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The Debt Cycle Hypothesis

By Edited Mar 29, 2016 0 0

As development proceeds, changes in domestic income, rates of saving, capital stock accumulation, and rates of return on investment can be expected to alter the rate and direction of international capital flows. This has led to the formulation of the debt cycle hypothesis: countries will move through stylized balance of payments and debt stages. Each stage is characterized as follows:

Stage 1: Young debtor

  • Trade deficit.

  • Net outflow of interest payments.

  • Net capital inflow.

  • Rising debt.

Stage II: Mature debtor

· Decreasing trade deficit, beginning of a surplus.

· Net outflow of interest payment.

· Decreasing net capital inflow.

· Debt rising at diminishing rate.

Stage III: Debt reducer

  • Rising trade surplus.

  • Diminishing net outflow of interest payments

  • Net capital outflow.

  • Falling net foreign debt.

Stage IV: Young creditor

  • Decreasing trade surplus, then deficit.

  • Net outflow of interest payments, then inflow.

  • Outflow of capital at decreasing rate.

  • Net accumulation of foreign assets

Stage V: Mature creditor

  • Trade deficit.

  • Net inflow of interest payments

  • Diminishing net capital flows.

  • Slow-growing or constant net foreign asset position.

In the aggregate, of course, the world cannot be in either a net debt or net asset position. Therefore, as more countries move toward the mature creditor stage, the relative size of their asset position should tend to diminish. The fact that industrial countries' collective net asset position is small relative to their GNP, although gross capital flows are very large, corresponds well with the debt cycle hypothesis. So does the pattern of structural balance of payment changes in the United Kingdom and the United States over the past 150 years. Until very recently the balance of payments of these two countries followed the five stages quite closely.

For developing countries, the evidence is mixed. In the colonial period, many countries, particularly primary product exporters, ran current account surpluses, becoming, in effect, capital exporters. A small group of advanced developing countries moved from the young debtor to the mature debtor stage between 1950 and 1975, but most oil-importing countries remained in the first stage until very recently. A few, such as China, remained net creditors throughout all or most of this period.

The debt cycle model does not predict reliably how long a country may remain in any given stage of the debt cycle. The trade account and net interest payments continue in deficit throughout. The rate of return on investment (as approximated by the inverse of the incremental capital output ratio) is higher than in surplus countries, warranting a mutually beneficial transfer of savings to the developing country. In the first decade, the real growth rate of exports is lower than the real interest rate, leading to rapidly growing current account deficits and debts; the latter rises from zero in the first year to $100 million after ten years. When the debt service and debt to GDP ratios reach what are regarded as their maximally sustainable levels of 30 percent and 40 percent, respectively, a surge in exports is required to finance interest payments and amortization. In the fifteenth year, growth rates of exports and GDP, as well as the debt ratios, settle down to their long-run sustainable levels. Export growth has risen to 6 percent, which is sufficient to sustain continued current account deficits and steadily growing debt.

Sudden shifts in major economic variables, as have occurred with particular force the predicted path. During the latter half of the 1970s, many developing countries thought to be mature debtors reverted to the early debtor stage, importing capital and running mounting trade deficits. In the 1980s, many of these same countries have been moved to the third or early creditor, stage reducing net debt by running huge trade surpluses. The developing is, of course, the mirror image of what have occurred in some industrial countries. For example terms of the debt cycle hypothesis, the UnitedState recently reentered the early debtor stage of the debt cycle, incurring debt at an accelerating rate while increasing its trade deficits. The reasons for these shifts any complex and are explored in the Report.

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