wou ld help markets in the area of risk management. OECS members need to avoid depending on short term external borrowing and seek to secure financing on a long term basis. Countries need to keep enough foreign reserves which could be used to provide insurance in the event of negative externalities. Foreign reserve portfolios should be managed effectively paying particular attention to the fluctuation of major currencies which normally contributes to foreign exchange risk. Countries should find alternatives to decrease the burden of expensive debt and implement strategies to reduce the need of wanting to borrow externally. Debt should be monitored regularly with the aid of suitable tools, such as debt sustainability analysis which would assist I reducing and maintaining the debt burden and keeping it at a sustainable level. Data relating to debt and is various disbursements has to be computerized so as to increase efficiency and timeliness of information. The governments should ensure that data relating to debt is transparent and meets the international standards. Members of the OECS have to provide support for each other in the event that any member has difficulty in raising capital on an international basis. Members should also work together with the Eastern Caribbean Central Bank (ECCB) to strengthen the bond market. The debt management systems within the OECS should be improved as fast as the economic environment evolves. The governments of the OECS could seek alternative sources of financing that does not require any repayment. For example, the investment and educational ties with China could be strengthened. Since we have strong ties with the US, the Bill and Melinda Gates Foundation could be used as an option to help fund the repairs and construction of schools. The governments could also seek the return of ex-patriots to invest and build in the OECS countries.