World Bank Document

5 Managing foreign finance
The previous chapter showed that sound eco- what is the appropriate composition of capital
nomic policies can raise the expected return from inflows and debt?
international borrowing. Furthermore, with adaptable
policymaking and flexible economic struc- Managing the level of capital inflows
tures, countries can also reduce the risks involved
in foreign borrowing. This chapter switches the In a world where all decisions were made by marfocus
from the policies that determine the level ket forces alone, governments would not be
and effectiveness of capital inflows to the manage- involved in deciding how much their countries
ment of the inflows themselves. By the manage- should borrow from abroad. In reality, they are
ment of capital flows we refer to the technical and involved-for two main reasons. First, in most
institutional aspects of organizing the external lia- countries the public sector itself is the largest borbilities
and assets of the nation; its purpose is to rower. Second, the set of prices facing private compick
the best possible combination of risk and panies may be distorted by government policies,
return consistent with the supply conditions in so the private sector may be encouraged to borrow
capital surplus countries.
too much or too little. While private companies can
Effective management of foreign capital is not a be expected to try to ensure that their investments
substitute for sound macroeconomic management; will generate enough domestic currency to repay a
it is an essential part of it. Lending and borrowing loan, the availability of enough foreign exchange is
decisions cannot be made independently of macro- the responsibility of the monetary authorities.
economic policies. Debt managers need a clear
understanding of expected macroeconomic devel- How much borrowing?
opments, while policymakers must have a good
grasp of expected new borrowing requirements Each individual loan must be justified on its own
and debt service payments. Although these princi- merits. But experience suggests that it is also necples
seem obvious, many countries suffer from a essary to pay attention to the aggregate level of
lack of communication between debt managers inflows and debt. The sustainable rate of borrow-
(usually in the Ministry of Finance), reserves man- ing depends on the rate of growth of a nation's
agers (usually in the central bank), and macroeco- income and more particularly its exports. As long
nomic planners (often in the Ministry of Planning). as income is growing faster than the rate of interest
Governments have often treated the level of capi- over the long run, the country is solvent. To minital
inflows as a residual and have framed their fis- mize the likelihood of liquidity problems, it is neccal
and monetary policies independently of their essary for the rate of growth of exports to exceed
effect on the level and structure of debt. A recent the rate of interest-that will ensure that the prostudy
of twenty countries by the IMF found that portion of export revenues required to service the
only one-fifth of developing countries were explic- debt will not continually rise (see Box 4.4).
itly managing their debt systematically. Several A number of rules of thumb have been sugcountries
are now arranging to bring debt manage- gested for managing the overall level of indebtedment
into the mainstream of economic decision- ness-such as the need to limit the total debt sermaking.
vice ratio to 20 percent-but caution must be
This chapter discusses two sets of issues. First, exercised. No simple rule is adequate in all circumto
what extent should governments seek to regu- stances. A country's ability to sustain any particulate
inflows of foreign capital, beyond ensuring lar debt ratio depends on a number of factors
that their economic policies are sound? Second, including the outlook for the country's exports,
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