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Financing economic development in developing countries with special reference to Iraq.

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Financing economic development in developing countries with special reference to Iraq.

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Content FINANCING ECONOMIC DEVELOPMENT W IN DEVELOPING COUNTRIES WITH SPECIAL REFERENCE TO IRAQ by Ghazi Abdul Razzak Alnakkash tu A Thesis Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree MASTER OF ARTS (Economics) February 1971 UMI Number: EP44864 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Published by ProQuest LLC (2014). Copyright in the Dissertation held by the Author. Dissertation Publishing UMI EP44864 Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code ProQuest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106- 1346 UNIVERSITY O F SO U TH ER N CALIFORNIA T H E G R A D U A T E S C H O O L U N IV E R S IT Y P A R K LO S A N G E L E S , C A L IF O R N IA 9 0 0 0 7 £ \1S-T? Sc J7l /tasz This thesis, w ritte n by ....... under the direction o f h^M....Thesis Com m ittee, and approved by a ll its members, has been p re sented to- and accepted by the D ean o f The G raduate School, in p a rtia l fu lfillm e n t o f the requirem ents f o r the degree o f MASTER OE ARTS............ 'Tn^fo Dean Da^.„FebruarY...1. 971. . ... THESIS COMMITTEE ( % J L ~ Chairman ACOTOWLEDGMENE3 j It is a great pleasure to acknowledge my deep .appreciation and gratitude to professor John H. Niedercom (chairman of the committee) for his innumerable valuable suggestions, advice, help, and guidance he offered me, not only during the writing of this thesis, but throughout my graduate work as well. Particular thanks are due to Professor E. Bryant Phillips and Professor A* Morgner for their pertinent sug gestions, comments, and cooperation. i ! I am very grateful to Dr. Saadi Ibrahim, Dr. A. Aal. Alsagban, Haghib Fahmi of the Ministry of Finance for the encouragement and help they offered me. Many thanks, also go to Gulbenkian Foundation for helping to initiate the fellowship programme. i My personal appreciation is extended to Jeanne i M. Murry for her interest, help, and precious assistance in typing the manuscript of this work. J j Particular gratitude due to the Cultural Attache I Office in Washington D.C. for offering every available helpful facility that participated in this research. In the meantime, I would like to thank the I.M.F. Institute in the person of its Director Mr. F. A. G. Keesing for ii his kindness and providing the research facilities during my stay in Washington D.C. | Finally, I must thank my family for their j i patience, support, and encouragement to me while I am iabroad• TABLE OP CONTENTS l Page j ACKNOWLEDGMENTS . . . ............................ . ii LIST OP TABLES................................. INTRODUCTION............... . . ................. I Some Aspects of Economic Development Organization of the Study Chapter I. CONCEPTUAL FRAMEWORK, STRUCTURE AND ANALYSIS . . ........................... 9 Economic Development and Financing; History and Background Financing: Capital Formation - Analytical Approach Criteria and Analysis of Capital Formation Sources of Capital; Internal Financing Financing; Concise Remarks II. EXTERNAL DEBT: CRITERIA AND ANALYSIS .... 41 External Financing Factual Background Theoretical Background Conceptual Framework and Analysis Liquidity Aspects of Servicing Capacity Debt Service Ratio Concluding Remarks for the Analysis A Statistical Test Export Fluctuations and Debt Servicing Problems III. MOBILIZATION OF RESOURCES; CAPITAL REQUIREMENTS AND POLICY MEASURES ..... 89 Introduction Analytical Approach for the Problem iv Chapter IV. I Page J Problems of Supply ! The Capital Gap j Finance Measures toward Development ' Domestic Financial Resources | External Financial Resources Private Lending The Situation of the Oil Pro ducing Countries Oil Output Output, Revenue, and Profit Sharing 1950-1964 The Impact of Development Expenditures on the Iraqi Economy Deficit Financing Policy; Origin, Means and Objectives Deficit Financing and Public Investment Counter Cyclical Fiscal Policy The Role of Deficit Financing in Developing Plans Economic Effects of Deficit Financing Policy INTERNATIONAL ORGANIZATIONS (IMF AND IBRD)........................... 143 What Role These Organizations Can Play in Financing Economic Development International Monetary Fund (IMF) Form of Fund Resources and Transaction Fund Policies on Drawings Stand-by Arrangements Policies on the Use of Fund Resources Stabilization Programs Fund Resources and Capital Movements Compensatory Financing of Export Fluctuations International Bank for Reconstruc tion and Development (IBRD) Loan Policies and Resources International Development Association (IDA) International Finance Corporation (IFC) Chapter V. VI. , ~ l vi ; i I Page | Financing Agriculture j Financing Industry Financing Education j Financing Public Services ; Loans to Iraq { DEVELOPMENT BAMS: DEFINITION, FUNCTIONS I AND SIGNIFICANCE IN A DEVELOPING ECONOMY............... 204 Development Banks Bank's Resources Banking Function Development Function Proportioning of Capital Between Debt and Equity Sources of Capital for Development Banks Domestic Public Sources of Capital Attitudes Toward Government Par ticipation in the Ownership of Development Banks Reasons for Government Partici pation THE ROLE AND IMPORTANCE OF THE NON-OIL SECTOR IN THE IRAQI ECONOMY.......... 231 Introduction Capital Formation as a Source of Development Finance Domestic Sources of Development Finance Central Banking and Money Market Monetary Policy Measures The Public Debt Management of Government's Domestic Debt and its Strategy in Economic Development Taxation and Economic Development in Iraq Tax System and Policy Measures Sources of Financing the Five- Year Economic Plan 1965-1969 Economy in Public Expenditures Concluding Remarks vii Chapter Page VII. SUMMARY AND CONCLUSIONS................... 281 BIBLIOGRAPHY ................... 295 ! LIST OF TABLES Table Page 1. Recent Short-Term Declines in Export Earnings from Peak to Trough, and Commodity Concentration of Exports ..... 57 2. Relationship Between Merchandise Exports and Direct Investment Earnings without Time Lag in Twenty Less Developed Countries, 194-8-1961......... . 82 3* Relationship Between Merchandise Exports and Direct Investment Earnings with One- Year Time Lag in Twenty Less Developed Countries, 194-8-1961......... ............ 85 4-. Revenue from Oil as Percentages of Total i Government Revenue 109 5* Iraq: Crude Oil Production and Oil Revenue 194-6-64- 116 6. Sectoral Contribution to the Net Rational Product (1956 Prices) .......... 11? 7. National Income, Value Added by the Oil Sector, Value Added by Non-Oil Sector, and Value of Imports, 1950-64 (Millions of Iraqi Dinars) • . • • o. . • . ...... 119 I I 8. Changes in Prices and Export Earnings for Primary Producers, 1962-1965 .......... 174- I 9. Debt Contracted or Guaranteed by Public I Sector in Selected Developing Countries (In Millions of TJ. S. Dollars and Per Cent)...................................177 10. Service Payments on External Official Debt as Percentage of Exports of Goods and Services ......... ............ .. 201 11. Statement of Loans for Selected Countries (June 30, 1969)......................... 203 viii f IX Table Page 12. Savings, Deposits, and the Supply of Money 1950-1964- (Millions of Iraqi Dinars) ..................... 24-1 13. Iraqi Government Debt, 1960-65 (Millions of Iraqi Dinars).............. 254 14. Total Revenue, Tax Revenue, and Current Expenditures Relative to National Income 1950-1964 .............. ..... 257 15. Direct and Indirect Taxes, Fiscal Years 1950-64 (Millions of Iraqi Dinars) .... 262 16. Non-Oil Revenue, Tax Revenue, and Current Expenditures, Fiscal Years 1950-64 (Millions of Iraqi Dinars)............. . 264 17. Division of Aggregate Investments between Private and Government Sectors for 1965-1969 (in Million Dinars) ....... 265 18. Budget of Government Central Investment for the Years 1965-1969 (in Million Dinars) ............. 267 19. Contribution of the Private and Public Sectors to National Income in Iraq (in Million Dinars)........... . 269 20. Development Revenues and Expenditures, Fiscal Years 1951-64 (Millions of Iraqi Dinars)........... 270 21. Total Planned and Actual Development Expenditures and Expenditures for Industry, Fiscal Years 1951-64 (Millions of Iraqi Dinars) ............ 272 22. Functional Distribution of Current Expenditures, Fiscal Years 1955-64 (Millions of Iraqi Dinars) • ............ 274 23. Distribution of Iraqi Investment during 1965-1969 (in Million Dinars) . . • 275 24. Budget of the Planned Government Central Investment for the Years 1965-1969 (in Million Dinars)............... 277 Table 25. Page Sectoral Distribution of Iraqi Investment over the Five-Years 1965-69 (in Million Dinars) 278 INTRODUCTION A. SOME ASPECTS OP ECONOMIC DEVELOPMENT There is one central problem which is common to all the underdeveloped regions. The essence of economic development everywhere is the building up of capital equipment on a large enough scale in order to increase productivity in industry, mining and agriculture. Fi nancing is the most significant factor in the economic development, and capital, of course, is the important ele ment that can be considered as a synonomous term for fi nancing in the discussion. Capital in the form of schools and laboratories is required for raising the general standard of technical know-how. Equipment in the form of up-to-date machines, is essential if people are to receive more than the neces sity of life from their farms and factories. At any given time, a society can produce only a limited amount of goods and services from its available resources for current con sumption in the form of food and clothing; or for the for mation of capital goods for increasing its productivity in the future. If it wants more capital formation, it must 1 denote a smaller proportion of its current income or i i capital output to consumption and save the rest and invest| it in productive equipment. A rapid accumulation of capital requires, there fore, a high rate of savings on the part of the people, and a proper use of the savings for productive purposes. Thus, it can he said that the major portion of the financial cost of economic development (as financing is ^concerned) ordinarily falls upon the subject country. An important question exists, however, as to how much supple mentary financing a country should attempt to obtain jexternally in support of its developmental efforts. Fun damentally, the extent to which an underdeveloped country comes to rely upon supplementary external capital, rests I on its degree of availability, as well as the terms gov erning access to it. If external capital is not to be had under any circumstances, it follows that a developmental effort needs to be sustained by domestic means as such, if t it is to proceed at all. ! Assuming, however, the access to external capital, the matter of potential advantages versus potential dis advantages becomes relevant. The task of both development and growth theory, is to explain the level of development attained by any par ticular society at a point in time, and the rate at which that level changes between any two points in time. To c j make any progress in explaining development we must have ! I originally some generally accepted criterion for measuringj development. How is development to be measured? Although any number of indexes of development have been suggested, none is as comprehensive, or as generally accepted as gross national product (or national income), per capita. This index requires the existence of national accounts, and statistics, which are not yet available for all the countries in the world. However, despite these difficulties in applying the per capita income criterion !to some countries, it remains the best general index of development. Some of the oil producing countries in which the largest economic activity consists of exporting a natural resource (oil), the quest for one or more "broader" industries of development has been quite unsuc- I cessful. Nevertheless, per-capita income is relatively free of bias as to the specific goals which a society may |wish to attain (in terms of consumption, employment, in vestment, leisure, and national defense), and is fairly neutral with respect to taste, climate, location, and development. The factors affecting economic growth, according to most theories, start from the point of view that income "Y" at any one point in time, depends upon: (1) The stocks of physical resources-(K), (2) human resources-(H), j i and (3) technical knowledge-(T), and (4-) the ability of | society to utilize these stocks which might be called J ”efficiency"-(E). I ( It generally is agreed that the role of the devel-J opment or growth theorist does not stop with explaining ! i the relative impact which each of these factors play. Instead, he is expected to have the factors that change ! the level of income. As a matter of fact, it is feasible to mention that such modern growth theory and the role of the techno- I logical change can be greatly emphasized as such. The 'inspiration for such modern growth analysis was the work of Harrod and Bomar, which provided the analytical tools linking Keynesian macro-economics and standard equilibrium theory. There are causes and conditions, causes of growth and conditions to be determined under which growth may Itake place. ; Specifically, the growth model proposed by Harrod jand Domar contains: (1) Keynesian savings function, S=sY, (2) a simple production function in which potential out put (Yp) is determined by the stock of capital (K) and a fixed technological parameter, the capital output ratio (Y), i.e., Yp=K/Y, and (s) the equilibrium condition Y=Yp, which also implies savings (S) which equals investment In the dynamic context of growth, if it is assumed that S and V remain constant, the equilibrium rate of growth A y % i.e., that at which A y = z^Yp turns out y Y Yp to be given by the ratio of (S) to (¥). Thus, if 3=.12 or 12 per cent of income and the capital-output ratio is 4, Ay = Ayp a s = .12 = .03 or 3 per cent per annum.1 Y Yp V 4 Many recent growth formulations have extended the analysis first by utilizing more realistic production functions in which more than one factor of production would appear, e.g. K, and H, or K, H and M imports as argued by Professor Chenery and Professor Strout who maintain that a scarcity of foreign exchange and hence, inability to import raw materials, intermediate and capi tal goods imports required in the production process acts 'as a significant obstacle to more rapid growth in the less developed countries, with some specified degree of substi- 2 tution possibilities between them. Second, they have relaxed the constancy of the technical and behavioral par- s Jameters, such as (S) and (V), and third, have explicitly j See, Evesy D. Domar, "Capital Expansion, Rate of p-rowth and Employment,” Econometrica. Vol. 14, 1946. pp. 437-147; and Roy F. Harrod. "An Essay in Dynamic Theory,” Economic Journal. Vol. 49, 1939* pp. 14-33. p Hollis B. Chenery and Allen M. Strout. "Foreign Assistance and Economic Development," American Economic Review. Vol. 56 (September, 1966), pp. 679-733* introducing technology and technological change (T), and j efficiency, (E). Thus, it is that growth can be made in I the general formulation of an aggregate production formu- | t lation given in which: Y=f(K,H,T,S) The specific formulation of growth suggests how these variables interact; i.e. the interaction in which the rate of growth in income (output), depends on the rates of growth of physical capital, human resources, technology and efficiency, is widely accepted and most likely that these variables and the use of alternative specifications seems at this point to be largely a matter of choice. Some empirical work has been undertaken to try to sort out the relative importance of some of these factors and relationships, but an extensive testing of the numer ous hypotheses that are to be required before any such results can even be depended upon is sorely needed. i I j B. ORGANIZATION OF THE STUDY l | This study is mainly concerned with various meth- i ods by which the resources that the developing countries could achieve in order to enhance the economic development in their countries and discussing the major forms by which capital can be obtained in its various types, whether through domestic or external ways, and methods of financ ing. In other words, consideration will be given in Chapter I and Chapter II to the internal as well as the I i external financing and how capital plays a significant ! i l role in the mechanism of the economic growth process and discussing its dynamic process that takes place through investment, whether from within or with the help of the outside world as well. The location of various techniques that can be obtained by ranking different economic factors and through which resources can be realized to maintain the wheel of economic progress rolling ahead, attaining the planned goals and performing the most suitable ways of treatment i for the problems of the underdeveloped countries in gen eral will also be covered. Chapter III will discuss in detail the problems of i financing from different points of view, taking into account the various and many-sided aspects of methods of financing in general and with further analysis and appli cation to Iraq as a developing country sharing with all jthe other underdeveloped countries the same common charac teristic of underdevelopment. Iraq, as an oil producing country, is spared some of these problems, but still to analyze the situation with respect to the non-oil sector, impact on the economy and what can be done to avoid any prospective and uncertain ups and downs in the oil sector as such. Chapter IV will discuss the role of the Interna- j tional Monetary Fund and the International Bank for Becon-| i struction and Development as the two major international | i agencies to which Iraq has "belonged since 194-5, and dis cussing the functioning criteria of these two agencies in relationship to the "benefits they have given Iraq from her participation in them. The procedures and mechanism of both agencies are discussed in their relationship to Iraq in particular and the developing countries in general, and the roles they can play to enhance economic development in jthe short-run and the long-run. 1 Chapter V will include special analysis of devel- f . iopment Banks; their functioning, structure and signifi cance in the developing economies, as important intermedi aries in financing the process of economic development. Chapter VI will be a detailed analysis of the : Iraqi economy and the measures taken in the field of 'financing the economic development of Iraq, which will be idiscussed in the various forms of financing in Iraq with jrespect to the economic growth process. Included is an outlook on the prospective future of Iraq, and the achievements she can hope to attain. Chapter VII will contain the final conclusion and suggestions, as well as a summarization of the study. Statistics and diagrammatic explanations are included, and will prove to be of great significance. CHAFTER I j I CONCEPTUAL FRAMEWORK, STRUCTURE AND ANALYSIS | Economic Development and Financing; History and Background Economic growth, today is widely accepted as a major goal of national policy, both in the industrialized countries and in countries that are less fully developed. The advanced countries want more growth so that their expanding labor forces will be fully occupied and f jtheir living standard will continue to improve. The less developed countries want to begin closing the gap between their income levels, and the more fortunate countries. ,They want to enjoy more of the fruits of modern science i and technology, and to break the circle of poverty, low ; productivity, and stagnation within which too many of I their people have been confined for generations. The nature of economic growth is a complex process, which has been given intensive study over the past two decades. However, it still tends to be true that policy questions have nearly always proceeded the construction of formal techniques for analyzing their questions systematically. As it can be said that accelerated growth requires 9 more work and less leisure, more investment and less con- I ■ i sumption relatively, more concern with the future relative to the past, and the replacement of traditional values and i responses with a greater indication toward a spirit of experimentation and innovation. When the implications of these psychological costs^ of growth are fully taken into account, some societies may waiver their allegiance to accelerated growth as a domin ant national goal.*' The less developed countries today quite generally regard development as a process to he planned and guided !by the state. The mere fact that a nation attempts to i iplan its development does not insure that this development will actually proceed more rapidly that it would in the absence of a plan. Examples of poor development planning abound; nevertheless, planned efforts at economic develop ment have characterized the policies of many, if not most nations, since the end of World War II. Comprehensive I [planning has become the accepted technique in efforts to guide and hasten the development process in nearly all countries. In examining the financial and economic conditions I *Robert B. Bangs, Financing Economic Development. Fiscal Policy for Emerging Countries (Chicago: University of Chicago Press, 19^8;, pp. 1-4. and policies of various developing countries in Asia and j other parts of the world, one can find that the developing nations are either involved in preparing development plans, and programs, or only investments for the public sectors. In addition to projects, primarily interested in general questions, such as the expected increase in na- | I I ,tional income resulting from new investments, and mostly calculated in a questionable (capital-output ratio), and in estimated foreign exchange requirements that could serve as a basis for foreign assistance requests. As to ,internal financing government savings as a source of in vestment was used to be assessed too optimistically. i Gradually, when difficulties in internal financing 'emerged, leading a number of countries to inflationary i jpressure, more attention is to be paid to the problem of how to generate savings and provide funds for important I sectors of the national economy; long-term funds for in- i !dustries being considered particularly important. As [development proceeded, it has been realized that it is easier to establish and to manage textile, cement, and paper mills or power stations, than to organize capital markets that must be based on a continuous flow of 2 transferred savings. 2 Walter Krause, Economic Development; The Under developed World and American Interests (Belmont. Calif.: Wadswoeth Publishing Co., 19£>1),pp. 60-64, 185-187. 12 ! I l In the first place, the plants can he built and j i managed by experienced foreign firms, whereas in the field of capital markets, technical assistance, while useful, isj limited in its effect. Success depends on local measures ; i i and on a host of circumstances often including a change j i in savings habits and establishment of a new type of ! efficient financial institutions. The condition of capital markets vary from country to country and some of them apply to the problem of gen erating government savings. With economic development gathering momentum, certain countries became aware that ;further growth would depend on generating savings in the i form of financial assets and made various efforts in this direction. They also realized that it would not be pru dent to rely on continuous influx of foreign funds for an extended period of time. Financing: Capital Formation - Analytical Approach | It is emphasized that capital formation is a major jfactor governing the rate of development. Professor i 3 Rostow, for example, explicitly specifies a rise in the rate of productive investment to over 10 per cent of na tional income as a necessary requirement for a countries ^Walter W. Rostow, "The Stages of Economic Growth," The Economic History Review (August, 1959)» PP» 1-5• i 15 i I "take-off." Similarily, in presenting his model of a dualj economy. Professor Arthur Lewis contends that the central! i problem in the theory of economic development is to under-] i 1 :stand the process by which a community which was previ ously saving and investing A- to 5 per cent of its national income or less, converts itself into an economy where vol untary savings is running about 12 to 15 per cent of na tional income, or more. Thus, a capital accumulation, \ l i including knowledge and skills with capital. The importance of capital has been stressed so much by development economists that a reaction has set in. There is emerging a strong minority view that the role of capital has received attention to the neglect of other essential components of the development process. To the | • extent that an increase in the rate of investment is quite necessary; there must be a mobilized savings toward that direction, in a developing country. A fundamental issue ,here, is the estimating of capital requirements; the gen- j eral rate of development is always limited by the shortage I ;of productive factors. If any one source factor associ ated with underdevelopment should be singled out, it would be capital. The final goal of development programming is a Arthur W. Lewis, Economic Development with Unlim ited Supplies of Labor (The Manchester School, May, 1954-), pp. 56-57. therefore, to find the best way of breaking the vicious j circle between capital shortage and underdevelopment, and j to design the most efficient and optimum rate of capital accumulation. Capital increases by investment and more J investment necessitates more savings or foreign assist- j ance, the latter if it is not in the form of grants, means a burden in the future, to the extent to which foreign 5 loans can be saved at home in the future. This will be discussed in detail in the next chapter, when referring to external financing. Domestic savings are, therefore, the most reliable I source of investment to break the vicious circle of pov erty and underdevelopment. Domestic savings can be in creased only by a sacrifice in consumption, which has to :be compared with the future increases in consumption which it promises.^ ' Investment, moreover, yields different results, !depending on the industries in which it is made. There- jfore, the government of an underdeveloped country, in ;order to design an appropriate plan for development, must i 5 "United Nations, ECAFE, "Programming Techniques for Economic Development," Report of the First Group of Experts on Programming Techniques (Bangkok. 19^0), pp. 8-13. 6 Gerald M. Meier, Leading Issues in Development Economics (New York: Oxford University Press, 1964), pp. 90-95. be informed of the quantitative aspects of savings and | ! investments, and their affects on production and consump- I tion. J These quantitative aspects are of crucial impor tance in determining the most desirable rate of develop ment. There are some useful concepts which should be born in mind in planning the rate of development. These con cepts may be described in terms of investment. First, there is the concept of minimum rate of investment, which measures the rate needed to prevent per capita income from falling in the decline of population growth. Also, a second concept of use, is the practical I maximum rate of investment. In theory, the maximum rate of investment may refer to a level of capital accumulation, which involves savings and investings of at least all in- I come above, say a subsistance level. ! Clearly, such a maximum is of no practical signif icance. A practical maximum may, therefore, be determined j ^differently in the light of the extent to which the popu- i |lation will be willing to accept austerity now, so as to I enjoy a higher standard of living in the future. This rate also can be determined by the evaluation of peoples potential propensity to save. The main general objective of economic development is to maximize the national income or the rate of economic growth* According to this fact, the criteria which are most suitable for allocating the available investment resources in the pursuit of this objective have to be considered in a group that cover the capital output ratio or the rate of capital turnover, social product analysis 7 as well as the rate of savings and investment• The incremental capital output ratio seeks to stand for the amount of additional unit to produce an additional unit of output, therefore, this ratio is usu ally based on an analysis of past experience where possi ble, but may allow for anticipated changes in the future. The over-all capital output ratio can be used as ia tool for estimating capital requirements for the whole a r* n - n n m - r r 8 .economy* i | However, the sectoral capital output ratio (sector by sector or project by project) may vary widely with the ! stage of economic development assuming a stable relation ship between capital and output. J. J. Polak argued in ; respect of the capital output ratio when applied on a pri ority criteria which is also the same as capital turnover, i _ . ,.... —.... . . - . . - . —. "^United Hations, ECAFE, "Criteria for Allocating Investment Resources Among Various Fields of Development in Underdeveloped Countries," Economic Bulletin for Asia and the Far East (June, 1961), pp. $0-31. 8Ibid.. p. 3$. and. thus, to meaningful income'. Choice should be made of q investment projects with a low-capital output ratio. However, this criterion has some limitations. 1. The time element plays a key role since quick i maturing projects with a low-capital output ratio in the short-run, do not necessarily have a lower ratio in the long run. 2. The supplementary benefits of an investment project to other economic activities are neglected in view of project complementary. In fact, a project with a high capital output 10 ! ratio should not be accorded a lower priority. 3. When applying that concept to agriculture in underdeveloped countries, it has to be noted that the magnitude of fixed capital investment may be quite small in proportion to the total input; e.g. of working capital, so that the fixed capital-output ratio may vary widely due to factors other than capital. The social marginal productivity criterion is expressed in terms of once-and-for-all effort on the ^J. J. Polak, "Balance of Payment Problems to Countries Reconstructing with the Help of Foreign Loans," Quarterly Journal of Economics (February. 194-3), pp. 208- 232. 10United Nations, "Economic Commission for Asia and the East." Op. cit. (November, 1961), pp. 25-26. i 18 i 1 i national income, and does not include the specific multi plier effect of investment or future income levels, i.e., it does not take into account what happens to the final ! i products, this determines, in part, the investment rate inj future, which in turn, determines the future income j levels. Nor does it take into consideration the changes 'in the nature and quality of the factors of production such as population and labor force that may, partly, be an indirect outcome of the current investment allocation. W. Galenson and H. Leibenstein assumed that the appropriate goal of development should be the maximization of per capita output, or average income at some future point of time rather than the maximization of national income now. Hence, the correct criterion for investment must be to maximize the rate of savings and, thus, of re- 11 investment. Two types of capital-output ratio can be distin guished, one from the other, and both from the marginal .productivity of capital. In the diagramatic representa tion of the production function on page 19» which is a mathematical expression of the relationship between inputs of factors of production and outputs of a given good. 1XW. Galenson and H. Leibenstein, "Investment Criteria, Productivity and Economic Development," Quar terlv Journal of Economics (August, 1955)» PP* 34-3-3&1. THE CAPITAL OUTPUT BATIO K Labor 0 0 - Capital output ratio as distinguished from MEC (Marginal Efficiency of Capital) i The production functions in which lines 1, 2 and 3 ^represent successively higher isoquants, or amounts of equal product which can be produced with varying inputs of I capital and labor, assuming only these factors. Every ! point on line (1) represent the identical amount of out- I put, and each point shows a possible combination of capi tal and labor which can be used to produce that output. Isoquantjcan be drawn infinitely close together to repre sent infinitely small differences in output slant are usu ally portrayed at discrete intervals in the figure, with : 20 1 ► j OK (capital) and OL (labor), the optimum on least cost i output occur at point P, which lies on the highest pos- J sible isoquant attainable. Average capital output ratio I . is that between OK (capital) and OP (output), Now if | capital is increased to OK’, output increases too, This increase depends on the marginal efficiency of capital ! 12 and the efficiency of inputs of either factors. A third concept, is that of a highest rate of investment, constant with ’ ’absorptive capacity.’ ’ Absorp- I tive capacity depends upon natural resources, taxes, the labor supply, the level of labor, technical and managerial iskills as well. ^u^H^c^p'SO'ity sets a limit to the amount of efficient investment physically possible. Although it can be increased through further investment, it does effectively limit the rate of development possible, par ticularly, in the short run.1^ Thus, one of the logical ways to start planning the general rate of economic development is, first, to I ; estimate the amount of domestic savings and capital im- jports that could be expected, with no change in economic i policies, than to calculate the rate of growth that this level of savings and investments would provide. And 12 Charles P. Kindleberger, Economic Development (New York: The McGraw-Hill Book Co. Inc., 195&), pp. 40- 42. •^Ibid.. pp. 94-101. This will be discussed in more detail in Chapter III of this thesis. finally, to compare it with the desired rate of growth. i [ Usually, the ratio of savings to income is fairly stable i i over long periods of time, and these saving-income ratios j I . are lower in the underdeveloped countries than in the developed countries. Any empirical estimation of this ratio must start with the new observation of the rates of savings experienced by the country in the recent past. The estimation may be based on data for incomes, and the savings of households, business and government as well, and domestic investments, which means capital im ports, After estimating the current rate of savings, the * crucial question will be what amount of net national out- ,put may be expected from the investment to be made on the basis of the estimated savings. The amount of capital 'required to increase output by one unit per annum in each sector of the economy, and for the national economy as a whole, is called capital-output ratio, or capital coeffi- ;cient. | Although this ratio is calculated as the average jcapital output ratio, what really matters is the marginal or incremental capital output ratio. We need information on the capital required to increase the national output. If we want to increase output by twenty, and the capital output ratio is four, then the required addition to the capital stock, to be provided by new investment, is ! 22 ' eighty. Eventually, the figure four stands for the incre-, i mental capital output ratio. ! As a matter of fact, the criteria that featured the underdeveloped countries, is the low level of capital,j I i.e., the economic activity in them is carried out without! the assistance of large quantities of capital assets (com-i I munication, machinery, equipment, and tools). The low j level of capital is also indicated by statistics of con- j ; sumption of energy for purposes of production. The gen- I eral effects tend to be aggravated by factors which ; reduce the economic effectiveness of a large part of the I available capital. Much of it is in the form of agricul tural holdings and improvements, and of durable consump tion goods, and is essentially specific and personal. The effectiveness of the available capital assets, ;is curtailed by the narrowness of markets and poor commun ications. The general implication of low capital is low ; level of output, and a low level of consumption per per son. Another feature is the high rate of interest in the underdeveloped countries. The low level of capital tends to bring about high rates of interest, reflecting its scarcity, and this in turn, induces both lenders and borrowers to make the most available supply. The structure of the interest rates in the organ ized money market of underdeveloped countries is usually J i more or less the same in developed ones. The short term ! j rate of interest is generally much below the long term j : rates indicated by the spread of between the government treasury bills rate and the government bond yield; the rate at which bills of exchange are discounted is also lower than the rate at which loans and advances are granted. i The lowest market rates are usually the call loan 1 rates between commercial banks. The next lowest are those I ! jpaid by commercial banks on short term deposits, followed I |by the government treasury bill rate. In general, the level of interest rates in underdeveloped countries even ;in an organized money market (that are characterized by |both ratios; ratio of deposit money to supply and ratio of ! ; the banking systems claims of mostly loans, advances, and ■ i bills discounted, on the private sector to national in- home) is higher than in the more developed countries. The most notable difference between the two groups of coun tries is that the range of interest rates is generally I Imuch wider in underdeveloped ones. The volume of loans granted at relatively low interest rates in the latter is not very important, as only limited amounts of financial assets are available to serve as a collateral for lending -in low rates. It is usually the foreign business firms with longer experience and larger capital which sire able to borrow at the lower rates, | Interest rates in unorganized money markets of ! underdeveloped countries are generally very high in rela tion both to those in the organized money markets and to what is needed for rapid economic development. Those high interest rates are caused by the disproportionately large demand for loanable funds coupled with a generally inelastic and limited supply of funds. The large demand stems from the special social and economic factors preva lent in the rural areas of underdeveloped countries. The low level of income leaves little surplus for saving and i i I for the accumulation of capital self-financing of agri- • culture and handicraft production. The uncertainty of weather which affects crop yields incomes, causes an additional need for outside funds in bad years. A sig nificant portion of demand in rural areas for loanable |funds is for financing consumption. Anyhow, the high !interest rates can be said, also, due to both demand and ' 14- jsupply factors. ! Meanwhile, it can be said that high interest i ratiojare due also, as far as all types of investment are 14 UTun Wai, "Interest Rates in Organized Money Markets of Underdeveloped Countries," International Mone tary Fund Staff Papers. Vol Y, No. 2 (August, 1956.), pp. 249-255. Also, "Interest Rates Outside the Organized Money Markets of Underdeveloped Countries." concerned in these countries, to high risk in investment j that tend to keep it high."^ j Attempts by legislation to fix the rate of inter- j est helow the equilibrium level, are likely to be ineffec-j ; l tive. But, if they are effective, they are likely to re- | duce the supply of capital, and lead to its Uneconomic O use* Criteria and Analysis of Capital Formation It is sometimes said that a vicious circle con stricts underdeveloped countries in their attempt to raise i their low level of capital. A low national income means a negligible rate of saving and capital formation. A low rate of Gapital formation means low productivity in agri culture and manufacturing, and low productivity once again means a low national income. Internal capital accumulation takes place as part i of a process of economic development and change; however, low income per head may have been at one time, part of burrent income set aside to create and augment, a stock of i bapital. The vicious circle has been broken in the past, provided the general circumstance and opportunity is fav orable for economic growth. ^ Ibid.. Vol. Vi, No. I (November, 1957), PP. 80- 83; 94-97. There are numerous impediments to private savings,J I for instance, in the underdeveloped countries# Those in- J elude the imperfect maintenance of law and order, politi- ; cal instability, unsettled monetary conditions, and lack I of continuity in economic life. All these impair the j i ability and willingness of people to look beyond the im mediate present, and to take a long view, qualifies that are necessary both for decisions to save and defer con sumptions. Also, to use resources in the expectation that !their deferred outputs will be profitable and advantageous, is important. Where the general environment is not favor- ;able to productive investment, it is likely that a large 'part of savings is kept in the form of holding assets for different forms of wealth, which are not productive. This pattern of investment is primarily a reflec tion of certain economic and political conditions. It is ;not a major factor retarding economic development, nor j evidence of an inability to take long views in investment ;decisions. { i Investments in industrial and transport enter- I jprises or in plantation agriculture, are much more readily undertaken once political conditions become more stable and institutional arrangements more favorable to long-term investments. When inflation is controlled or removed and when supplies are accessible, then the capital expands. 27 j i When these changes take place, both the margin of current income, and some savings previously accumulated in other forms, then savings become available for industrial and j i commercial investments. ! Few underdeveloped countries try to attempt to make an effective Job in mobilization and placement of capital arising domestically. But what if very little in the way of domestic capital proves forthcoming? If volun tary saving is low, the inflationary method of financing, (involving forced savings), is sometimes involved. Under |this approach, a country’s total money supply is expanded |(through bank credit creation to support loans to business lor government), and the effect of which is to alter the i relative shares of purchasing power held by various major segments of the population. But the technique of forced jsaving is not new to underdeveloped countries. A number ! |of them have invoked forced savings in the interests of accelerating economic development. s ' Effective as it is from certain standpoints, it is i not free of criticism. First, the real income of con sumers is reduced, or is held below levels otherwise cur rently possible. It is the consumer on the scene, who pays for the development that results, and he does so in voluntarily. Second, the resultant domestic price in creases tend to impair the ability to export, and affect foreign trade balances adversely. Therefore, the question] is, how are the needed imports to be financed? Third, thel prospect of a rising price level tends to distort financ- j ing itself. Also, long-term financing in fixed interest j securities comes to be deferred. Forth, domestic holders j of funds, fearful of financial ruin, as a consequence of rising prices, are encouraged to seek refuge in investment in real estate or capital flights. If savings, voluntary or involuntary, are not [forthcoming in sufficient amounts to allow support for a desired pace of development and if such a development pace 'is deemed essential, the remaining major resource open to ian underdeveloped country, is that of access to capital, originating abroad. Unfortunately, a number of obstacles 1 fi are also likely to be encountered in this connection. | j Sources of Capital: Internal Financing j Actually, sources of capital formation involve Ithree stages: (1) An increase in the volume of real sav- i i ings, so that resources can be released for investment i purposes, (2) The channeling of savings through a finance and credit mechanism so that investible funds can be col lected from a wide range of different sources and claimed by investors, and (3) The act of investment itself by 16 Walter Krause, Economic Development (Belmont, Calif.:) Wadsworth Publishing Co., 1961), pp. 67-71* which, resources are used for increasing the capital stock* The first requirement, an increase in the volume of real savings, is of fundamental importance if a higher j rate of investment is to "be achieved without generating inflation. This significant step of mobilizing savings should not be confused, however, with the monetary financ ing of investment. The significance of financial institu tions lie in the making available the meansto utilize ' savings. Although the existence of more developed capital markets and financial intermediaries will aid in the col lection and distribution of investable funds, they will in no way lessen the need for real saving. The rate of investment which is physically pos sible to carry out, is limited by saving and a "shortage nf capital," in the sense of a shortage of real resources i ! available for investment purposes. The rate of investment I jcannot be solved merely by increasing the supply of fi- jnance. Indeed, it is comparatively easy to introduce institutional arrangements to increase the supply of fi nance, and a lack of finance, need not persist as a seri- 17 ous bottleneck. Once a sizable class of savers and borrowers come 17 'Edward Hevin, Capital Funds in Underdeveloped Countries (London: 1961}, pp. 75-85* into being, financial intermediaries are likely to appear,] and leading institutions are readily created. But the J I creation of new financial institutions are no substitute i 18 1 for necessary performance of real saving. It is therefore important to be clear on the various sources from which the necessary savings can be mobilized to provide the requirement for capital expendi ture. Prom internal sources, an increase of savings may be generated: (1) Voluntarily through a reduction in con sumption, (2) Involuntary through additional taxation; compulsary lending to the government, or inflation, and i 1(3) Finally, by the absorption of unemployed labor into j productive work. And from external sources, the financing of development may be met by investment of foreign capi tal, which will be discussed in full detail in the next ^chapter. Also, restriction of consumption imports bring ;an improvement in the country's terms of trade. [ | An increase in voluntary saving through a self- i jimposed cut in current consumption is unlikely, when the average income is so low. At least, it can be hoped that when income rises, the marginal rate of savings may be greater than the average rate. Instead of relying on ■^^United Nations, Development Financing. Publics tions A/5852.6023, E/Conf., 46/141, Vol. I, V). voluntary savings, the government will normally have to resort to ''forced" savings through taxation, compulsary lending or credit expansion. As for taxation, the country1s "taxation poten tial" depends upon a variety of conditions, namely: (1) the level of per capita real income, (2) the degree of inequality in the distribution of income, (3) the struc ture of the economy, (4) the political leadership, and (5) administrative powers of the government. It is generally true that in underdeveloped coun tries, the actual ratio of tax revenue to national income, i is at present, less than the tax potential, i Another internal source of saving is represented by the investable surplus of unemployed labor. If this surplus is utilized in productive activity, the national ;output will be increased, and the required savings might be generated for additional output. It should be noted ;that the direct formation of capital through the use of i , unemployed labor can be obtained by what is termed "unit ! 19 multiplier" method. y If labor has zero productivity in a given culture, it can be withdrawn and put to work on investment projects 19 'James, Duesenberry, "Some Aspects of Theory of Economic Development" Explorations in Enterpreneurial History (London: 1958), Vol. Ill, No. 2, pp. 65-^7. like construction, irrigation works, and road building, 1 i without a drop in agricultural output. Most of the pay- ! , ment of the additional wages will be directed toward 1 foodstuffs, and agricultural income will rise. The higher; income may then be taxed, and the tax revenue can finance j i the investment projects. If taxes are levied in an amountj equivalent to the additional wage-bill, there will be no j change in consumption, but income will have risen by the ;amount of the investment. When the investment projects are completed, there will be an increase in output, and isome of this increase in income may also be captured i I through taxation. i Financing: Concise Remarks As a matter of fact, one can conclude that there ;are two main types of financing. The one we have dis- :cussed already is called the internal financing. The iother, which will be discussed later (one aspect of which |is the foreign loans and debt servicing) is called exter nal financing. The internal implies the domestic saving and all ways or means by which this essential form can be encour aged. It includes the private and the public savings. External financing restricts itself to the foreign savings and foreign governments aid, which do not play a great role in the process of economic growth. In addition, : 33 these self-financing ways were through the international trade, which creates a favorable term of trade where the surplus can be channelled by using up the acquired foreign i exchange in the underdeveloped country for importing cap- I ital goods necessary for the domestic investments. This will be explained in more detail in respect to Iraq. High rates of economic growth are associated with high rates of investment and saving. But, it is also recognized that the lack of financial resources, i.e., savings, represents the main obstacle for economic devel opment. In developing countries, where the low level of income does not make saving sufficient, the rate of in vestment and the growth of national income remains low i too. This is producing a vicious circle that I referred to before. Various suggestions have been presented to !break down this circle and to promote savings. Economi- :cally speaking, there are four ways of promoting savings: ;(1) The financial system, (2) The fiscal method, (3) i iCentralized planning techniques, and (4) Inflation. The i financial system seems to be considered by some econo mists, as the most efficient way of inducing savings and of channelling them into investments. However, it works better in the economies of these countries, especially during the earlier stages of development, when savings are in the form of tangible assets (bonds). So the first step lies in the monetization of the ! economy by setting up appropriate financial institutions. | i This enables the introduction of money in transaction, j i particularly in rural areas. At this stage it could be necessary to fight the preference of population to keep its savings in cash hoardings which include currency, gold or foreign exchange. When the process of industrializa tion is starting, it is necessary to induce people to save in the form of financial assets. This may require the promotion of a general atmosphere of confidence and a sound credit policy. The savings income ratio cannot be i pushed, upward unless some of the glaring uncertainties iconcerning money, labor and marketing projects can be dissipated.^ Since the financial structure is not efficient, ithe fiscal techniques can be used. But in that way the !reaction of saving changes. Savings collected through |financial institutions are referred to as voluntary or jcontractual savings. By restraining the net disposable income through taxation, the government introduces a com pulsory element to savings. The method of collecting savings is also different, since the collectors are not 20 R. Nurkse, Problems of Capital Formation in Under developed Countries and Patterns of Trade and Development New YorkT Oxford University Press, 1967)» PP« 28-45. private entities but state officials. Usually, savings collected by taxation are channelled to finance public , i investments, so it could be described as public saving. Centralized techniques of planning are used in ; i countries in which the means of production belong to gov- j ernment, so that economic activity needs to be coordinatedj under a planning authority. This central bureau draws up ! the investment program and savings needs. Savings are collected through the budget, so appropriation of revenues on public enterprises, so that decentralized financial institutions are not needed. As this technique is based 1 on predetermined targets of production, it requires price control of commodities and services. Inflation can be used as a way to induce savings. Since inflation reduces real wages and revenues, it could 1 redistribute resources through forced savings, and it has j its consequences, which are aside from this discussion now. If, in the short run, moderate inflation mobilizes i savings', in the long run it will inhibit voluntary saving i and will deter the inflow of foreign capital. By increas ing the supply of money, or by creating a budget deficit, inflation tends to distort the level and structure of relative prices. Furthermore, inflation tends to waste resources by stimulating undesirable investments, and by creating balance of payment disequilibrium. It is necessary to refer to private savings and to the policies that would lead ultimately to the encour agement of private savings, on one hand, and the develop- I I ment of financial institutions on the other hand, so as to give a full picture to the situation prevailing in the i developing countries. The importance of increasing the rate of saving raises the question; what policies, theoretically and practically, should be followed, and what mechanisms are needed accordingly to support the flow of savings? It goes without saying, that the maintenance of a reasonable [degree of monetary stability is a prerequisite for devel- oping savings; i.e., particularly for households. This l favorable environment may be sustained by educational propaganda efforts. But encouragement for savings require jmore than publicity. Various incentives have to be de- I :signed to increase the overall ratio of savings in the ieconomy. Moreover, these incentives have to avoid induc- i ,ing savings in one sector, at the expense of others. Several devices may be used for these purposes: (A) Providing information on savings institutions, (B) Protecting the value of savings, (C) Improving the return on financial savings. The first step for improving sav ings flow, lies in providing savers with adequate informa tion about the availability, advantages, and disadvantages of alternative savings media. The issue arises princi pally, for savings invested in equity shares. Some forms of public supervision assure the saver that the informa tion available to him is accurate and indispensable. Dis closure of essential financial information should make the investor capable of making an appropriate judgment about the risks involved. However, few savers possess sufficient training to understand corporate balance sheets and financial accounts in order to assess the risks in volved. Nevertheless, since the need for information is a prerequisite for the development of security markets, a financial intermediary may play an important role in in forming savers and developing their confidence in finan- 1 21 ! cial assets. The savers' confidence in financial assets may require the governmental protection for particular types of savings through guarantees or insurance of the savings Entrusted to private institutions. These institutions may .be subject to supervision by government agencies with re- jspeet to liquidity and solvency. Special insurance cor porations may also offer insurance of savings deposits up to a certain amount. The awareness of this supervision and insurance facilities would tend to increase household savings and reinforce the saver's confidence. ^Walter ¥. Heller, Fiscal Policies for Underde veloped Countries in the UN (New York: 1954'K Sales No. II, H. I. In addition to the need to protect the normal ! i value of saving, care must "be taken to protect its real i i value against loss from inflation. Some indexing tech niques may be used to preserve the saver's purchasing j power; government or private bonds, may be issued with j I I index clauses related to the price index of specific good j even though the effectiveness of such measures is doubt ful. Conditions favorable for the expansion of savings i i require changes in the existing legislations in order to : improve the organization and the administration of finan cial institutions. i In many countries, because of certain fail ures in joint-stock companies and instances in dishonest and incompetent management, the joint- stock effort has suffered considerably in public esteem— it is of paramount importance that gov ernments in underdeveloped countries re-examine the adequacy of their laws and regulations re- ! garding company promotion, organization, admin istration, etc., and build up business morals and public opinion against mismanagement, dis honest policies of companies.22 ! The main devices that can be used to increase the i [return of financial savings are: (1) Increasing the rate of interest - (in the neo-classical analysis, saving is a function of income, not only the interest rate. This is especially true in the developing countries). And the Second device is: Subsidizing savings. 22 S. C. Yang, Capital Supply and Economic Growth: Sources of Savings (Edited by E. Berril, Macmillan, 1964), 39 : i ! It is very important to pay proper attention to j interest rates, since inadequate rates discourage savings j in financial forms and impede the development of financialj intermediaries and capital markets. In many countries low interest rate policies have been designed to stimulate the investment or to facilitate! public debt management. But, in the developing countries,J i the more serious problem is on the side of capital supply, rather than of capital demand. In these countries the volume and composition of saving are greatly influenced by structure of interest rates. The experience of some countries indicates that ;even the savings of farmers have risen higher as the rate of interest increased, because savers have responded to changes in interest rates. It should be noted that a high interest rate does not necessarily increase savings per ;se, but that is considered desirable. The implication is, i that a flexible interest rate policy, along with attrac- I jtive instruments, and physical assets, may prove effec tive. But, it may be that as the level of interest rates I goes high enough to induce savings, the financial assets would represent too high a cut in funds to permit profit able finance of investment. In an attempt to resolve the dilemma of inhibiting p. 163 40 ! 1 investment "by permitting rates to rise sufficiently to j induce the right kind of savings, it may be wise to resort i to subsidizing savings through payments of premiums or taxj I exemption on the income from savings, or on the portion of the current saving flow. If such plans are applied to specific types of financed assets, they may produce shifts among financial assets in order to take advantage of the subsidization program. On the other hand, these incentive plans provide the principal benefit for upper-income groups who are expected to save substantially. Conse- |quently, in order to limit the attractiveness of these incentives for wealthier savers, some countries have radopted a policy of limiting the amount of income from savings eligible for tax exemption of premium payment. CHAPTER II EXTERNAL DEBT: CRITERIA AND ANALYSIS EXTERNAL FINANCING When we look to the external sources of financing development, the capital assistance provided by foreign economic aid, and the private investment of foreign capi tal, are the main important factors to he considered, ; But the terms on which development assistance is made available may be determined on the basis of the :capacity of the recipient country to service foreign obli- |gations. Anyhow, when the domestic financing, in the under developed country is bound to be limited, the need for foreign capital takes place. It is worthwhile to discuss j :in some detail, the main criterion of borrowing, what the i foreign loans yield, whatsoever its sources are. How it 1 affects the borrowing country, is determined by debt ser vicing analysis. Emphasis will be given in this chapter to an important factor of financing, which is borrowing. But, the question of limits to external indebtedness is relevant to the terms on which aid is provided to devel oping countries. The terms on which aid is provided will 41 42 I i depend on the circumstances of individual countries, i Each case involves three main questions. First, I what circumstances are relevant? Secondly, what kind of analytical assessment of these circumstances would he helpful to the decision-makers when they judge what the | appropriate terms of assistance should be? Thirdly, how grave should these circumstances, e.g. debt servicing difficulties, be and what their origin to justify a modi fication in the conventional terms of international capi tal flows? The main objective of this study is to concern it self with the first and second question; it follows in |referring to the ways of recognizing the conditions which may be considered relevant and it also attempts to provide a conceptual framework. Also, it concerns itself with the i idebt-servicing difficulties and their causes and magni tude, while it does not make any actual investigation in i jrespect of the appropriate terms of assistance because the : latter depends on the volume of funds which the interna tional community is prepared to provide for development I ■ finance and on the standards of risk which the capital- supplying countries and lending agencies consider suitable 1 to approve. ^J. M. Keynes, "The German Transfer Problem; The Separation Problem, Views on Transfer Problem," Economic Journal (March, 1929; June, 1929; September, 192^7^ 43 ; i FACTUAL BACKGROUND I i 1 i Since tlie war, international capital flows have \ taken a variety of forms, ranging from grants and free ' provision of technical assistance at the "soft" and to short and medium-term loans at fairly high rates of inter est at the "hard" end* The provision of capital on soft ! terms has a marked advantage for the borrowing countries j as it does not give rise to debt servicing obligations. ,0n the other hand, the capital supplying countries find it much easier to make loans on conventional terms, since they can be financed by savings voluntarily provided from private sources, even though temporary budgetary expendi tures may be incurred where lending is done through public lending agencies. A further characteristic of hard loans, is that they impose a certain pressure on the borrower to use the proceeds efficiently in strengthening his economy, although it may be argued that the same end could be achieved in other ways as well, particularly in the case i |of a developing country, which is likely to need a con tinuing net capital inflow for a fairly long time. An inevitable consequence of a provision of capi tal on hard terms, is that debt service obligations, in crease over time. Given the substantial role of hard loans in total capital flows, the process whereby this occurred, is likely to continue, although not necessarily 44 I at the same rate. Increases of external indebtedness and of debt i service liabilities, even when large, do not necessarily | imply difficulties for borrowers. Increases of service payments have to be measured against the strengthening, which has occurred in the borrower's economy. The provision of capital on soft terms has a marked advantage for the borrowing country as it does not give rise to debt servicing problems and obligations. On the other side, the capital-supplying countries find it much easier to make loans on conventional terms, since !they can be financed by savings voluntarily provided from I private sources, even though temporary budgetary expendi-^ tures may be incurred where lending is done through public lending agencies. A further feature of the hard loans is ,that they involve a certain pressure and strain on the ! borrower to use. i i i ! THEORETICAL BACKGROUND j j The problem in estimating debt servicing capacity, !to give substance to the formulation: What is meant by "strengthening of the borrower's economy"? And, also, is there any precise way of strengthening to be measured? What are the respective roles of quantitative analysis and judgment in the measurement? The problem of permissible limits to external borrowing, is still more complicated. The government of the borrowing country cannot print international money in order to pay its debts; the solution to which the debtor governments have occasionally resorted to in the past, with respect to their internal debts, cannot be of help in meeting international financial obligations. If anything, domestic inflationary financing makes :the fulfillment of external debt obligations more diffi cult certainly over the short run. The borrowing country must lay its hands on international currency in order to pay its debts. In the post-war period, there has been an !absence of violent fluctuation in the imports and capital flows out of industrialized countries. The general prob- ;lems of economic growth of the developing countries have attracted considerable attention. During the last ten years, probably the most I debated single question has been the rate of capital |accumulation, needed for accelerated growth of the less |developed countries. The external capital requirements of I the developing countries and the related issues of ade quacy of domestic resource mobilization, and resource use, have been the ma<jor issues of contemporary economic theo ry, and economic and political debate. Recent discussions of the capacity to service external debt (and of debt servicing difficulties which 46 i t ( may be called the pathology of international capital j flows) have been a natural extension of the discussions ofj capital requirements. Furthermore, the mere fact that the| debt service has inevitably lead to an increase in atten- ! tion paid to debt servicing problems. It was only to be expected that as the process of meeting capital require ments evolved, the return of law would take place after a time lag, and that it would then necessarily raise another number of difficult questions. But, in most cases the need for capital is still a major problem. This factor can proceed efficiently in strengthening the economy, al though it may be argued that the same end could also be ^achieved in other ways, particularly, in the case of a developing country which is likely to need a continuing net capital inflow for a fairly long time. Therefore, an inevitable consequence of provision of capital on hard terms is that debt-servicing obliga tions increase over time. Another problem arises here i jwhich is the transfer problem. During the twenties much 'attention was given to the problem; whether the debtor 'country, in addition to the burden of accumulating domestic currency in order to meet external debt service, also faced an additional burden in transferring these domestic savings into foreign exchange. The great discussion regarding whether a country making the transfer inevitably experiences a deterioration 4? | in its terms of trade has remained unsolved. Also, Keynes! who maintained that there was no additional burden, prob- j i ably had the better of the argument, at least under cer- j 2 1 tain conditions. i In the postwar period, on the other hand, there has been an absence of violent fluctuations in the imports and capital outflows of industralized countries. On the other hand, the general problems of economic growth of the developing countries have attracted considerable atten tion. As a result, a discussion of international indebt edness has been directed into new areas. During the last ten years probably the most debated single question has been the rate of capital accumulation needed for acceler ated growth of the less developed countries. The external capital requirements of these coun tries and the related issues of adequacy of domestic !resource mobilization and resource use have been the major i (issues of temporary economic theory and economic and po- I ^ 5 I litical debate.-' j The discussion of the debt servicing difficulties I |and the capacity to service a debt, have been a natural 2Ibid. -'One of the first representative analyses was con tained in United Nations "Measures for Economic Develop ment of Underdeveloped Countries." 1951- debate has culminated at the U. N. Conference on Trade and Develop ment held in the Spring of 1964. extension of the discussions of capital requirements. In J addition, the sheer fact that debt service has been in- J i creased during the last decade has inevitably led to an j i increased attention paid to debt servicing problems. It was only to be expected that as the process of meeting capital requirements evolved, the return flow would take place, after a time lag, and that it would necessarily raise a number of very difficult and analytically most i interesting questions. Some limitations can be incurring j in the study of the theory of debt servicing capacity. The theory of capacity to service external debt is un- 1 likely to be developed until the basic issues of the theory of economic growth have been resolved. The capac ity to service a debt of a country, just like that of a 'business firm, is inexorably linked with its performance !in output (sales), savings (plough-back earnings) and developmental returns to capital (rate of profit). But, |while when believing that we know something about the factors that help explain financial success or failure of i |a film, one is much less certain when asked to explain why certain nations show an amaxing rate of growth while others lag behind. Also, the appraisal of credit worthi ness of anybody - be it an individual, a business firm or a country - is a mixture of facts and judgments. Even if we have a theory of debt servicing capacity, and could explain the likely behavior of ma^or variables and their time-path, we would still be facing the uncertainties arising from current economic and financial policies which the decision-makers in the borrowing country may choose to adopt• CONCEPTUAL FRAMEWQBK AND ANALYSIS Debt servicing capacity of a developing country may conveniently be discussed in terms of benefits and cost of foreign capital, in the process of economic growth. The role of foreign capital is to supplement ! national resources in raising the rate of capital forma tion. By making possible a higher rate of investment than Iwould otherwise be feasible, foreign capital raises the rate of income growth. Again, this benefit to the national economy, there is the cost of foreign capital in terms of payment of debt I service. This payment implies that the borrower country i ihas to forgo a certain amount of purchasing power, which eould otherwise be used for consumption or investments. I Debt servicing capacity depends on the ease with which a . country can reconcile competing claims on its resources; on the one hand, there is the demand for a higher standard of living, on the other hand, there is the obligation to foreign creditors. A default implies the undermining of confidence, denial of foreign long-term loans in tlie future, and at the extreme, isolation from the major world centers of finance and commerce. Debtor countries have to balance what may appear to be immediate advantages of higher con sumption and/or investment against the adverse impact on future economic growth of being isolated from internation al finance. The problem of reconciling competing claims on .resources has a different complexion, depending on the time horizon under concentration. At a point in time, or in the short period, debt servicing difficulties take the form of a liquidity crisis. Disequilibria in the balance :Of payments are the heart of the matter. Whether a debtor can make both ends meet depends on the relative strength of elements of rigidity (i.e., the contractually-fixed 'external obligations, minimum tolerable level of imports) and countervailing elements of flexibility (i.e., availa- Ibility of compensatory finance and inessential imports). 1 It also depends on the skill of the authorities of the i 4 jdebtor country in managing the balance of payments. Difficulties in transferring debt service payments at a point of time may result from cyclical or accidental fluctuations in exports, capital inflow and imports, or 4. United Nations Publications, "Economic Develop ment," Reports No. A/6023 and Add. 1, TAB, 1st Seas. Report, and E/Conf. 46/141. Vol. I-VII. pp. 76-79. (Sales Nos. 64.11 B. 11-18). / from capital flight or a bunching of repayment obliga tions. Alternatively, the liquidity crisis may be a symp tom of structural weaknesses of the economy. Frequently, but not in all cases, it is a combination of purely tran sitory disturbances and long-term factors. In real life, debt servicing difficulties almost always manifest themselves in liquidity crises in the balance of payments. ^However, a thorough appraisal of creditworthiness cannot be based on short-period analysis ^only. Debt servicing capacity cannot be divorced from the general problem of economic growth, particularly when i the main focus of attention is a low-income country. I Reconciliation of competing claims on resources is easier when total resources are growing than in a stationary 5 ;economy. : As long as the incidence of debt service falls on 'a part of the increment in per capita income, it is pos- ! sible for consumption and nationally financed investment !to rise "pari passu" with service payments. And, if the rate of increase in real income and savings, remaining available after the claims of foreign capital have been met, is reasonably high, if growth occurs in a continuous / fashion, and if its benefits are widespread, it can plau- 5 •^Gerald M. Alter, Economic Development for Latin America. Proceedings (International Economic Association) New York, 1961. Under the title "The Servicing of Foreign Capital Inflow by Underdeveloped Countries." . sibly be argued that debt service payments will also be 6 made smoothly. j I The opportunity cost of fulfilling external obli- ' gations is less obvious and presumably less burdensome : i than in a situation in which service payments impinge on | existing living standards and employment levels. Therefore, it can be argued - and this is the fun damental judgment on which this study rests - that con tinuing growth in ’ ’ per capita” production and the tinder- lying process of rapid accumulation of productive capital is the basic long-run condition of debt servicing capac ity. The main task of long-run analysis is to define the conditions under which the economic growth process, which is partly financed by foreign capital borrowed on conventional fixed terms, can succeed; and which can pro vide a basis for continuing servicing of external debt, and, if necessary, for its ultimate retirement. It has been suggested by Pieter H. Liettnick that growth biases the maturity structure of the less developed country’s international debt toward short and medium-term obligations, thus increasing the need for compensating 6 Avramovic Dragoslaw, Debt Servicing Capacity and Post-War Growth in International Indebtedness (1958); and Debt Servicing Problems of Low-Income Countries. 1956-1958. (Baltimore, Maryland: The John Hopkins Press, 1958 and I960 respectively), pp. 11-15. infusions of external capital on easy terms. The reason for this is the existence of such countries of a rela tively high marginal propensity to import out of private income. The rising incomes that accompany growth thus generate increased private imports of "both consumer and capital goods that are eligible at best for short or 7 medium-term export or supplier credits. Relationships between several crucial variables - return on capital savings, investment, growth of output, required foreign capital inflow and the associated cycles of debt service ratios - should be formulated and their time-paths followed. Values for the variables can then be chosen on the basis of available evidence and the implica tions of such choices explored. Since national economic growth occurs in the framework of the world economy and since we are concerned with debt service obligations to external creditors, the discussion cannot be limited to domestic variables only. iFor growth to materialize, it is not sufficient just to raise the rates of savings and investment. The pattern of 'resource use must be such as to lead to a reasonably com petitive production of international goods, i.e., products i 7 'Pieter H. Liettnick. External Debt and Debt- Bearing Capacity of Developing Countries (Princeton.New Jersey: Princeton University Press, 1966). Princeton Essays in International Finance, No. 51, P* 19* that can enter exports at remunerative prices or that can | i replace imports. j i Any borrowing on conventional terms results in a j return flow of interest and amortization in fairly rapid succession. Meanwhile, the larger the ratio of debt service obligations to ordinary foreign exchange earnings, the greater the risk that short run disturbances will pre vent debtors from meeting their obligations and the more :likely it is that creditors will be forced into explicit refinancing of the existing obligations simultaneously with maintaining the normal inflow of capital to new pro- 8 Ejects and other-end-uses. In the case of foreign borrowing, debt service payments are a charge on domestic real income and savings. These payments have to be transferred abroad either by expanding exports, by curtailing imports, or by further ‘borrowing abroad. Capital inflows, and particularly ex ports of primary producing countries, are fluctuating. On i I the other hand, debt service on public and private loans ! jis contractually fixed. | The successful growth-cum-debt process ultimately depends on four variables: the size of the investment activity which a developing country succeeds in undertak- 8 Clive S. Gray, Resource Flows to Less-Developed Countries (Hew York: Fredrick A. Prager, 19^9)♦ pp. 1A5- 155^ ing, the rate of return on investment, the rate of plough- hack of the increment in income generated by the new in- ! vestment, and the international rate of interest charged j I on borrowed loan capital. It is a matter of policy which j i one of these variables will be chosen as a target of pol- j icy action. In some developing countries, it will suffice! i to raise the absorptive capacity and thus attain a higher rate of investment consisting of high yielding projects. In all of them, it is necessary to attain a high 'rate of plough-back, and thus raise the average rate of savings which is the ultimate determinant of self-sus- itained and independent national economic growth. And for isome of them, the international rate of interest - that key variable in the process of growth-cum-debt - will have to give in if the international investment system is to ■ | function with tolerable smoothness. THE LIQUIDITY ASPECT OP SERVICING CAPACITY i The factors which affect the balance of payments jand, hence, the country’s capacity to service debt in ishort and medium-term can be classified as follows: I. Fluctuating Variables: A. Exports B. Capital Flows C. Emergency and Inflation - Induced Imports II. Offsetting Variables: A. Reserves B. Compensatory Finance C. Compressibles Imports III. Bigid Variables: A. Debt Service - Interest B. Debt Service - Amortization ' i The economic policy of tbe borrowing country ! i affects tbe behavior of many of these variables in a sig- ! I nificant manner. In particular, the external financial ; situation may be aggravated i& fiscal and monetary prac- j tices are inflationary and their affect on external accounts is not offset by an adequate balance of payments management, e.g., through flexible foreign exchange pol icy. I. Fluctuating Variables A. Exports ! A major element of balance of payments vulnera bility of many developing countries arises from instabil ity of export earnings. Short-term declines in export i i earnings have, in the past, originated largely in cyclical declines in international demand. In addition, there have I I been falls in export receipts caused by occasional natural i ;failures in supply. Further, a number of developing coun tries have experienced reduced earnings over the medium- i i iterm, originating in excess production of primary products in relation to demand. Finally, export declines may be caused by domestic policies which adversely affect the in centives to produce for export to sell on the internation al market. As a matter of fact, periods of above trend TABLE 1 i RECENT SHORT-TEEM DECLINES IN EXPORT EARNINGS PROM PEAK TO TROUGH, AND COMMODITY CONCENTRATION OP EXPORTS Period of Decline Percentage Decline Share of Two Prin cipal Commodi ties in Total Exports Uruguay 1956-59 5^ 77 Boliva 1956-58 58 60 Sudan 1956-58 55 62 Turkey 1957-58 28 42 Columbia 1956-61 27 86 Pakistan 1955-58 25 64 Thailand 1957-58 22 57 Nicaragua 1955-58 22 58 Ethiopia 1957-58 21 64 Dominican Rep. 1957-59 19 63 Brazil 1956-62 18 60 El Salvador 1957-59 18 74 Costa Rica 1958-59 16 76 Honduras 1956-59 14 65 Ecuador 1960-61 15 77 Argentina 1960-61 11 70 Phillippines 1958-60 11 52 China (Taiwan) 1955-56 q . 49 Spain 1959-60 2 25 Venezuela 1957-58 2 91 Source: International Monetary Fund, Financial Statistics, various International issues. 58 I i exports are also periods of high consumption and invest- ; ment expenditures and there is little set aside for a per-j i iod of below trend exports. In such cases, in case of | I countries experiencing fluctuations over the medium-term, ; a measure of maximum decline from a peak would portray the situation more accurately than would a measure based on Q | decline from a trend. I Fluctuations in export earnings over the short term are related to the commodity concentration of ex ports; other things being equal, the aggregate value is likely to fluctuate more frequently and more sharply in a 'country whose exports consist mainly of one or two commod- i |ities than in a country with a diversified export struc ture. But the correlation is far from perfect, since other things are not equal. A petroleum exporting country Iwith 90 per cent degree of concentration on one product, shows smaller fluctuations than an economy where two ;agricultural products amount to 50 per cent of the total I exports. It is necessary to consider not only how highly iconcentrated a country's exports are, but, also, the specific commodities involved and how supply, demand and price of these particular commodities are likely to be have. The evidence shows that for many primary producing countries there has been a tendency for esqport earnings to 9Ibid., p. 147. fluctuate markedly and sometimes violently. An example of medium-term export earnings provided by the past was de velopment in export earnings of the countries depending on I coffee, the second largest commodity after petroleum, mov ing in international trade.^ The problem of medium-term supply-induced fluctua tions still exists in all its intensity, and it is un- I likely to be solved until an advance is made in the sys tematic diversification of the production and export structure of countries heavily dependent on products ex periencing medium-term production cycles and until these countries undertake some measure of international coordin- ,ation of their investment programs and achieve further progress in their joint export sales strategies. In the j ;context of the long-run relationship of various factors in the growth process, we find a number of developing coun tries exports are likely to grow at a slower pace than ■income and investment; as a result, there is a tendency j for to be concentrated increasingly on the most essential items. Also, demand for imports is very strong as a re sult of income growth targets. This is further intensi fied by expansionist domestic fiscal and monetary poli- ^International Bank for Reconstruction and Devel opment, International Development Association, Economic Growth and External Debt. Vol. I. An analytical frame work, staff study of the economic department; March 12, 1964, pp. 10-14. cies, which are frequently pursued irrespective of the phase of the price cycle and of the state of external accounts.^ J B. Capital Flows j Historically speaking, there are two main charac- j i teristics for international capital flows featured the j period up to the second world war. First, a considerable proportion of capital inflow into developing countries was speculative in nature. Private investors in the main capital markets were not always aware of conditions in distant lands and invested in numerous ventures which did inot have a sound basis. Secondly, these capital flows ;were extremely sensitive to the ups and downs of the busi ness cycle. During a recession, the liquidity problem was further aggravated by cessation or even the reversal of capital flows. Phe flow of foreign capital in the devel- 1 oping countries presents a different aspect nowadays. Private direct investment abroad is based on much more i , information than in the earlier periods, and investment j decisions are much better prepared. National and inter- j national lending agencies are now large suppliers of foreign investible funds and these are lent mainly for productive purposes. While downward swings in capital inflow into individual developing countries have not been 1^Ibid. 61 absent postwar periods, by and large such inflows have tended to compensate for declines in export receipts or, at a minimum, they have maintained a fairly stable trend 12 i in the majority of countries. i l As a matter of fact, it might be true that a coun try would have no debt servicing problem if capital inflow were always sufficient to allow it to meet its debt ser vicing obligations while at the same time maintaining im ports at a level which the country considers the minimum acceptable. However, despite the stability in the aggre gate flow of capital recorded thus far, for the majority of countries it is not present circumstances possible to | forecast for a longer period the prospective levels and t fluctuations of capital imports and the range of terms on which they will be available. These, are, however, some forms of capital inflow ion which a developing country can rely with a fair degree ;of assurance, e.g., disbursements on project loans will |continue so long as work on project goes forward and any (other conditions of the loans are complied with. Suppli- l ers' credits are usually available unless the country is considered to be in very severe balance of payments dif ficulties. But the terms may become progressively dis advantageous as the liquidity crisis approaches. On the ^ Ibid.. p. 16. 62 I other hand., private direct investment will necessarily j 1 tend to fluctuate in response to changing conditions in I hoth the capital importing and the capital exporting coun-j tries. But since a considerable fraction of foreign pri vate capital in developing countries is now invested in manufacturing for the domestic market, this will exercise a stabilizing influence. The domestic markets for manu facturers in the developing countries tend to expand at a rapid and fairly steady pace whenever the over-all growth rate is satisfactory, since all investment loans from in ternational agencies are not sensitive to short-run fluc tuations in the balance of payments. Loans and grants provided by governments in the capital exporting countries behave in different analytical approach. But there are other causes of instability in government-to-government flows, largely of political na ture. Yet another source of disturbance, which is of I great importance in some countries in certain periods, is I the sudden outward movement of domestic capital. This j phenomena is caused by a number of factors, primarily of political and monetary nature. Countries which have ex perienced bursts of inflation and successive devaluations would be particularily exposed to capital flight. Despite the fact that these perverse capital movements from the less developed countries to the developed countries have 63 been frequent, not enough is known about their magnitude, | i But it is highly likely that this outward flow has been j substantial and the assets held abroad are very large.^ j This potential source of finance of capital formation in the developing countries has not been yet topped anyhow, G, Emergency and Inflation - Induced Imports To make it obvious, the irregular increase of im ports may be destabilizing to the balance of payments. Crop failures and bad harvests may lead to significant in crease in the important food and other agricultural com modities, while, in terms of domestic consumption of these :commodities, these increased imports may be marginal; in |the balance of payments they may lead to large savings. And such savings have been an important feature of the balance of payments of a number of developing countries during the post war period. Another important source of import increases may be domestic inflation within the framework of pegged ex change rates. This has been a familiar and fairly wide spread phenomena in the developing countries during the last two decades. Agricultural production in many developing coun tries lagged behind domestic demand, which has risen rap- ■^The Study Submitted by IMF to the United Nations Conference on Trade and Development; “Flow of Private Cap ital from Developing to Developed Countries." (E/Conf/ 46/20), Dated January 9» 1964, 64 idly in response to growth in income and in certain cases I as a result of subsidized food prices. j i Consequently, the frequency and magnitude of im- ' t port increases may well become greater in the future un less measures are taken to increase domestic output by applying as modern and efficient methods of production as possible. Similarly, although, there is an increasing awareness in developing countries of the consequences of inflationary finance, it would be too optimistic to expect that inflationary pressures will not recur. It is becom ing increasingly recognized, however, that fixed exchange |rates in the face of continuing inflation are bound to give rise to excessive imports, and therefore, flexible exchange rate practices may have to be applied. Even if some such mechanism is used, it is unlike ly to work efficiently unless the rate of domestic mone- itary expansion is kept within limits. Also, unless flight :of capital abroad is reduced because this, by itself, will |disturb the foreign exchange markets.^ II. Offsetting Variables A. Reserves (External) Reserves comprise gross official gold holdings, convertible foreign exchange and a country's gold tranche position with the International Monetary Fund. 14Ibid., p. 17-18. Two fundamental changes in the level of reserves | i and its complexion have taken place in the post war peri- j I od. First, with emphasis on economic development and a ; i .growing need for investible resources, the opportunity j cost of maintaining foreign currency and gold reserves has risen. A number of countries have partly run down such reserves for financing economic development, while others have spent their reserves on excessive imports caused by I inflationary pressures. Secondly, provision of liquidity through the International Monetary Fund has to a certain extend re duced the need to maintain large reserves of gold and con vertible foreign currency. The lack of flexibility intro duced by the first development has been partly compensated by the second.^ Actually, the country's own reserves by themselves iare not a complete indicator of its ability to adjust it self to liquidity crisis. Specifically, in this discus sion, one has to consider the compensatory finance avail- i jable from international agencies and private sources, i B. Compensatory Finance i The operations of the IMF have been of great im portance in assisting developing countries to cope with their balance of payments disequilibria. Recently, the 15Ibid r 66 1 i Fund introduced a new compensatory facility to offset J fluctuations in export earnings. The important source of J compensatory finance in some cases since the war has been j lending by public agencies in the developed countries, ! particularly the United States. Another form of compensa tory financing is short-term borrowing in the private mar ket. Such borrowing facilities were readily available up j to 1929 to many countries in balance of payments difficul ties. Short-term capital movements between developed countries has reappeared as a device of adjusting to short-term fluctuations in the balance of payments. ! Among the developing countries, the case of a developing country is known which has on several occas ions, during the post war period, succeeded in borrowing Ifrom the private market to weather temporary difficul ties.16 1 Compensatory financing is an effective substitute jfor the maintenance of large reserves of gold and foreign jexchange. Countries which enjoy close and harmonious re flations with the major financial centers may be regarded I [as having a second line of reserves. Although the draw ing facilities provided by the International Monetary Fund are a definite advance in the provision of greater liquid ity, most developing countries do not, at present, have 16Clive S. Gray, op. cit.. p. W . , IBED and IDA op. cit.« p. 21. ready access to the private short-term capital market. j The flow of short-term private capital from devel-; oped to developing countries has had two features. First,j in many cases it has flowed largely through the hranches of the developing countries’ financial institutions. ! These institutions have, during the course of time, built i up an expertise in such transactions. Secondly, where such conditions did not prevail, lenders charged a high premium for risk. Such lending, in effect, added to the possible future threats to liquidity. 'And, when compensatory finance, whether from this or from other sources, has been contracted on short-terms, and (while the export declines later provided to last a number I of years, an overhang of debt with short maturities was created. This overhang is today the magor threat of liquid ity in several very important developing countries. C. Compressible Imports i I Which imports can be included? This depends largely on the pattern of production and demand in each I jcountry. Some countries may produce most of their manu factured consumer goods domestically but import food and raw materials. Others may be largely self sufficient in food and some raw materials but consumer goods. Can the imports of the latter be regarded as com pressible and not of those of the former? And how much hardship is a government able and prepared to impose on the population? The historical approach would require the study of a correlation that may have existed in the past between fluctuations in external receipts and imports - either concurrently or with a time lag. Furthermore, an investigation has to be made of the patterns of import reduction in times of difficulty and whether these pat terns tend to change in the process of economic develop ment. Judgment could then be made as to whether the im port policy in the future would be similar or different. A rough indicator which may be used to indicate the degree of compressibility is the proportion of consumption goods, 17 ;other than foods in total imports. ' The assumption is that the developing countries would rather cut down on this item, at least over the short-term, than resort to a reduction of imports of food, raw materials, fuels and ^capital equipment. Thus, an important factor in assessing !a country's debt-servicing capacity is the amount of "com- I pressible" items in its import bill; i.e., imported goods i jand services a government could afford politically to i iseverely restrict or even eliminate in order to save for eign exchange for the purpose of meeting debt-service .— — — i ■ ■■ i-Ti n ■ in ii. i " m u I i i n " in i 'i 11 r — « " i -| n I i "i. . . . . . . . . . . . . . . .- - . ^Dragoslav Avramovic and others, International Bank for Reconstruction and Development and IDA. Economic Growth and External Debt. Yol. I, An Analytical Framework (March 12, 1964), p. 22. 69 1 18 1 obligations. i It may be argued that the process of economic j i development tends to introduce an element of rigidity in j the import structure of developing countries. Expansion of the industrial base requires expanded imports of fuels, raw materials and capital goods. Seduced imports of these goods may cause unemployment and affect the momentum of growth. III. Rigid Variables A. Debt Service - Interest Interest on the foreign debt is the most rigid element of a country's balance of payments. Interest is contractually fixed and is a recurring charge on the economy regardless of the borrowers' fortunes. Fixed in terest debt in most countries consists today largely of public and publicly guaranteed debt. Consequently, any failure to pay this recurring i icharge adversely reflects on a governments' ability to ,save and to transfer savings and thus inevitably under- 'jmines its credit standing. Equally rigid, is the service !on loan capital borrowed by private parties in the debtor countries. On the other hand, it has been a fairly widely accepted assumption that returns on equity capital fluctu- 18 Clive S. Gray, op^ cit.. p. 145. 70 ; i ate with export earnings. If foreign capital is invested ! in export industries, one would expect that profits and dividend remittances would fluctuate pari passu with, and i i i some direction as, the country's export earnings. As a j matter of fact, these fluctuations should be even more , i intense, since profits generally show wider amplitude of j 19 ! movement than gross sales* 7 This hypothesis can be tested on a sample developing country's which will be referred to later in this chapter as a statistical test for the relationship between the fluctuations in export earnings and direct investment income payments. A partial explanation seems to be a change in the pattern of foreign investment. The major concentration of foreign capital in the earlier periods of economic history was in production for exports (so called enclave invest ment). Consequently, profits moved parallel with export learnings. Today, foreign direct investment in less developed jcountries flows into distinct directions. First, there I are still countries where foreign private capital is in vested extractive industries, e.g., petroleum, aluminum and other minerals. This flow continues to account for a major part of private direct investment in the less devel oped countries. In these cases, profits fluctuate as 1^Ibid., p. 24. 71 i i l exports fluctuate, 1 j B, Debt Service - Amortization ; i The contracual obligation to pay amortization ! i exists irrespective of what happens to other items in the j | balance of payments, while in general, new capital inflows! i may tend to overweigh amortization liabilities. The crit ical situation is that when a country is facing liquidity difficulties, creditors, faced by unpaid or delayed bills, i ; may be compelled to refrain from rolling over old debts and extending new credits. The most severe liquidity crisis are caused by the concentration of maturities in a i ;short period. If the debtor country has to repay a large proportion of its debt with a few years; if no foreign exchange reserves have been accumulated to enable the retirement of the debt; and if the creditors are not will ing to undertake the refinancing of the debt - liquidity difficulties will be acute. A vicious circle of such a sort exist. Creditors may be reluctant to reschedule the 1 Idebt over a longer period because of their past; resched- luling would not help much if the debtor were to pile up I new short-term debts as soon as the existing ones have been funded. On the other hand, the debtor country, if it is unable to space over time the maturities, is almost com pelled to resort to more short-term borrowing, frequently 72 1 i at prohibitive interest rates. Its debt structure worsens; i further. Breakdown is avoided if the debtor country j drastically curtails its imports and thus releases re sources for the liquidation of short-term debts; this helps restore its credit abroad. But in the meantime, the process of economic growth is assisted. Alternatively, I creditors may agree to postpone collections and this pro vides another chance. But if the postponement is only for a few years, a new liquidity crisis occurs in short order. This succession of the crisis inevitably affects the flow of long-term capital that is needed for development. And, it may happen that developmental returns to new investment ,are high, but these investment opportunities cannot be ex ploited because the debt servicing problem at present is i acute.20 DEBT SERVICE RATIO The ratio signifies the proportion of foreign exchange earnings on current account (i.e., exports of goods and services) absorbed by public debt service (i.e., both interest and amortization). The higher - this pro- i portion, that is, the higher this ratio - the greater is considered to be the pressure of debt service on the debtor's economy. The merits of the ratio as an indicator of short run rigidity are substantial. 20Ibid., p. 28 73 ! i I The magnitude of the ratio of deht service to for-! I eign exchange earnings is relevant to appraising the "bur den of debt obligations in the context of cyclical or j i other short-term declines in external receipts. A higher j ratio of fixed service commitments to external earnings implies a considerable short-run rigidity in the debtor country's balance of payments. The ratio indicates the pressure to which debtor country's may be exposed in peri ods of downward movements of their foreign exchange earn- 21 ings. The opportunity cost of default is greater now than in the earlier periods of financial history, since capital flows are now both larger and more stable so that the "typical” debtor would think twice before he went into default. But there again, some countries get more foreign loans and some less, and therefore, the "opportunity cost" will vary. Perhaps most important, policy responses to bal- ;ance of payments pressures inevitably differ from one ;period to another and from country to country. For these ireasons, attempts to identify the critical level of the ratio, at which breakdown of the balance of payments is 22 likely to occur, have been largely unsuccessful. 21 Dragoslav Avramovic and Ravi Gulhati, Debt Ser vicing Problems of Low-Income Countries. 1956-1958. (John Hopkins Press, I960), pp. 101-105* 22 Rymond F. Mikesell, The Capacity to Service For eign Investment in U. S. Private and Government Abroad. History provides little guide for determining the j maximum (debt service) ratio which countries can sustain j ] without default or without interference with the transfer I ! of earnings. Argentina maintained investment service in the late 1890's with an investment payment - current receipts ratio of over 40 per cent - but the country de faulted on public debt obligations in 1933 with a ratio of 36 per cent and restricted transfers after 1949 with a ratio of only 10 per cent in 1945. Argentina's ratio in 1889 rose to 66 per cent, highest ratio in recorded his tory, but she was forced to renegotiate her debts in 1891. Australia managed to avoid defaults during the 1930's with an investment service-exchange income ratio ranging from 35-44 per cent during 1930-1934; and Canada's ratio reached 37 per cent in 1932 without defaults on government obligations or the introduction of exchange controls on current transactions....The degree of tolerance varies iconsiderably from country to country with the breaking point in most countries during the 1930's at 25 to 30 per jcent. On the other hand, it was a sharp rise in the ratio I resulting from the fall in export earnings that brought about the defaults.^ i i (Oregon: University of Oregon Press, 1962), pp. 382-383. 23 ^David Pinch, "Investment Service of Underdevel oped Countries," Staff Papers, IMP. September, 1951» pp. 42-45. CONCLUDING REMAHKS FOB THE ANALYSIS i Most of the developing countries now consider the ; acceleration of economic growth a major task facing the j i ; present generation. Growth targets are ambitious comparedj to resources that can be mobilized domestically for fi- j nancing investment needed to achieve these targets. The ! i responsibility of governments in promoting more investment and faster growth are certainly greater today than they i were, on the average, in earlier periods of economic his tory. Therefore, there is a demand for massive capital inflow from abroad and the major channels through which this inflow is transferred are governments in developing Countries which either borrow on their account or guaran- i tee loans made to private parties. Sooner or later, if economic growth is a success, the structural change in external accounts, with a consequent rapid rise in exports ,and the relaxation of rigidities. But in the meantime, ■and for the foreseeable future, debt service, as a propor- i ;tion of exports, will be very high and the sensitivity of .the economy to declines in its capacity to import will be I I very great. Under these conditions, even minor fluctuations in exports and minor policy errors of the borrower may have major repercussions. The problem of rigidities and fluctuations and of 76 financial danger that imply, are only one aspect of the debt servicing capacity of the developing countries* From the long-run point of view, there are three other funda mental factors. First, the rate of return on prospects must be higher than the international rate of interest. Otherwise, ho basis exists for successful servicing of foreign capital on conventional terms. Secondly, the savings out of newly generated in- come must be sufficient to enable the economy to finance an increasing proportion of its own investment require ments out of domestic resources. At some point of time :aggregate domestic savings must exceed aggregate domestic i 1 investment by a margin that is sufficiently large to meet at least interest charges on the previously incurred debt. ;If that point is never reached, funds would have to be 'continuously borrowed and indebtedness would have to in crease continuously just to meet interest, and as new iborrowings would also carry interest, the debtor - and I the creditor - would face a spiral of steadily rising debt and debt service obligations. Thirdly, the total flow of inve stmentpro j e c t s in the economy must be sufficient to yield an increase in aggregate national output at a rate in excess of popula tion growth. Otherwise, it may be presumed that the pop ular pressures would interfere with debt servicing; and 77 also, the flow of domestic savings is unlikely to expand ; sufficiently unless aggregate real income rises reasonably! fast. I i It might be useful to state the conditions which , would have to be met for the mechanism of international lending at hard-terms to work reasonably successfully. | The assumption is that no arbitrary ceilings in lending i are set and that all projects whose yields exceeds, with a reasonable margin, the international rate of interest (say 6 per cent) are financed. The conditions are: a. Financial 1. The creditors agree to lend continuously despite high debt service ratios and despite the general rigidi ties in the balance of payments of their debtors. The ;length of the period of lending depends on how far partic- 'ular debtors are from the point of "self-sustained" i 1 growth. : Self-sustained growth is defined to mean a rate of I income increase of say 5 per cent p. a., financed out of domestically generated funds and out of foreign capital which flows into the country because it wants to do so. 2. The debtors manage their external accounts in a way which enables them to pay their bills as they fall due, with no questions asked. 78 ! ! 3. The fluctuations in export earnings of the debtorsj are greatly moderated, thus facilitating the fulfillment j i of condition 1 and 2. , 4. Some way is found to solve the "cash squeeze'' problem of those countries which have to pay an extremely large proportion of their debt, over the nexrt few years. For the solution to be lasting, a number of very difficult issues would have to be satisfactorily handled. b• Growth 5. The return on capital is higher than the interna tional rate of interest. 6. The plough-back of profits is high enough so that, I at some point, domestically generated savings exceed do mestic investment requirements and thus leave a surplus :which can be used to meet service payments. I 7. The number of investment projects that are under taken and that meet the condition (5) is sufficient to ;enable the total output to grow at a satisfactory rate. [A reasonably high-income growth rate will also help in meeting the condition (6). "A STATISTICAL-TEST" EXPORT FLUCTUATIONS AND DEBT SERVICING PROBLEMS RELATIONSHIP BETWEEN THE FLUCTUATIONS IN EXPORT EARNINGS AND DIRECT INVESTMENT INCOME PAYMENTS 1. The debt service ratio (the ratio of service pay- ; 79 I J I I ments on external fixed-term debt to foreign exchange j earnings on current accounts) is a convenient indicator of i debt servicing burden in the short run. Debt service is j contractually fixed. In contrast, external earnings (par ticularly of primary producing countries) continually fluctuates. The higher the ratio of fixed service payments to external earnings, the greater the strain which a debtor country may experience when external earnings contrast sharply. While the debt service ratio is an incomplete and imperfect indicator of present or potential liquidity problems and should never be used isolation of all other variables relevant to the appraisal of these problems, it does draw attention to the cash flow squeeze to which an economy, and particularily an economy in the process of ■growth, may be exposed. i Fixed-interest debt consists of public (including public-guaranteed) debt and private debt. Debt service on ! both introduce rigidity into the economic system and into the balance of payments of the debtor; and, ideally, debt |service ratios, when used as an indicators of potential I jand actual liquidity difficulties, should include in the nominator, debt service obligations on both public and private accounts. In practice, the more frequent that only public and publicly-guaranteed debt service ratios are computed and shown. The main reason is that today, 80 j fixed-term debt in most developing countries consists I largely of public and publicly guaranteed debt. Also, the' I data on purely private debt are usually lacking. Another reason may be the proposition that it is j 'the governments obligations, which are of the highest j I order of priority, and, therefore, only public and pub- j i licly-guaranteed debt service ought to be shown in the j i i debt service ratio; but, this proposition cannot claim a | i • I general validity and is likely to remain controversial. i This depends on the context of the analysis and on partic ular interests of particular creditors at a certain time. A more general and more interesting question con cerns the treatment of profits of private direct invest ment. The traditional "creditworthiness" analysis assumes that returns on equity capital fluctuate with export earn ings, and, therefore, they should not be included in the idebt service ratio as an indicator of the debt service i |burden over the short run. j Section 2 and J test the validity of the assump- jtion stated above. Section h sets forth the implications of the findings in the wider context of debt-servicing problems of the developing countries as they arose against the background of continuing and frequently violent fluc tuations in their external earnings. 2. The Test The test consists of correlation analysis of fluctuation in receipts from merchandise exports and of fluctuation in direct investment income payments. Exports are considered the independent variable and direct investment income payments, the independent variable. The time series of both variables have been used as a basis for analysis. Since the object of the exercise is to determine the relationship between fluctuations in the two series, coefficients derived from the first differences in the two series are of greater significance than those derived from the raw data. The raw data are affected by trends and factors common to both series. The test is carried I out on sample of 20 developing countries. Continuous data for export receipts and direct investment income payments were available for these 20 countries for the period 1948- 1961. There are no serious conceptual or statistical problems in the time series of merchandise exports. Some problems arise with respect to the time se- ;ries of earnings on foreign direct investment. First, on jthe statistical level, the data are imperfect. Secondly, on the conceptual level, there is the question whether both transferred and reinvested earnings should be in cluded in the analysis or only the former. It is decided to use the gross concept, i.e., the total earnings flow. Decision on whether or not to transfer earnings is TABLE 2 RELATIONSHIP BETWEEN MERCHANDISE EXPORTS AND DIRECT INVESTMENT EARNINGS WITHOUT TIME LAG IN TWENTY LESS DEVELOPED COUNTRIES, 1948-1961 First Differences Raw Data | Significance Significance! 9 at 5 per p at 5 per | Country . r r . cent level _ c . r r cent level Iraq .930 .853 * .995 .988 * Venezuela .913 .818 * .776 .570 * Honduras .888 .770 * .674 .409 * Costa Rica .745 .512 * .362 .059 X Chile .696 .438 * .432 .119 X Ecuador .52? .212 close .961 .918 * Peru .485 .163 X .926 .846 * Ceylon .465 .143 X .374 .068 X Dominican ! Republic .458 .138 X .200 .040 X El Salvador .391 .076 X .821 .646 * iParaguay .361 .031 X .127 0 X !Nicaragua .326 .025 X .425 .112 X Haiti .307 0 X .144 0 X :Mexico .267 0 X .750 .526 * . ■ Colombia .257 0 X .041 0 X Panama .262 0 X .318 .011 X Uruguay .254 0 X .747 .521 4 1 ;Argentina .243 0 X .177 0 X !Guatamala .088 0 X .559 .255 X Ethiopia .054 0 X .707 .457 * r - Coefficient of correlation. , - p ,r - coefficient of determination corrected for the ; degrees of freedom. * - significant. X - not significant. Source: IMF, Balance of Payments Yearbook - various volumes. 83 j f affected by a number of factors, among them the overall | i economic and political prospects of the country; some times, the ability to transfer them is influenced by gov- ! ernment policies of the country where investment is lo- i cated, and tax considerations can frequently exercise a decisive influence. All these factors are essentially exogeneous. If there is a systematic relationship between i fluctuations in exports and fluctuations in earnings on j foreign direct investment, it should be found in total t ;earnings, transferred, as well as reinvested. 3. Findings I The findings are for five out of 20 countries: Iraq, Venezuela, Honduras, Costa Rica and Chile. A • clearly significant correlation fluctuation in the two series was found. For the sixth country, Ecuador, the significance of this correlation was less certain. Two factors are common in all these countries: !(1) Direct foreign investment is heavily concentrated in i the export sector (oil in Iraq and Venezuela; bananas in Honduras, Costa Rica and Ecuador; mining in Chile); (2) Products of industries in which direct foreign capital was invested amounted for the following proportions of mer chandise exports in 1955* one of the middle years of the series. Iraq Venezuela Honduras Costa Rica Chile Ecuador 91 per cent Petroleum 96 per cent Petroleum 80 per cent Bananas 41 per cent Bananas 8? per cent Minerals 54 per cent Bananas For 15 out of 20 countries the correlation between! 'Vl.PC | fluctuation in the two time series was/significant. In ; i order to throw further light on these cases a further test; was carried out: it was assumed that direct investment income payments would follow merchandise report receipts with a one-year time lag, so indicated in Table 5» raw data give mixed results. However, the relevant correla tion between fluctuations in the two series is of signif icance only for one country, Mexico. which do not show the characteristics indicated before in the beginning of the discussion (in the theoretical back ground) , direct investment income payments need not neces- Isarily fluctuate with fluctuations in export earnings. A ipoor correlation of the two line series examined reflects ! one of the following two situations, or a combination j thereof; (a) Export earnings, and fluctuations in them, depend on products of industries in which foreign direct invest ment does not play a major role. This tends to be the case in countries where exports are concentrated in coffee or cotton where equal capital stock is largely domesti- It may be concluded that in developing countries ( TABLE 3 RELATIONSHIP BETWEEN MERCHANDISE EXPORTS AND DIRECT INVESTMENT EARNINGS WITH ONE-YEAR TIME LAG IN TWENTY LESS DEVELOPED COUNTRIES, 194-8-1961 First Differences Raw Data Significance Significance Country r r2 at 5 per cent level 2 r r at 5 per cent level Iraq .075 0 X .928 .848 * Venezuela .233 0 X .555 .246 X Honduras .567 .254 X .561 .252 X Costa Rica .245 0 X .742 .510 * Chile .028 0 X .149 0 X Ecuador .383 .062 X .922 .836 * ;Peru .292 0 X .809 .623 * Ceylon Dominican .378 .057 X .682 .417 ■ * Republic )E1 .288 0 X .426 .107 X ' Salvador .034 0 X .834 .667 * Paraguay .721 .472 * .541 .228 X Nicaragua .059 0 X .641 .357 * Haiti .009 0 X .095 0 X Mexico .660 .380 * •826 •654 * Colombia .010 0 X . 082 0 X Panama .310 0 X .254 0 X Uruguay .016 0 X .703 .449 * Argentina .247 0 X .254 0 X Guatamala .094 0 X .317 .019 X ■Ethiopia .028 0 X .769 .554 * r - Coefficient of correlation. i 2 r - coefficient of determination corrected for the degrees of freedom. * - significant. X - not significant. Source: IMF, Balance of Payments Yearbook - various volumes. 86 ; cally owned, and where exports of industries with sub- ; stantially foreign direct investment are of minor signif- 1 icance. , . i (b; Foreign investment is concentrated in industries ; catering essentially for the domestic market, while flue- J , i tuations in export earnings do not directly affect produc-j tion and earnings in industries selling in the domestic market; it may be assumed that lower or higher export earnings will be reflected, with a certain time lag, in reduced or increased demand for certain domestic products. 'Such "automatic' * adjustment will only take place if gov ernment policies are not directed towards monetary expan sion during periods of falling exports and toward anti inflation during export booms. Table 3 indicates that only in Mexico did direct investment income payments, in fact, follow fluctuations in export earnings. This may have something to do with the fact that Mexico pursued financial policies which can be considered conservative in comparison with other developing countries. | 4-. Implications i If foreign capital is invested in export indus tries, one would expect that profits and dividend remit tances would fluctuate pari passu with, and in, the same directions, the country's export earnings. As a matter of fact, these fluctuations should be more intense since profits generally show wider amplitude of movement than gross sales. The above findings indicate that in the majority of countries in the sample, there was no such automatic tendency for profits and dividends to fluctuate with fluctuations of export earnings. A partial explana tion seems to be a change in the pattern of foreign in vestment. The major concentration of foreign capital in the earlier periods of economic history was in production for exports (so-called enclave investment). Consequently, profits moved parallel with export learnings. Today, foreign direct investment in less devel oped countries flows into two distinct directions. First, there are still countries where foreign private capital is invested in extractive industries, e.g., petroleum, alum inum and other minerals. This flow continues to account ;for a major part of private direct investment in less developed countries. i In these cases, profits fluctuate as export fluc tuate. There is, however, a second set of countries which !are establishing industries producing import substitutes I or completely new goods that are sold on the domestic market. Foreign private investment has played a consider able role in this development, not only with respect to consumers goods, but also in the fields of capital goods 88 I I and. basic chemicals. | Domestic demand for these products is increasing j rapidly and without much fluctuations. j The implication is that a change in economic structure which will have a favorable long-term effect, has been accompanied by an increase in the short-run rigidities in the balance of payments of many developing countries. Their exports still consist of primary prod ucts which continue to fluctuate, while debt service pay ments, including profits of foreign-owned companies, some of which are liable to be transferred to the parent organ- I iizations, originated in a rising and barely fluctuating (domestic) market. And .the problem is further complicated if inflationary pressures operate in the developing coun try while its exchange rate is kept overvalued. CHAPTER III MOBILIZATION OF RESOURCES; CAPITAL REQUIREMENTS AND POLICY MEASURES INTRODUCTION Of all the obstacles to economic development, the availability of resources for building up the stock of productive assets in a country is, of course, of paramount importance. This stock embraces not only machines, fac tories, irrigation facilities, transportation, etc., but less tangible assets such as human skills. The one common ingredient to all these is that they require resources to be made available if their supply is to be augmented. This flow of investible resources to any one country can ■be managed by assistance from other countries or organiza tions on either grant or refundable loan terms. However, jdeveloping countries face one of the obstacles to their idevelopment and to achieve this goal through their own inational efforts to raise their domestic rates of savings that would be the major contribution to augmenting their stock of capital. Also, what is also of great significance in this regard is the attempt by lending agencies to determine the 89 extent and type of external financial assistance given to j a country on the basis of the country's own efforts to ^ overcome the internal obstacles to its development. J i It has come to be recognized that the ability to service external debt is essentially dependent upon two general considerations. First, its ability to use in- ;vestible resources in a productive manner so that real national product increases overtime, and, secondly, upon its willingness and ability to save a growing proportion of this increment to its national income. If the domes tic performance is good in this crucial respect, then the growth of external debt burden gives far less cause for alarm than is sometimes supposed. Of course, the debt burden is still likely to raise short-term liquidity problems for a country from time to time and it might, ;furthermore, be judged undesirable to have such a large ;reverse flow of principal from developing to developed ;countries or international lending agencies as such, :especially for countries where the period over which ex- i j ternally supported development takes place is likely to be long. Certainly, the existence of these reverse flows is of concern to lenders. For a variety of reasons, most economists have argued that the major increase in the na tional development effort is the direction of increasing domestic savings, can only be accomplished by direct gov ernment action which would compulsorily reduce personal 91 consumption, either by increased imposition of direct i takes to reduce personal disposable incomes, and/or by the! increased imposition of indirect taxes to reduce the real value of a given level of monetary disposable income. ' i I ANALYTICAL APPROACH FOR THE PROBLEM The underdeveloped countries are generally under stood to mean the vast areas of the world in which income t per capita, and, consequently, the average standard of living is below the level prevailing generally in western Europe and the United States, Canada and Australia. Near ly all the underdeveloped areas comprise countries in ;Latin America, Asia and Africa at large. Although partic- ; I iular conditions affecting the development differ from country to country, a common characteristic of the under developed countries is then, on the whole, production is carried on with a relatively small amount of real capital per head and with relatively backward techniques. Econom ic development is the process of increasing real capital :and improving techniques of production. i i This basic problem, in order to achieve higher i standards of living, is to ensure that the increase in capital and the introduction of better techniques are so applied as to make the best possible use of existing and [potential and physical resources for the purpose of rais ing real income per head. 92 ; i The desire for certain types of development for , i strategic reasons, e.g., is one of the factors influencing! i the direction in which capital and technique are applied • for the purpose of increasing production. ! The desire to meet certain domestic social or po- i litical requirements is another factor. These non-economic aims may he important to any given country, though they can normally be attained only at some sacrifice of real income. Whatever the aims, how ever, the process of development, namely the addition to existing capital and improvement of techniques for the purpose of production, is generally the same anywhere. I The application itself of capital and technique may take place in many different forms, as shown by the varying patterns of development in different areas and i countries at different times. Capital formation may occur in agriculture through ; the use of better tools and the application of fertili sers, through mechanization, irrigation and better proces sing facilities; or in mining, through new exploration and the use of more efficient extracting and refining equipment; or in industry, through the growth of light consumer's industries or the establishment of a heavy ^United Nations. "Methods of Financing of Economic Development in the Underdeveloped Countries.1 ' (New York; 1^4-9), pp. 90-91. 93 ; industry; or in the fields of economic activity. i i Additions to housing, transportation, communica- | tions and power normally constitute a major part of capi- ! ! tal formation. Improvements in general education and in technical knowledge are indispensable concomitants of i development. Development is necessarily a long, hard process, measured in decades, not in years. There are many limit ing factors of which inadequate availability of finances is not the only one. External financing is useful for development only when it is productively imployed; if it is wasted, the economic progress of the recipient country, instead of 2 I being advanced, is retarded by the burden. The very fact of the underdevelopment cannotes an insufficiency of the talents necessary to translate devel opment concepts into practical propositions, ready for ;execution. The lack is not just of the highest skills; in jmany countries the need is as much for foremen and skilled [mechanics as for managers and supervisors. Moreover, the data of kinds, including economics, are fragmentary and often unreliable. The need for hydro-electric power and irrigation, e.g., will in many areas take some years to satisfy, simply for the lack of geological and hydrologi- 2Ibid., p. 91. 94 j cal information. In addition, the necessary political and social foundations for development can gradually he j “ built. Low productivity and living standards are as much | the product of unstable government, unsound finance, bad health and lack of education as of inadequate resources or the lack of productive facilities. The assistance that the international, as well as national, agencies can be rendered to the underdeveloped countries might lower these hurdles and the absorptive capacity of these countries for additional financing to be increased accordingly. PROBLEMS OP SUPPLY Absorptive capacity is the amount of foreign capi tal a country is prepared to demand at various rates of return. At no cost (such as in the case of grant aid), a country's demand for capital might be substantial or equivalent to broad uses in some development plan, but private rates its demand would be narrowed to projects offering commercial rates of return or able to service 'private investors. Developing nations are able to advance only a limited number of such projects; thus, it is most useful to think of absorptive capacity as being a demand schedule for funds at different costs (and terms) and over varying time periods. This can be interpreted that the demand for capital rises at an increasing rate as the re quired rate of returns declines as can be seen in the following figure. Hate of Return Absorptive Capacity A B C D C A. B ; CAPITAL INVESTMENT At high private rates, e.g., A or B absorptive ■capacity is narrow, at low rates of return (characteristic of subsidized capital) the demand (C) is naturally great er. In today's highly competitive international capi tal market, funds are provided at many rates; therefore, ;absorptive capacity is a variable and not any single figure• THE CAPITAL GAP The difference between the actual level of invest ment by developing countries and the amount they must in vest to achieve a selected target rate of growth has been termed the capital gap. Since there are no agreed upon Phillip Perera, Development Finance. Institu tions. Problems, and Prospects. (New York: Frederick A. Praeger, 1968), pp. 52-55. 96 target rates, significant variance in estimates of the i gap prevail. The following figure depicts the gap. If an amount of capital (point A) were invested and it produced a growth rate of (X), the difference between A and B rep resents the additional capital that must be invested to l L achieve Y per cent. Bate of Growth Y X CAPITAL INVESTED FINANCE MEASUBES TOWABD DEVELOPMENT Domestic financial resources In low-income countries it is difficult to in crease the volume of current domestic savings. Much can be done, however, to institutionalize saving and encourage its investment in the fields of greatest urgency and pro ductivity for the economy.^ The particular methods adopted must take account of the pecularities of each country and the preference of its population. When saving is held in the form of Ibid., p. 69. 5See, U. N. ECAFE, SEC, ’ ’ Some Financial Aspects of Development Programs in Asian Countries," Economic Bulle tin , Vol. Ill, No. 1-2; January-June, 1955._______________ 97 ; i hoarded cash, it does not contribute directly to the ag- I i l gregate investment of the economy. In some countries, the| i nonproductive saving (hoarding) of cash has been offset j i by the expansion of credit, but this method of finance hasi the obvious disadvantage that it may be rendered unsound if changes in savings habits reduce the proportion of cur rently hoarded cash.^ The principal alternative to cash are bank depos its, bonds and other obligations, equities, precious metals and Jewelry, foreign exchange assets and fixed (investment) assets. There can be no doubt that it is desirable in an |underdeveloped country to encourage saving in the form of 'savings accounts, ordinary bank deposits, bonds, stocks and other financial instruments, while it is at the same time important to discourage the private holding of pre vious metals and foreign exchange and the direct holding of certain fixed assets (investments) in which a low-in- icome country could do without or postpone such as luxury iapartment buildings. But development of savings institu tions and of capital market should not be an end in it self. In fact, there has been a lack of the right type of financial institutions, and, also, an excessive diversion of their resources (for many underdeveloped countries) to 6Ibid. 98 short term, often speculative, types of activity, with little contribution to the types of investment most ! needed by the economy. That such diversion has occurred | is a consequence of the misdirection of the demand for investment funds, and, in many cases, of the lack of ' ’enterpreneurship'1 which factors are in turn bound up with the low levels of development.7 The particular institutional measures taken to l ;encourage and mobilize savings may concern improvements in i the banking, savings and insurance institutions; the crea tion of specialized credit agencies or banks; the estab lishments of social security or pension funds; the regula tion of corporate and business savings devices; the devel opment and regulation of securities markets; the devising i . of credit instruments for special preferences of savers i :and so on. Appropriate tax inducements can be used to |encourage desirable types of investment. The creation of !conditions of general confidence and stability is usually i ian essential element in inducing institutional savings, i i and particularly in discouraging nonproductive forms of i |savings and investment. Any measure taken, however, either to channel savings through particular financial mechanisms or to encourage certain types of investment or discourage others, can only be fully successful if pursued 7U. N., Loc. cit., p. 93. with a framework of a coordinated real investment program, i Where the volume of saving that can he channelled j i i towards banking, savings and insurance institutions or j 'towards the private capital market is not very large in ;relation to investment needs, or not suited to the partic ular types of investments required, a further way of mo bilizing saving or development is through appropriate taxation or through issues of government bonds. In either, the purpose would be to carry out public capital requirements of the type normally not undertaken by pri vate capital, and/or to promote, participate in and en- !gage directly in various types of undertakings that are i temporarily not attractive to, or completely feasible by, private capital. The latter aspect is illustrated by the establish ment of development corporations or institutes, which in most cases as autonomous government agencies, are playing a significant role in many countries. j A consistantly important point to consider in the !choice of methods of domestic financing, and particularly in the choice of objects of investments, is that it should be such as to set in motion a self-generating process of investment and saving whereby each new stage of capital formation leads to additional and stronger sources of saving that can be tapped for further investment. Gradual 100 'evolution of banking and financial institutions and care fully drawn up development programs and policies should result in a successful and increasing utilization of domestic saving as levels of income rise, A part of the process of mobilizing and channel ling domestic saving is the utilization of a country's foreign exchange assets. The latter usually results from (the export of goods and services. ! In the absence of capital movements, they increase when exports exceed imports. It follows that a current account surplus in the ,balance of payments is productive of increased domestic 'income, and, consequently, of saving, which can be a 'source of investment. A policy of export promotion, and within limits, one of imports, can be a way of making available domestic !saving at the same time that the country is provided with i i !foreign exchange with which to pay for additional capital ! |goods or consumption goods required by a development pro- I gram. Expansion of trade and an adequate export-import price relationship are important determinants of a coun try's economic development. Inability to earn sufficient foreign exchange or limitations in the use of past or current accruals on the necessary import goods can be serious obstacles to devel opment too. The fullest possible utilization of domestic fi nancial resources should be the mainstay of capital forma tion in the underdeveloped areas. In the financing of utilization of domestic financial resources, it is empha sized so much role of domestic finance in economic devel opment because it is believed that that is the prerequi site for enabling countries to implement the social, po litical and economic policies which they consider most suitable for the improvement of their standards of living. The role of foreign finance in economic develop- O ment can, therefore, be of a subordinate character. EXTERNAL FINANCIAL RESOURCES It is frequently the case, especially in the de veloping countries where income per capita is lowest, that current domestic saving, even if efficiently mobilized and idirected to productive investment, is not enough to pro duce satisfactory rate of growth or economic development. The addition of outside financial resources may be a necessary, and, in some instances, a substantial feature j jof such development, particularly in order to accelerate jdevelopment. External financial resources are transferred Q United Nations, "Mobilization of Domestic Capi tal: Report and Documents of the Second Working Party of Experts.1 1 Department of Economic Affairs, Trade and Fi- hance Division; Economic Commission for Asia and the Far East (Bangkok: 1953)» PP* 24-49. 102 to the developing countries fundamentally in the form of imports. They represent, therefore, direct addition to i the available real resources. The addition of foreign | I capital can be of more benefit when the combined utiliza tion of domestic and external financial resources results ;in a high rate of investment. Economic development suggests various forms of external financing, of which three main types may be dis tinguished: direct or enterpreneurial investments, loans i and grants. These three forms are neither mutually ex clusive, nor, on the other hand, suited for every purpose. iAll three may originate in either private or public sources. The predominance of any one at certain times or in certain areas is bound up with particular processes. 'Conditions, and what is more important today, the domestic I development policies, differ from country to country, and ’are favorable or unfavorable to one or another method of i Q external financing. ! Private, direct or enterpreneurial investment from !abroad has several distinct advantages for an underdevel oped country. One of them is the combination of capital, technology and managerial skill under one unit of control. A further feature of such investment is the facility with which once established, it can expand through reinvest 9Ibid., pp. 95-99 103 I ment. It is also flexible in that it allows for varying | I degrees of participation with local capital. A special ! I advantage from the balance of payments point of view is j that direct investments do not create a fixed burden of , ,out payments in times of declining activity and trade. On the other hand, private direct investment may i not fulfill all the development requirements of a country J i :or may encounter impediments that are not easily remove- able. In the past, the major volume of private interna tional investments has been made either in the more devel-j ,oped countries or in the raw material or foodstuff export .industries of the underdeveloped areas. A certain amount has also gone into public utili ties and railways. Only a minor part has been invested in production for the domestic market of the underdeveloped countries. This is an important consideration, because it ; draws attention to the fact, often insufficiently empha- i |sized at the present time, that private investment, are ! I attracted by markets, and market demand does not lead t necessarily to a balanced all-around development. Where economic activity is small, and particularly where, as in most underdeveloped areas, effective markets are narrow and weak (which does not need, of course, that needs are not great), there may be both technical and economic i o 4 - n reasons why little inducement is felt by foreign private j Q j capital. On the other hand, where there is a possibility i i of producing for export to the world market, or for par- ! i I ticular foreign markets, there is a greater market attrac tion for the foreign investor - in addition to the possi bility of directly earning foreign exchange out of which to service and amortize the investment. The fact that, today, world markets are to a large extent broken up into bilateral or regional compartments and that heavy invest ments are often required in the initial stages of new development, is likely to be one of the major political - ieconomic elements affecting the outlook for private for eign investment. The other elements influencing private investment :are related to the question of "climate" and national |policies and to foreign exchange difficulties and prac tices. In order to protect themselves against outside in- |fluence in domestic affairs, many countries have imposed |restrictions on foreign capital which in some cases have ■ q ;been excessively rigid. Some underdeveloped countries desire to pursue 1QFoundation for Economic Research of the Univer sity of Amsterdam. "Management of Direct Investment in Less Developed Countries" (New York; H. E. Stenfert Kruese, 1957), pp. 20-34. ■^Lyle W. Shannon, Underdeveloped Areas (New York; Harper and How, Pub., 1957), pp. 200-206. 105 ! J 1 I strongly nationalistic policies that may envisage ultimate| government control or ownership of large sections of the J economy. Others have worked out or are tending more and more to formulate fairly comprehensive development pro- j grams in which certain fields of investment may be re served to domestic capital or certain activities may be held more desirable than others for foreign capital par ticipation. In some cases, substantial direct sharing of a venture with local capital is required by law. The existence of such policies and programs in the 'underdeveloped countries poses a delicate problem of ad- ; ! ijustment between the conditions and requirements of for- ,eign investors and the needs and requirements of the capi tal importing countries. In addition, numerous administrative and technical I obstacles to private foreign investments have been signif- i ;icant factors, both in general and in particular cases: i , (a) Lack of equality in access to law and fear of arbitrary behavior by the administrative authorities: j (b) Double taxation; (c) Fear of discriminatory taxation; (d) Compulsory reinvestment of profits; (e) Compulsory participation with domestic capi tal ; 106 : (f) Inflexible provisions regarding employment of foreign personnel; f (g) Restrictions on ownership of land, mineral ! ! i deposits, etc.; (h) Restrictions on transfers abroad of profits; said (i) Lack of assurance of appropriate compensation in case of nationalization or expropriation. i Some of these obstacles may be more removable than, others if sufficient feasibility can be introduced into certain of the provisions regarding foreign investments to attract foreign capital. Bilateral negotiations, partic ularly on matters of double taxation, can also be helpful in achieving similar results. lax inducements by both :capital-exporting and capital-importing countries are a ! I ? useful incentive. PRIVATE LENDING The encouragement of private portfolio lending, a ( 1 type of investment that in many cases has played a leading i !role in underdeveloped areas, presents a somewhat differ- ! jent set of problems. The uncautious lending and borrowing of the 1920's and the affects of world depression on the borrowing coun- 12 "Management of Direct Investment in Less Devel oped Countries," Loc. cit.. pp. 28-34-. 107 j tries capacity to service and repay the loans and wide- ! I spread defaults combined to narrow very considerably the j I ! outlook for foreign lending from private investors in the ' present post-war period. More basically, perhaps, the un settled state of international political and economic affairs discouraged the potential investor from wishing to take a risk abroad. The relative attraction of domestic investment in the case of United States private capital, and the urgent domestic capital needs in the case of west- ■ ern Europe countries also strongly influences the flow of .capital to the underdeveloped countries. i THE SITUATION OF THE OIL PRODUCING COUNTRIES One of the most striking features of the world oil map is the concentration of the crude oil reserves in few countries. In the western hemisphere most of the oil re serves are concentrated in the United States and Fenezuela. In the eastern hemisphere they are concentrated in the [Soviet Union and some of the middle eastern countries. Because of the stage of economic development of the United iStates and the Soviet Union their oil industries were de veloped to meet their country's own demand for energy in the first place. The other oil-producing countries, how ever, have a very low indigenous demand for oil. This means that the oil industries in the Middle East and 108 ' i Venezuela must be developed to meet the advanced coun- ' i tries' demand for oil. However, the capital and techno- i j logical requirements for developing, producing, transport-j ing and refining the crude oil and finally marketing the products are well beyond the capabilities of countries like Venezuela, Iraq, Iran, Kuwait, Saudi Arabia, Libya, J Indonesia and Algeria. As an illustration of the magni tude of this industry's capital requirements, by the end of 1962, gross investment in fixed assets outside the United States and the Soviet Union was estimated to be $54.9 billion; of this amount, $16.7 billion was invested in the production phase of the oil industry.^ This inability to develop their oil resources has resulted in the influx of capital and technology. But to exploit the oil resources profitably and to benefit from the economics of large scale production, a simple produc ing firm has to be awarded the concession for the develop ment of oil deposits in a large tract of land. Iraq falls i into this category where concessions for the development of oil deposits were awarded to foreign companies. The main explanation for the oil industry's growth was the tremendous increase in demand for oil in the post war period. This, because of the European reconstruction, 13 •'The Chase Manhattan Bank. Capital Investments of the Vorld Petroleum Industry. (New York: 1962) p. 4. TABLE 4 REVENUE FROM OIL AS PERCENTAGES OF TOTAL GOVERNMENT REVENUE Country Percentage Year Iran 41 1959/60 Iraq 61 1959/60 Saudi Arabia 81 1959/60 Kuwait 87 1957/58 Behrein 83 1959 Source: United Nations Statistical Yearbook, 1961. pp. 562-563 : 110 ' 1 I the exceptional increase in military demand during peace | I time, the tendency for agricultural mechanization and the ! f general increase in the number of motor vehicles. More- j over, it was thought that the United States, which became a new importer in 194-8, would rely to an increasing degree upon importing foreign oil more cheaply than it could pro- 14 duce oil at home. While the rise in demand for crude oil provided for Iraq's expanding output, the newly introduced profit- sharing principle provided for a higher per ton revenue. The average per ton received by Iraq from the period of ;1951 to 1959 was 50 as compared with an average of 1 ill.75 per ton from 1934- to 1950 (according to the articles jof agreement of 1952). It is apparent from the present contractual arrangements between the government and the operating 'companies that oil revenue is determined by: (a) cost of ■production; (b) price of crude oil at the Iraqi border; j(c) share of the government profit (it is 50 per cent of the profits annually, that resulting from the operations of the companies in Iraq, which are defined as the differ ences between the posted price of oil imports and the cost of production multiplied by the number of tons); and (d) output. And since (a) and (c) are fixed by the agreement 14 J. E. Hartshorn, Politics and World Oil Econom ics (New York: Frederick A. Praeger, 1962), p. 37. " itself, the determinants of oil revenue are, therefore ; i output and price. J I i OIL OUTPUT j The oil industry is composed of interrelated phases of operation designed to bring the oil to the final consumer. At the first stage of operation the production of crude oil requires a considerable amount of investment j for developing, finding and producing the oil. However, once crude oil is found, the lifting costs (variable cost) 1 are much smaller than the initial capital expenditures (fixed costs). The fact that most of the oil reserves are :found in the underdeveloped areas of the world only adds to the magnitude of the initial capital which must be "sunk” before the oil is even found, because an oil pro ducer has to invest in a host of installations, houses, iroads, and other social services which would already have been found in more advanced economies. In an industry like this, where the marginal cost i ! is low in relation to the average cost, a fall in the price of the product will not induce the producer to con tract the production as long as the unit variable costs are covered by the price. This kind of cost structure will expost the producer to market hazards if he has no assured outlet for the oil he produces.^ 15 ^John McLean and Robert Vm. Haigh, The Growth of 112 ; The importance of the assured outlet for the pro- J ducer and the fact that the crude oil has to he refined I I I before it can be used as a source of energy led to the ; integration of these two distinctive, though highly inter related, phases of the industry. This becomes more impor tant if we know that refineries are characterized by a high proportion of fixed capital. This phase of the in dustry requires that in order to be profitable, a refinery i should always be operated at or near full capacity. This i is so because processing costs per barrel may rise as much as 60 per cent to 85 per cent as the through-put falls 100 per cent to 50 per cent of the refinery's de signed capacity. This requires that the refiner must have an assured market for his products, on the one hand, and ■an assured source of crude oil supply on the other hand. The importance of an adequate supply of crude oil 'is made clear by the fact that its cost represents between :70 per cent and 80 per cent of the value of the petroleum ! i c : products. i j This sensitive position of the refinery provides janother incentive for carrying forward the integration Jprocess to involve the control of marketing network to reach the consumers. The success of this integration Integrated Oil Companies (Boston: Harvard University Press, 1954), p. 663. 16Ibid. 113 process depends on not only the control of the crude oil and the refinery and the distribution network but also the! control of adequate transportation facilities especially j designed for the oil industry. The incentive for vertical integration is strengthened by the nature of the elasticity of the demand for crude oil. Since the demand for crude oil is "de rived" demand and since the demand for its product is inelastic in the short-run, it follows that a reduction in price will not promote the demand to any considerable ;extent. Moreover, the nature of the activities of the oil 'industry, which requires considerable amounts of capital, also had its effect on the emergence of very few interna tional oil firms with enough financial resources under their control to develop the oil resources scattered around the world. These international oil firms are Standard Oil jCompany (New Jersey), Royal Dutch/Shell Group (Shell), Gulf Oil Corporation (Gulf), Secony Mobil Oil Company j(Socony), Texaco Oil Corporation (Texaco), Standard Oil of California (Socal), British Petroleum (BP) and Companie Prancais des Petroles (CPP). By I960, the first six of these produced 34.1 per cent of the United States oil and 87 per cent of the Venezuela oil. The eight companies in the same year produced 92.3 per cent of the Middle Eastern Oil. Thus, the commanding role which these eight interna 114 tional integrated firms play is providing the link between the separated producing and consuming centers is indis pensable.^ In Iraq, as well as in the other oil producing countries, the operating company which produces the crude oil is owned jointly by more than one of the eight com panies. Thus, in one combination or another a number of br all of the major oil companies own 100 per cent of the operating companies in Kuwait and Saudi Arabia, 94 per cent in Iran, and 95 per cent in Iraq. In addition to these joint ventures, five major firms are parties to long-term contracts of the sale and purchase of oil from i * | ^ Kuwait and Iran. OUTPUT, REVENUE AND PROPIT SHARING 1950 - 1964 During the period 1950 to 1964, both output and revenue continued to increase in Iraq. Iraq, as well as ithe other oil producing countries, is different from other jprimary product exporting countries in that the demand for i [oil, because it is a source of energy, continued to grow i jduring this period. Unlike the demand for other raw ^P. H. Frankel, "Prospects of International Petroleum Industry.1 1 In United Nations, Technique of Petroleum Development (New York: 1964), pp. 334-33$• 18 Wayne A. Leeman, The Price of the Middle East Oil (Ithaca, New York: Cornell University Press, 1962), Chapter II. 115 ! materials, the demand for oil is not affected by mild ! i recessions in advanced countries. As a matter of fact, j only once in the history of the oil industry was there an I i absolute decline in demand for oil, and that was during the great Depression. The impact of the oil industry on the Iraqi econ omy takes two forms. First, through its contribution in terms of government revenue, foreign exchange earnings, employment, supply of energy, demand for local products, j and national income. Second, an indirect impact through j i financing development investment expenditures. THE IMPACT OF DEVELOPMENT EXPENDITURES ON THE IRAQI ECONOMY In analyzing the impact of the economic develop ment policies during the period of 1950 to 1964 it can be attempted to measure the effect of the investment expen ditures on national income, consumption expenditures, capital formation in non-oil sectors, and per capita in- I jcome as well. National income has been estimated to be ID 158 j million in 1950 and ID 526.5 million in 1962. The real national income, however, was estimated to be ID 165 million and ID 424 million in terms of 1956 prices, re spectively. In the following table the relationship between TABLE 5 IRAQ: CRUDE OIL PRODUCTION AND OIL REVENUE 1946-64 Year Production Million Tons Revenue ID Million 1946 5 2.3 1947 5 2.6 1948 3 2.0 1949 4 3.2 1950 7 5.3 1951 8 13.3 1952 18 32.4 ;1953 28 49.9 ;1954 30 65.4 1955 33 84.4 ! 1956 31 68.8 1957 22 48.6 1958 35 79.9 11959 41 86.7 'i960 47 95.1 1961 48 94.8 |l962 48 95.1 '1963 56 110.1 11964 I 60 126.1 Sources: S.H. Longrigg, Oil in the Middle East (Oxford: Royal Institute of International Affairs, 1961), pp. 368-69; British Petrol- eum, Statistical Review of the World Oil Industry. 1963 (London. 1964); Central Bank of Iraq, Quarterly Bulletin, selected issues; Government of Iraq, Statistical Abstract. : 117 ' i i ! TABLE 6 | I SECTORAL CONTRIBUTION TO THE j NET NATIONAL PRODUCT | (1956 PRICES) ! Sector 1955 1958 1961 1962 1963 ; 1. Agriculture, Forestry, and Fishing 32.6 24.6 29.8 22.5 16.4 2. Crude Oil Ex traction less Income to Abroad 20.7 24.2 25.9 24.4 29.0 5. Hanufac turing and Mining 7.5 9.2 11.5 11.6 11.7 4. Construction and Ownership of Dwellings 7.5 8.7 5.7 4.7 4.0 5. Transport, Com- munication, Electricity, Banking, Insur ance, and Real Estate 8.7 9.4 9.9 9.9 9.7 6. Wholesale and Retail Trade 7.1 7.1 7.5 7.4 6.6 7. Services 7-5 7.5 8.7 6.4 9.0 8. Public Administra tion and Defense 8.6 9.5 10.2 11.0 12.6 Net National Product at Factor Cost 100.0 100.0 100.6 100.0 100.0 Sources: K. Haseeb, The National Income of Iraq. 1953- 1961 (London! Oxford University Press), p. 20; K. Haseeb, ’ ’ National Income of Iraq, 1962-1963” Baghdad, 1965)» p. 20. 118 ! I national income, the oil sector and the rest of the econ omy can be seen. It can be found that all the time the I i development investment expenditures amounted to ID 44-0.3 j million during the period, the value added by the non-oil j sector of the economy increased from 158.9 million in 1951 to ID 421.3 million in 1962. An increase of 262.4 mil lion, i.e., an annual average development expenditures of ID 36.7 million, was associated with an annual average :increase in the value added by the non-oil sector of only ID 21.9 million. The reasons for this weak response of the economy can be found in the nature of the development investment expenditures, the distribution of income, and the trade and fiscal policies; i.e., the pattern of the development expenditures were concentrated on projects which are by themselves incapable (of increasing the productive capac ity) of the economy as such, especially in the short-run. Therefore, the bulk of the capital investment |could not increase the employment of the different factors jof production in such a way so as to create more output I and purchasing power. Another reason for the lack of responsiveness of the non-oil sector is the distribution of income, that is to say, most income available in either used for hoarding, speculation or for conspicuous consump- - tion by the holders of it. Finally, it should be noted that in Ifcaq, the TABLE 7 NATIONAL INCOME, VALUE ADDED BY THE OIL SECTOR, VALUE ADDED BY NON-OIL SECTOR, AND VALUE OF IMPORTS, 1950-64 (MILLIONS OF IRAQI DINARS) National Value Added Value Added Income by by Non- Development Year (Current Prices) Oil Sector Oil Sector Imports Expenditures 1950 158.0 12.3 145.7 29.2 — - 1951 184.0 25.1 158.9 42.5 2.1 1952 217.0 48.7 168.3 47.7 7.8 1953 9^3.9 64.9 179.0 55.5 12.3 1954 284.0 73.8 210.2 68.4 20.9 1955 289.3 81.1 208.2 90.9 34.0 1956 334.8 77.7 257.1 117.2 43.0 1957 352.7 67.2 285.5 111.8 57.4 1958 374.0 87.7 286.3 99.8 52.2 1959 391.6 95.4 296.2 99.4 49.9 I960 437.1 104.1 333.0 124.9 45.5 1961 484.2 104.4 379.8 133.5 61.2 1962 526.5 105.2 421.3 12 7.7 58.5 1963 515.4 120.2 395.2 112.5 53.5 1964 546.3 136.3 410.0 146.7 51.8 Sources: R. G. Fenelon, Iraq, National Income and Expenditures (Baghdad: Al-Rabits Press, 195^); K. Haseeb, National Income of Iraq, 1955-1961, (London: Oxford University Press, 19^4), p. 20; K. Haseeb, "National Income of Iraq, 1962-1963" (Baghdad, 1965), p. 20; Carl Iversen, Monetary Policy in Iraq (Baghdad: National Bank of Iraq, 1954); Central Bank of Iraq, ; Quarterly Bulletin, selected issues. h ; ; 120 ; structure of the economy is such that fluctuations in agricultural output may offset the changes which are ;taking place in other sectors of the economy. ' The increase in the value added by the oil sector from 69.5 million in 1954- to ID 77.4-, in 1955, and an increase in development expenditures from ID 20.9 million to 34- million was more than offset by a decline in agri cultural value added from ID 113.8 million to 68.4 mil lion. This led to an absolute decline in real national income from ID 322.5 million to ID 301.4 million. I DEFICIT FINANCING POLICY; ORIGIN, MEANS AND OBJECTIVES The problem of financing economic development can be solved as suggested by resorting to deficit financing in the underdeveloped countries. As Professor Nurkse’s first work in this context, in his book Capital Formation i in the Underdeveloped Countries (Oxford, 1953), it has ’ become more traditional to be thought of the underemployed i workers of these countries to be regarded as a reservoir, |easily tapped for capital formation so urgently needed. i i In other words, that there is much such underemployment in these areas is evident. Well, the question is, what limit deficit financing is feasible method for bringing these resources into use in the sense of increasing total net production? As a matter of fact not all types of labor 121 are unemployed in these countries. In fact, skilled labor I of all kinds is almost always scarce and what is most expected from the deficit financing policy is to bid them j i away from their present occupations into more' productive ones. There seems, probably, to be some net general in- flationary effects in such bidding but likely, the amount to be very small and as uninteresting as such. Much more j serious are the bottleneck variety of skills place on the efficient use of unskilled workers, whether in government projects the private projects from which the skilled work- i iers have been enticed. In the absence of appropriate numbers and kinds of skilled workers, the gross output of the unskilled labor transferred to new jobs may be exceed- I ingly small, and the danger of inflation from their em- j ployment correspondingly large. The underdeveloped coun tries can increase their supply of skilled labor, perhaps using deficit financing for this purpose, but this is a long process. Normally, perhaps it can be safely assumed that the program of economic development fired by deficit financing will not be postponed until adequate additional I 19 supplies of such skills are available. y With respect to unskilled labor, the situation seems to be different. By offering high enough money ^Gardner Patterson, "Impact of Deficit Financing in Underdeveloped Countries; Some Ne^fleeted Aspects," Journal of Finance, Vol. XII, No. 2 [May, 1957), pp. 179- 189. 122 i wages, a substantial amount of such, labor, especially from1 the rural areas, probably can be obtained without directly reducing the production of the sector of the economy from which these people are drawn. It seems to be noted that j whereas deficit financing can doubtless bring some under employed, unskilled labor resources into new additional and productive employment, that is, can increase gross production, there are for a time large and direct immedi ate offsets. Moreover, the offsetting of goods are often in short supply and likely to be so for some time inasmuch 'as the immediate object of making use of the unemployed labor resources is assumed here to be the creation of pro ductive capital goods rather than consumer goods, durable or otherwise. These offsets, are not included in any in crease in demand occasioned in the economy as a whole as a consequence of the higher monetary incomes growing out of ; deficit financing. The possibility of deficit financing I bringing unemployed resources into new production seems .! -likely to be limited largely to unskilled workers in the .underdeveloped countries and unfortunately, even here, the Inet increase in production for capital formation purposes may be relatively small for a considerable time because of the increase in consumption that such employment will be followed by. Now'the other aspect of the deficit financing policy is the extent to which increased savings can be j l induced or forced by this policy and practices as such, in! i other words, whether it yields some net increase in cur- ' t rent production or not; is the net additional purchasing power the government can create an effective device for transferring real resources from consumption to investment in those countries! In reality, a large part of which has not been monetized there may well exist a large untapped savings potential. As long as the deficit-finance inspired inflation is relatively mild, the price rises may well, as Professor Lewis has so argued, serve to increase the profits of the { industrial and mercantile classes and by doing so increase their savings.^ Indeed, if the entrepreneurs now hoard their cash or pay off past bank loans or buy government bonds, the ;inflation tends to taper off very quickly and the infla tion has induced the required savings for the planned in- l 'vestments. But, if this group now spends their funds, they will feed the finflation, and in either situation the case does involve a redistribution of income against other sectors of the economy, particularly wage earners and farmers. 20 W. Arthur Lewis, The Theory of Economic Growth (Homewood, 111.: Richard D. 'Irwin, Inc., 1955)» pp. 195- 198. 124 I Nonetheless, if the intrepreneurial class or the j government make appropriate investments with the new j ■i funds, in the longer run labor productivity will presum- I i ably increase and real wages improve. j But, anyhow, there is more to be said of the re- ! I actions by the labor and farmer groups to inflation bred by deficit financing. If the labor force is unorganized, wages tend to be rigid and deficit finance-induced infla tion can well result in reduced consumption from current income • However, this will not necessarily result in an ! equal amount of forced savings. Any fall that might take place in the already low consumption standards of these people is likely to be offset partly through disinvest ments; such kind take many forms, among them, failing to Maintain workers' houses and other durable personal prop erty, and less investments in the training and education i land health of these groups in general. What the case will ;be if the labor is organized then? The response of infla tion is likely to be a quick and strong demand for wage i I increases to take place. Such increases will probably tend to lag behind price increases but the lags have a way of becoming shorter now that the nation of escalator clauses is widely known. These high wages will, of course, hinder the transfer of real resources to the government deficit- 125 ! I financed investment projects inasmuch as wage earners in , i i countries where per capita income are very low tend to j have a high income-elasticity of demand and a low price- ! elasticity of demand. Moreover, from the savings that j might he forced out of the labor groups in the process must be subtracted not only the disinvestments noted above in the case of unorganized workers but also the goods and services not produced during the strikes slow downs, and general impairments of labor efficiency which so often accompany these efforts of organized labor to maintain their real incomes in the face of inflation. In all 'cases, for both economic and political reasons there seems :little prospect for inducing any large amount of forced savings from wage earners via inflation. In the long run, it is always hoped that inflation jgenerated by deficit-financed economic development in ■underdeveloped countries will be self-limiting as the additional goods and services flow from the investments, jand that these investments will result in substantially higher per capita real incomes. The reservation here as I to the effectiveness of deficit financing policy as a means for encouraging economic development stem not from the fear that it will fail at first - indeed it can be a powerful and helpful tool especially in the very beginning of the program when much of the economy has still to be monetized nor are reservations serious if deficit financ 126 1 I ing is restrained to amounts less than the increase in ; i productivity each year, and if it is so restricted to ! fields where returns are quick and which have a large out-! ! put-capital ratio. Its major shortcomings are rather thati those using it will seriously overestimate the unemployed resources that can thus he brought into work. Overesti mate the net increase in production that will result from whatever unemployed are underemployed factors of produc tion can be put to work, underestimate the cost of infla tion in terms of disinvestment elsewhere in the economy, and underestimate the adverse impact of inflation on the 'willingness of the peoples in the underdeveloped countries 21 to embrace economic charge. Professor Raja J. Chelliah argued that the deficit i spending and the underemployment that the experience of many underdeveloped countries during the war and post war Iyears shows that they were indulged in considerable i I amounts of deficit financing, first for prosecuting the Iwar and later for purposes of reconstruction. ! j This resulted in a good deal &f inflation and I | monetary instability. It is quite clear that underdevel oped countries cannot rely upon this, the deficit spending policy, as a short route to full employment and higher 21 Gerald M. Meier, Leading Issues in Development Economics (Few York: Oxford University Press, 1964;, pp. 176-178. 127 ""I output. The great volume of underemployment and unemploy--! ment that one finds that, e.g., rise in an over populated ' country arises from a lack of complementary factors of production that can he obtained to he combined with labor j » op j and not because of lack of monetary demand as such. j ; f This is a long run problem calling for a long-run solution. The economic process consists of two distinct categories; one in which, given the level of economic ■ i development, the economy moves from low employment to full employment; and the other in which it moves from full em ployment at a given level of economic development to full ; employment at the next higher level of economic develop ment.^^ A solution to short-run unemployment is sought through an increase in investment. One aspect of invest ment is that it increases demand and income via the oper ation of the multiplier, the other aspect of investment is i jthat it increases the productive and employment offering Icapacity of the economy over a period of time. It is the Jlatter process that can lead to a solution of the long-run problem of underemployment while the former is important | 22 Raja J. Chelliah, Fiscal Policy in Underdevel oped Countries (George Allen and Unwin, Ltd., 196*5), p. 33. 23 ^V.K.R.V. Rao, Investment Income and Multiplier in an Underdeveloped Economy Indian Economic Review, Vol. I, No. 1 (February, 1952), pp. 66-67. in tackling a fall in employment due to a fall in effec- j tive demand. The aspect of investment which is ignored J in the traditional Keynesian analysis is of great signif- i Oil ' icance in economic growth. DEFICIT FINANCING AND PUBLIC INVESTMENT In fact, the difficulty of transforming the re sources that are available into a real output is indeed a deeply rooted difficulty needs a lot of efforts. Mean while, different analysts have differed about what these and other root causes are - and actually, they may be dif ferent as between different underdeveloped countries. iLack of enterpreneurship or technical knowledge, the lack of adequate framework of public services, lack of incen tives for increased effort, ignorance, lack of market or :credit organization, lack of communications, immobility of resources, absence of adequate economic institutions have I all been cited with different degrees of emphasis. s A common factor of all these obstacles is that jthey relate to deficiencies of effective supply rather than effective demand. Public capital formation assumes particular importance in creating the preconditions for an expansion of output, and this may add to the importance of public investment, financed, if necessary, by deficits. 2^Raoa A. Chelliah, op. cit.. pp. 33-34. i 129 Again, however, the criteria of public investment and the compensatory public finances in more developed countries during periods of depression is more superficial than real. The purpose of the public expenditures is different in the two cases. In the depression case, it is to in crease incomes and create the demand and price incentives for resumed production. The greater the multiplier, the greater the effect. The public capital formation is jus tified by its monetary and secondary effects. That is why it might even consist of building a 'monument or burying gold or bank notes in unused coal mines. In underdeveloped countries, public investments could be economically justified only for its impact on productivity, for lowering cost curves and increasing the 'elasticity of supply curves - not for raising the demand curves. Therefore, the monetary income effects of defi- I Icits incurred to finance public investment are not the main purpose, but an unintended by-product, ! 1 If output can not be expanded under the impact of | raising demand, the case for deficit-financed public in vestment is obviously weakened. The expansion of public service is essential. The income effects of a deficit will normally be at best a helpful accessory. The redis tribution of income in favor of profits, as well as, the broadening of demand, may possibly serve to assist in the 130 ] i movement towards the main objective, e.g., by adding fur- J ther inducement to private investors to take advantage of j I the opportunities presented by lower cost as a result of ■ I the provision of better public services. But lowering the! 25 real cost curves remain the chief objective. ^ The marginal rate of savings or taxation may be particularly low where the increase in incomes associated with the act of deficit-financed public investment will accrue partly in kind. For instance, where previously 1 unemployed or underemployed farmers are drawn from the countryside as a result of deficit-financed public works or construction of urban public utilities, the real per 'capita income of those remaining on the land is increased. But this increase may take the form, not of higher money incomes through additional sales, but of increase in con- isumption in kind, since the persons drawn from countryside ;will in their turn also have a high propensity to consume, ! and specifically to consume food, the multiplier may be- ! i jcome very high and the inflationary gap may express itself I jsharply in terms of food shortages. Thus, while the mul tiplier is likely to be high in underdeveloped countries, the response of supplies to price increases and pressure of demand is likely to be small. Where the factors reduc- ^H. W. Singer, "Deficit Financing of Public Capi tal Formation" Social and Economic Studies (September. 1958), pp. 91-93. 131 j ing the productivity or lowering elasticity of supply are simultaneously tackled, there may, of course, he an ex pansion of supplies hand in hand with the deficit-financed public investment; alternatively, the public investment itself directed towards removing some of the obstacles. In the first case, the combined result need not to be in flationary; in the second case, while the immediate effects would be inflationary the long term effects would be beneficial, and the inflation would be self-correcting after a time if it is not allowed to become cumulative in the earlier stages. Productive public investment directed towards reducing obstacles to increased supply in more immediate future, or at the same time with an attack on i these obstacles by other means, provide the classical case in defense of deficit financing. Added to low productivity and to low elasticity of ^supply when confronted with increased demand, there is a jthird related characteristic; this is the resource immo- 1 jbility, i.e., low capacity of shifting resources from one ,use to another or from one sector to another. i As underdeveloped country has neither much capital to depreciate nor a large volume of fresh resources from 27 growth. Resource immobility has an important implica- 26H. V. Singer, op. cit.. pp. 92-96. 27 Gardner Patterson, op. cit., pp. 183-189. 132 tion. To set free resources to the extent of say, 5 per ; cent of the national income in order to augment investment! by that amount, it is not sufficient that the same amount j i of resources should be taken away from consumption or pri-; vate investment or current public expenditures. If the resources set free by the reduction in consumption or other expenditures can not be transformed into the re sources required for additional investment. It is not difficult to conceive of situations where an increase in investment by 5 per cent of national income may involve curtailments in other directions of perhaps 8 per cent of ^national income. This situation has some resemblance to i •the multiplier effect involved in curtailing domestic in- I homes in order to achieve certain required reductions in 28 itotal import demand. COUNTER CYCLICAL EISCAL POLICY As a matter of fact, even for purposes of a short- jrun policy of stabilization of anti-depression action in i ^underdeveloped country, the Keynesian analysis may not be of much use as a theoretical background. It is not meant to imply that the savings-investment approach to the theory of income determination is not necessarily valid for underdeveloped economy. It may be true that the approach embodied in the Keynesian analysis is the only 28Ibid 133 1 I possible method of analyzing the process of income deter- j mination in any country. Actually, this method was em- | ployed in the previous discussion to follow through the | effects of deficit spending. But the genesis of booms j j and depressions and nature of the economy are such that j the usual Keynesian prescriptions of counteracting cycli- j cal fluctuations are not likely to be of much avail in a ; i typical underdeveloped economy. Underdeveloped countries are as much subject to | economic fluctuations as advanced industrial countries are. But the main fluctuations do not originate in under developed countries themselves. They originate in the more advanced countries and j i are then transmitted to the less advanced through foreign trade transactions. As is well known, many of the under developed countries are export economics and a substantial :part of their national income is derived from the export lof a few primary products. I I In this situation, the state of foreign demand for export determines to a large extent the state of the econ omy. Fluctuations in foreign demand immediately set up i inflationary or deflationary movements. Thus, a sudden boom in exports, through the operation of the foreign trade multiplier, leads to a rise in national income and prices; the converse happens when there is a fall in 29 i exports. ' j It is argued that if taxation is not possible, then expanding the supply of money may reduce consumption. ;The object of such inflation is to affect a permanent structural change in the distribution of income in favor of the government and the saver. Should the entrepreneur ial class be too small to take the lead achieving a high rate of capital formation, the increase in saving will go to the government. Once the structural change is a- 'chieved, the inflation stops and prices are stable at a higher level of growth. In order for such self-liquidat ing inflation to succeed, certain conditions must be met. i First, inflation should result in an increase in the out put. Second, the marginal rates of taxation; if the re distribution is to favor the public sector, should be higher than the average rates. This is necessary if share bf the tax revenue. The government will ultimately be i 'able to finance its expenditures without having to create I more money. A third condition for a successful inflation i is command over the loopholes, command over the foreign exchange, over the flight of capital, over luxury consump- Z Q tion, luxury building and such, ^Raja J. Chelliah, op. cit.. p. 34. 30 W. Arthur Lewis, The Theory of Economic Growth (London: George Allen and Unwin, 1955)» Chapter V, espec- ially pp. 122-123. Also, Arthur Lewis, Closing Remarks, "Inflation and Growth in Latin America" (Warner, Baer and Aside from the theoretical objections to such a ! method of finance, Iraq has neither the need nor the ad- J ministrative machinery for such a policy. I Iraq's problem, at the present time, is not lack ! K I ■ of capital funds, it is rather a lack of balance in the expansion of current expenditures and current revenue. If Iraq is in a position to meet all the necessary condi tions for a successful self-liquidating inflation, the problem would not have arisen in the first place. In I other words, what has started as inflation for capital formation may evolve into inflation for current expendi tures, and, should not prevent the government from in- I creasing its debt as a supporting source of finance. There are many reasons to defend this viewpoint. First, public debt can be used as an instrument in developing a capital market. Aside from financing its needs for funds, the government can resort to borrowing in jorder to provide the market with income earning assets. ! jThe central bank which bought securities in the first I Iplace can sell all or most of its holdings. To enhance the investors' confidence in these securities, the govern ment or the central bank may have to stabilize their prices within certain limits. If the government succeeds in creating a financial Issac Kerstenetzky, (ed), Homewood: Richard D. Irwin, pnc., 1964), pp. 29-51*___________________________ 136 environment which would discourage hoarding and encourage the exchange of money for income earning assets, then the implicit subsidy can be considered a necessary cost for 51 i such an outcome. What makes such an increase in the public debt acceptable is that neither the government nor the central bank have engaged actively in such operations. Government ;securities by the end of I960 covered only 9 per cent of 1 :the currency in circulation while the legal limit is 30 per cent, with gold and foreign assets making up the bal- iance. And even this small amount of securities took the i 1 form of government bonds rather than treasury bills. > What is needed is a wide spectrum of income earn ing assets designed primarily with the needs of the in- ■ vestor in mind. The central bank should activate its own I portfolio of these securities in such a way as to stimu- ! | late the interest of the public in these securities. This ; will make the public debt a vehicle through which local ; i funds can be transferred for the finance of real capital i 32 formation.^ In conclusion, Iraq should resort to external loans as a supplementary source of finance. Iraq was, ^Edward Nevin, Capital Funds in Underdeveloped Countries (London; Macmillan & Co., 19^1), pp. 89-96. 52IMd. until recently, indifferent toward foreign loans. This, again, may be explained by the availability of oil reve nues and the failure of the development expenditures to reach their target. It was not until 1959♦ that the gov ernment decided to borrow abroad for development purposes. THE ROLE OF DEFICIT FINANCING IN DEVELOPMENT PLANS In financing their plans, some countries have assigned an important place to deficit financing. In general, where the deficits are thus planned, the saving Required to meet investment objectives is expected to come 'from increased private domestic saving or from a transfer of foreign resources. i As a general rule, unbalanced budgets will exert more effect on macroeconomic variables than will balanced ; budgets. Budgets may be unbalanced in two directions. Government expenditures may exceed tax revenue or tax rev- I lenue may exceed government expenditures. In this context ithe important part is the unbalanced budget because of in- i creased expenditures over tax revenues. A deficit budget is defined as an excess of ex penditures over revenue during a specified period of time, normally, a fiscal year. Deficit financing may come about in three ways: (1) Expenditures may be increased while the level of taxes remains unchanged; (2) the level of expenditures may be maintained while taxes are reduced or 138 i while tax collections decline; and (3) both expenditures i and taxes may increase with the greater expansion in the ! former, or both may decline with greater fall in taxes. i A budget deficit, regardless of the method by which it is j created, must be financed. Therefore, sound financial J planning is required to secure funds to cover the deficit. On the whole "there are two basic ways of securing such funds: borrowing or creating money. The financing of a deficit can be as important as the means of creating it in determining its affect. Var ious techniques can be used to finance a deficit, among ithem are: (1) borrowing from the public, (2) borrowing from commercial banks, (3) borrowing from the central bank, and (4) printing new money. If the government decides to finance the deficit by borrowing from the public, it will offer government bonds in exchange for purchasing power that otherwise Iwould be spent on consumption or investment. This, in- ideed, must be classified as a restrictive means for fi- i nancing a deficit budget since it has a contractionary effect upon the economy. However, this must not be true in all cases. Such borrowing is not likely to reduce con sumption significantly because those who purchase govern- 33James Buchanan, The Public Finances (Homewood, Illinois: Richard D. Irwin, Inc., 1965)? P»97* ment bonds would probably not spend these same funds on consumer goods anyway. Also, if the funds should be drawn from private hoards, from idle resources, there would be no reduction in private spending. Still, it is not wise to finance a ? deficit by borrowing from the public during a period of recession; especially if the very purpose of creating a deficit is to generate expansion in income spending flow. Borrowing from commercial banks may produce a restrictive effect upon the economy when the government sells bonds to the commercial banking system at a time when banks do not possess excess loanable reserves. Such a technique to finance a deficit budget will restrict loans to private sectors. The demand for private bonds is required; prices i 34 are pushed down, and interest rates are driven up. This would cause a reduction in aggregate demand jwhich would tend to neutralize or offset the primary ex pansionary effects of the initial multiplier. On the other hand, when the government sells the bonds to the i banks at a time when banks possess substantial excess re serves, there will be an expansionary effect on the na tional income. This expansionary effect may come from the utilization of excess reserves to finance deficits which will allow for an expansion of the total stock of currency 34 Norman Keiser, Macroeconomics. Fiscal Policy, and Economic Growth (New York! John Willey, 1964), pp. 382- 140 : i and Bank deposits by some multiple of the initial amount ! borrowed by government. This is very clear because when ! • i the government borrows directly from the commercial Banks,! these institutions add to the total supply of money and i credit available for consumption and investment expendi ture. When government sells the bonds to the Banks, the Banks in turn create deposit credit and place it at the disposal of the treasury. An additional expansionary means of financing a deficit budget is to sell treasury bonds to the central Bank. The central Bank then creates new treasury deposits accounts. These deposit accounts are liabilities to the central Bank but the bonds purchased, by the. central Bank but the bonds purchased by the central Bank are classified as assets, as the government spends the funds in purchas ing goods and services in the private economy. Subsequently, checks are drawn by the treasury ^department on its deposits accounts in the central Bank. jThese checks are received as payments by individuals and (firms who sell goods and services to the government. Or dinarily, these checks will be deposited in the commercial Banking system. These checks have, in effect, to be cashed by the central Bank, as a result the commercial Banks receive deposit credit with the central Banks, 382. 141 : i ,thereby obtaining new excess reserves and increasing zc 1 capacity to expand bank l o a n s . I ■ i The government could simply print money equal to | I the amount of the excess of government spending over tax j collections. Unrestricted monetary creation by government i may cause hyperinflation. Such results, however, need not occur in a well controlled economy. Governments are attempting to obtain resources by printing money, because of the political resistance which they encounter if they raise taxes; instead, the results depend on how much money is created, how people react, and how well the economy is :managed. An increase in the supply of money will not raise prices if it is limited to matching an increase in output or the demand for money. ECONOMIC EFFECTS OF DEFICIT FINANCING POLICY There are many ways of extracting savings from the ; public, quite apart from these, which are to be adopted by I the government as in the previous analysis in the form of j taxation. "The economic effect of deficit finance is to transfer command over economic resources to those receiv ing the new money, leading through their increased spend- ^Bernard Herber, Modern Public Finance (Homewood, Illinois: Richard D. Irwin,' Inc., 196>6), pp. 405-408. 142 36 ing to a pressure on goods and services.’ ’^ It is hoped of the^deficit financing policy will bid the idle resources away from their present occupations into more productive ones. But, the question is to what extent deficit financing is a feasible method for bringing those resources into use in the sense of increasing total net output. The most important objective of deficit fi nancing is the generation of economic surplus during the iProcess of development. This because the volume of saving depends directly on the economic surplus currently gener ated in the economy. During the development plan, surplus labor and unemployed resources would be utilized by the entrepreneurs and government. If this saving is ulti mately mobilized and utilized effectively, then deficit financing, in the initial stages of planning, can be re- 1 garded as a process of advanced borrowing from the poten tial saving of the community. The net saving, which comes mainly from the creation of economic surplus during the I i process of growth, is fundamental building block of any process of development finance.^ 36 Ursula Hicks, Development Finance (Hew York: Oxford University Press, 1965), p. 49. ^Meier, op. cit.. pp. 176-178. i I I I I CHARTER 17 ' I I INTERNATIONAL ORGANIZATIONS i (IMF AND IBRD) WHAT ROLE THESE ORGANIZATIONS CAN PLAY IN FINANCING ECONOMIC DEVELOPMENT (IMF) International Monetary Fund The Fund is an intergovernmental organization |comprising over 100 states. Among world organizations the ;Fund is unique in that it combines three major functions: [ regulatory, financial and consultative. In its regulatory ,aspect it is a guardian of code of good behavior in the international payments sphere, a code set up by multi lateral agreement at Bretton Woods. In its financial ,aspect, it is an agency with resources amounting to some ;$15,000 million, available for lending on short to medium- i ,term to national monetary authorities to meet balances of payments deficits. In its consultative aspect, it pro vides a center for international cooperation and a source of counsel and technical assistance to its members. The purposes of the International Monetary Fund are: (1) To promote international monetary cooperation 14-3 through a permanent institution which provides the machin ery for consultation and collaboration on international monetary problems; (2) To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive re sources of all members as primary objectives of economic I policy: (3) To promote exchange stability, to maintain orderly exchange arrangements among members and to avoid competi tive exchange depreciation. (4) To assist in the establishment of multilateral (system of payments in respect of current transactions between members and in the elimination of foreign exchange restrictions which hamper the growth of world trade; (5) To give confidence to members by making the funds Resources temporarily available to them under adequate i !safeguards, thus providing them with opportunity to cor- jrect maladjustments in their balance of payments without restoring to measures destructive of national or interna tional prosperity. (6) In accordance with above, to shorten the duration and lessen the degree of disequilibrium in the interna tional balance of payments of members, the T*und shall be 14-5 ; guided, in all its policies and decisions by the purposes j set forth in the article.1 j j Article III of the Article of Agreement stated the Quotas and Subscription: "each member" shall be assigned J a quota. The quotas of the members represented at the j United Nations Monetary and [Financial Conference which accept membership before the date specified in Article XX, Section (e), shall be those set forth in schedule A. The i quotas of other members shall be determined by the Fund. The Fund shall at intervals of not more than five i years conduct a general review, and if it deems it appro priate an adjustments of the quotas of the members, it may also, if it thinks fit, consider at any other time the adjustment of any particular quota at the request of the member concerned. An eighty-five majority of the total ■voting power shall be required for any change in quotas proposed as the result of a general review and a four- fifths majority of the total voting power shall be re- 1 jquired for any other change in quotas. No quota shall be P .changed without the consent of the member concerned. Also Section 3 concerning the subscription stated: (A) The subscription of each member shall be equal to j i I International Monetary Fund. Articles of Agree ment. Article I, 1968, (Washington B.C.), pp. 2-3. 2 Articles of Agreement, op. cit.. pp. 3-4-. the quota and shall be paid in full to the Fund at the j appropriate depository on or before the date when the j i y v I member becomes eligible under Article XX, Section 4 (c) or; I (d), to buy currencies from the Fund; j (B) Each member shall pay in gold, as a minimum, the smaller of; (1) twenty-five per cent of its quota; or (2) ten per cent of its net official holdings of gold and U. S. dollars as at the date when the Fund notifies members . . . that it will shortly be in a position to begin x exchange transaction. Each member shall furnish to the Fund the data necessary to determine its net official holdings of gold and U. S. dollars. (C) Each member shall pay the balance of its quota in its own currency; (D) If the net of final holdings of gold and U. S. ;dollars at any member as at the date referred to in (B) i j(2) above are not ascertainable because its territories I have been occupied by the enemy, the Fund shall fix an appropriate alternative date for determining such holdings if such date is later than on which the country becomes eligible under Article XX, Section 4 (C) or (D), to buy ^Ibid., p. 4. 147 I currencies from the Fund, the Fund and the member shall I agree on a provisional gold payment to he made under (B) i above. And the balance of the member's subscription shallj I be paid in the member's currency - subject to appropriate adjustment between the member and the Fund when the net 4 official holdings have been ascertained. FORM OF FUND RESOURCES AND TRANSACTION i i The Fund, as a financial institution, has a very legal form which, to some extent, obscures certain simi larities in operations to those of other financial insti tutions, such as banks. Its liabilities consist, almost entirely, of capital subscriptions and its assets predom inantly of member currencies and gold. It also holds a certain amount of investments arising out of special oper ations, and on the liabilities side has accumulated a small reserve. It also has a large potential assets and 1 liabilities arising out of the General Arrangements to i jBorrow of 1961-62.^ Up to now the aggregate amount of the Funds re- ! !sources has been determined almost exclusively by members' i 4Ibid.. p. 5. ^In order to enable the IMF to fulfill more effec tively the role of the International Monetary System in the new spread of widespread convertibility, including greater freedom of short-term capital, the main industrial countries have agreed that they will strengthen the Fund by general arrangements under which they will stand ready to lend their currencies to this Fund up to the amount - 148 subscriptions, though the composition of these resources j has been affected by a variety of operations. Each memberj is under obligation to subscribe an amount equal to its | quota, and until it has so subscribed, is precluded from j using the Funds resources. As and when its quota is in- J 1 ,creased, an additional subscription is required. The amount subscribed normally consists of 25 per cent gold and 75 per cent of subscribing member’s currency. In this ;case of initial subscriptions, the proportion payable in I gold may be fixed at less than this if the country's net reserves are very small in case of quota increases. The Fund is empowered to reduce the gold proportion below 25 .per cent if the net reserves are very small, indeed (i.e., less than the new quota), but has not done yet in prac- i itice. The member, as a result of its subscription, ac- i iquires rights to draw on the resources of the Fund - rights which, though subject to a greater or lesser extent 1 to conditions, relate to amounts that are potentially much i | larger than the gold subscriptions. i | Apart from the operation of replenishment, trans- 1 I !actions between the Fund and its members take the form of j an exchange of currency against currency, or an exchange | ; ------------------------------------; — J under Article VII., Section 2 of the Articles of Agreement ;to forestall or cope with an impairment in International Monetary System when supplementary resources are needed. See for more details selected Decision of the Executive Directors and Selected Documents, IMF, Third Edition (Washington, D.C., Jamuary 1965)» PP« 67, 58-72. 14-9 i of currency against gold. One of the currencies involved 6 is generally that of the member making the transaction. j Members who wish to use the Fund's resources to make in- 1 i ternational payments purchase from the Fund some foreign currency they can use, and pay to the Fund a corresponding amount of their own currency, which the Fund then holds, j Such a transaction is analogous economically; though not legally to an act of borrowing by the drawing member; it .involves deterioration in the member's position on balance; of claims vis-a-vis the Fund. Conversely, when a member makes a repurchase, it purchases its own currency from the ;Fund in exchange for gold or some currency acceptable to !the Fund. Such a transaction is analogous to the repay- i ment in that the repurchasing members net position vis-a- vis the Fund improves. The Fund is thus a credit inter- 7 mediary between different members.' The purpose for which the Fund resources are to be 'made available is stated in the articles to be that of providing members with an opportunity to correct malad justment in their balance of payments without restoring to ! measures destructive of national or international prosper- i i i 1 6 k member may, however, sell gold to the Fund m order to obtain currency of another country. 7 'Marcus Fleming, The International Monetary Fund. Its Form and Functions (Washington, D.C.: 1964, pp. 27-28. it y.8 This implies temporary use of, as also does the statement that the Fund is not intended to provide facil- q ities for relief or reconstruction. Moreover, an early interpretation of the articles of agreement made it clear that the resources of the Fund are to he used to give temporary assistance to members in financing balance of payments deficits on current ac count,^ and this was understood to include assistance in connection with seasonal, cyclical and emergency fluctua tions in the balance of payments. The implication of all 'this for repurchase requirements of the Fund was drawn precisely in 1952, when the Executive Board decided that exchange purchased from the Fund should not remain out standing beyond a period reasonably related to the pay ments problem for which it was purchased from the Fund, and that the period included should normally fall within ; 11 an outside range of three to five years. Since that jtime, any member making a drawing undertakes or indicates I 8 i In Article I (V) of the Articles of Agreement. 9In Article XIV, Section I. 10 Pursuant to Executive Board Decision No. 71-72, September 26, 1964, See selected decisions, Decisions of |the Executive Directors, Second Edition; Washington, September, 1963, p. 53* ^Decision No. 102-(52/ll), February 13, 1952. Selected Decisions, p. 21. that it would repurchase the Fund’s holdings of its cur- ; rency acquired in the transactions not later than three to! five years after the drawing, if these holdings have not j been otherwise reduced. For drawings under stand-by j 12 I arrangements, the maximum period is three years, j i I FUND POLICIES ON DRAWINGS j ! The proviso that a drawing member should intend to repay the drawing within three to five years is an example i of a condition or understanding attached to the Fund draw ing. The right of a member to draw on the Fund has always / been to a greater or lesser extent subject to conditions. It is clear from the Article that a member cannot draw ; ■ i from the Fund for long-term purposes such as reconstruc- ! tion or development, and that it can be declared ineligi ble to draw if the Fund is of the opinion that it is using Fund resources in a manner contrary to the Fund purposes. . Moreover, unless the Fund, at its discretion, [grants a waiver, even a member that is eligible to draw :cannot draw in any year more than the equivalent of 25 per icent of its quota or draw beyond the point at which the Fund is holding its currency to the amount of 200 per cent of quota. The granting of such a waiver may, of course, 12 Articles of Agreement, IMF, op. cit.. Repurchase Provision, Article V, Section 7» P* 13• 152 I be made subject to the acceptance by the member of certain terms safeguarding the Fund’s interest. j However, it might be argued that any member that ; l had not been declared ineligible to draw could draw free- i ly, in amounts for which no waiver was required. On the j strength of its mere representation that the currency to be drawn was presently needed for making, in that cur rency, payments consistent with the provisions of the ‘ agreement. Given the widespread prevalence, the late 194-0's of overvalued currencies and inflationary domestic conditions, the acceptance of such a degree of automatism in drawings might have been exhausted by drawings which might have meant that the Fund's resources of gold and drawable currencies (at the time confined to the U.S. f dollars) might have been exhausted by drawings for which there was little prospect of early repayment. Another school of thought argued that the member's irepresentation that the drawing is consistent with the ! jprovisions of the Agreement was open to challenge by the I IX (Fund without proceeding to eligibility. ^ • i According to this view, which ultimately pre vailed, the Fund could reject a request that it challenged or could impose conditions on a drawing designed to safe- 13 "iSee, Articles of Agreement, op. cit.. Article XX, Sec. 4(c); Article III, Sec. 3(a); and Article XX above Sec. 4(d) ii, for more details. 153 I i guard the Fund's proposes even when no waiver was re- J i quired. These purposes, include not merely the correction! of maladjustments and the reduction of disequilibria in balance of payments multilateralism, and the elimination ; of exchange restriction. The triumph of the discretionary view was, in a sense, too complete. While it certainly safeguarded the Fund's resources from abuses it also cre ated obstacles to their use, even when that was perfectly 1 appropriate, because countries were uncertain as to the conditions on which they would be allowed to draw and reluctant to receive a rebuff. This Uncertainty was not 14 .diminished by an early Executive Board decision, under which beneficiaries of the European Recovery Program were 'urged to request the purchase of U. S. dollars from the Fund only in exceptional or unforeseen cases. So the next stage in the development of the Fund’s drawing policies was to encourage greater use of the Fund, and thereby, in crease the Fund's influence over the policies of members, by making it easier for the latter to determine in advance |the conditions in which they could obtain access to the Fund's resources. This was done by the main devices: (1) enunciation of drawing policies to be applied to the use of successive tranches of Fund Credit, and (2) the intro duction of stand-by arrangements.. 14 Of April 1948; Annual Report, p. 74. The enunciation of tranche policies come in two stages. In 1952 the Executive Board decided that a member .could count on receiving the overwhelming benefit of any doubt respecting drawing within the so-called gold tran che, i.e., drawings which would raise the Fund's holdings of its currency to not more than its quota.^ This meant that if a member had a net balance of claims vis-a-vis the Fund*^ it could draw on that balance virtually at will, It would have to make the usual representations to present -need to draw and intention to repay, but, these represen tatives would not, save in extraordinary circumstances, be challenged. Later on, in 1955 and 1959, the Fund added idefinitions of its drawing policies in the so-called credit tranches, i.e., for drawings beyond the 100 per 17 cent point. ' S The Fund's attitude to request for drawing within the "first credit tranche," (that is, drawings which bring t the Fund's holdings of a member's currency above 100 per i jcent of quota) is a liberal one, provided that the member is making reasonable efforts to solve its problems. "^Executive Board Decision No. 102 (52/11); February 15, 1952, Para. 5 (Selected Decision p. 25). 16 Here the subscription is counted as the member's claim on the Fund, and the Fund's holdings of currencies as the Fund's claim on the member. ^ Annual Report, 1955» pp. 84-85; and 1957, pp 119-120. 155 ' } Requests for drawings beyond the 120 per cent require substantial justification. They are likely to be favor ably received where the drawings in question are intended to support a sound program aimed at establishing or main taining the exchange stability of the member's currency at a realistic rate of exchange, and may therefore, reason ably be regarded as establishing the conditions for sub stantial progress toward convertibility "convertibility” in Fund parlance means acceptance of these Fund policies on transactions are couched in terms of amounts of cur rency held by the Fund, and, hence, in terms of amounts of j drawings outstanding - rather than in terms of amounts |drawn per annum, and that the higher the "tranche” in which transactions take place, the greater is the justi fication required. The members ability to draw is thus Related to the size of its quota and the extent to which I this has already been drawn upon. | STAND-BY ARRANGEMENTS i Parallel with the sharpening definition of the I Fund policies on drawings went on increasing reliance on new procedure for making drawings - the stand-by arrange ments. Under this procedure, which was initiated in 1952, a member received assurance that, during a fixed period of time, requests for drawings up to a specified amount will be allowed on the member's representation as to need. r 156 ~j Such arrangements are usually granted for a period of 12 J months, or 6 months if member's problem is purely seasonall i but they,.are renewable. In considering a request for a j ! stand-by arrangement, the Fund applies the same policies, j varying according to tranche, as are applied to requests ' 18 for immediate drawings. As in the case of immediate drawings, stand-by arrangements are generally accompanied by a declaration on the part of the country concerned re- Igarding the policies it intends to pursue. Frequently, j these declarations are more precise than is customary in ,the case of outright drawings. In these cases, the right ;to draw conferred by the stand-by arrangement is usually ,phased over time - as much as can be drawn at once, so much after three months, etc. - and the member undertakes, if it is unable to carry out certain of the policies spec ified in its declaration, to refrain from another draw- ! ing and to negotiate with the Fund new understandings on I ]the basis of which drawings may be resumed. J In considering the rate of the stand-by arrange ments, a distinction should perhaps be drawn between those that permit drawings without legal conditions - though the i granting of the stand-by itself may have been subject to understandings as to policy, and those that envisage draw ings, part of which are available only later, and subject 18 Selected Decisions, on. cit.. Decision No. 270 (53/95); December 23, 1953), pp. 26-28. 157 ! to the fulfillment of rather precise conditions. The ! first type provides for a limited period, virtually auto matic access to balance of payment financing, useable ! almost as freely as reserves and at a very low cost. , Stand-by facilities beyond the gold tranche cost only one- quarter of 1 per cent per annum so long as they are unused. The second type of stand-by arrangement attempts to reconcile conditionability with predictability. The fact that it cannot be used at once provides the Fund with a sanction against misuse of its resources, assurance that { the conditions will be observed. And, it provides the member with assurance of being able to draw, provided that rather precisely defined conditions are met. The monetary authorities of the country often find that the stand-by conditions strengthen their hand against political pres- i jsures. And the fact that resources are still available to i a country under stand-by arrangements indicates to all i Iwhom it may concern that the Funds regards the country as creditworthy. POLICIES ON THE USE OF FUND RESOURCES Policies governing the use of Fund resources have developed gradually in the light of experience and changing international conditions. These policies have emphasized two principles: Fund assistance is available only for a 158 I limited period, and a country can regard this assistance as a means of permitting it to undertake a constructive program to restore domestic and external stability, with- j nut recourse to restrictions on trade and payments and other undesirable practices. In conclusion, the policies governing the Drawings and Repurchase i.e., in making available its resources, the Fund largely is guided by the following: (1) Requests for transactions in the gold tranche are granted on a virtually automatic basis and under proce dures which normally make it possible to deliver the ex change to a member two business days after receipt of the | request by the Fund. (2) Requests for transactions in the first credit tranche are granted on a liberal basis, provided that the jmember itself is making reasonable efforts to solve its iproblems. J (3) Requests for transactions beyond the first credit I i tranche require substantial justification. They are like ly to be favorably received when the drawings or stand-by arrangements are intended to support a sound program aimed at establishing or maintaining the enduring stability of member's-currency at a realistic rate of exchange.^ Drawings beyond the first credit tranche are very 19 ^Selected Decisions, loc. cit.. Decision 155 (53/59); 71-2, pp. 24-25. : 159 frequently provided for by stand-by arrangements. These arrangements usually include specific under takings as to the policies to be pursued by the member, and the drawing rights are phased over time. If the mem ber is unable to refrain from requesting purchases under ,the arrangements and, instead, to consult with the Fund ;and agree with it on the terms for a period of one year, but may be followed by a new arrangement. (4) Requests for drawings to compensate for temporary shortfall in receipts from exports may be expected to be granted under a special facility, provided that the short- ifall is largely attributable to circumstances beyond the |control of the member country. The amount of drawings outstanding under this arrangement will not normally exceed 25 per cent of the imember's quota. No specific undertakings are required, i jother than the willingness of the member country to coop- jerate with the Fund in an effort to find, where required, I .appropriate solutions for its balance of payments diffi culties. (5) Any drawing or stand-by arrangement exceeding 25 per cent of a member's quota within any 12 month period (except to the extent that the Fund holds less of the members 75 per cent of its quota), and any drawing or stand-by arrangement which would increase the Funds hold ings of that currency to more than 200 per cent of the quota, require a waiver. Waivers of the latter kind have been granted only on a few occasions. The 200 per cent limit has been exceeded only twice - in a drawing made in ; October, 1963 and in a stand-by arrangement concluded on j February, 1964. The drawing was under the policy relating to the compensatory financing of export fluctuations, in which a special provision for such a waiver is included. In the stand-by arrangement, the Fund's holdings of the .member's currency exceeded 200 per cent of its quota for a brief interval during the period of the stand-by arrange ment. (6) Drawings are required to be repurchased, subject to the provisions of Article V, Section and (b), within an outside range of these to five years from the date of re- 'purchase. Stand-by arrangements stipulate repurchase in three years, but repurchases are, at the request of the 'member, frequently scheduled to be completed in five Jyears. A member is required to consult with the Fund when I jthe charge on any outstanding segment of the Fund's hold- jings reaches 4 per cent a year, and agree upon appropriate arrangements to ensure the reduction of the Fund's hold ings of the member's currency within the maximum period of five years. So far, these have been only two instances where a repurchase has not taken place within the period of five years. Several members, however, have been in a 161 ~ j 20 1 :debtor position to the Fund for more than five years. STABILIZATION PROGRAMS j In fact, we have already had some examples of the j type of conditions the Fund attachs to the use of its re sources. These cover not only undertakings regarding re- | purchase, and regarding those aspects of international j i behavior that are subject to Fund jurisdiction, such as the maintenance of exchange stability, the simplification of multiple exchange rate systems, the reduction or re moval of bilateral payments agreements, and the reduction or removal of exchange restriction. They include, also, : undertakings or declarations of intention regarding other aspects of international good behavior, such as the adop tion of sound domestic financial policies and the limita tion of trade restriction. It has been found, in prac tice, that, unless countries hold in check any inflation- i lary tendencies, they may be experiencing, they can never : repay their drawings from the Fund within due time nor i 'progress toward the achievement of Fund objectives, such as exchange stability and the removal of restrictions on current international transactions. Therefore, drawings and stand-by arrangements are often made conditional upon the adoption of programs of financial stabilization, in- 20 Subinal Mookerjee, Policies on the Use of Fund Resources (International Monetary Fund Staff Papers: November, 1966), pp. 4-21-4-2$. 162 1 eluding rather precise undertakings with respect to puhlicj finance, quantitative limitations on central bank credit I i expansion, minimum reserve requirements for commercial j 21 i banks, etc. ■ In some parts of the world the Fund's practices ofj encouraging policies of internal financial stability has j come under fire on the grounds that a measure of inflation! is necessary to obtain domestic savings or to avoid stag- j :nation and Under-employment. Experience, however, has shown that as a general rule even a fairly moderate infla tion of prices tends to bring about overvaluation, and, ithereby, to discourage exports, especially the relatively I new exports that are so important for diversifying the 'economy. By necessitating reliance on quantitative re strictions and multiple currency practices they lead to I the encouragement of all sorts of uneconomic industries; in extreme cases, countries become so short of foreign ;exchange that they cannot afford to import the materials ,and plant replacements necessary to keep the economy go- I I ing. ! The continuance of rising prices in many parts of the world promotes militant trade unionism and result in cost-price spiral. In the attempt to keep down the cost 21 J. Marcus Fleming, International Monetary Fund. Its Form and Functions (Washington, B.C., 1964), pp. 35-36. of living, the government is often led to hold down the prices of certain essential consumer goods and public services, with the result that domestic output of the most essential items is discouraged. Domestic savings in the broad sense may not decline, but as a rule capital is tempted to escape abroad or is directed into channels such as inventory accumulation, that are not the most produc tive. The banking mechanism can no longer perform its functions of channelling domestic capital into productive 22 use. ' Owing to the stagnation of export industries, for eign capital, which would otherwise be attracted to these i industries, is often discouraged from entering the coun try. Countries that have suffered from inflation for ;any long period are usually in no doubt about its unfavor able effects on their development, and welcome assistance in supporting programs of stabilization. ! So first, such programs sometimes do lead to a temporary setback to growth and development, because in ventories have to be worked off, because it takes time to l iredirect investment into more economic channels, or be cause cost and wage inflation persists after demand infla tion has been brought to an end. However, if the stabili- ^J. M. Fleming, Ibid.. p. 36 164 ! i I I zation program is accompanied, as it should be, by an ade-j \ quate adjustment of exchange rates, the growth of output j i and investment is usually resumed with only a short inter-j 'mission and at a higher rate than before. I I t FUND RESOURCES AND CAPITAL MOVEMENTS I i i i Capital movements are those international receipts and payments which are not current payments; they include transfers of funds from one country to another for such purposes as investment or speculation. Under Article VI, Section 3, member countries are free to control capital movements subject to certain safeguards. Article XIX de fines as current payments for the Fund purposes certain 'international payments, some of which are regarded for some non-Fund purposes as capital movements, e.g., pay ments of moderate amount of amortization of loans.^ One condition for drawing from the Fund which is ilaid down in the Articles is extraordinary difficult to t apply, sind, the provision that a member may not make net use of the Fund's resources to meet a large or sustained i ?4 [outflow of capital. | Immediately after the war there was a great appre hension lest the resources of the Fund, then badly needed 23 J. Keith Horsefield, Introduction to the Fund (Washington, D.C., 1965), p. 2T, (2nd edition). 24 Articles of Agreement, op. cit., Article VI, Section 1 (a), p. 16. ’ 165 j I by many countries to pay for essential imports, might be j wasted in financing capital flight from countries whose currencies were overvalued. Under these circumstances, an 1 \ 25 I interpretation of the Articles in 1946, ^ in establishing ; i that the Fund's resources could be used only to give tem porary assistance in financing balance of payments defi cits, said flatly that, the said deficits had to be "on current account" without even mentioning the various types of capital movements whose financing was explicitly per mitted by the Article. In practice, however, it is impos sible, without applying arbitrary conventions to say whether the Fund's resources are being used to meet any ■particular element in the country's balance of payments. The problem of allocation is not made any easier by the ^provision in the Articles that a country can use its own resources to meet a capital outflow. Then, again, when a payments deficits takes place a considerable time may i 'elapse before the nature and magnitude of the net capital ! movement can be established statistically. | Fund assistance cannot reasonably be withheld until a statistical analysis becomes possible. As the years passed, and circumstances changed, it came to be appreciated that disturbances in the normal flow of capi tal, provided they are temporary, are eminently suitable ^ Pursuant to Executive Board Decision Uo. 71-72. September 26, 1946. Selected "Decisions, p. 53, 166 [ I for fund financing, since they are extremely difficult to prevent by controls and if not financed may necessitate j i undesirable changes in exchange rates or resort to the kind of restrictions on current transactions which the | Fund has always sought to eliminate. Consequently in 1961, when it had become obvious that capital transfers were going to be an important feature of the payments scene, the Fund clarified the interpretations of 1946 to make clear that such facilities as were provided by the Articles for the financing of these transfers remained 26 unimpaired. Moreover, the General Arrangements to Bor row (GAB)2 ^ also negotiated in 1961, mentioned short-term capital movements as one of the new conditions affecting the International Monetary System that called for the strengthening of Fund resources. The general level of Fund resources, including the substantial resources avail- able to the Fund, in certain circumstances, under General Arrangements to Borrow, must, of course, be taken into ^account in considering what magnitude capital transfers must have in order to be considered "large." It seems un- jlikely that the Fund will, in the future, take unduly nar row views of its powers to finance capital flows. 26Decision No. 1238-(61/43), July 28, 1961. Sel ected Decisions, p. 53* ^Selected Decisions, p. 55* 167 j COMPENSATORY FINANCING OF EXPORT j FLUCTUATIONS28 I i I The following shall he recorded as the decision of' the Executive Board on the Compensatory Financing of fluc tuations in exports of primary exporting countries,^ i (1) The financing of deficits arising out of export shortfalls, noticeably those of primary exporting member countries, has always been regarded as a legitimate reason for the use of Fund resources, which have been drawn on frequently for this purpose. The Fund believes that such financing helps these ; members to continue their efforts to adopt adequate meas ures toward the solution of their financial problems and ;to avoid the use of trade and exchange restrictions to deal with balance of payments problems, and that this en ables these members to pursue their programs of economic development with greater effectiveness. i i (2) The Fund noted in its 1962 report that trends in ,prices of basic commodities in the past few years have adversely affected the export earnings of many Fund mem- Decision No. 1477(63/8), "Selected Decisions of the Executive Directors and Selected Documents," Interna tional Monetary Fund (Washington, D.C., January, 1965), p. 4o. (3rd issue) 29 'Selected Decisions, loc. cit.. Decision No. 1477 (63/8), p. 40. Also, "Compensatory Financing of Export Fluctuations" (Washington, D.C., 1965), pp. 37-39. Second Report by the IMF, pp. 168 ; 30 ' bers, which, has increased the strain on their reserves. j i In view of this and in order to ensure the maximum! I effectiveness for its support to members - in particular, j primary exporting members - that are faced with fluctua tions in export proceeds, the Fund is taking the action set forth below: (A) Quotas: (3) Ihe quotas of many primary exporting coun tries, taken in conjunction with a reasonable use of their own reserves, are, at present, adequate for dealing with !export fluctuations, such as have occurred during the past !decade. In those instances, however, where adjustment of the quotas of certain primary exporting countries, and in particular of countries with relatively small quotas, ; would be appropriate to make them more adequate in the ilight of fluctuations in export proceeds and other rele vant criteria, the Fund is willing to give sympathetic 31 consideration to requests for such adjustment.v j (B) Drawing Policies: (4) Under the present policies and practices on the use of Fund resources, any member is given the over whelming benefit of the doubt in relation to requests for 3QIbid.. p. 38. 51Ibid. transactions within the gold tranche, and the Fund's atti-j t tude to requests for transactions within the first credit j tranche is a liberal one provided the member itself is i making reasonable efforts to solve its problems. In the higher credit tranches, the Fund gives assistance, on a J substantial scale, toward meeting temporary payment defi cits, including deficits arising out of export shortfalls. The policies and practices of the Fund on drawings and stand-by arrangements have been developed in order to 'help members to meet more effectively their temporary bal ance of payments difficulties and to enable them, where necessary, to pursue policies aimed at restoring external and internal equilibrium. Fund assistance in accordance with these policies and practices has made an effective !contribution to the solution of the difficulties of these members and the achievement of equilibrium. It has often :led, moreover, to the provision of further resources from ;public and private sources for meeting immediate and long- i term needs. In the application of its policies and prac- itices governing the use of its resources, the Fund's atti- i tude has been a flexible one, and account has been taken 32 of special difficulties facing members, i (5) The Fund has reviewed its policies to determine ^Article V Section (3) of Articles of Agreement, The International Monetary Fund. Washington, D.G., Deci- sion No. 14-77 (68/8) Compensatory Financing of Export Fluctuations. Also Selected Decisions, p. 41. 170 ! I how it could more readily assist members, particularly primary exporters, encountering payments difficulties pro duced by temporary export shortfalls, and has decided that; i such members can expect that their requests for drawings ; will be met where the Fund is satisfied that: (a) The shortfall is of a short-term ; character and is largely attributable to circumstances beyond the control of the member, and (b) The member will cooperate with the Fund in an effort to find, where re quired, appropriate solutions for its balance of payments difficulties. The amount of drawing outstanding under this decision will not normally exceed 25 per cent of members quota, and the draw ings will be subject to the Funds estab lished policies and practices on repur chase. When drawings are made under this decision, the Fund will so indicate in an appropriate manner. (6) In order to implement the Funds policies in connection with compensatory financing of export short falls, the Fund will be prepared to waive the limit on Funds holdings up to 200 per cent of quota, where appro priate. In particular, the Fund will be prepared to waive 171 j its limit (1) where a waiver is necessary to permit com- i pensatory drawings to he made -under paragraphs (4-) and (5)| I above; or (2) to the extent that drawings in accordance j ^ 5 * 5 ^ with paragraph (5) are still outstanding. ^ i Whenever the Fund's holdings of a member's cur- j i rency resulting from an outstanding compensatory drawing j under paragraph (5) are reduced, by the member's repur- | I chase or otherwise, this will restore the member's facil- I ity to make a further compensatory drawing under that par agraph, should the need arise. (7) In order to identify more clearly what are to be regarded as export shortfalls of a short-term char acter, the Fund, in conjunction with the member concerned, will seek to establish reasonable estimates regarding the medium-term trend of the member's exports on the basis of appropriate statistical data in conjunction with the qual itative information about its exports prospects. I In 1966, and after three years had elapsed since the creation of the compensatory financing facility, it has been deemed desirable both to clarify the circum stances under which the facility can be used and to intro duce into it certain modifications to increase the effec tiveness of the assistance which the Fund provides to mem bers, and in the light of many considerations and experi- ^Ibid., p» 4-2. ences the Executive Board Decision No. 14-77-(65/8) has | i been amended by the deletion of paragraphs (5) through (7)j i and the substitution of the following paragraphs: j "(5)H The Fund has reviewed its policies to deter mine how it could more readily assist members, particu larly primary exports, encountering payments of difficul ties produced by temporary export shortfalls, and has decided that such members can expect that their requests for drawings will be met where the Fund is satisfied that: (a) The shortfall is of a short-term character and is largely attributable to circumstances beyond the control of the member, and (b) The member will cooperate with the Fund in an effort to find, where re quired, appropriate solutions for its balance of payments difficulties. | Drawings outstanding under this paragraph (5) may jamount to JjjO per cent of the members quota provided (1) 'except in the case of shortfalls resulting from disasters i or major emergencies, such drawings will not be increased by a net amount of more than 25 per cent of member's quota in any 12-month period, and (2) requests for drawings which would increase the drawings outstanding under this paragraph (5) beyond 25 per cent of the member's quota will be met only if the Fund is satisfied that the member has been cooperating with the Fund in an effort to find, j where required, appropriate solutions for its balance of ^ payments difficulties. The existence and amount of an ; i export shortfall for the purpose of any drawing -under thisj paragraph (5) shall be determined with respect to the latest 12-month period proceeding the drawing request for which the Fund has sufficient statistical data, and any excess of a shortfall over the drawing under this para graph (5) in respect to that shortfall cannot be carried forward and covered by a later drawing under this para- I graph (5).^ M(6)" In order to identify more clearly what are to ;be regarded as export shortfalls of a short-term charac ter, the Fund, in conjunction with the member concerned, will seek to establish reasonable estimates regarding the medium-term trend of the members exports based partly on statistical calculation and partly on appraisal of export Iprospects. "(7)1 1 A member requesting a drawing under paragraph j(5) will be expected to represent that it will make a repurchase corresponding to the Decision (102/52/11) adopted in 952 and renewed by Decision 270 (53/95) in 1963» with a view in application of these principle appro- 34 IMF, Second Report, Compensatory Financing of Export Fluctuations. Development in the Fundfs Facility (Washington, D.C., 1966), pp. 30-31. 174 TABLE 8 CHANGES IN PRICES AND EXPORT EARNINGS FOR PRIMARY PRODUCERS, 1962-1965 Commodity Prices^ Percentage increase or decrease (-) from previous year 1963 1964 1965 4 Metals and minerals I 21 ±1 Agricultural products 20 — -12 Food 31 - >17 Coffee 4 30 —5 1 Sugar 185 >31 -64 1 Cocoa 20 -8 -26 Wheat 1 4 -5 ! Non-food 4 -5 Cotton 2 29 -6 Wool 18 — -13 Rubber -7 >5 -1 a All exports 18 2 -9 !1 Group price changes are derived from indices published hy the National Institute of Economic and Social Re search, London. Specified Commodity price series re- j late to world market quotations for representative grades only, and thus exclude the influence of prices determined under contracts. 4 Excluding petroleum. Source: IMP Statistical Yearbook, Various issues. Also; IMP, Second Report, "Report on Compensatory Financing" (Washington, D.C., 1966). 175 I i l TABLE 8-Continued j Countries mainly dependent on 2 specified commodities Percentage increase from previous year, 1963 1964 19655 Metals and Minerals 2 24 12 Agricultural products 12 10 Coffee 12 8 7 Mixed tropical foodstuffs 11 11 5 Mainly temperate products 14 12 2 Fibers and rubber 10 2 9 Mixed 7 11 5 Mixed mineral and agricultural 8 7 2 All countries 11 10 4 2 Countries obtaining at least one half of export earn- ings from commodity groups indicated. Excludes coun- tries dependent on petroleum. Data relate to 71 i countries. Provisional. i Source: IMP Statistical Yearbook, Various issues. Also; IMP, Second Report, "Report on Compensatory Financing" (Washington, D.C., 1966). ! 1^6 | priate to drawings under paragraph (5), the Fund recoin- | mends that, as soon as possible after the end of each of j i four years following a drawing under paragraph (5), the ! t member, repurchase an amount of the Fund's holdings of the; member’s currency approximately equal to one half of the amount by which the member’s export exceed the medium-term trend of its exports. Calculations of export excesses for this purpose will be made with respect to successive 12- month periods following the period of the shortfall with respect to which the drawing was made and on the basis of statistical information only.^ (8) Whenever the Fund's holdings of a member's currency resulting from an outstanding compensatory draw- ' I ing under paragraph (5) are reduced, by the member's re purchase or otherwise, this will restore the member's facility to make a further compensatory drawing under that paragraph, should the need arise. (9) When drawings are made under paragraph (5) j jt'he Fund will so indicate in an appropriate manner. With- ! in six months from the date of any drawing which is not under paragraph (5), and to the extent that it is still outstanding, a member may request that all or part of the jdrawing be reclassified and treated, for all purposes of [this decision, as a drawing made under paragraph (5). The 55Ibid., p. $1 TABLE 9 DEBT CONTRACTED OS GUARANTEED BY PUBLIC SECTOR IN SELECTED DEVELOPING COUNTRIES (IN MILLIONS OF U. S. DOLLARS AND PER CENT) Region and Selected Countries Outstanding at the End of 1967 Total Debt Commer cial Debt Total Debt Europe Cyprus 31.5 1.2 0.1 Greece 533.1 99.0 1.2 Malta 15.3 — — Spain 747.3 112.4 1.7 Turkey 1,738.1 35.9 4.0 Yugoslavia I4519.0 478.6 Subtotal (6 countries) 4,584.1 7^7.1 10.£ Asia Ceylon 254.6 46.4 0.6 China 741.3 91.6 1.7 India 6,997.6 90.7 16.3 Indonesia 2,221.7 376.4 5.2 Iran 1,744.8 587.3 4.1 Iraq. 279.1 57.9 0.6 Jordan 120.1 . . . . 0.3 Lebanon 92.1 20.5 0.2 Korea 1,221.9 971.0 2.8 Malaysia 409.0, 10.0, 1.0 Pakistan 2,810.0 230. y 6.5 Philippines 429.2 134.5 1.0 Singapore 74.7 — 0.2 Thailand 32?,8 34.1 0.8 Subtotal (14 countries) 17,719.9 2,470.7 41.2 ^In June 1968 Source: International Monetary Fund. Balance of Payments Yearbooks and International Financial Statistics (export data, f.o.b.) International Bank for Re- construction and Development, debt statistics. 17S j TABLE 9-•Continued .As Percentage of Region Grand Total 1968 Service Payments and Selected Countries Commer- Gial Debt Total Debt Commer cial Debt Europe Cyprus 0.0 3.8 0.4 Greece 1.1 49.0 19.6 Malta — 1.3 — Spain 1.3 72.5 17.8 Turkey 0.4 116.2 13.2 Yugoslavia 5.5 262.9 103»9 Subtotal 8.4 505.7 154.9 (6 countries) Asia • Ceylon 0.5 19.1 5.1 China 1.0 35.5 16.1 India 1.0 515.0 79.9 Indonesia 4.3 168.2 71.3 Iran 6.8 137.8 54.9 Iraq 0.7 15.0 4.4 Jordan 3.6 Lebanon 0.2 5.5 ---- Korea 9.1 45.1 38.1 Malaysia 0.1 30.0 1.7 Pakistan 2.6 134.4 15.4 Philippines 1.5 56.5 34.1 Singapore 2.5 Thailand 0.4 33.6 11.7 Subtotal 28.4 1,199.8 332.7 (14 countries) I TABLE 9-Continued j l Region and Selected Countries n r \/z o 1 1968 Debt Service Ratio j I7O0 " " Current Foreign Exchange Receipts ■ Total Debt Commer cial Debt .Europe Cyprus 182.3 2.1 0.2 Greece 951.9 5.1 2.0 Malta 117.6 iL . — Spain 5,355.0 2.2 0.5 Turkey 788.0. 14.9 1.7 Yugoslavia 1.831.0 14.4 5.7 Subtotal 7,215.8 (6 countries) Asia Ceylon 373.8 5.1 1.4 China 1,041.4 3.2 1.5 India 2,145.0 24.0 3.7 Indonesia 877.0 19.2 8.1 Iran 2,101.0 6.6 2.6 Iraq 1,145.8 1.3 0.4 Jordan 104.2. 5 3.4 Lebanon 206.1 * 2.7 Korea 880.3 5.1 4.3 Malaysia 1,494.8 2.0 0.1 Pakistan 750.8 17.9 2.0 Philippines 1,156.0 4.9 2.9 Singapore 1,570.3 0.2 Thailand 1.077.0 3.1 1.1 Subtotal 14,923.5 8.0 2.2 (14 countries) 1196? data. Merchandise esqports. Fund will agree to such a request, if at the time of the j | request, the member meet the requirements for a drawing j i of an equal amount under paragraph (5). I I INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT (IBRD) The world Bank was created as a new type of inter-j i national investment institution to make or guarantee loans! for productive reconstruction and development projects, both from its own capital, which would be provided by its member governments, and through the mobilization of pri vate capital. The Bank's share capital was so structured !that any risk involved in its operations would be shared by all member governments, roughly in accordance with their economic strength. The Bank, although an intergov ernmental organization, relies mainly on the world's cap ital markets for the bulk of its financial resources. According to the Articles of Agreement the sub scription of applicant countries is based on the economic ■ strength of the member. Upon joining a Bank, a country I J pays 10 per cent of its subscription. One per cent of this amount is paid in gold or U. S. dollars and is freely usable in the Banks operations; the other 9 per cent is paid in the country's own currency, and is available for use only with the consent of the member. The remaining 90 per cent is not paid in but may be called by the Bank if required to meet its obligation arising out of borrow ings or guaranteeing loans. A requirement for Bank membership is that a coun try must subscribe to an agreed amount of capital shares of the Bank. Capital subscriptions on June 30, 1969, aggregate $23 billion. Of this sum 10 per cent ($2.3 bil lion equivalent) had been paid in as follows: one per cent in gold or U. S. dollars, freely usable in all Bank operations; and 9 per cent paid in the national currencies of members, which can be lent only with the consent of the member whose currency is to be used. Out of paid-in cap ital , the Bank has been able to lend or schedule for lend ing the equivalent of about $1.9 billion. The remaining $400 million has not been released by the contributing 41 members for loan operations. The 90 per cent of capital subscriptions remaining unpaid amounted to $20.7 billion on June 30, 1969. Under present arrangements, this position cannot be used for lending. It can, however, be called upon if required to meet Bank's obligations to investors in its bonds and notes, or in loans guaranteed by the Bank. In the event of such a call, default by one or more members would not relieve any other member from its obligation to make pay ment under the call, though a member should be required to pay more than the unpaid portion of its capital subscrip 41 World Bank. March, 1970. IBRD, p. 63 182 | j tion, however, the existence of this huge goal of inter- j governmental credit, supporting the Bank's own credit, hasj "been of enormous value in developing a broad international' market for the Bank's bonds and notes. It is this market ! that supplies the largest portion of the Bunds which the ap Bank lends to its developing member countries. The standard lending rate of the Bank is between 5)^-6 per cent. Terms vary but average twenty years. The Bank normally limits the financing to the foreign exchange cost of imported goods and services for particular pro jects or programs. Local costs are supposed to be met by 'the borrower from other resources. The Bank plays its ! role mainly in the reconstruction financing; for the last fifteen years it has focused principally on financing the infrastructure of developing nations, e.g., transportation and electric power projects. At the end of its twenty- five years (June 30, 1907) the IBRD cumulative loan was ;$10.7 billion.4^ The following statistics show the cumulative total ;of world Bank loans as of June 30, 1966 by area and use: 42Ibid., p. 64. 43 ^Phillip Perera, Development Finance; Institutions, Problems. and Prospects (New York: Frederick A. Praeger, Pub., 1958), p. 410. By Area Per cent Africa 13 Asia and Middle last 34- Australia 5 Europe 21 Western Hemisphere By Use Per cent Electric power 34- Transportation 33 Telecommunications 1 Agriculture, Forestry and Fishing 9 Industry 16 Water Supply 1 Education Projects * Engineering Loans * General Development 2 Postwar Reconstruction _4 - *Less than 1 per cent 100 Source: 1965-1966 World Bank Annual Report LOAM POLICIES AND RESOURCES I Except in special Circumstances a world Bank loan imust be for a specific project in a member country, or a i i territory controlled by the member, i.e., loans must be i . jfor specific productive development projects except under jvery special circumstances, where a loan may be used for i |more general, but still clearly defined and supervised, economic development purposes. Loans are made only after the Bank and the borrower come to a clear agreement on the specific purpose of the loan. The Bank and the borrower 184 must also agree on a clearly defined list of items on which, the proceeds of the loan are to he spent, after ex haustive analysis of all aspects of the project* This : helps both the borrower and the lender to prepare and execute the project in such a way that it will be of real value to the economy of the borrowing country. Meanwhile, the project which the loan will assist must be technically and economically sound, and of high priority for the economic development of the country. The Bank must be satisfied that the project will be well man aged, both during its implementation and after completion. There must be reasonable assurance that the loan will be 'repaid, and the loan must not impose an undue burden on i the economy of the borrower. The Bank also ascertains that the prospective bor rower cannot obtain finance or reasonable terms from other i 44 : sources. ; Thus, the Bank's lending program is basically i jdetermined by the country's need and the availability of I jthe projects suitable to be financed. Also, the credit worthiness position of the borrowing country is a very important factor involved in this context in determining extending a loan or not. The following factors have to be analyzed when ^ World Bank. March, 1970, pp. 13-15. 185 i considering a project in detail: j i (1) Economic, including the demand for the goods or j I services the project will provide, the extent to which the project will employ domestic resources (including labor) j which would otherwise be utilized, the balance of pay- ! ments, effects of the projects and the relative merits of different ways of producing the goods and services re quired. A comparative analysis is made of the economic cost and benefit streams which are likely to flow from the I project. (2) Technical, including examination of the detailed jplans for the project's construction and operation, the ;location, scale, layout and design of the project, the types of process and equipment to be used, the timing of the projects, and the availability of factors of produc tion and of technical staff. Cost estimates are also examined in retail, and provision for general cost in- i icrease and contingency allowance are checked. (5) Institutional, managerial, and organizational. I (4) Procurement and commercial, including all arrange ments for buying and selling, both of the materials needed during the implementation of the project, and of the pro- I ject's output after its completion. The Bank normally re quires national competitive bidding for project construc tion and equipment but allows a margin of preference to local suppliers for all tut construction work. 1 i i (5) Financial (in the case of revenue - earning enti- J ties) including assessment of the funds needed during pro-] I jeet implementation and their source, and of the projects operating costs, revenues and prospective liquidity after completion. The Bank usually provides only a part of the whole of the foreign exchange component of a project's total cost; arrangements for the provision of the remain- 45 ,mg finance are examined. The Bank reduces the impact of interest payments on "borrower countries' resources by charging interest only on the portion of each loan which has been disbursed. It applies a small commitment charge (currently 3/4- of 1 per cent) on commited but undisbursed sums. i . It also might capitalize the interest on a loan jduring the period of the project's construction, including |the interest cost during this period, in the loan amount. I INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA) The International Development Association was es tablished as an affiliate of the IBRD in I960 to meet the needs of many Bank members countries who could not proper ly borrow on conventional terms due to debt service limi tations. By September of 1965, ninety five countries had 45Ibid., pp. 19-20. 187 | joined IDA's operations are merged with, those of the Bank.; IDA's credits carry a slight service charge (3/4 j per cent) in lieu of interest and enjoy maturity of fifty j i years. Typically, repayment is due in foreign exchange, and a grace period of ten years is allowed; 1 per cent of 'principal is repayable annually for ten years and 3 per cent for the final thirty years. As of June, 1967* IDA had provided cumulative credit of $1.7 billion. These funds have been used almost exclusively in Asia and the Middle East. About 40 per cent of total credits have gone to transportation and about 20 per cent to agriculture, forestry and fishing. Industry has also received 20 per cent. Also, IDA provides both foreign exchange and local 46 currency credits. i INTERNATIONAL FINANCE CORPORATION(IFC) The International Finance Corporation (IFC) is a member of the world Bank group; its purpose is to promote i 'the growth of the private sector of the developing na tions. Over the 11 years of its existence (1956-1957) membership has grown from 31 to 84 countries and its paid- in share capital from $78 million to slightly over $100 million. Following an amendment to its charter in 1965, 46 Development Finance, on. cit.. pp. 412-413. 188 the (IFC) is permitted to "borrow up to four times its capJ ital from the world Bank; in 1967 fiscal year, it borrowedj $100 million in this manner. By June 30, 1967* it had j undertaken gross commitments in excess of $221 million in-i volving over 100 enterprises in 36 countries. The IFC serves as the world Bank family's main instrument in deal ing with private enterprises; its loan and equity invest ments in privately owned business to that was $100 million with an average return to nearly 7)£ per cent. The (IFC) finances without government guarantees (required by IBRD and IDA), and almost all of its investments to date have been priority industries - iron and steel, pulp and paper, cement, fertilizer, etc. - and development finance compan ies. It can make loans and direct investment but only in exceptional occasions will it make loans without equity participation or an option thereon. Its loans in 1967 received between 7% - 8# per cent, and terms have averaged jbetween 10 - 12 years. Its average investment through • June 30, 1966 was $1.5 million.4' ' 7 FINANCING AGRICULTURE Agriculture remains the sector whose rapid growth is most urgently needed in the majority of the developing countries. 47Ibid., p. 414. 189 ; i In some countries, increases in agriculture pro- 1 I duction are the only alternative to serious privation. In! t I many others the dominance of agriculture in the economy j i makes its modernization the key to general economic growth. The Bank group's assistance to agriculture has risen substantially in recent years. During 1969 agricul tural loans and credits extended by the Bank and IDA reached a total of SJ67.3 million, more than double the level achieved in the immediately proceeding years, and about three times that of average of the last five years. In expanding its financing of agriculture, the group has spread its assistance far more widely than in the past by providing support to new types of projects and by assist ing countries which had previously received little or no Bank group finance. Policies for increasing agricultural production in developing countries need to take account of economic efficiency and market possibilities. The desirability of j (diversification in agricultural output and exports com- I • jbined with increasing awareness of the importance of im- ! proving the quality of diets in developing countries them- ! jselves, has led to a new emphasis on projects for live stock development. Most of the Bank and IDA loans were !used for crop development credit and loans for agro-indus- Jtries. I Many developing countries need to transform their 190 ; agriculture from a subsistance-based activity to one based; on production for the market, and to diversify tbeir agri-| cultural production. The Bank group continues to encour- , ! age these trends through lending for general agricultural 48 development, which totaled $72.2 million in 1969. Diversification into new crops which provide a source of cash income and improved production of existing ones, was encouraged by loans or credits to support some of the traditional crops in various developing countries. A new field of agricultural development which the Bank and IDA consider of special importance is that of agro-industries and related activities such as fisheries. The absence of facilities for processing, storage, distri bution and marketing of crops and livestock production can iseriously reduce the benefits of the new agricultural technology to producers and consumers. The group recog nizes the importance of supporting the processing stage of agricultural development and expects to finance an in creasing number of projects of this nature in the years 'ahead. ! Bapid agricultural development, made possible by scientific innovation and improved technology, requires a i comprehensive operational approach. A well defined pro- 48 World Bank. International Development Associa tion, Annual Beport, 1969, p. 7. r ' - | ; 191 j ! gram of action, encompassing all the elements necessary i for success and stating clearly the objectives to be | achieved, is a necessary prerequisite for project imple- j mentation. ' The size and geographical distribution of loans and credits during the Financial year 1969 reflect the greater diversity and flexibility which the group is in troducing into its assistance to agriculture. 1 FINANCING INDUSTRY The pattern of Bank group financing as a whole is designed to provide developing countries with a stock of physical infrastructure and an economic climate conducive to further growth through new productive investment. The Bank believes that its work should create a favorable en vironment for foreign private capital flows into the de veloping countries for the establishment of new industries ,and the consequent beneficial diversification of develop ing countries' economies. Industrialization in developing member countries of the Bank and IDA is also encouraged by t the element of procurement policy (which ordinarily re quires international competitive biding to ensure the low est economic cost in the execution of projects) provide a margin of preference (usually of 15 per cent or the actual tariff rate if it is lower) to domestic suppliers in the borrowing countries which participate in the bidding. 192 Finally, the Bank group provides member countries with finance which directly assists the process of industrial development, apart from the work of its affiliate, the :IFC, International Finance Corporation with the private i sector, the Bank and IDA lent a total of $366.0 million^ for industry during the 1969 fiscal year. Development finance companies can play a major part in the economics of the developing countries. As well as providing productive enterprises with finances by i supplying them with equity or loan capital, or by under writing issues of their securities, institutions of this kind can give technical and managerial assistance to en trepreneurs, and can act as financial intermediaries, bringing together local and foreign capital and skills for mutually beneficial joint ventures. Moreover, by encouraging the investment of domes tic savings in business ventures, development finance i companies can also assist the evolution of their coun tries' capital markets. The Bank groups, during the last jfive years, have extended assistance totaling $640.7 mil lion to 25 out of 28 developing finance companies with which it is associated. The provision of capital is only one aspect in assistance the Bank extends to development finance compan- 49 'This figure includes the program credit to India of $125 million for industrial imports. 195 ! ies. Before making a new loan, the Bank undertakes a com prehensive analysis of the company's operations, paying particular attention to the quality of its portfolio, j I which reflects the ability of management. This procedure | encourages the maintenance of high standards of project J i appraisal and supervision, and of enlightened lending pol-i . . I ucies. i i I FINANCING EDUCATION j I The priority placed by the Bank in investment ' 'designed to develop human resources is reflected in the irapid growth of loans and credits for education projects since the Bank entered this field in 1962. At the end of ,1969 fiscal year, the total Bank Group assistance to edu cation stood at $244 million with $2 projects having been assisted in 28 countries. The 1969 year saw a considerable increase in the inumber and value of education loans and credits approved. As an institution whose function is specifically to promote economic development, the Bank considers that it should concentrate its assistance on those areas of education where it can have the greatest impact on member c ountri e s' e c onomi c growth. The general objective of the Bank Group's lending for education is to modernize the education systems, to make them more efficient and more relevant to the coun tries’s needs, and, thus, to maximize the contribution of the educational process to economic growth within the countries' given resources. In particular, the Group's ; strategy for educational lending emphasizes projects which increase the availability of trained manpower - indus trial, technical, administrative and agricultural. Before making a loan or credit the Group under takes a careful study of the structure of the potential borrower's educational system to assess how effectively its output is geared to the country's manpower needs and how relevant the curriculum is to its existing or future level of development. The Bank pays special attention to i ithe possibility of qualitative changes in the system i .through curriculum reform and other improvements in the 'overall framework of education. Many developing countries have inherited educational systems which are inappropriate to their immediate needs, emphasizing academic rather than i practical subjects, and designed to prepare the students i |for further university education rather than to train them I in every day skills. Technical education is another area which the Bank and IDA are especially concerned in their lending as such.^ ! 5°Ibid.« p> 9# 195 FINANCING PUBLIC SERVICES i i The existence of an adequate public service infra-J i structure is an essential precondition for sustained eco nomic growth. Since its inception, the Bank Group has 'lent on a large scale for investment in public services; about 63 per cent of the cummulative total Bank loans and IDA credits to date have been channelled into projects to create or improve transportation networks, power supplies, water supply or sewage systems and telecommunications facilities Although much has been achieved, the need for further investment is still pressing; during the fiscal year 1969, the Bank loans and IDA investments in public i services totalled $960 million. i LOANS TO IRAQ ! FIRST LOAN: The International Bank for Reconstruction and (Development had made the first loan to Iraq in 1950 of ^$12,800,000 (or equivalent in other currencies) to the Iraqi government for the construction on the Tigris River of a flood control system urgently needed to prevent re current flooding of large areas of cultivated land and urban property. This was the first loan the IBRD had made to a middle eastern country. 51Ibid., p. 13 196 j The loan, which was secured by an assignment of j i i oil royalties, was for a term of 15 years and carries an ; interest rate of 2-3/4- per cent, plus commission at a rate! ■of 1 per cent which was in accordance with the Bank's Articles of Agreement was allocated to its special reservej Fund. Amortization payments calculated to retire the loanj by maturity, would start on April 1, 1956. j The system to be constructed, was known as the Wadi Tharthar Flood Control Project, would involve a total capital cost of the equivalent of $28,700,000, of which the Bank's loan of $12,800,000, would cover only the esti mated foreign exchange costs. The foreign exchange costs were expected to in clude purchases in the United States, the Sterling Area and possibly elsewhere, of equipment and materials to be used in excavation and in construction of levees and head- works. Under the terms of a tripartite project funds jagreement between the government of Iraq, the National I i 52 Bank of Iraq,' and the International Bank, an arrangement !was established for the provision by Iraq from its oil t ^royalties of sufficient funds to meet the domestic costs of the project. The Wadi Tharthar Flood Control Project contained only the flood control elements of a more comprehensive 52 ' Now is the Central Bank of Iraq. 197 j plan, which provided for water storage, regulation of j I water supply and irrigation, in addition to flood protec- ! i tion. The initial flood control project, for which Bank | I financial assistance was being rendered, provided for the ' construction of a dam across the Tigris River at a point ! f about 50 miles above Baghdad, which would direct excess flood waters through a diversion channel to an unpopulated ! and barren depression known as Wadi Tharthar. j i This project is of vital importance to the eco nomic development of Iraq. Over 80 per cent of the popu lation of Iraq (at that time) was engaged in agriculture. Agricultural development, however, is primarily dependent on irrigation, which, in turn, depends upon control of the country's rivers, the Tigris and Euphrates and their trib utaries. Although water is abundant in Iraq, its produc tive use in a modern sense remains to be fully developed. In spite of the budgetary difficulties at that time and |which were remedied then, there were factors in Iraq's i ieconomic position which permitted sound external borrowing |within the nations capacity of repayment. In addition to ! jits resources of oil, Iraq has considerable cultivated land, which, with more effective use of water, can be turned to productive purposes at comparatively modest expense. The oil resources provide a reliable and increas ing source of revenue which should enable Iraq to service “ 198 ! I i .the loan and still leave considerable income for further i development, ! i Anyhow, this loan was cancelled by Iraq in 1955 ! because of an increase in the government's financial re sources and the amount outstanding was repaid.^ SECOND LOAN: In 1966 the Bank approved a loan equivalent to $23 million to Iraq for a road construction and mainten ance project. The loan would assist in financing five main roads totaling 250 miles in different parts of the country, a bridge over the Euphrates, a road maintenance program, and jconsultants’ services to assist in this work and to carry out a road transport study. Iraq has an area of 172,000 square miles and a population of more than eight million. The population and I !agriculture are concentrated on about a sixth of the land, !along the Tigris and Euphrates rivers. Road and rail net- I ; works are centered on the Mesopotamian plain, extending i from the mountains in the North to the gulf. Bank funds will be used for the purchase of addi tional modern equipment for road maintenance and the em ployment of outside experts to study and recommend im- 5:5 ^International Bank for Reconstruction and Devel opment, Press Release No. 192, Washington, D.C., pp. 2-3* 199 j provements in the present organization of Iraq's mainten ance operations. This program is essential to protect the considerable investments made in Iraq's road system. (The road transport study were to be carried out by consultants who would advise the government on a coordin ated long-term program of road transportation investments. Until recently, expansion of the highway system in i Iraq has been guided by the need to connect the main urban centers. Further needs, however, would not be so obvious and more comprehensive studies would be required to iden tify priorities of both type and location of roads. The Directorate General of Roads and Bridges in the Ministry iof Communications, which is responsible for Iraq's road i network, would execute the project with the assistance of consultants. The total cost of the project was estimated at the equivalent of $54- million, the Bank loan of $23 million i would cover the foreign exchange requirements and the re- ;maining costs would be met by the government of Iraq. | Construction is already under way and all con tracts are being awarded on the basis of international competitive bidding by prequalified contractors. The loan would be for a term of 20 years and bear interest at the rate of 6 per cent per annum. Amortiza 200 tion would begin July 15, 1970*^ I C/L ' International Bank for Reconstruction and Devel opment, Bank Press Release No. 66/34- (July 8, 1966). Washington, D.C., pp. 1-3. TABLE 10 SERVICE PAYMENTS ON EXTERNAL OFFICIAL DEBT AS PERCENTAGE OF EXPORTS OF GOODS AND SERVICES Selected Countries 1961 1962 1963 1964 1965 1966 1967 1968 Africa , Morocco n.a. 2.0 n.a. 3.0 4.9 7.4 7.5 12.8 Nigeria 0.9 1.9 3.0 2.7 2.8 4.8 3.4 6.6, Sierra Leone n.a. n.a. 2.1 5.0 5.3 6.6 8.6 7.8-1 Sudan n.a. n.a. n.a. n.a. 5.7 6.5 5.5 7.4 Middle East Iran n.a. n.a. n.a. n.a. n.a. n.a. n.a. 6.8 Iraq n.a. n.a. n.a. 21 • S t • n.a. 0.8 0.7 n.a. Jordan n.a. n.a. 0.5 0.6 1.0 1.3 n.a. 1.8 South Asia Ceylon India^ n.a. n.a. 1.4 1.5 1.9 2.6 3.8-, 21 • 9.« - I 12.6 10.7 9.8 15.2 13.2 16.3 18.51 21.61 Pakistan 5.5 6.4 10.7 9.7 10.5 12.4 16.6 18.8 n.a. Signifies that data are not available on debt service, export earnings, or both. 1 Exports of goods only. 2 Debt service does not include suppliers' credits Source: International Bank for Reconstruction and Development (IBRD), , 1969 Annual Report. ro ! o . TABLE 10-Continued Selected Countries -1961 -1962 1963 1964 1965 ■1966 -1967 •1968 Western Hemisphere Argentina n.a. n.a. n.a. 24.4 20.3 25.5 26.6 26.4 Bolivia n.a. n.a. XI • 9 1 • H * Q . • n.a. 5.6 5.8 n.a. Brazil n.a. n.a. 26.3 24.6 22.8 24.7 30.4 20.3 Chile 22.6 22.2 17.7 17.9 16.0 11.5 14.2 XI • 3 . • - i Uruguay 4.8 0.3 9.1 10.5 6.7 13.8 n.a. 30.41 Venezuela 4.3 4.7 3.4 2.8 1.7 2.6 1,9 8.9 STATEMENT OP TABLE 11 LOANS FOR SELECTED (JUNE 30, 1969) COUNTRIES Members in whose territories loans have been made Effective loans held by Bank Loans not yet effective Disbursed portion Undisbursed portion Total India 1498,472,66? $112,927,759 $611,400,525 $40,500,000 Iran 138,192,019 74,757,441 212,9^9,460 70,000,000 Iraq 9,142,639 15,757,561 22,900,000 --- Mexico 474,060,830 122,980,035 597,040,863 65,000,000 Morocco 41,902,182 25,008,722 66,910,904 --- New Zealand 81,494,010 9,012,180 90,506,190 --- Nicaragua 19,878,917 18,909,083 38,788,000 --- Nigeria 132,410,178 38,669,816 171,079,994 --- Norway 88,927,125 --- 88,927,125 - — Pakistan 262,594,689 200,476,561 463,071,250 22,500,000 Source: International Bank for Reconstruction and Development (IBRD), 1969 Annual Report. ro o CHAPTER V DEVELOPMENT BANKS: DEFINITION, FUNCTIONS AND SIGNIFICANCE IN A DEVELOPING ECONOMY DEVELOPMENT BANKS Development Banks are institutions established principally to provide long-term financing for industry. ;The development Bank intended to provide capital for the private industrial sector and to mobilize savings, enter- iprise and skills for productive investment in that sector. ! During the last two decades most of the less- developed countries were swept by a determination to ac celerate the pace of their economic development. This determination has been manifested by an increasing empha- ■ sis on industrialization. Progress has been impeded in 'most countries by the lack of inadequacy of various in- Igredients of industrial development. The first impediment i |is a shortage of capital for industrial investment. The i less-developed countries, spurred by the rapidity of their political advancement during recent years, feel it a ne cessity to achieve their economic growth at a faster pace. But their resources do not permit the accumulation of 204 205 1 * i earnings sufficient to finance a rate of growth satisfac- i tory to them. Some capital does exist in the form of pri- i vate savings hut not enough. Only a small savings is in i any event readily available for investment in industry; wealth is traditionally invested in land or commercial ,enterprises. The lack of effective mechanism for channelling into productive investment a sufficiently large proportion , of such savings as exist, lack of capital market means the absence of, or little knowledge with, investment financing techniques. A number of these Banks have been established with ;the assistance of the International Bank and in some cases the Bank has provided the foreign exchange needed for their operations. I The main reason for the World Bank’s original interest in Development Banks was that they offered a ; practical solution to the difficulties the World Bank en- |countered in financing small private industrial projects |directly. Where the projects were many and the amounts sought were small, the Bank could not afford to undertake the detailed technical and creditworthiness appraisal which are a normal preliminary to a loan. Moreover, effective appraisal of such projects called for a greater knowledge of local conditions and the business standing of 206 ~ j the sponsors than the Bank possessed or could readily | acquire. j i However, it was feasible for most private enter- j i prises to obtain the government guarantee required by the J World Bank's Charter when a loan is made to a non-govern- I mental borrower. These difficulties were avoided or sur mounted when the borrower was a local financial institu tion which could readily obtain a government guarantee, could select the promising enterprises for financing out of the proceeds of the Bank's loan and could undertake the necessary technical and financial appraisal. The success !of these institutions in stimulating new investment in and !by the private industrial sector, and in making available new skills and enterprise as well as capital, has proved { them a valuable instrument of economic development. I Most are public institutions owned and managed by the government. Several are owned jointly by government and private capital, the latter generally having a minor- jity interest. I Some development banks play a major role as fi- i jnancing institutions; for others providing finances, is of jless significance. A few are a source of capital for gov ernment undertakings as well as for the private sector. Most assist industrial enterprises exclusively; some will also finance large scale commercial and agriculture or agricultural undertakings integrated with a manufacturing 207 ; operation. i Many development Banks provide their clients with j i various kinds of technical assistance (engineering, ac- | I counting or management advice) on projects they finance; some will advise on a project even if they are not financ ing it. Some Banks investigate promising new investment opportunities, bringing them to attention of private busi nessmen. Many of these Banks enter the industrial arena f ! directly, establishing enterprises and arranging for their] operation until such time as private capital can be in duced to take them over. Some Banks engage in activities designed to promote a capital market, activity seeking to broaden the base of industrial ownership by selling in vestments from their portfolios, by underwriting industri al issues, or more indirectly, by issuing their own secur ities. The design of the Bank must be drawn in the light of its purposes and of the economic, social and political 'environment in which it is to function.^ I i In some situations, government finance and direc tion are obviously called for; e.g., where the Bank is to (operate entirely in the public sector, channelling public Funds to public enterprises or executing or operating pub lic projects such as highway construction, power develop- Hfilliam Diamonds, Development Banks (The John Hopkins Press, 1957), PP* 19-4-0. 208 n I 1 ment or public works. I | Development Banks and the investment Banking in- ; stitutions can be considered as two vital financial inter-! mediaries that play a growing role in stimulating and I broadening industrial growth. In many emerging nations, J t t these institutions' functions are combined in a single in stitution as it is the case in Development Finance Compan ies in Pakistan, Phillipines, etc. Development Bankers focus on the assembly and financing of new enterprises and, by providing technical assistance, help them to ma ture into companies with public investment appeal. In vestment Bankers, on the other hand, deal principally with seasoned securities of established enterprises, which they underwrite and sell to a broad public. By creating enter prises, seasoning them, and then selling their securities to a wide number of individuals and institutional inves tors development and investment Bank teams can be an im portant catalyst in industrial development, j The ideal relationship between these two types of !institutions would be as follows: the Development Bank | [would identify, study, and assemble sound investment op portunities into projects which it would guide until they were "seasoned." An investment banking affiliate would .then underwrite these seasoned issues and distribute them to a broad market. The existence of efficient development investment Banking teams would greatly enhance the devel- ? opment effort. BANK'S RESOURCES The Bank ought to have sufficient capital to en able it to make an impact on industrial development and to earn enough for expenses, the accumulation of adequate re serves and, in case of private institutions, payment of satisfactory dividend. A particularly perplexing problem !in setting up a development Bank under World Bank stand ards is to determine its proper structure.^ There is idanger both in over-capitalization and in under-capitali- i Ization. Shirley Boskey states: ; The Bank ought to have sufficient capital to enable it to make an impact on industrial development...on the other hand, resources should not be so large that they greatly ex ceed what appears reasonably necessary to the fulfillment of the Bank's purposes. Over-capitalization, the sense, of having 1 a great deal more funds than are needed to do 2 1 P. Perera. Development Finance, op. cit., pp. j 148-14-9. i 5 I ^Since 1950, the most important privately con trolled development finance institution that is considered the type advocated by the World Bank, and more especially by its affiliate the International Finance Corporation, is the Industrial Development Bank of Turkey, a privately controlled institution that was established with the assistance of the World Bank and other parties. It was designed to perform the Development Banking functions of medium and long-term lending, the guaranteeing of loans, underwriting, subscribing to shares of projects, and pro viding technical and professional knowhow to protect im plementors. It is known now as the Development Finance Company. 210 i i the job whether this is providing finance and technical assistance or establishing industry they give rise to strong pressure to do too much too early and too fast. Whatever the capital structure, it must be suffi ciently leveraged to assure a level of earnings necessary i to meet staff and management costs (which are high when a ! Bank engages in project promotion), to build sound re serves, to meet tax payments, and to enable the Bank to pay a reasonable dividend as soon as possible. Most pri vately controlled development banks enjoying World Bank I encouragement have received either interest-free or low ;cost liberally termed loans from their local host govern ment. It is popular to label these advances as "quasi- |equity" since they are subordinated to the claims of other public and private creditors and frequently to sharehold ers claims in the event of liquidation. The World Bank, ; among other public creditors, will include "quasi-equity" i |as part of the local institution's borrowing base, i.e., t to mobilize loan funds for in excess of typical 3:1 or 4:1 ratios. The terms "quasi-equity" loans vary from fifteen to twenty-five years, e.g., $6 million interest free loan advanced to Nigeria Industrial Development Bank by the government of Nigeria. This loan has a 25 year term and 4 Shirley Boskey, Problems and Practices of Devel opment Banks (Baltimore: The John Hopkins Press, 19^4), 4th ed., p. 22. a grace period of 15 years. Concessionary assistance is important, in that it helps a bank to achieve a profitable operations rapidly and cushion shareholders in the early years before ade quate reserves have been built up. The existence of quasi-equity can be crucial in mobilizing large amounts of capital from multilateral agencies such as the World Bank. To illustrate, if share holders committed on dollar in equity and were able to obtain |1.50 in "quasi-equity," a typical pattern, this "borrowing base" (capital reserves and quasi-equity) 'could, under normal conditions, mobilize up to three times as many World Bank dollars.^ With quasi-equity of 1% times shareholder capital, a dollar of shareholder's equity on a 3:1 basis could mo bilize nine dollars of additional resources. This is : called multiplier effect, as shown in the figure below: Borrowed funds impose fixed charges. Equity cap ital imposes no fixed charges, but at the same time it may ibe more costly in the long-run. If the Bank is a success, f it is likely that a larger total sum will be paid out as 5 ^The World Bank will sometimes lend up to a 4:1 debt-to-equity ratio and higher, but for banks in the start-up stage, a 3:1 ratio is the norm. 6 Loans made to Development Banks by the Interna tional Bank are in the form of a line of credit, interest being charged on the amount withdrawn and outstanding from time to time. 212 I Multiplier Effect of Quasi-Equity j 8 . 7 3:1 6 5 4 3 _________________________ __ 2 ^ Quasi-Equity q Shareholders Equity j I ' I .-'I'...........min i .— I. — — — ....................................................... dividends than would have been paid out as interest on sin equal amount of loan capital obtained on conventional terms. To the extent of the difference the amount of ;funds available for reinvestment and new earnings - will | ■ be reduced. In the above discussion it can be said that |these considerations have little significance for a wholly government-owned Bank which is not under pressure to earn |large profits for its shareholders and which looks to the government for all of its resources. But, they may be im portant even for a public Bank, if it is contemplated that the Bank may sometime wish to borrow from other sources, perhaps through issuance of its own obligations. Considering the relationship between the debt and 3:1 Quasi-Equity Shareholders Equity 213 f t equity in the Bank's capital structure also has implies- i tions for the Bank's investment policies should not he j overlooked; Boskey explains: j In determining the proportion of its re- ] sources which it can he prudently employ to purchase equities, the Bank must he mindful of the need to have sufficient Funds in liquid or readily realizable form to meet its fixed obligations. A Bank capitalized heavily with borrowed Funds would probably be reluctant to invest heavily in equities, and might even accept only the more conservative loan pro- | posals. Therefore, it may be said that if it j is the primary purpose of the Bank to provide I risk capital, the Bank's own capitalization should not contemplate a relatively high proportion of loan capital. On the other hand, a preponderance of loan capital would not be inappropriate for a Bank expected to make few or no equity investments.< i i With respect to the financing of public Banks, it suffices to note that what corresponds to the share of capital may be provided in various ways. Funds may come jas annual appropriations, or Treasury advances or a lump !sum allocation not in the form of subscription to share I ;capital. In Yugoslavia, publicly owned enterprises are required to the public development Bank's lendable re- isources, annually, the equivalent of a fixed percentage of their assets. Certain tax proceeds are earmarked for the development Bank, a technique followed in other countries as well. 7 Shirley Boskey, Problems and Practices of Devel opment Banks, Third Edition, 1964, p. 24-. r 214 | * i A development Bank’s equity investments should notj exceed its paid-in capital and free reserves. All invest ments should be in projects of measurable commercial value I and economic benefit to the country. Lending operations should focus primarily on the financial and economic I I soundness of ventures. Lending terms should correspond to actual project needs and capability to repay; they also should reflect allocation of investment resources in the local economy. Grace periods should be realistic and i should allow a project to start up before the repayment cycle begins. Interest rates should be set in accordance with the cost of capital and not at artificial levels. f Artificially high rates can impede development, while low i rates can breed uneconomic projects that are viable only ! 8 because they are subsidized. Industrialized nations have a multiplicity of fi nancial intermediaries for efficient mobilization and 'transfer of savings to productive investment; in most de- i jveloping nations, however, relatively few operate effec tively because of inflationary pressures, a lack of trained management and traditional patterns of investment. The commercial Bank is the principal taskmaker, and it bears the major responsibility for transferring savings in emerging nations. Q IFC, "Private Development Finance Companies,” June, 1964. A 215 ] Unfortunately, since the staff and managements of i such Banks are generally oriented to the liquidation value; i of collateral rather than future earnings of investment i projects, the value of these institutions to the long-term industrial financing service and the encouragement of in- i dustrial entrepreneurship is limited. j Most of the private development Banks have not /been effective development and investment Bankers at the same time. Experience suggests that very different phi losophies and staff skills are involved, e.g., consider able missionary work must be done to build investment » acceptance among household savers, and this requires full- i ;time investment Bank attention. Personnel with an investment Banking background and a flair for securities merchandizing are needed. : Therefore, a number of private development Banks are par ticipating in taking steps to encourage investment Banking I companies. i i | In fact, government in the emerging country should jobserve the following five principles to optimize its im- I pact on development: (1) It should use its funds selectively to cata lyze the maximum industrial development; (2) It should initiate state-owned projects only when they are proven sound and vital to the economy and 216 | 1 i when private sponsors cannot or will not sponsor them; I (3) It should emphasize the attraction of the j ■greatest possible amount of private foreign capital in ; j ;the critical growth years. Since such capital and know how are closely related; i (4) It should provide the missing links in the j chain "by using the savings to finance project promotion, 'feasibility studies, and other activities that are re- I |quired by, but are often not within the capabilities of, j | ■the private sector; (5) It should isolate development financing from purely political motives and protect fund disbursement ifrom misuse by individuals. i BANKING FUNCTION The principal financial function that a develop ment Bank must perform is the provision of medium and q long-term capital to economic development projects. j : It is certainly not necessary that these projects be restricted to the field of industrial development, also history has shown that there is an area which a country determined to increase its per capita production must not overlook. However, projects which stimulate agricultural development or which relate to the development of a coun- 9 yJ. T. Dock Houk. Financing and Problems of Devel opment Banks (New York: Frederick A. Praeger, Inc., Pub., 19^), p. 2. 217 1 i try's infrastructure or which stimulate the growth of cer-; I tain institutions such as cooperatives, can, in specific j instances, have as much for more impact on economic j "development.” Other financial functions of development Banks as apply to industrial Banking as to any other type of development Banking and include the investment hy the Bank in the equity of a borrower, the guaranteeing of a ■loan by a third party to a borrower, the underwriting of i !attempts by a borrower to raise equity or debt and service of providing broad financial contacts, both within and ^outside of the developing country.^ DEVELOPMENT FUNCTION ! A financing institution which restricts its activ- !ities only to the Banking functions mentioned above should !not be classified as a development Bank. A development iBank, must, in addition to its Banking function, attempts to relate to certain problems of, or bottlenecks to, de- i jvelopment, the magnitude and importance of which may vary I 1 11 |from country to country. i I PROPORTIONING OF CAPITAL BETWEEN DEBT AND EQUITY A very important consideration with respect to capital requirements for development Banks is the propor- 1QIbid.. p. 3 11Ibid. 218 * tioning of capital "between debt and equity. First of all, j let us define both "debt" and "equity." "DEBT" is defined as the Bank total fixed payments and guarantee obligations minus those obligations of a commercial Banking nature, if any, which will mature in one year, and minus, also, any borrowings furnished the 12 Bank in the form of subsidies (quasi-equity). "EQUITY" is defined as all paid-in capital, stir- plus, free reserves and, in addition, any borrowings as above which are furnished the Bank in the form of subsi dies (quasi-equity) The debt-equity ratio is used for industrial firms as well as for Banks as one of the measures of financial soundness. It sets forth a certain relationship between owned and borrowed Funds and is a measure both of financial risk and of investor leverage. The essence of the dilemma of debt-equity ratio is I :that equity owners, to a certain extent, would like to see I a high debt-equity ratio because it gives leverage to i jequity capital. That is, with a high debt-equity ratio there is less risk for investors and these same investors stand to make greater profits per unit of capital invested. 12 J. T. Dock Hook, op. cit.. p. 63. 15Ibid. 219 j In addition, with a small amount of equity it is j easier for a small group to maintain control. Creditors, j i on the other hand, are looking for security of their in- | | vestment. Although realizing that debt is an important j ; part of the financial structure of the Bank, they are in- j terested in the security of their loan. Consequently, they hesitate to permit the borrowers to have a debt- equity ratio in excess of a certain amount. SOURCES OF CAPITAL FOR DEVELOPMENT BANKS Capital has been attracted to development Banks :from many different sources and for many different rea sons. Both equity and debt capital have come from domes- I tic private and public sources and have also come from j foreign private and public sources and international sources, as well. DOMESTIC PUBLIC SOURCES OF CAPITAL A development Bank, even one which intends to be ;privately controlled, should not overlook the possibility i j of local public sources for both equity and debt capital. J Very often, in a developing country, the private sector is too capital-poor to provide, in the beginning, sufficient capital to build an adequate borrowing base. Therefore, they might turn, and indeed have turned, to 220 | \ local public sources for both equity and debt. Governments of many developing countries realize that a development Bank can be a very effective tool for the accomplishment of many economic and social objectives. Governments, therefore, have been sponsoring bodies either as sole owners, as participants, or as lenders, in a great number of development Banks. ATTITUDES TOWARD GOVERNMENT PARTICIPA TION IN THE OWNERSHIP OP DEVELOP MENT BANKS PRO 1. Easier to obtain capital 1. from many sources. 2. Tends to lessen the 2. threat of government ex propriation or other int e rvent i on. 3. Greater possibilities 3» of obtaining significant amounts of government capital and other gov ernment concessions. 4. "Inside track" to assist 4. borrowers to obtain dis counts, permits, conces sions, and other govern ment-controlled require- CON Political or social considerations may be brought more easily on the Bank to use Punds in less than optimum uses. Disclosure by borrow ers to Bank with gov ernment ownership will lead to "leak age" of business in formation to other branches of the gov ernment such as tax collection agencies. The scope of the Bank is likely, at govern ment assistance from within, to be ex panded with costly services. Selection of Bank personnel is likely to be influenced by political favorites at the sacrifice of capable leadership 5. 5. A) Bank will become ! over-staffed with people who are not i productive, yet who, j because of their [ political connections' cannot be fired. j I B) Lack of profit motive may cause the Bank to become care less with its Funds. REASONS FOR GOVERNMENT PARTICIPATION Governments have a number of reasons for their ■ participation in both equity and debt of development ( Banks. These reasons can be examined as follows: A. Economic Objectives As a tool of economic development, Banks can re late to a number of pressing bottlenecks to economic growth. 1. Entrepreneurial Development: j One of the bottlenecks in the eyes of many prac- Ititioners of economic development is the critical lack of i | entrepreneurs. These are the individuals, or, as the case may be, institutions, in a society that mobilize resources for development, and associate factors of production in productive, viable combinations to produce goods and ser vices needed and demanded by the people. Many writers in the field of economic development have noted the impor- 222 ! I i tance of the entrepreneurial function to development, and ! i many governments, casting about for ways to accelerate thej pace of growth in their countries, have turned to develop ment Banks as a way to relate to this problem. | 2. Capital Mobilization: j A development Bank is a proven technique for the I mobilization of capital for productive purposes. Most j governments realize that great amounts of capital in their country, which potentially could be bent to the use of i economic development objectives, are presently in unpro ductive uses, such as, in land, in buildings, luxury hous- iing, inventories, hoards, and especially in Bank accounts t ;or other assets in foreign countries. I A development Bank does much more for mobilizing capital for economic development than just the filling out • of its own capital structure. Each project that it ap proves has a heavy content of other Funds. And very often ja development Bank with its extensive financial contacts, ,both within or outside a country, can assist its borrowers ,in obtaining other financing, such as suppliers' credits or investment from other sources of capital. The Indus trial Finance Corporation of India estimated in 1965 that it had been associated since 194-8 with projects whose total investment amounted to over 50 per cent of the pri- 1 U- vate capital formation in India. The many things that a 14Ibid., pp. 76-77 development Bank can do to strengthen the capital market, : such as underwriting, portfolio sales, stock and bond i issuance, and the like, make it an ideal tool to accom- j J plish a government's economic objective of capital mobili zation. 3. Investors' Confidence: A pressing problem with which governments inter ested in economic growth must deal is the problem of lack of confidence on the part of domestic and foreign inves tors. This lack of confidence springs both from their lack of experience and knowledge and, perhaps, from vari ous kinds of instability within the country, such as po litical turnover or price changes. Government investment in development Banks, although certainly only one of many ways in which the government can relate to this problem, could be a clear demonstration of the government's inter est in economic development, and its intention to do some thing about it. Investors' confidence relates both prob lems of entrepreneurial development and capital mobiliza tion mentioned above, but is separated here because of its crucial relationship to foreign capital flows. 4. Plan Implementation: Many countries have turned to planning as a way of rationalizing the process by which resources are directed to the satisfaction of consumers' needs. 224 Although, from many points of view, this method j of economic development carries with it additional prob- , | lems such as fostering initiative, building confidence, j i and creating incentives, nevertheless, planning has achieved in many countries a high degree of respectabil ity and will certainly be very much in use by the devel oping countries until at least the "take off" stage of economic growth. The relationship between formulating their plan and its implementation, however, is extremely weak in many countries. No matter how good the plan looks on paper it somehow just does not get translated into actual I production. A government may look upon a development Bank' as a medium through which it can have an impact on the ;allocation of resources in the country according to the development plan. Governments in many countries have chosen development Banks as their chosen instruments for investment. Nacional Rinanciera in Mexico and many others I I are examples of this kind of development Bank. 5• Revenue: i Another objective for the participation of a government in a development Bank might be the obtaining of revenue. The investment by the Japanese Government in the Japan Development Bank has been extremely profitable and has yielded 6 per cent on its borrowings and has paid to 225 ; the government of Japan more than the capital which the j 15 I government originally contributed. In the twelve and j , one half years from its establishment to September, 1965, j the Japan Development Bank paid to the government of Japan i $706 million (equivalent) which was $539 million in inter est and $367 million in earnings. This is more than 8 per cent more than the Bank's $650 million initial capitali zation.^^ B. Political and Social Objectives Governments have invested in development Banks not only to stimulate their countries' economic development but, also, to achieve certain political and social objec tives. Governments are concerned with their political position within the country and equally concerned with the attainment of certain social goals and objectives. Consequently, there are times when it appears that their investment in development Banking is oriented toward the achievement of certain of these non-economic goals, especially: 1. Regional Balance; Very often government is concerned with the strength of its economy and investment in a development Bank in order to influence the allocation of the Bank's 15Ibid., p. 79. 16Ibid. 226 resources to this end. One gets the feeling that the government of Pakistan is somewhat displeased with the j pattern of investments of the Pakistan Industrial Credit I i and Investment Corporation in that this corporation has j chosen productive investments which have been overwhelm ingly concerned in West Pakistan. Although the total amount of the loans in effect on December 21, 1963, ex pressed in dollars, amounted to $114.7 million, only $32.3 million had been loaned to projects located in last , Pakistan. It is easy to understand how a private devel- ,opment Bank such as the (PICIC) would concentrate its lending pattern in West Pakistan. The large markets are ' there; infrastructure is quite a lot further advanced in West Pakistan; the existence of skilled labor, business services, and other necessary ingredients for economic development are more helpful and plentiful. East I Pakistan, on the other hand, is a very low country, sub- ; ject to annual flooding which disrupts transportation and :does not have the tradition of industrial development that |West Pakistan enjoys. i The Industrial Finance Corporation of India, a development Bank in which the government owns nearly half the equity, has been extremely sensitive to the geograph ical pattern of its investments: The corporation continued to give special assistance to less-developed areas of the country. A number of loans and other facil- ! ities were sanctioned during the year for in- j dustrial units to be located in less industri- j alized states like Assam, Andahra Pradesh, 1 Orrisa....*' ! 2. Grass-Soots Popular Impact: j i Many governments realize fully well that progress in raising material standards of living is an indispen- ,sable element in political stability. Consequently, in order to satisfy public demand for economic development, many governments are casting ;about for institutional solutions. A development Bank f ! has been proven to be one of the effective institutions. ! 'Through the impact made by the investment of the develop ment Bank on the economy and in the additional employment and prosperity which these investments should achieve, a government, by its investments in the development Bank, is relating to this problem. Because of the necessity for government investments to reach the small investors, gov- jernments have tried interesting experiments in development jBanking. t 3. Private Initiative: I The governments in many developing countries are examining ways in which they can relate to the private sector in a way in which the advantages of private initia- Industrial Finance Corporation of India. 1964 Annual Report, p. 16. 228 j tive can be realized within the framework of over-all gov-^ ! ernment discretions, and within a framework which protects! i ] people against potential abuses or excesses. These gov- , i ;ernments are beginning, now, to realize that a positive j i incentive of personal gain, properly controlled and di rected, is the only way to achieve a dynamic and viable ,productive economy. Their investments in development Banks all over 18 the world are elequent testimony to this fact. In Iraq, there has been the state-owned industrial Bank that was created as part of the industrialization i ipolicy measures that were adapted by the government to I encourage the establishing of industries in the country. iThe legislation of the Industrial Bank is designed to 'function through the appropriate means and measures for i the achievement of the Bank objectives: 1. Lending money for establishing, operating, expand ing and improving industrial enterprises, and for purchas ing and importing tools, machinery and raw materials; for i assisting in exporting industrial products and for carry ing out anything that deemed to promote industry in ac- i 19 cordance with the provisions of law. y 18 J. T. Dock Houk, Financing and Development Bank ing, Prepared for the Fund for International Cooperative Development (New York: Frederick A. Praeger, Pub., 1967), p. 82. ■^Legislation of Industrial Bank, Law No. 62 for 2. Participation as founder or shareholder in indus trial enterprises to be undertaken by public limited stock companies. 3. To mediate in the importation of machinery, tools j j and raw materials for industrial purposes; and the expor- ! i tation of industrial products for the account of its cli ents of industrial enterprises, in accordance with in structions to be issued by the Board in these respects. 4. To store machinery, tools, raw materials, and ' products belonging to industrial enterprises in its own •warehouses or in other stores to be selected by it. 5. To undertake Banking, deal in foreign exchange, | and issue guarantees, provided that business of such na ture is confined to matters connected with industrial enterprises, in accordance with provisions of the law for . the control of Banking and the foreign exchange control law. j 6. Offering technical assistance, advice, and infor- i [ mation on economic, engineering, administrative and ac counting affairs to owners by industrial enterprises. 7. Carrying out studies and research necessary for the establishment and promotion of industrial enterprises; for the expansion; or for changing their purpose directly or in cooperation with companies, individuals, official establishments or services, etc. the year 1961. Baghdad.________________________________ 230 I 4. To insure any administrative, vocational or other ] I l service to industrial enterprises by seeking the assis- | I tance of the technical staff of the Ministry of Industry, and, also, to assist clients in laying down a suitable plan for establishing the enterprises connected with the required loans. At the request of the client, the Bank may also carry out such studies against fees to be agreed 20 upon. In fact, it can be said that the need for estab lishing a development Bank with all the advantages re ferred to in the above discussion is of urgent necessity in order to assist in mobilizing a large share of the re sources as such toward industrial development in the country and to be interested with the most significant tasks that only such type of Banking functions could achieve. 20Ibid. CHAPTER 71 THE ROLE AND IMPORTANCE OP THE NON-OIL SECTOR IN THE IRAQI ECONOMY INTRODUCTION Iraq, possesses impressive potentialities for eco nomic development with a total population of about 8 mil- 1 lion and an area of 170,000 square miles* Iraq is sparse ly populated in relation to its resources. But at the !same time it shares with all the underdeveloped countries i I the same features of underdevelopment as well as a high i degree of resource immobility, a stagnant agricultural :sector, and a low productivity of labor. Iraq, however, can be distinguished from other underdeveloped countries in her potential for growth. As a matter of fact, the development of the agricultural sector to provide a higher level of output and to serve as an economic base for a number of industries should constitute one of the most l |important goals of any economic policy. In addition to i jthe availability of land and water, Iraq is endowed with another great natural resource, i.e., the oil. Because of the stage of development, foreign capital and technol ogy shouldered the task of developing, producing, trans- 231 232 | porting, refining, and marketing the oil. The develop- ! ment of this sector provided the Iraqi economy with an j outstanding source of revenue continuing to grow in im portance by providing 66 per cent of the government's total revenue in 1963 as against 12 per cent in 1950. The importance of oil revenue goes far beyond its being a mere source of finance} its availability saved the policy-makers in the economic field from difficult problems in the area of balance of payments, foreign ex change earnings, currency stabilization, and income fluc tuation. At least in the short and medium-term and maybe ’even in the. long run as such, unless some sort of politi- I cal changes that might take place and affect the situation :in one way or another and, of course, this should be of an international or regional aspects. Therefore, since oil ;is an exhaustible asset, it is only natural that Iraq should derive maximum benefits from oil while it lasts. ! I This requires the channelling of oil revenue in such a way las to create a self-sustained, growing economy capable of j generating sufficient saving and investment for continued I growth without undue dependence on one section, i.e., the oil sector. Indeed, this cannot be performed and attained un less the structure of the non-oil sector of the economy is to be transformed. Agriculture has been and still is the main indus try employing about 60 per cent of the population. Its ! contribution to national income is roughly from 20 to 29 : per cent. Thus the rural majority cannot be expected to j generate savings for investment on the land to improve its yield and because its low level of income this major ity cannot be expected to provide the markets necessary for the absorption of the industrial output. Moreover, without increasing its productivity, this sector should .not be expected to provide the raw materials and the labor force needed for the industrial development. To start the ;task of economic development a minimum of social overhead icost in the form of irrigation, drainage, transportation, and communication is necessary. These, needless to say, cannot be carried out except by the government, i.e., the public sector. Changing the structure of the economy is the only course to be followed if the non-oil sector is to generate enough saving and investment to sustain its own growth. I To put it in a different way, any economic policy must be judged in terms of its contribution to the process of re ducing the economy's dependence on oil revenue. The main core of this study is to make clear and to analyze the impact and the response of the non-oil sec tor of the economy to the stimulus that the oil sector provided and the study of the prospect of the contribution 234 I of the non-oil sector to the financing of economic devel opment in Iraq. j CAPITAL FORMATION AS A SOUSCE ! OF DEVELOPMENT FINANCE As a matter of fact, there are two sources of cap ital in development finance which are, as we classified these sources previously; (1) domestic sources and (2) foreign sources. The process of capital formation in volves three stages: A. Increase in the rate of savings; B. The channelling of savings through a finance and :credit mechanism; and I ' C. The investment criteria, hy which resources are used for increasing the capital stock. The first re quirement, which an increase in the volume of savings is ;of crucial importance for the development finance as such, meanwhile, it has to be achieved without generating infla tion. j This procedure is very clear because the rate of investment, which is physically possible to carry out, is i limited by saving. In fact, the main distinguished criterion in sources of finance is between domestic and foreign sources. The fundamental element in the process of capi- 1Edward Nevin, Capital Funds in Underdeveloped Countries (London: Champion-Hall, 1^61), pp. 75-79. tal formation is domestic finance. Foreign Funds can certainly speed up the process and make it less arduous, less violent, "yet external sources can scarcely make a significant contribution to :economic growth unless there is complementary action on o the home front." External resources cannot provide a solution to the problem of capital formation. Domestic action is essential for effective use of external contributions, in the form of credits or loans from private, public or in ternational agencies, as well as for the tapping of poten- i itial domestic sources. DOMESTIC SOURCES OF DEVELOPMENT I FINANCE Domestic savings may be undertaken by business, 'households, or by government. Government savings may come :from the excess of current revenue over current expendi- ture. Private savings may consist of (1) savings invested ;directly in securities; (2) savings transferred to fi nancial institutions and invested by these either directly i . jor through the capital market, and (3) savings used by savers for self-financing or lent privately to others. Based on the above analysis, from internal sources, an in crease of savings may be generated in three ways: (1) 2 Nurkse, loc. cit.« p. 141. 236 I voluntarily through a reduction in consumption; (2) in voluntarily (forced saving) through taxation, compulsory lending to the government, or inflation; and (3) fey afe- | | sorption of unemployed lafeor into productive work (savings in kind).^ Private savings is the major source of finance of capital formation, usually it finances not only the whole of the private investment, feut also a substantial propor tion of government investment as well. Since the level of !real income determines the capacity to save, it is quite [ ,obvious that increase in voluntary saving through certain !voluntary cut in consumption is unlikely when the average i ;income is low. Increases in government saving have been a key element in most development plans as such. Huch reliance has been placed on government policies to increase the 'proportion of current saving out of the total income. Government saving, defined as surplus on current account, i |has assumed growing significance as a possible source of ! jpublic investment in the developing countries. i ! If voluntary saving is low, the inflationary meth od of financing, which involves forced saving, is some times involved. Under this approach, saving can be under- x -'Meier, op. cit.. p. 113. See Kindleburger, op. cit.. p. 97* See Antonin Basch, Financing Economic Development (New York: The Macmillan Company, l9£4)» pp. 2-5. 237 taken by government, and can be forced on households and corporations by inflation. In this case, the deficit is i financed in an inflationary fashion, the saving is invol- ! untary, and is represented by the reduction in consumption -caused by the rise in prices. The over a^Ll impact is one of a reduction in total consumption, and of a shift in total productive effort as the orientation of production i comes to be less toward consumer goods and more toward ( investment goods. Therefore, recipients of current income who had not chosen voluntarily to save more are forced to save in the sense that their consumption purchasing power is reduced and forced saving is being created.^ The government will normally have to resort to forced saving through taxation, compulsory lending, or credit expansion. As for taxation, the country's "taxation poten tial" depends upon a variety of conditions; the level of per capital real income, the distribution of income, the i 'administrative powers of the government, the stage of eco nomic growth, and the structure of the economy. At the i present time, various governments are trying to reform their tax structure as a means to insure substantial in crease in public revenue. Governments in developing coun tries have relied on indirect taxation (taxes levied on a Krause, op. cit.. pp. 60-64. 238 foreign trade) as a means of raising public revenue. But, also, recently most of these countries have made appreciable use of direct taxes. Frequently, the possi bility of raising public revenue from the agricultural sector has not been fully utilized.- ' It is supposed that if Iraq is to maintain a rate of growth in per capita income more than 26 per cent of national income must be invested. Like any other under developed country, the private sector should not be ex pected to generate enough savings voluntarily. And this should not mean that whatever voluntary savings the pri- 1 vate sector is capable of accumulating should be neg lected, but since government does not have all the finan cial resources needed to achieve the investment target, the private sector should be called upon to provide sav ings to finance at least part of the gross domestic capi tal formation. The recognition of the importance of vol untary saving must be accompanied by the development of a ! financial system whose primary task is to channel saving into investment. Otherwise, the unorganized money market will continue channelling the voluntary saving into con sumption.^ 5 ^Walter Heller, "Fiscal Policies for Underdevel oped Economies." Conference on Agricultural Taxation and Economic Development• April, 1954• 6 Douglas Paauw, Financing Economic Development. The Indonesian Case (Glencoe: The Free Press, I960), 239 CENTRAL BANKING AND MONEY MARKET The complexity and sophistication which character ize the money and capital markets in advanced countries have been attained through a long process of development in response to the needs of the economy. In a country like Iraq where the mobilization of voluntary savings is essential, the evolution of a capital market should receive the actual support of the Central Bank. ' Prom the table inside, it can be seen that the total of time deposits plus postal savings was small in relation to the supply of money (currency plus demand deposits). This reflects the attitude of the income re cipients toward channelling their savings into the finan cial Intermediaries and the limited scope of the opera tions of these intermediaries. This becomes more pro nounced if we know that over 4-5 per cent of the national r income in I960 was in the form of rent, interest and .prof- j The importance of currency component of the money i jsupply can also be seen from this table, while in advanced countries the demand deposit component of money supply is several times higher than that of the currency, it is the I pp. 129-130. ^Haseeb. The National Income of Iraq, 1953-1961 op. cit.. Table 8, p. 257---------- ----- 240 "1 i i other way around in Iraq. This reflects the degree of ; i underdevelopment of the people toward the kind of assets j in which they prefer to hold their wealth. j The successful mobilization of voluntary savings requires the widespread recognition of the importance of exchanging one type of asset, currency, for others, demand deposit, time deposit, and securities. In other words, ithe facilities of the Banking system must be used exten sively if we are to bring the voluntary savings into the organized money market. This requires the creation, development and spread of Banking facilities outside the large urban centers where they are located now. In 1963* the commercial Bank ing system had only 86 Bank offices serving 6.9 million 8 people, and state-owned specialized Banks had 61 offices. MONETARY POLICY MEASURES , In Iraq, monetary policy is defined to affect the I following: (1) the channelling of national savings; (2) i the regulation of monetary credits; (3) the financing of capital formation, (4) the monetization of short-term business fluctuations; and (5) channelling the availabil ity of loanable Funds. Meanwhile, the specialized Banks operating in Iraq 8 Government of Iraq, Statistical Abstract 1958 (Baghdad, 1959) > P • 163• TABLE 12 SAVINGS, DEPOSITS, AND THE SUPPLY OP MONEY 1950-1964 (MILLIONS OP IRAQI DINARS) Year Time Deposits Postal Savings Demand Deposits Money Supply Demand * Deposits 1950 2.8 .9 15.0 49.5 30.3 1955 2.9 2.5 14.1 67.3 35.8 I960 5.9 3.8 44.8 130.0 34.4 1962 8.0 3.9 55.0 146.7 37.* 1964 7.1 3.5 52.4 161.7 32.4 *As a percentage of money supply. Source: Derived from Central Bank of Iraq, Quarterly Bulletin. 242 play an important role in the field of medium and long term financing. The Central Bank of Iraq was established in 194? as a state-owned Bank possessing three main traditional instruments of general monetary control: (1) open market ; operations; (2) changes in the discount rate; and (3) i changes in the reserve requirements. The effective use of these techniques to control and channel credit into i certain sectors of the economy depends upon the over all objectives of the development of planning as such. As it : is known that the objectives of the monetary policy, i whether in an advanced or underdeveloped country, are: ! (1) promotion of a high rate of employment and economic growth, (2) maintenance of reasonable price stability, and (3) preservation of the external value of the cur rency. There is a substantial difference in emphasis on ; these objectives. While the avoidance of inflation or ; deflation is the main objective of policy in advanced I countries, economic growth in underdeveloped countries tends to overshadow all other objectives of national eco- o nomic policy.7 As regards the techniques adapted by the Central Bank of Iraq in exercising greater control over the mone- ^Arthur I. Bloomfield, "Central Banking in Under- developed Countries," Money and Economic Activity (Boston: Houghton Mifflin, 1961), pp. 445-454. (Lawrence S. Ritter, ed. 243 tary system, commercial Banks have become public concerns. This was done according to law No. 100 for 1964.^ ! According to this law, all non-government Banks and branches operating in Iraq, have become state Banks. Under this law, the Central Bank of Iraq enjoys the power to fix the amount of all or some of the assets to be held by each Bank or a group of Banks. Each Bank is required to hold 10 per cent of its assets in the form of money deposits with the Central Bank of Iraq; five per cent in the form of treasury bills and Iraqi Government Bonds; 11 and five per cent in the form of other monetary assets. The Central Bank rediscount rate of four per cent | is still the same, and the limit of discount is fifteen per cent of deposits. The Bank Nationalization Law No. 100 for the year 11964 attached the public establishment for Banks to the Central Bank. Therefore, the activities of these Banks were sub- i * i ject to supervision and inspection of the Central Bank. jMost of these activities deal with foreign exchange re strictions and credit policy. The public organization for Banks enjoy an auton omous financial and administrative status and take charge 10 Central Bank of Iraq, "Annual Report* ' (Baghdad, 1964), p. 31. i:LIbid. 244 1 ! of administering all nationalized and government commer- 'cial Banks operating in Iraq. The Central Bank can take the initiative in developing a financial system capable of reaching the largest possible segment of the popula- j tion. This can be achieved by the establishment of new ( commercial Banks and Bank offices outside the largest i cities, the establishment of savings Banks, rural credit agencies, and Banks to supply certain lines of business i with medium and long-term credit. The development of such a system should increase and channel savings into the organized money market. By offering the public a variety of income earning assets which can be turned easily into cash, it may be induced to refrain from hoarding part of its income or consuming all •of it. In addition, to the inducement of the development of such a financial system, it would help give savings greater mobility both geographically and among indus- 12 tries, i i The Central Bank can assist in developing a market jfor government securities in order to make open market j operations an effective instrument of policy and to help i mobilize savings. The contribution of the Central Bank can take the form of advising the government on the appro priate timing of its issue and on fixing of interest, 12 Lester V. Chandler, Central Banking and Economic Development (Bombay: University of Bombay, ly&2), p. 17• maturity structure, and other terms designed to appeal to ! different classes of potential investors. It can widen | ! the market for government securities as part of their i legal reserves and by continuous selling and buying in , ix I order to prevent price fluctuations. ^ j The limitation on the role that the Central Bank J can play in widening the government securities market, is the size of the public debt itself. In 1950, the domestic public debt was AID 6 million; in 1962, it was ID 46.6 million or 7*5 per cent of the GUP. THE PUBLIC DEBT Management of Government's Domestic Debt and its Strategy in Economic Development Like taxation, government borrowing is undertaken I to finance government expenditure. Whether the expendi ture is for consumption or investment, for military needs I or economic development, every borrowing government must .face the same set of questions: first, how to borrow the jmoney (from whom, or how long, and what interest rate); j and second, what effects each borrowing choice will have upon the economy as a whole and upon particular sectors within it. Like the decision to tax, every government decision to borrow represents a political determination •^Bloomfield, op. cit.. p. 451. 246 that additional resources are to be diverted to the publicj sector and allocated to the fulfillment of particular J goals where these additional resources are to come from I ! will depend upon the kind of borrowing that a government chooses. It may borrow outside the country, which will bring additional resources from abroad, or it may borrow domestically, which (in the absence of unemployed re- ;sources that may be readily mobilized) will in one way or another reduce the use of resources in the rest of the economy and allocate them to government. There are sever- ,al ways by which the "incidence” of the domestic borrowing ; may be fixed. When a government borrows from individuals or in- i stitutions through compulsory loans it diverts resources from those to whom the funds would otherwise have gone :(potential borrowers from the institutions, alternate saving recipients and perhaps the individuals themselves) jthus reducing their own outlays. When a government bor rows in the market, it diverts resources from other bor rowers who will be unable to pay the higher interest rates that result from the competition for funds. In the process of borrowing in the market, redis tributive side effects will also occur, directing in creased interest payments from all borrowers to lenders and, perhaps, increasing the flow of savings from poten- 247 tial lenders as well. i Unlike taxation, government borrowing does not j always succeed in reducing the use of resources in the j l rest of the economy at the time the proceeds are obtained. Sometimes the diversion of resources will come only later on, when the loans proceeds are expended. When a govern ment borrows funds, which would not otherwise be used, as from the Central Bank or from hoards or idle balances, its ■ expenditure of the loan proceeds is expansionary, bringing a net addition to demand for resources. In the absence of unemployed domestic resources ithat may be quickly mobilized, or of available foreign jexchange, this diverts resources not from the lenders, who were in any event not going to use their funds to purchase resources, but instead, from those who pay the "inflation tax" when prices go up and they can buy less. i ' ; By whichever domestic means the government chooses to borrow, therefore, it is the diversion of resources from I ! other users (not the interest to be paid) which is the t I cost of spending the loan proceeds. The interest paid i !represents only the cost of persuading the lenders to part with their claims on the use of resources in exchange for the government’s promise to repay, voluntarily, for market borrowing and at a politically acceptable price for com pulsory lending. When the time comes for the government 248 1 1 to repay the loan, the cost or burden consists of divert- ! 1 ing the resources from use by the government, or its tax- ! i i payers, if taxes are to be increased, to those who hold i the government's debt* As one would expect, this cost is | quite different in character from a loan from abroad, which buys additional resources to begin with, and which must be repaid through a parallel transfer or resources I abroad. In a sense, foreign debt is like a personal debt which will have to be repaid to others of the country's ifuture income or borrowing. A domestic debt, on the other hand, is more like a country's debt to itself, on which interest and eventually capital is to be paid on the tax- i paying citizens to debt-holding citizens. With domestic debt, the strain of interest payments on the budget, the frictions of raising taxes to repay the debt, and the re distribution of domestic income resulting could be impor tant if the debt is large. j The "burden" caused by both foreign and domestic i idebt, however, will depend on how fruitfully the borrowed funds have been used. It is usually assumed that, while taxes are paid by reducing consumption, lending to the government is accomplished by reducing other investments. If the governments borrowing diverts funds from productive investment to current consumption, or to projects bringing 249 no increase in the nations income, the country (like any one who consumes his capital) will be poorer for it in i the future. In this sense the public debt may be a "bur- I ! den" both upon present and future generations. i The Choice of Borrowing Almost all the governments in the developing countries have had to choose some forms of borrowing to supplement their tax revenues.^ Borrowing abroad has been their major frequent choice and foreign debt forms the major portion of the public debt in most developing countries. The sources of this foreign debt over the past two decades has been ;chiefly international agencies and official lending insti tutions. Governments have also drawn upon short-term and medium-term external credits from suppliers and Banks. The contracting of most foreign debt, therefore, is now |dependent mainly upon a country's ability to prepare and carry out investments projects and on maintenance of its |capacity to repay. Sound management of government's for eign debt, however, requires: 14 Jonathan Levin, "The Management of Public Debt in Developing Countries," Finance and Development. Vol. 7 No. 2, June 1970, p. 30. 15 ^While this is the usual reason for borrowing, governments may, on occasion, issue debt instruments to facilitate development of a capital market for their securities. 250 1 1 (1) that the particular project generate suffi cient return, either in itself or to the economy as a whole, to cover repayment of the loan; (2) that the volume and maturity structure of the debt he such as to hold the overall burden of foreign debt repayment, public and private, to within a reasonable pro portion (often taken as being 20 per cent) of foreign earnings; and j (3) that the burden of debt repayment remain sustainable in the light of the economy's growth and level ;of income. j While these principles, other than the foreign ■exchange limitations, apply to domestic debt as well, it is debt placement that is the primary concern of domestic 1 debt management (from whom to borrow and with what effect ;on the economy) so it is debt placement that mainly con- ’cerns us here. | The difficulties of placing government debt within !a developing country spring mainly from the insufficiency i |of savings and the limited development of financial insti- i tutions. The evolution of markets for claims and equities is dependent not only on the generation of savings but also upon the emergence of saleable and reasonably secure promises to pay or share. Against this background of 251 limited financial development governments have tried a j variety of means to place their debt within the country, j i The cumulative results of these efforts may be gauged from i a comparison of total domestic public debt as a per cent of gross domestic product (GDP). The Public Sector Most Central Banks are prohibited by their basic statutes from lending more than a limited amount directly to the government. This amount is usually some proportion of the previous year's total government revenues and is 1 designed to cover seasonal variations between the pattern ! of revenues and expenditure within the fiscal year. The 1 actual independence of the Central Bank varies widely from country to country, however, so that such prohibitions do not always withstand the pressures of particularly diffi cult situations. Whether a particular Central Bank is to be an ;engine of inflation has been determined not by laws alone but by the whole constellation of influences which lead a government to pursue their expansionary or more conserva tive policies. As generally recognized, the Central Bank is the most expansionary source of government borrowing, first because it can draw upon funds that need not otherwise be used, and second because the money lent to the government by the Central Bank can serve to increase the reserves of the Commercial Banks and provide a base for a multiple expansion in their credit. An expansionary impact may be ! desirable in some circumstances, depending upon over-all developments in the economy. In fact, determining the appropriate amount of Central Bank credit to the govern ment constitutes one of the most important elements of government economic policy. The dependence of governments in many developing countries upon Central Bank credit may 'be gauged from Professor Raymond Goldsmith's findings. These indicated that while Central Banks in the developed countries studied held an average of 15 per cent of their government's public debt, this proportion averaged about 16 50 per cent in the developing countries. In the absence or inadequacy of other sources of financing, the Central Bank becomes the lender of last re sort not only for the Banks, but, also, for the government as well. The Private Sector Within the private sector the compulsory placement of government securities has focused upon several targets, most of them with the circle of financial institutions. Most commonly, it is the commercial Banks which are com- 16 Raymond Goldsmith, Financial Structure and Development (New Haven: Yale University Press, 19&9)» p. l6l. pelled to purchase government securities, by reserve re- ! i quirements or minimum liquidity ratios which must be met j l in a whole or in part by holding government securities equal to specified portions of their deposits. Even when government securities form only optional part of such liquidity ratios or reserve requirements, the interest they pay, however low, makes them so much more attractive than the alternative of vault cash or noninterest bearing deposits at the Central Bank, that the option to hold securities is likely to be exercised. In some instances, holdings of government securi ties have been required as reserves against only a partic ular kind of Bank liability. The extent of government borrowing from commercial Banks differs widely among developing countries, however, and Professor Goldsmith finds that commercial Banks did ,not appear to hold a distinctly higher percentage of the * itotal public debt in developing countries than in devel oped countries. Their holdings in both groups of coun- i I tries ranged from very little to 30 per cent of the total ! public debt.*'7 I • ! In its expansionary effects government borrowing from commercial Banks may be second only to borrowing from the Central Bank. Just how expansionary government bor- 17Ibid.. p. 167 TABLE 13 IRAQI GOVERNMENT DEBT, 1960-65 (MILLIONS OP IRAQI DINARS) End of Calendar Tear Kind and Source I960 1961 1962 1963 1964 1965* Internal Loans Government Bonds 10.2 9.4 8.6 7.8 6.0 11.0 Treasury Bills 15.0 20.0 35.0 17.0 30.0 45.0 Total 25.2 29.4 41.6 24.8 36.0 56.0 External Loans Oil Companies 4.5 .4 - - - - Kuwait Loan - - mm 30.0 30.0 30.0 Soviet Loan 1.7 6.7 16.5 25.0 32.5 34.7 Agricultural Surplus Agreement (P.L. 480) mm mm 1.6 4.2 3.9 Export and Import Bank Loans mm — — — .9 2.4 Total 6.2 7.1 16.5 56.6 67.6 71.00 Grand Total 31.4 56.5 58.1 81.4 103.6 127.00 *As of October 31. Source: Central Bank of Iraq, Quarterly Bulletin. 255 rowing from co-eroial Banks is to be, however, will a .- ] pend upon whether the government borrowing is added to i other credit so that total credit is expanded, through i i the use of unused reserves or of Funds made available by ! i -the Central Bank.*® A second source of compulsory private sector lend- I ing to the government lies in the nongovernmental contrac tual savings institutions: insurance companies, pension Funds, and where they exist, mutual Funds and investment companies. While a few countries have brought life insur ance into the government sector with the creation of na- I I tional insurance companies like in Iraq, India, Costa Rica, in most countries insurance companies remain in the private sector and are required to hold at least a given portion of their reserves in government securities. Be cause most contractual savings institutions will have to ;make parallel reductions in other investments, their lend ing to the government should generally have no expansion ary impact. When insurance companies are closely tied to I firms abroad, their compulsory purchase of government securities may sometimes be an alternative to investment jabroad. Compulsory lending to the government by those out side the circle of financial institutions - private per 18Ibid., p. 168. 256 , sons and nonfinancial corporations - is quite different ! and less frequent practice. Resort to such, schemes may "be! preferred to outright increase in taxation primarily for 1 psychological reasons, as when government may feel that j i the present limits of taxation have already been reached. J While seldom sustained over long periods, such compulsory savings schemes have been attempted in a number of coun- IQ I tries, levied, usually, on the basis of income. J | i TAXATION AND ECONOMIC DEVELOPMENT IN IRAQ TAX SYSTEM AND POLICY MEASURES j One of the striking features of the fiscal system i of Iraq during the past decade is the declining importance of taxes relative to the national income as is shown from the data table. It can be seen that both the total reve nue and the tax revenue have declined in significance in relation to national income. The share of the former in !the NI declined from 26.2 per cent to 19*1 per cent and the latter from 14-.9 per cent to 15.7 per cent in 1950 and 1964 respectively. This negative development in revenue took place at a time when the relative importance of cur rent expenditures increased from 20 per cent to 54-.5 per cent of national income. 1 9 yA. R. Prest, "Compulsory Lendings; Schemes.” Staff Papers (IMP and IBRD) March 1969* PP• 2^-52. TABLE 14 TOTAL REVENUE, TAX REVENUE, AND CURRENT EXPENDITURES RELATIVE TO NATIONAL INCOME 1950-1964 Year Non-Oil Revenue as per cent of NI Tax Revenue as per cent of NI Current Expenditure as per cent of NI 1950 26.2 14.9 20.0 1952 24.5 12.9 26.4 1954 15.5 11.4 24.9 1956 15.8 12.3 26.3 1958 16.9 12.3 26.9 I960 15.8 12.2 33.4 1961 16.0 12.1 30.5 1962 15.5 11.4 30.5 1963 17.6 12.0 37.7 1964 19.1 13.7 34.5 Sources Derived from Directorate General of Accounts, Annual Reports (Baghdad, Government Press; Central Bank: of Iraq, Quarterly Bulletin, various issues. I The share of government revenue in national income: in Iraq, is lower than in many underdeveloped countries as ' i i such, e.g., it is more than 20 per cent of the GUP in I i Ceylon, Egypt, Surma and over 30 per cent in many advanced 20 countries like the United States, Sweden and others. The problem which faces Iraq now would probably not have arisen in the first place and instead, it was decided to meet the rise in government expenditure by re- I ducing the share of development expenditures from 100 per cent of the oil revenue in 1950 to 50 per cent in I960. If we assume that the recent trend in current expenditures is to continue in the future and the existing tax struc ture is to be maintained, when a further reduction in the real capital expenditure should be expected. To avoid such a consequence it is necessary that the tax system be thoroughly revised so as to make the revenue more respon sive to the changes in the national income. ; In 1959* direct taxes contributed 12.5 per cent of i ;the government revenue• One reason for such a low share is the low yield of income tax. Corporate taxes for the same year, and personal income tax as well contributed only ID 3*9 million or 8.4 per cent of the total revenue or 11 per cent of the tax revenue. Prom this, it can be 20 John Adler, "Fiscal Policy in Developing Coun tries1 1 in Readings on Taxation in Developing Countries (Baltimore': The John Hopkins Press, 1$6&), pp. 31-38* Richard Bird and Oliver Oldman, ed. ; 259 seen that Iraq's personal income tax plays a very minor ‘ i role in the tax structure. It contributed 4.2 per cent ofJ the total revenue and 5*5 per cent of tax revenue in 1961.j The number of taxpayers was, on the average, less than .5 ! 21 per cent of the total population in 1961. One of the major defects of the income tax system is that it exempts a very large segment of the population from paying any income tax. There is very little justi fication for such a policy at a time when the level of current expenditures was rising. The only explanation jthat can be offered is that the rising level of oil reve nues may justify the high income tax exemption. Another major defect of the tax system is that agricultural income !has never been subject to any income tax. Given the small i number of taxpayers, high level of exemption, and low tax rates, it is quite obvious that the income tax, as a ^ource of revenue for development, has been neglected. i ^According to the new tax law, taxable income is the net I 22 jincome acquired by taxpayers from the following. (1) Profits arising from commercial enterprises or which are of commercial nature, industries and profes sions. 21 Government of Iraq, Ministry of Finance, Annual Report (Baghdad, 1961), pp. 1-31. Government of Iraq, "Tax Law No. 129 for 1964 (Baghdad, 1964). 260 (2) Interests, commission, discount and profits arising from dealing in shares and bonds. (3) Hents of agricultural land. (4) Profits arising from the transfer of owner ship or use of real estate. (5) Salaries, pension salaries, fixed fees for a definitive service. (6) Profits arising from compensatory funds paid in connection with land requisitioned under Agrarian re form law. The new law includes the following exemptions: (1) Agricultural income realized by cultivators from agricultural produce. (2) Income of property on which the owner pays the tax. (3) Income of legally acknowledged religious in stitutions, charity and educational establishments formed for public interest. I , (4) Salaries and allowances paid by foreign lega- j tions to their diplomatic officials. I (5) Salaries and allowances paid by foreign coun tries to their subjects employed in Iraq. (6) Income of cooperative societies. (7) Salaries and allowances paid by the United Nations. i The tax levied according to this law is mainly based upon the principle of progressive taxation. ' Other important sources of revenue which have been; neglected in Iraq, and which have great potential are the corporate tax, real estate tax, and the agricultural land i tax. Corporate income tax is subject to a maximum income tax rate of forty-five per cent• Many industries were exempted from corporate income tax without any justifica tion. The real estate is levied at a flat rate of 10 per cent of the rental value. The land tax is levied at the rate of 5 to 15 per cent depending on the method of irri gation. But all beneficiaries from the Agrarian Reform [ are to be exempted from the tax. Also, a number of agricultural products were ex empted from the tax because they were necessary for con- 23 sumption of the majority of the people. ^ Indirect taxes in Iraq contributed 85.2 per cent of the tax revenue in 1961. Import duties are the most important single source of taxation. Excise taxes levied pn cement, salt, liquors and petroleum products, etc., in creased from ID 2.8 million in 1951 to ID 12.9 million in 23 'Government of Iraq, Ministry of Finance, Annual Report (Baghdad, 1^61), pp. 15-17. 24Ibid. 262 TABLE 15 DIRECT AID INDIRECT TAXES, FISCAL YEARS 1950-64 (MILLIONS OF IRAQI DINARS) Direct Taxes Indirect Taxes j Personal Import j Fiscal Year Total Income Tax Total Duties I .1950 3.4 1.0 18.3 9.0 1951 3.3 1.1 20.3 10.1 1952 2.6 1.0 19.4 11.0 1953 3.4 .8 22.4 14.5 1954 3.6 .9 25.3 16.3 1955 3.8 2.1 28.2 19.4 ,1956 4.3 1.3 28.3 19.1 ;i957 4.7 1.2 32.3 20.8 1958 5.7 1.4 30.5 18.8 ;1959 6.2 1.8 29.4 19.4 I960 7.0 2.6 36.6 24.1 1961 8.4 2.6 38.1 23.9 1962 11.6 3.0 36.2 22.9 1965 12.7 3.5 34.6 21.5 1964 l 14.9 3.6 41.1 25.5 Source: Derived from Directorate General of Accounts, Annual Retorts Baghdad Government Press; Central Bank of Iraq. Quarterly Bulletin: Government of Iraq, Statistical Abstract. SOURCES OF FINANCING THE ! FIVE-YEAR ECONOMIC PLAN 1965-1969 | The five year economic plan that was prepared by ; the Ministry of Planning during 1965 was aimed at achiev ing a large increase in production and living standards as well. According to this plan ID 561,2 million was assumed to be allocated for meeting the expenditures required by the plan. On the other side, there were the revenues that were estimated by the same amount to leave no shortage or deficit in covering the required expenditure. ID 142.0 million of the government central investment was allocated for the agricultural sector. It is also expected that the private sector will participate in agricultural investment to the extent of ID 12 million and the Iraqi economic or ganization to the extent of ID 3 million - giving a grand total ID 157 million. In the field of agriculture, the major projects were concerning irrigation and drainage projects, etc.; in the field of industry ID 168.0 million I of the government central investment was allocated for in dustry. It is expected that the private sector will par ticipate in the industrial investment to the extent of ID 5.0 million, the economic organization to about ID 5*0 million too, which reads to a total of 215.0 million. In the field of transport and communication, the government’s 264 TABLE 16 NON-OIL REVENUE, TAX REVENUE, AND CURRENT EXPENDITURES, FISCAL YEARS 1950-64 (MILLIONS OF IRAQI DINAHS) Fiscal Year Non-Oil Revenue Tax Revenue Expenditures Tax Revenue as per cent of Expenditures 1950 38*2 21.8 29.2 74.7 1951 30.9 23.6 30.8 76.6 1952 41.0 21.7 44.5 48.8 1955 52.7 25.8 50.1 51.5 1954 55.4 28.9 53.8 53.7 1955 50.0 51.9 55.3 57.7 1956 42.1 32.6 70.3 46.4 1957 47.2 57.0 73.9 50.1 1958 49.6 36.2 79.2 45.7 1959 46.4 55.5 100.2 35.4 I960 54.1 41.6 114.3 36.4 1961 62.6 47.1 119.2 39.5 1962 65.2 47.9 128.4 37.3 1965 69.5 47.3 149.0 31.7 1964 78.3 56.0 141.6 39.5 Source: Derived from Directorate General of Accounts, Annual Reports Baghdad Government Press; Central Bank of Iraq, Quarterly Bulletin: Government of Iraq, Statistical Abstracts. TABLE 1? DIVISION OF AGGREGATE INVESTMENTS BETWEEN PRIVATE AND GOVERNMENT SECTORS FOR 1965-1969 (IN MILLION DINARS) Sector x Investmeilt Percentage Government Sector 640 Investment 78 Private Sector 181 Investment 22 TOTALS 821 100 Source: TLe Five-Year Economic Plan 1965-69 266 j i central investment amounted to ID 91 million, while for j I buildings, housing and social services, the necessary ! i amounts for investment estimated at a total of ID 263*5 ; million, of which ID 97.7 million were to come from the government's central investment, ID 24.8 million from the capital expenditures of municipalities, and ID 141 million 25 | from the private sector. i The major sources available for financing govern- j ment central investment are the followings (1) The balance of cash surplus (ID 30.7 million) carried over on March 31» 1965. (2) Fifty per cent share of the plan from income tax on oil companies. It is noted that minimum oil reve nues are expected to amount to ID 780 million during plan years, and actually it approached the figure by the year » !1969 (February 30, 1970). The planned revenue expected to be attained from this source is supposed to be ID 390 million (based on keeping the share of the plan 50 per I cent). I (3) Participation of the Iraqi Ports Directorate in financing its productive projects: Iraqi Ports Admin istration would contribute ID 8.0 million to finance ^Central Bank of Iraq, Annual Report (Baghdad, 1964), pp. 250-255. Pfi Government of Iraq, "Law No. 87 for 1965" (Baghdad: Ministry of Culture and Guidance, 1965)* p. 86. 267 TABLE 18 BUDGET OF GOVERNMENT CENTRAL INVESTMENT FOR THE YEARS 1965-1969 (IN MILLION DINARS) ; Anticipated Revenues Amount Anticipated Expenditures Actually Realized Amount Cash Balance Brought Forward on 3/51/65 30.697 Industry 168.000 Share of Flan from Oil 390.000 Agriculture 142.000 The Flan's Revenue from Government Services 12.000 Transport and Communica tions 91.000 Foreign Loans 95.000 Building and Housing 97.697 Domestic Loans 30.000 International Liabilities and Repayment of Loans 25.000 Other Revenues t 3.470 Planning, Statistics and Follow- up Systems Ministry of Defense Productive Project 2.470 35.000 TOTAL i 561.16? TOTAL 561.167 i 1 Source: The Weekly Gazette of Iraq, No. 48, Baghdad: Ministry of Culture and Guidance 268 1 i production projects. I (4) Net profits of government services and insti-j tutions; certain government services and institutions, , such as government refineries and national electricity i services supposed to participate by the amount of ID 4 million for financing the plan investment. (5) Foreign loans: it was decided to limit fi nancing foreign loans to ID 95 million. (6) Domestic loans: it is supposed to finance part of the government central investments by expansion of Bank credit. The potentiality of this source of finance is estimated at ID 50 million. ! This amount does not exceed four per cent of the Value of total investment. From the above analysis it can be seen that the financial detailed resources for the de railed economic plan are of two folds. First are internal sources to be paid in national currency: I (a) government income from oil i 1 (b) income of official and semi-official t ; services; and i ! (c) private income (shares and loans). Foreign sources to be paid in foreign currencies: (a) International Banks and institutions (The World Bank, etc.), (b) governments, and (c) private establishments. 269 I j TABLE 19 I t j CONTRIBUTION OP THE PRIVATE AND PUBLIC > SECTORS TO NATIONAL INCOME IN IRAQ (IN MILLION DINARS) Sector National Income 1953 IDM Percentage National Income I960 IDM Per Cent Private 208.27 85.4 337.41 77.2 Public 55.68 14-.6 99.72 22.8 . TOTALS 24-3.95 100.0 437.13 100.0 Source: The Central Bank of Iraq, Annual Report 1962, p. 60. TABLE 20 DEVELOPMENT REVENUES AND EXPENDITURES, FISCAL YEARS 1951-64 (MILLIONS OF IRAQI DINARS) Year Revenues Expenditures Surplus or Deficit- 1951 7.5 3.1 4.4 1952 24.0 7.8 11.2 1955 55.1 12.3 23.0 1954 40.7 20.9 19.8 1955 60.8 34.0 26.8 1956 51.1 43.0 8.1 1957 55.9 57.4 21.5 - 1958 61.7 52.2 9.5 1959 55.6 49.9 6.6 - I960 47.6 45.5 2.1 1961 66.7 61.2 5.5 1962 70.0 58.5 11.5 1963 67.6 55.5 14.1 1964 66.6 51.8 14.8 Source: j Derived from Central Quarterly Bulletin. Bank of Iraq, ! 271 In the tables it can be seen the various sources of financing the five year Economic Plan 1965/69* and, j i also, the revenues and allocations of the investment pro- | grams for the said period or the so-called - the govern ment central investment. j I ECONOMY IN PUBLIC j EXPENDITURES In 1950, the shares of the government non-oil sec tor revenue and recurrent expenditures were 26.2 per cent and 20 per cent of the national income respectively. In 1964, the ratios were 19.1 per cent and 54.5 per cent respectively. Had it not been for the availability of the ' oil revenue, the growth of current expenditures (ID 29.2 million in 1950 against 141.6 million in 1964) would prob ably have been less spectacular. If the rate of invest- :ment is to be maintained, the attempt to increase revenue must be associated with an attempt to economize on recur rent expenditures. Two main items of expenditures can be reduced I j without affecting the quantity or quality of the services 1 1 provided by the government. | First, is the defense expenditures. In Ira* this I increased from 53.2 per cent of government expenditures in 1950 to 40.1 per cent (ID 9*7 million to 56.8 million) in 1964. This is one of the highest allocations in the 272 | ! TABLE 21 TOTAL PLANNED AND ACTUAL DEVELOPMENT EXPENDITUBES AND EXPENDITUBES FOR INDUSTRY, FISCAL YEARS 1951-64 j I (MILLIONS OF IRAQI DINARS) Total Planned Expenditures Actual A P For Industry Planned Actual A P 1951 9.4 3.1 33 — 1952 20.5 7.8 30 3.0 00 o • .02 1 1953 28.4 12.3 43 5.0 .5 9 1954 51.7 20.9 66 6.0 2.1 34 ,1955 46.6 34.0 73 4.1 2.9 70 11956 81.9 43.0 53 17.0 5.0 30 1957 101.6 57.4 57 16.0 8.6 54 1958 99.6 52.2 52 11.0 11.8 108 1959 85.3 49.9 58 9.2 4.9 53 i960 137.0 45.5 33 12.6 5.7 45 1961 147.5 61,2 41 18.6 7.1 38 1962 108.1 58.2 54 24.7 10.3 42 1963 117.6 53.5 45 39.6 9.5 24 ; 1964 119.6 51.8 43 43.0 12.6 29 !Source; 1) Central Bank of Iraq, Quarterly Bulletin, j Selected Issues. j 2) Law No. 54 for 1956, Central Bank of Iraq, j Quarterly Bulletin. Selected issues. ! 3) Ministry of Development, Annual Report on the Accounts of Development for the Fiscal Year 1954. One of the main reasons for this slow rate of performance was the political instability which disorgan ized the development effort and affected industrial in vestment in both public and private sectors. 273 world within the Middle East. Egypt allocations is 5*5 per cent, and in Turkey 4.17 per cent of their respective GNP's for defense, for the defense expenditures of the 22 underdeveloped countries studied by Adler, the average share of defense expenditures is 4.43 per cent of the GNP.27 CONCLUDING REMAHKS In the previous analysis, it is shown that Iraq has failed, to some extent, to adopt the necessary fiscal and monetary policies to mobilize and increase domestic i savings. The availability of the oil revenues induced a !reduction rather than an increase in the tax burden. It ;can be said that the government fiscal policy, rather than i the economy's taxable capacity, should be held responsible 'for the retardation of the fiscal system. If the national objective is to maintain the same rate of increase in the per capita income in the future, ]certain measures must be adopted for this purpose. I (1) The personal income tax should be widened by i lowering the exemptions and raising tax rates in the lower income bracket. (2) The agricultural income should make its con- 2^John H. Adler, op. cit.. Table I, pp. 53-54-. Adler included the oil sector in Iraq when he derived the share of defense expenditures in Iraq's GNP. He calcu lated the share as 5»40 per cent as mentioned earlier. But here, the oil sector is excluded. TABLE 22 FUNCTIONAL DISTRIBUTION OF CURRENT EXPENDITURES, FISCAL YEARS 1955-64 (MILLIONS OF IRAQI DINARS) 1955 1956 1957 1958 1959 I960 1961 1962 1963 1964 National Defense and Security 22.J 28.6 30.1 31.3 37.3 44.0 45.1 49.3 61.3 56.8 Education 8.2 10.0 11.2 14.4 20.2 24.5 29.1 32.4 33.3 27.2 Social and Munic ipal Affairs 2.4 2.8 6.5 6.8 7.7 5.6 6.6 7.8 8.9 8.2 Health 4.3 5.0 4.9 4.9 5.4 6.2 6.9 7.5 7.1 7.2 Economic Affairs 8.1 11.9 9.2 9.2 12.8 15.9 12.5 12.6 18.8 , 23.0 Communication, Public Works, and Housing 2.7 2.8 3.6 3.3 4.1 4.1 4.4 4.7 3-7 1.9 Administration, Justice, and Foreign Affairs 5.0 5.9 4.1 3.8 5.6 6.1 6.5 4.7 5.1 3.2 Pensions 1.8 2.9 3.8 5.0 6.3 6.9 7.3 8.3 9.8 10.7 Other Expenditures .4 .4 .5 • 6 .7 .9. .9 1.0 1.1 .4 Total 55.5 70.3 73.9 79.2 100.2 114.3 119.2 128.4 149.0 141.6 Note: Detail may not add to totals because of rounding. Source: Central Bank of Iraq, Quarterly Bulletin. TABLE 23 DISTRIBUTION OF IRAQI INVESTMENT DURING 1965-1969 (IN MILLION DINARS) Economic Sector Central Invest ment Municipal ities and Local Ad ministra tions Economic Organiza tion and Government Services Private Sector (Except Oil Com panies) Total Agriculture 142.000 •mmm 3.000 12.000 157.000 Industry, Elec tricity and Water 168.000 42.000 5.000 215.000 Transport and Communica tion 91.000 8.000 20.000 119.000 Building, Housing and Social Services 97.697 24.833 141.000 263.530 Trade and Services 1.000 3.000 4.000 International Commitments and Loan Re payment 25.000 .. 25.000 Source: The five-year Economic Plan 1965-1969; Government of Iraq, Law No. 87 for 19&5. TAILS 23-Continued Economic Sector Central Invest ment Municipal ities and Local Ad ministra tions Economic Organiza tion and Government Services Private Sector (Except Oil Com panies) Total Planning, Sta tistics and Follow-up Bodies * 2.470 2.470 Productive Projects of the Ministry of Defense 35.000 — — - 35.000 277 TABLE 24 BUDGET OF THE PLANNED GOVERNMENT CENTRAL INVESTMENT FOR THE YEARS 1965-1969 (IN MILLION DINAHS) Economic Sector Expenditures Agriculture 142,000 Industry- 168,000 Transport and Communications 91,000 Building and Housing 97,697 International Liabilities and Repayment of Loans 25,000 Planning, Statistics and Follow-up System 2,470 Ministry of Defense Projects 35,000 TOTAL 561,167 Source: Law No. 8? for 1965. (CABLE 25 SECTORAL DISTRIBUTION OF IRAQI INVESTMENT OVER THE FIVE-YEARS 1965-69 (IN MILLION DINARS) Government Private Sector Investment Investment Agriculture 142 12 Industry (Electricity and Water) 168 5 , Transport and Communications 91 20 Buildings and Con struction 97 141 Trade and Services — 3 Source: The Five-Year Economic Plan 1965-1969. 279 1 I tribution to the national revenue. This is especially j important because of the benefits which this sector has j been deriving from public expenditures. j (3) Heal estate taxes should be administered in such a way as to bring more revenue. This will be impor tant not only as an end in itself but, also, as a means to prevent land speculation and to force capital funds in productive uses. (4) Indirect taxes, such as import duties and excise duties, should be increased to provide more reve nue. The introduction of a wholesale sales tax promises a higher level of revenue. (5) All government enterprises must be run on a business-like basis with full cost pricing providing a policy guide. (6) There is considerable room for saving in the current expenditure. The present share of defense expend- iiture of the GUP is very high relatively. A cut in the j defense budget would release a considerable amount of j Funds. ! (7) The government and the Central Bank must cooperate in developing a financial system to attract and mobilize domestic saving for financing capital formation. (8) Public debt should be resorted to not only as a means of providing a supplementary source of finance 280 ! ! "but, also, as an instrument for mobilization of hoardings i and savings• I CHAPTER VII SUMMARY AND CONCLUSIONS j Iraq is a developing country with nearly the same common aspects of problems that characterize the under developed countries generally, whether on the governmental or private levels. Iraq is also involved in preparing development plans; investment programs on an annual basis for various sectors of the economy. They imply public contribution towards development, and to some they limit private participation, even though not very much. Excluding the oil sector as a major source of fi nancing, there are many difficulties in internal financing shown in the five-year plan where, according to the com petent authorities' calculation that an important part of financing is to be achieved through external financing. 'Therefore, great attention is paid as to how to create and i jgenerate domestic savings in the face of the uneven oper ation of the plan and achieving the estimates put forward in advance, and how to provide funds for important parts and sectors of the Iraqi economy, such as long-term funds for industries and projects schemed in the plan. As a problem it is easy to carry out in the process certain light industries, but very difficult to organize capital 281 282 I I I market that leads to the continuous flow of private sav ings. Meanwhile the problem as represented on the local measures, in most circumstances, does involve savings I habits and establishment of new types of efficient finan- ! cial institutions. In addition, there is a problem of generating government savings where the public sector is dominant. Saving invested in financial assets, particularly in institutional savings, will be required to finance ade quately the proposed investments. A macroeconomic ap proach is often used; the amount of investments needed to increase the national output annually at a certain rate is calculated, based on an assumed capital-output ratio of the proposed amount based on the rate of gross domestic savings, whether from taxation or from oil revenues. It will not be sufficient to determine how much Funds are necessary for public and private investment unless the sources of these Funds are identified. Savings used in ternally for construction of housing, small manufacturing ienterprises, land improvements and similar purposes would i not help for building power stations, railways, ports or factories. An overall estimate of resources expected to be available for investment must be supplied by an indi cation of the source of saving. At this moment one could propose that the use of gross capital formation for in- vestment in various fields, are the following: j i I Domestic Savings implies: ! i 1. Government savings (excess of current revenue I over current expenditure, or deficit financing i policy to he followed up in the ordinary hud- ! get as it is claimed to he for the purpose). 2. Private Savings: a. Savings used hy savers for self-financ ing or lent privately to others, h. Savings transferred to financial insti tutions and invested hy these either ! directly or non-directly. c. Savings invested directly in securities (usually Banks are investors because various group Banks are nationalized or governmental and semi-governmental as such)• Foreign Savings comprise: 1. Loans on conventional terms whether hard terms or soft terms and private foreign investments. 2. Loans usually from IBRD, and some other inter national agencies or from the UN. As a matter of fact, fiscal policy comprises the deliberate use of taxes, government spending, and public debt operations, to further objectives such as stability 284 and growth. Therefore, it is concerned primarily with the, impact of these operations on aggregate demand and output, ! I the price level, the balance of payments, and other gen- ; i eral aspects of the economy, meanwhile, the government fi-| nanced operations, besides, are influenced by a variety ofj :other objectives and limitations that should be taken into account in appraising these operations. Indeed the fiscal |policy objectives as shown above could be achieved either within the short-run stabilization or long-run. But now, concentration has been put on the second role that it could play, relatively at least. Therefore, and apart from this source, a decrease i ,in exports, of course, represents a fall in income which can't be made up, by compensatory financing or compensa tory fiscal action designed to maintain or esqpand money income if neither foreign exchange reserves nor external credit is available. A deflationary fiscal policy may be i necessary, and a less restrictive fiscal policy may be t i i appropriate in the short-run, but in later time fiscal |restraints may be required to hold back demand for imports and allow the rebuilding of reserves on the payment of external loans. The government, usually assigned for an active role in the enlargement of productive capacity, finances and manages various sectors of the economy. It is really 285 impossible to stimulate growth to a significant extent i I ,simply by policies that increase aggregate public and ! i private spending in the long-run growth process. The j I additional expenditure will call forth little increase in i output, owing to the absence of necessary skills, capital equipment, and organization. The best prescription for the government is to direct the fiscal policy toward the increasing of saving and investment in the public and private sectors. A later formulation calls for an increase in the proportion of resources used for high priority developmental purposes throughout the economy. These proposals include, in addi tion to physical capital formation, the provision of cer tain general services for education, health, the introduc tion of improved techniques and also the operation and !maintenance of productive facilities. Investment in inefficient industries and in pres- Itige projects in the public sector, as well as the private ;sector, gain certain items of physical capital. The state i ‘Undertakes large expenditures for developmental purposes, and even when these outlays are highly productive, the re sulting growth does not automatically provide the govern ment with the resources needed to carry forward its pro gram. The main task of the fiscal policy is to finance large and growing government expenditures in an organized, efficient and objective manner. I This requires that potential inflationary effects | i of government expenditure be affected by measures that absorb the purchasing power with the minimum of avoidable interference with production and in accordance with the communities standards of social justice. Broadly speak ing, the available measures are borrowing, taxation and the sale of service or products of government owned enter prises. The possibilities of borrowing from abroad are limited by the availability of Funds and balance of pay- j ments to be considered. In Iraq, opportunities for bor- ! rowing from nom-Bank sources are narrowly restricted by the low rate of private savings and lack of financial in stitutions and habits conducive to such borrowing. With- !out inflation, only a small amount of government spending jean be financed by borrowing from the Banking system, i Iwhich all are either the nationalized group of private or i |semi-private Banks, or the governmental or semi-governmen- i |tal Banks. This is particularly true because the amount ■ of savings which the public is willing to continue in the form of claims against the Central Bank and commercial Banks (currency and deposits) is small, relative to na tional income, and secondly; their savings will grow mere ly a fraction more than their income. Furthermore, part of the expansion of the Bank credit is needed to finance 287 j certain activities in the private sector. The government J can sometimes increase borrowing opportunities by stimu lating the establishment of provident Funds and pension I systems or by introducing compulsory lending. As for taxation, this is the major source of fi nance in the Iraqi Budget, (excluding the oil sector reve nues), if it is determined to avoid stagnation and infla tion. Iraq may be required to establish a tax system that ,will raise large amounts of growing revenue plus an effec tive system of government budgeting expenditure control. Modernization of the fiscal system is an essential objective of taxation. In a developing state like Iraq, i !one must limit private spending in order to allow re sources to be diverted to high priority uses in the public sector. This, of course, involves selective restraints of iprivate consumption and investment. Careful planning, which has consequence and great importance, and execution governed by sound control of public expenditures, are re- i jquired, to assure that priorities are observed in the use of the resources made available by taxation and the share of oil revenues. Another important point, concerns the operation of the government owned enterprises. Remunerative prices for the production of the public enterprises are a source of revenue that is often neglected. There is no universally valid rule concerning the appropriate price policy for these enterprises. It should he recognized, however, that when charges do not cover costs of operations plus capital costs, consumers of the services or products are being subsidized, and the enterprise's deficit must be covered :by other means. In view of the limitations on the amount of re sources obtainable by taxation and borrowing, the financ- iing of an enterprise deficit is likely to displace other government expenditures. The result is desirable only if the subsidy is enough to contribute more to immediate !social welfare or future development than the displaced |expenditure would have yielded, although the government .should make a profit on certain activities. Being an exhaustible resource, it is only natural |that revenue from the oil sector should be utilized in such a way as to create a self-sustained, growing economy, icapable of generating sufficient saving and investment for i ,continued growth without undue dependence on one sector, j isuch as the oil resource. j Iraq has all the potentialities for the transfor mation of agriculture into a growing sector. Agriculture could then provide the stimulus for the development of an industrial sector by providing the labor force, raw mate rials, and markets, in addition to raising the per capita level of income for the rural population. The goal of economic development should be to transform the economic structure from its sole dependence ! i on the oil sector as a major source of revenue, to a new means of economic growth through development of the agri- i i cultural and industrial sectors• The reason for this seems to "be that more dependence is put on this sector by the fact that its contribution to the national income has increased from six per cent in 1950, to twenty-nine per cent in 1963. While favorable conditions are to be established and various incentives promoted, financial institutions i ,can be developed to mobilize savings. Because the role of the financial institution in the promotion of savings is a [limited one, their presence can do little to change the basic fact that in a country like Iraq., saving is low es sentially because income is low. However, this amount of saving tends to remain inactive or to get dissipated in non-productive investment since the growth and spread of such a variety of institutions presents difficulties. ! jProfit-motivated financial institutions can be established i | only in localities where there is a reasonable deposit potential, and where the borrowers can offer a type of security which is easily marketable and has a low proba bility of loss. Commercial Banks may play an important role in collecting savings because of their acce’ ss to all classes of savers through the network of their branches. The gov- f ' 290 I i t ernment and the Central Bank can play a useful role in the growth of these institutions. Measures and policies aimed I at this purpose include the following: j 1, Providing incentives for Banks to open branch , offices where they normally would not have entered. An opening by the Central Bank it self; (some branching is pending the transfer to close Banks). 2. Improving remittance and clearing arrange ments, 3* Allowing Banks to hold shares or participa tion, but, the role of commercial Banks may vary greatly, depending on monetary policy. h. Creating a system of insured deposits to re inforce confidence in Banks. I The mobilization of savings may be affected by ; changes in interest rates, by liquidity regulations and | by the availability of rediscount or refinancing facili- 1 ties from the Central Bank. ■i. The commercial Banks can obtain more resources if they branch out and educate the public to put their idle balances into their Banks as deposits. Some commercial Banks issue trust certificates in small denominations to appeal to the small saver. A useful device for attracting household savings on a longer term basis is also the issue of debentures by 291 I commercial Banks, In order to increase confidence, of course, the Banking control has to Be organized in a use ful manner, I i Specialized Institutions, for financing specific investments like agricultural, industrial, mortgage Banks, which are now available, should also establish a finance corporation so as to direct savings into specific medium i and long-term loans. Since carrying out their objectives 'depends on the presence of other resources in addition to their capital, it may be interesting to consider the pos- •sibility for these institutions to accept time and saving deposits, and to borrow foreign Funds or to issue bonds on i the capital market, and to pay higher rates of interest, ,in some cases, on deposits. By collecting liquid savings and by financing con struction, the savings institutions are more able to meet both the preferences of savers, and meet the individual's i requirements for housing finance. They may also help in i I transforming liquid savings into longer-term Funds. Private Savings in the form of life insurance and pension Funds should be encouraged for many reasons. This form of saving seems to be directly associated with pre cautionary aims. Thus, the income of this saving is not likely to be a substitute for saving through commercial Bank deposits, but an addition to it. The contribution of insurance and pension Funds to! the supply of resources is increased by the contractual i i nature of their deposits. It is possible for these insti-| tutions to make forward committments to finance invest- j ments which would not be feasible otherwise. Household ! savings in these forms could be encouraged by favorable tax treatment of such financial institutions. Investment Trusts could also contribute to mobil ize savings. They tend to polarize security purchases by the public, and they tend to improve the structure of sav ing. The development of these institutions can be encour aged by enactment of legislation insuring high profession al standards in the management of these Funds under gov ernment supervision directly or indirectly. Since the government securities have to play an important role in the promotion of a security market, the government should take various steps to increase their popularity. Firstly, they can design and issue securities i with varying periods of maturity, at different interest t rates and different denominations to satisfy the needs of different types of savers. Secondly, the authorities will need to play a major part in the early development of rud imentary stock exchange by way of producing a stabilized force in the market. They should give basic support to trading in public debt instruments by offering a guarantee to buy or to sell their debt issues at minimum prices. Liquidity must thus be provided by government itself, if regular and systematic trading is to develop, although caution should be exercised in order to avoid that this procedure lead to government recourse to Bank credit. The development of trading facilities in public debt securi ties will enhance the possibility of the issue of other kinds of securities with the passage of time. Development Banks can be established to tackle most of the latest operations in stock exchange develop ment. Such an institution can use persuasion to introduce necessary reforms. The Bank may require the perspective borrowers in the market to distribute some shares through the public instead of issuing a debt instrument. In Mexico we have the National Financeria (development Bank) which has been able to collect amounts of private savings ! !by issuing participation certificates at high rates of i |interest. As the Financeria acquires shares and bonds of |the public corporations as well as private, the certifi- I cates are backed by a stock of securities. Moreover, I since the Financeria has the obligation to repurchase them at par value, the certificates are accepted as liquid assets. In several cases, a development Bank has been or ganized before a domestic Bank has shown signs of growing. 294- ! Its main task then was to serve as a channel through j which foreign capital would flow into the country. The j Bank would act as a distribution of foreign savings, and would at the same time be involved in preparing and super- I vising the prospects to which the capital inflow was di rected. In this way, the development Bank functions to promote the capital of the country to which it is estab lished. Finally, I would say that all the above men- :tioned measures and concerned proposals that this study has covered, play an important part in financing the eco- f nomic development of the underdeveloped countries in gen-' jeral, and the Iraqi economy in particular. I believe that with sound, stable, and adequate economic policies which take into consideration the prior ity of all the sectors of the economy throughout the proc ess of growth, Iraq shall continue to accelerate her de- \ |velopment in a competitive world. BIBLIOGRAPHY 295 BIBLIOGRAPHY BOOKS Adler, John. Fiscal Policy in Developing Countries. Readings on Taxation in Developing Countries. Baltimore: John Hopkins Press, 1964-. Auramovic, Dragoslav. Debt Servicing: Capacity and Post- War Growth in International Indebtedness. Baltimore: John Hopkins Press, l95&. Bangs, Robert B. Financing Economic Development; Fiscal Policy for Emerging Countries. Chicago: The Univer sity of Chicago Press, 1968. Basch, Antonin. Financing Economic Development. New 1 York: The Macmillan Company, 1964. IBauer, Peter T. Economic Analysis and Policy in Under developed Countries. Durham, N.E. Duke University Press, 1957. Bauer, Peter T. and Yamey, Basils. The Economics of Underdeveloped Countries. Chicago: The University of Chicago Press, 1997. Bloomfield, Arthur I. Central Banking In Underdeveloped Countries. Money and Economic Activity. Boston: Houghton Mifflin Company, 1961. iBoskey, Shirley. Problems and Practices of Development j Banks. IBRD, The John Sopkins Press', '1964, 4th ed. Buchanan, James. The Public Finances. Homewood, Illinois: Richard D. Irwin, Inc., 1966. Chandler, Lester V. Central Banking and Economic Develop ment. Bombay: University of Bombay, 1962. Chelliah, Raja J. Fiscal Policy in Underdeveloped Coun tries. London: George Allen and Unwin, Ltd., 19&9. Diamonds, William. Development Banks. Baltimore: John Hopkins Press, 1957. 296 iDomar, Evsey D. Essays ia the Theory of Economic Growth, j Hew York: Oxford University Press, 1957* i i Fatouros, A. A. Government Guarantees to Foreign Inves- i tors. New York and London: Columbia University Press. im. Fleming, Marcus• The International Monetary^Fund. Its Form and Functions. Washington, D.C., 1964. Gill, Richard T. Economic Development. Past and Present. Englewood Oliffs, New Jersey: Otto Eckstien, Editor, j 1907. ! Goldsmith, Raymond. Financial Structure and Development. I New Haven: Yale University Press, 1969* Gray, Clive S. Resource Flows to Less-Developed Coun tries. New York: Frederick A. Praeger Publishers, T§ 6§7 1 Hambidge, Gove. Dynamics of Development. New York: ; Frederick A. Praeger Publishers, 1^64. Harber, Bernard. Modern Public Finance. Homewood, Illinois: Richard D. Irwin, Inc., 1966. Hartshorn, J. F. Politics and World Oil Economics. New York: Frederick A. Praeger, 1962. Haseeb, K. The National Income of Iraq 1955-1961. London: J Oxford University Press, 1964-. Hicks, Ursula. Development Finance. New York: Oxford University Press, 19^5* ’ jHirschman, Albert 0. The Strategy of Economic Develop ment . New Haven: Yale University Press, 19$8. Horsefield, J. Keith. Introduction to the Fund. Washington, D.C.: I.M.F. 1965, 2nd ed. International Monetary Fund. Articles of Agreement. Washington, D.C.: 1968. Keiser, Norman. Macroeconomics. Fiscal Policy and Econom ic Growth. New York: John Wiley and Sons, 1964. Kindleburger, Charles. Economic Development. New York: McGraw-Hill Book Company, Inc., 1958. ’ 298'] I Krause, Walter. Economic Development. The Underdeveloped ! World and the American Interest. Belmont, California: Wadsworth Publishing Company, 1962. j Langley, Kathleen. The Industrialization of Iraq. I Cambridge, Massachusetts: Harvard University Press, 1962. Leeman, Wayne A. The Price of the Middle East Oil* Ithaca, Hew York: Cornell University Press, 1^62. Leibenstein, Harvey. Economic Backwardness and Economic Growth. Hew York: John Wiley and Sons, 1^57• Lewis, W. Arthur. Development Planning: The Essentials of Economic Policy. Hew York: Harper & Row, 1%6. Liettnick, Pieter H. External Debt and Debt-Bearing Capacity of Developing Countries. Princeton, Hew Jersey: Princeton University Press, 1966• Meier, Gerald M. The International Economics of Develop ment Theory and Policy. Hew York and London: Harper ! & Row, 1968. i ( Meier, Gerald M. Leading Issues in Development Economics. Hew York: Oxford University Press, 19&4. Mikesell, Raymond P. The Capacity to Service Foreign In vestments in United States Private and Government Abroad. Oregon: Universityof Oregon Press, 19€>2. Hurkse, lagner. Patterns of Trade and Development. Hew York: Oxford University Press, 1961. IHurkse, Ragner. Problems of Capital Formation in Under- | developed Countries. Hew York: Oxford University Press, 1967. Paauw, Douglas. Financing Economic Development. Glencole, Hew York: The Free Press, 19^0. Perera, Phillips. Development Finance Institutions: Problems and Prospects. Hew York, Washington and London: Frederick A. Praeger, 1968. Rao, V. K. R. V. Foreign Aid and Indian Economic Develop ment . Hew York: Asia Publishing House, 1963* . 299 Shanon, Lyle V. Underdeveloped Area. Hew York and Evanston; Harper & How, 1957. Warriner, Doreen. Land Reform and Development in the Middle East. London; Oxford University Press, 1962. Yang, S. C. Capital Supply and Economic Growth; Sources of Savings. London; K. Berril, Macmillan Company, 1964. International Bank for Reconstruction and Development. The Economic Development of Iraq. Baltimore: John Hopkins University Press, 1952. ARTICLES AHD PERIODICALS Alter, Gerald M. Economic Development for Latin America. Proceedings. International Economic Association. New York: 1961. Chase Manhattan Bank. Capital Investments of the World Petroleum Industry. New York: 1962. Chenery, Hollis B. and Strout, Allen M. Foreign Assist ance and Economic Development. American Economic Review. Vol. 56. September, 1966. [ Domar, Evsey D. "Capital Expansion, Rate of Growth and Employment." Econometrics Vol. 14, 1946. Pinch, David. "Investment Service of Underdeveloped Countries," International Monetary Fund. Staff Papers (September, 1951). Galenson, V. and Leibenstein, H. "Investment Criteria, ! Productivity and Economic Development." Quarterly Journal of Economics. August, 1955. pp. 135-165• Heller, Walter. "Fiscal Policies For Underdeveloped Countries," Conference on Agricultural Taxation and Economic Development. (April, 1954). pp. 38-6l• International Bank For Reconstruction and Development. International Development Association. "Economic Growth and External Debt." Vol. I, An Analytical Framework, Staff Study of Economic Department. March 12, 1964. Washington, D.C. 300 j i • ’ ’ The World Bank." Washington, D.C., 1970. I _______ . Bank Press Release, Ho. 66/34, July 8, 1966. I _______ . Bank Press Release, No. 192. Washington, D.C. I I International Finance Corporation. "Private Development Finance Companies.'* Report Washington, D.C., June 1964. International Monetary Fund. "Annual Report." 1948. ________. "Annual Report." 1955* _____ . "Selected Decisions of the Executive Directors and Selected Documents." Third Issue. Washington, D.C., January, 19&5* Kahn, A. "Investment Criteria in Development Programs." Quarterly Journal of Economics. February, 1951* pp. 38-61• Kruese, H. E. Stenfert. "Management of Direct Investments • in Less-Developed Countries." Foundation For Economic Research of the University of Amsterdam. New York; 1957* i Levin, Jonathan. "The Management of Public Debt in Devel oping Countries," Finance and Development. Vol. 7, No. 21, June, 1970. Lewis, W. Arthur. "Economic Development with Unlimited i Supplies of Labour." The Manchester School, May 1954. ;0.E.C.D. "Capital Market Study." Paris; 1967* Patterson, Gardner. "Impact of Deficit In Underdeveloped i Countries," Journal of Finance. Vol. XII, No. 2. (May, 1957), pp. 17^-189. Rao, V. K. R. V. "Investment, Income, and Multiplier In An Underdeveloped Economy." Indian Economic Review. Vol. I, No. I. (February, l^JI Rostow, Walter W. "The Stages of Economic Growth." Economic History Review. (August 1959), pp. 1-5. Singer, H. W. "Deficit Financing of Public Capital For mation." Social and Economic Studies. (September, 1958). : Wai, UTun. "Interest Rates In Organized Money Markets of ! Underdeveloped Countries." International Monetary I Fund. Staff Papers, Vol. V, No. 2. (August, 195^;. , UNITED RATIONS PUBLICATIONS "Analysis and Projections of Economic Development," An Introduction to the "Techniques of Programming," Department of Economic and Social Affairs. (E/CN. 12/363, New York, 1955). "Economic Development in the Middle East," 1958/1959. (ST/ECA166, New York, I960). "Economic Development in the Middle East," 1961/1963. Department of Economic and Social Affairs. (ST/Ecal85, New York, 1963). "Financing of Industrial Development: Working Capital Requirements of Industrial Enterprise." (E/C. 5/57, New York, 1964). iFrankel, P. H. "Prospects of International Petroleum Industry" in the United Nations Techniques of Petroleum Development. (New York, 1964). "Measures for the Economic Development of Underdeveloped Countries." Report by a Group of Experts Appointed by the Secretary-General of the United Nations. Department of Economic Affairs, New York, 1951. : "Methods of Financing Economic Development." New York, 1949. ; "Mobilization of Domestic Capital: Report and Documents ; of the Second Working Party of Experts," Department J of Economic Affairs. Trade and Finance Division. I Economic Commission for Asia and the Far East. (Bangkok, 1955). World Economic Survey. "Problems and Policies in Develop "" ment Decade." New York, 1964. GOVERNMENT OF IRAQ. PUBLICATIONS Central Bank of Iraq. Annual Report of the Central Bank of Iraq. Baghdad, Al-Jumhuria Press, 1961. 302 _______ . 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Core Title Financing economic development in developing countries with special reference to Iraq.

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