Class 13 and class 14

The themes are: > Measuring Investment Needs for the Economic Growth of the Developing Country, > Relationship between the Development Budget and the Balance of Payments for Foreign Deb

Class 13 and Class 14 Three Analytical Themes on Development Finance

Financing development can be partly understood by analyzing particular themes to which development practitioners might have been seeking answers In our present lecture, three such themes are briefly analyzed below

The themes are:

> Measuring Investment Needs for the Economic Growth of the Developing Country, > Relationship between the Development Budget and the Balance of Payments for Foreign Debt Management, and

> International Capital Needs/Availability for Economic Development of the Third World

　The following analyses simply ‘scratch’ the surface On the other hand, such analyses suggest that they would become excellent research themes for future theses and dissertations, once analytical methods are further elaborated and empirical analyses are carried out after collecting statistical data

1 Measuring Investment Needs for Economic Growth of the Developing Country (1) Economic Growth and ICOR

The relationship between economic growth and ICOR is, in its simplest form, expressed in the equation as follows,

∆Y/Y = I/Y ÷ I/∆Y (or ∆K/∆Y) - (1)

where ∆Y/Y is Economic Growth Rate, I/Y is Investment Ratio and I/∆Y

(or ∆K/∆Y) is ICOR

This equation implies that ICOR as well as the investment ratio play an important role in promoting economic growth The higher the ICOR becomes (other things being equal), the lower the economic growth rate becomes And, the higher the investment ratio becomes, the higher the economic growth rate becomes (other things being equal)

In developing countries, considerable attention and importance is given to ICOR when analyzing economic growth There are at least two major reasons One is that scarce capital is often the determinant of economic growth while labor tends

to be supplied in excess (on the contrary, in developed countries labor sometimes

becomes the restrictive factor in determining economic growth because of population decrease) The second reason is that it is often quite difficult to analyze the production function where three factors of production (capital, labor and TFP) are involved, as reliable data are not available

The view above suggests how important it is to investigate investment in analyzing economic development in developing countries Let us, then, analyze a specific investment need to attain a certain level of economic growth by a simple case study by manipulating the equation (1)

The equation (1) is re-written by introducing a time-lag factor as follows (Yt – Yt-1)/(Yt-1) = (It)/(Yt-1) ÷ (It)/(Yt – Yt-1) - (2)

Let us further assume that GDP in the year of t-1 is US$120 billion In order to

attain an economic growth rate of 6% {Gt = (Yt – Yt-1)/Yt-1}, namely to attain

$127.2 billion, on condition that ICOR does not change from the previous year at 4.5, investment has to reach $32.4 billion (therefore, the investment ratio in the year of t is 27%) in the year t

Similarly, if an economic growth of 6.5% in the year of t+1 with ICOR of 4.5 is

desired, investment in the year of t+1 has to reach US$37.21 billion (the investment ratio is 29.3%) The fact that ICOR stays constant at 4.5 and the economic growth rate increases from 6% to 6.5% implies that a considerable increase in investment is needed Further, if we want to achieve an economic growth rate of 6.5%, in the year of t+2 with ICOR {It+2/(Yt+2 – Yt+1)} of 4.2 (improved from previous 4.5 to 4.2), investment in the year of t+2 has to reach US$36.98 billion (a decrease of US$0.2 billion, and the investment ratio 27.30%) The fact that ICOR is improved from 4.5 to 4.2, while the aimed economic growth rate remains constant at 6.5%, suggests that investment does not always need to be increased As a matter of fact, the amount of investment in year t+2 decreased slightly from that of year t+1 owing to the improvement of ICOR

The above equation (2) enables us to project economic growth rates and trends based on past economic performances In other words, once the GDP, investment and ICOR are obtained on the basis of past economic performances, we can project future economic growth for economic development planning Table 1 below shows what is discussed above more comprehensively over 4 years

(Read Reference 1 Singer, H.W “Is Development Economics Still Relevant ?”, and comment on its contents.)

Table 1 Economic Growth and Investment Unit:　billion

(2) Public Sector Investment and Funding

Investment is broadly divided into two kinds; public investment and private investment The equations above include both public investment and private investment In other words, “I” denotes the total investment of both public and private As far as public investment is concerned, the government determines its level when the budget is prepared on the basis of the economic growth target and the assumed division of labor in investment The simplest way of setting a level of public investment is to divide the country’s required annual investment on a pro rata and historical trend basis

Once a level of public investment is determined, the government needs to secure its sources The government generally finances its investment expenditure domestically through tax revenues and domestic government borrowing If these two measures suffice the investment expenditure requirement, the need to procure funds from abroad both or either in the form of loan and/or grants does not exist Generally speaking, however, developing countries plan ambitiously to attain a high economic growth in spite of budgetary constraints They then turn around to request industrialized countries and multilateral aid organizations to supplement their financial shortages through ODA, OOF and PF The developing countries, as

a matter of course, prefer and seek softer conditioned funds from abroad such as ODA

In addition, it should be noted that a large number of developing countries have long made it a rule to integrate foreign financial assistance into annual budgetary procedures

(3) The Case of REPELITA VI and Its Economic Growth Targets (Economic Growth Rate, ICOR and Investment Ratio)

The Government of Indonesia set forth economic growth targets in the REPELITA VI (1994~1998) plan as shown in table 2 Those targets suggest that the Indonesian Government, in an attempt to attain the economic growth rate of 6.2%, put special emphasis on maintaining its investment ratio at a 27% or 28% level and to improve investment efficiency by reducing ICOR from 4.5 (1994) to 4.3 (1998) High economic growth and the stabilization of the external balance of payments are twin macroeconomic objectives However, if the economic structure remains unchanged, these objectives are antinomic to each other High economic growth requires high investment and high investment results in considerable foreign borrowing, which in turn deteriorates the external balance of payments It is evident that REPELITA VI tried to avoid this antinomy by improving investment efficiency through a more efficient economic structural change

It is, however, generally evidenced that ICOR deteriorates (increases) temporality at the stage of “the pre-conditions for take-off into self-sustaining growth” as public investment in new and renewal economic infrastructure considerably increases In order to decrease ICOR, the government has to continue its policy reform efforts

to create a more efficient economic structure through deregulation, market liberalization and so on

Table 2　REPELITA VI and Macroeconomic Targets

ICOR Investment Ratio

(%)

Economic Growth Rate (%)

2 Relationship between the Development Budget and the Balance of Payments for Foreign Debt Management

(1) Foreign Borrowing in the National Budget and Debt Repayment (Debt Service) (i) State Budget System of the Developing Countries

The budget system in developing countries often consists of the “Development Budget” and the “Routine (or Recurrent) Budget.” Needless to say, the budget system has two sides for each budget, revenue and expenditure There are, of

course, many developing countries whose budget system is characterized as one united budget, not two types of budgets This is increasingly true recently as the mid-term expenditure review methodology has been widely introduced in developing countries Indonesia, too, abandoned the traditional two-budget-system several years ago Even for the budget system which is not divided into two, we can conceptually sort out the above discussion as shown in figure 1 below

The domestic routine expenditure is intended to be used for the fixed annual expenses and, therefore, it has to be spent every year, while the development expenditure (domestic development expenditure and project aid expenditure) is intended to be used for investment on the part of the government (public investment) to achieve, say, 6% of country’s economic growth As figure 1 below indicates, the project aid expenditure, which is equal to the project aid revenue, is foreign capital inflow (loans and grants) that is to supplement the domestic development expenditure which aims to attain, for example, an economic growth

of 6% (Refer to the Two Gap Model)

Figure 1 Structure of Budget System of Developing Country

(ii) State Revenue and Development Revenue ~ with an Interest in Indonesia~

The breakdown of state revenues of Indonesia in 1997/98 is shown below

Revenues (in billion rupiah)

a Domestic Revenues Rp 88,069.7

① Oil and gas revenues Rp 14,871.1

② Non-oil and gas revenues Rp 73,198.6

 Income tax Rp 29,117.1

 Value added tax Rp 24,601.4

 Import duties Rp 3,321.7

 Excise Rp 4,436.3

 Export tax Rp 100.0

 Land and building tax Rp 2,505.0

 Other taxes Rp 632.0

 Non-tax revenue Rp 8,225.8

 Net oil profit Rp 249.2

b Development Revenue Rp 13,026.0

Project Aid (Loans and Grants) Rp 13,026.0

Generally speaking, in developing countries the government revenue tends to fall short of the required routine and development expenditure In order to supplement the shortage, governments can issue government bonds (denominated in domestic currency) and sovereign bonds (denominated in foreign currencies), or borrow from foreign governments and MDBs in the form of ODA and /or OOF In the case of Indonesia, the government maintains a balanced budget meaning that expenditures equal to revenues (including foreign, but not domestic borrowing)

“Project Aid” means, therefore, foreign borrowing No domestic borrowing is assumed

(iii) State Expenditure and Foreign Debt Service

Expenditures (in billion rupiah)

a Routine Expenditures Rp 62,167.8

① Personnel Expenditures

 Salary and pension Rp 17,084.4

 Rice allowance Rp 1,309.5

 Food allowance Rp 1,233.7

 Other domestic staff

expenditure Rp 1,009.9

 Other overseas staff

expenditure Rp 590.5

② Expenditure on Goods

 Domestic purchases Rp 8,478.0

 Overseas purchases Rp 417.2

③ Subsidies to Provincial and Local Government

 Personnel expenditure Rp 10,967.8

 Non-personnel expenditure Rp 568.0 ④ Interest and Debt Repayment

 Domestic debt Rp 334.2

 Overseas debt Rp 19,236.7 ⑤ Other Routine Expenditures Rp 964.9

b Development Expenditures Rp 38,927.9

① Rupiah Expenditures Rp 25,901.9

② Project Aid Rp 13,026.0

Over the two oil crises of 1973 and 1978/79, many non-oil producing developing

countries accumulated foreign debt The serious foreign debt problem of the Third World prevailed during the ‘80s, which threatened to collapse the international financial system Fortunately, owing to enormous efforts by the lenders of developed countries and borrowers of developing countries, the international financial system survived This experience demonstrated to us that foreign debt management is one of the most important macroeconomic policies

In other words, the government of developing country must grasp the real time state of affairs on debt service obligation vis-à-vis their state budget By doing

so, the government of any developing country can pursue a prudent debt management policy

The case of Indonesia above shows us that the foreign debt service shares

21%~22% against domestic revenues (total state revenue) This ratio is quite high, but is presumably within the sustainable level

On the other hand, the government needs to secure the development revenues for

development expenditures to attain their economic growth target, regardless of the foreign debt services

Another issue to which we have to pay attention to is that the figures of

“Development Expenditures” are shown in gross disbursement terms Net disbursement figures (“Project Aid Expenditures” minus “Overseas debt”) are regularly used in DAC statistics However, in our present analysis, net figures proved to be not very useful

(2) Relationship between Domestic Budget and Balance of Payments

In case that the government of a developing country secures revenues for development

expenditures in the form of project loan aid, figures which appear in the Capital

and Financial Account for the Balance of Payments are in conformity with figures that appear in the Development Expenditures of the State Budget To be more specific, it should be elaborated as follows

 Gross disbursement figures that appear in the “Other Investment (Loan)”

of the “Capital and Financial Account” are equal to the gross disbursement figures that appear in the “Development Project Aid (Loan)” of the

“Development Expenditures.”

 Gross disbursement figures that appear in the “Capital Account (Grant)” of the “Capital and Financial Account” are equal to the gross disbursement figures that appear in “Development Project Aid (Grant)” of the

“Development Expenditures.” As this case deals with grant project aid, gross disbursement is equal to net disbursement

From a viewpoint of debt servicing, the following two relationships need to be pointed out

 Gross figures of interest payments that appear as “Income” (of “Current Account”) under the Balance of Payments are equal to figures of interest payments that appear in the “Overseas debt” (of “Interest and Debt Payment”) of the “Routine Expenditures.”

 Gross figures of principal repayment that appear as “Other Investment” (of

“Capital and Financial Account”) under the Balance of Payments are equal

to figures of principal repayment that appear as “Overseas debt” (of

“Interest and Debt Repayment”) of the “Routine Expenditures.”

It is difficult to evaluate the relationship between the development budget and the balance of payments on an ex post basis However, the kind of analysis shown above helps to understand the relationship between the budget and the balance of payments in terms of effective and efficient foreign debt management

3 International Capital Needs/Availability for Economic Development of the Third World

There are at least the following five types of capital fund flows into the Third World, which are deemed to contribute to its economic development The industrialized countries should be bound to secure the maximum financial resources on those fronts (Read Reference 2 Rt Hon Simon Upton, “What Should World Leaders Focus on at the Johannesburg Summit?” 2002, and summarize and comment on its discussion concisely.)

(1) Official Development Assistance

Since the Pearson Report of ’69, the targeted ODA of 0.7% of GDP of the donor countries has not been attained How can we possibly implement this promise and when we meet this target, how much is available for the Third World?

(2) Philanthropy

As a source of development assistance, philanthropy should be encouraged by the international public or the civil society How much, then, is available for the Third World?

(3) Foreign Direct Investment (FDI)

FDI could be a driving force of economic development for developing countries It is expected that globalization helps to increase FDI in a more equitable manner How can we help promote FDI? How much FDI capital flow would be available for the Third World?

(4) Trade Liberalization

A variety of trade barriers imposed by developed countries should be lifted Trade liberalization on the part of the developed world must give tremendous economic benefits to the Third World What would the value of trade liberalization be worth

to developing countries?

(5) Freer Movement of People including Migration

It is well known that expatriate remittances are one of the major foreign exchange earnings for many developing countries There are pros and cons on free movement of people However, these remittances contribute to economic development considerably How much more could developing countries benefit if the restriction of freer movement of people in developed countries be allowed?

✍

(For reference) Balance of Payments Headings

Current Account

Goods and Services

Trade Balance

Exports

Imports

Services

Income ・・・・・・・・・・・・・・・・・・・・・・・(Interest Payment, Remittance by

migrant workers, etc.) Current Transfers ・・・・・・・・・・・ (Grants for consumer goods,

Contributions to international organizations, etc.)

Capital and Financial Account

Financial Account

Direct Investment

Portfolio Investment

Other Investment ・・・・・・・・・・ (Loans, Trade Credits, etc.)

Capital Account ・・・・・・・・・・・・・・・・ (Grants for capital projects, etc.) Changes in Reserve Assets

Errors and Omission