A* Exam Technique: Evaluating government borrowing to promote development

Here is an A* example of using chains of reasoning and evaluation to help answer a 25 mark question on the potential benefits of developing country governments borrowing to promote growth and development.

Question:

With reference to examples of specific developing countries, evaluate the potential benefits of developing countries borrowing to accelerate their economic growth and development. (25)

KAA Point 1:

In many developing countries such as Kenya and Zambia, direct and indirect tax revenues are below 15% of GDP, this means there are financing shortfalls to meet basic public spending needs.

As a result, a government might opt to borrow through the issue of bonds to finance investment projects. This is called debt-financing and can be done either via domestic and/or overseas creditors.

Borrowing might be to fund essential capital investment in infrastructuresuch as improving housing, transport networks, new hospitals and sanitation, the latter is usually seen as being a public good.

Borrowing to invest means that, over time, the capital stock of a country grows thus leading to an increase in productivity, long run aggregate supply and improved competitiveness.

Provided that borrowing is sustainable, it can be an important tool for faster GDP growth and absolute poverty eradication which ultimately will lift per capita incomes and increase tax revenues.

Productive state investment funded by borrowing raises a countries’ potential output, and therefore their ability to repay loans in the future. In this way, the potential benefits are large.

Evaluation Point 1:

However, often the positive effects of debt-financed investment for developing countries are reduced because of the damaging effects of corruption and the incomplete use of rigorous cost-benefit analysis before a project is undertaken. Both are examples of government failure. For example, Mozambique borrowed US$850m for their national fishing industry but instead spent the money on military boats and equipment. The result is that developing country governments are left with an increasing level of national debt which then adds to the annual cost of servicing these loans. Kenya for example is among 18 sub-Saharan countries in 2019 where government debt is above 50 per cent of GDP. Thegovernment debt of the lowest-income countries reached 55 percent of GDP, on average, in 2019—a 19 percentage point rise since 2013. Some economists argue that rising sovereign borrowing and debt can crowd-out the private sector either through higher market interest rates or an increase in business tax rates in the medium term both of which might reduce private sector investment.

KAA Point 2:

A second justification for borrowing to enhance growth is that it makes sense to invest in a nation’s human capital and natural capital specially to overcome market failures.

Increased state funding of primary & secondary education to raise enrolment ratios and lift average years of schooling can have a significant impact on productivity in the long term.

Borrowing can therefore help an emerging country to diversify to reduce primary product dependency. For example, a government might borrow to fund renewable energy projects such as solar.

The increased capacity from large-scale investments will help to reduce energy dependency, contribute to mitigating against climate change and make reliable power cheaper for firms.

If the private sector is unable or unwilling to provide the funding for public and merit goods, then the state has a key role to play in financing them directly or initiating public-private partnerships.

Without state borrowing and given low-tax-to-GDP ratios in many lower-income nations, growth would be held back and sustained progress in improving HDI scores would come under threat.

Evaluation Point 2:

A counter-argument is that borrowing also carries risks including the fear that high rates of lending now from external creditors in might lead to an external debt crisis in the future. Globalisation has allowed many economically less developed countries to raise finance in the capital markets of developed nations. For example, in 2018, sub Saharan countries borrowed $17 billion in Eurobonds (including oil exporters such as Angola and Nigeria). However this debt is often relatively expensive, contrasted for example with loans taken out with the World Bank. When debt stocks are high and interest rates rise, the cost of servicing this borrowing can climb sharply. In Kenya for example, external debt has grown to 36% of their GNI and interest payments on these loans account for 23% of the value of their exports. One big risk is that a fall in world commodity prices and a subsequent depreciation of the exchange rate increases the real value of debt expressed in a foreign currency leaving a government with less to spend on public services and welfare. This in turn can damage their medium-term growth prospects.

Final reasoned judgement (comment):

Government borrowing, if used well, can make an important contribution to sustainable development especially for countries with huge infrastructure needs. Keynesians point to the impact that such a fiscal stimulus can have on aggregate demand and medium-term productive capacity. That said,many low- and middle-income countries are vulnerable to changes in the growth of world trade and fluctuations in currencies and capital market interest rates. Instead of increasing the national debt, they might be better off by introducing structural reforms designed to improve governance and stimulate the private sector to attract stronger inflows of foreign direct investment and perhaps equity flows into their emerging stock markets. In this way, the burden on future tax-payers can be kept under control.