Introduction

In this age of rapid growth and development in every walk of life, it is very difficult, rather
impossible for a country to finance all of its development expenditures with its own resources.
Therefore, to cover up the gap between its expenditures and revenues, it has to borrow somehow
from internal and external resources. This practice is normal in certain limits but from the last
few decades, we notice an extraordinary debt growth in all the countries generally, and less
developed countries in particular. The purpose of this paper is to elaborate the origin and impact
of the external debt on the developing economies.

The Emergence of the Dept

The third world countries, accumulating massive debts, are in the same situation. They do not
earn enough from the exports of their f mineral and agricultural products to pay for the expensive
finished goods they import. The developed nations, through international banks and government
aid, lend them the difference. Each year they need more and more loans to make up their deficits,
and so their debt goes on accumulating. These less developed countries are obliged to supply
their low priced raw materials to their rich creditors and are unable to utilize their resources for
developing their own economies.

Several reasons are given of LDC's debt but, I) deficit in the budgets, 2) capital Night, 3) foreign
exchange problems and 4) high interest raw of all, deficit in the federal budgets originates when
the federal revenues are less than federal expenditures. Nearly all other LDC's are facing this
problem. Federal revenues and expenditures often major LDC debtors can be seen in the table
below.

Secondary reason for the high growth of debt is the capital flight. Many LDC’s kept their
exchange rates too high in late 70s and early 80s. So as a result there was a capital flight of $70
billion from Latin American countries only in early 80's.'The figure for all LDC's was much
higher.

The third major reason is the shortage of foreign exchange. Due to high
deficits in balance of payments, most of the LDC's have to borrow from
abroad to finance their projects fourthly, in the early 1980's, inflation fell
sharply but nominal interest rates remained high as 11 % in 1982.

Foreign aid plays very essential role in the overall development of a country provided it is
utilized properly. Due to the scarcity of economic resources and others natural constraints every
country needs the sufficient amounts of foreign funds in shapes of foreign aid. Generally foreign
aid is granted to reduce the budget deficit, trade promotion and strategic considerations. Foreign
aid can affect the macro and micro policies of the host country. Pakistan has been receiving
foreign aid from many countries and international monetary agencies. It is also living fact that
Pakistan has been graveyard of development projects financed by the many international donors.
In principle foreign aid could be a major source of capital, fueling the growth of developing
countries and helping to promote human development. To fulfill the two-gap theory developing
countries have to rely on foreign aid. These two important gaps are the import-export gap and
saving-investment gap. Pakistan like any other developing third world nation has been a recipient
of foreign aid during its 50 years of existence. This aid has been in the form of grants, tied aid,
project aid and huge inflows intended to keep the foreign exchange reserves at a safe level to
cope with industrialization related liberal import policy.
Foreign aid is a post World War II phenomenon. The World War II is supposed to be major point
in the evolution of the world economy. Priorities were changed and new regional alliances were
emerged in the world. New bitter economic realities were found and ties of friendship were
tightened on the scale of loyalty and common interest. Motivating but confronting ideologies i.e.
communism and capitalism were going parallel to parallel and waves of integration of the world
economy was also affected. All these factors ultimately alter the overall scenario of foreign aids
programs, diplomacy, and rules of the power. The motivation for foreign aid has evolved
specially in during this period.
In this analytical study many new dimensions of global foreign aid is explored and efforts are
made to evaluate the worthiness of foreign aid. Pakistan is receiving foreign aid since the very
beginning. But the overall economic stability and industrial growth, financial soundness and
infrastructure strength is not good. Due to shortage of sufficient funds for economic development
and poverty alleviation most of the countries of Africa, Asia and others parts of the world need
foreign aid. In most of the case donors countries or international monetary agencies like IMF,
World Bank, Asian Development Bank and Consortium imposed many conditions for foreign
aid, which ultimately slow the economic development of these countries.
The two-gap theory suggests that foreign aid plays very important role in the development of
developing countries. They have to rely on foreign capital inflows to fill two gaps: the import-
export gap and saving-investment gap. However, foreign aid can also be granted for some others
determinate like structural adjustment programmes, emergency relief, transformation of
economies, political objectives of the donors and recipients etc. Foreign aid has also transformed
entire sectors. The agricultural innovations, foreign investments, and policies that created the
green revolution improving the lives of millions of poor people around the world-were financed,
supported, and disseminated through alliances of bilateral and multilateral donors like World
Bank, IMF, and Asian Development Bank The idea of foreign aid / assistance is very old in
human history. Famous Marshall Plan was the key program to look after the basic needs of the
economies of Western Europe countries. The main aim of that famous plan was to give help in
the process of rehabilitation and reconstruction of these destroyed economies.
This plan was very successful in its aims (Bandow, 1985). Initially Bretton Woods conference
and the International Bank for Reconstruction and Development [IBRD] made bilateral foreign
aid very easy for the developing countries. After that many others financial institutions like
International Development Association [IDA], International Finance Corporation [IFC], Inter-
American Development Bank [IDB], Asian Development Bank [ADB] and Islamic Development
Bank [IDB] were also established for the sake and attainment of economic growth of the poor
countries via foreign aid (World Bank, 1992).
There are sharp differences upon the subject of foreign aid to the developing countries. Michael
(1999) stressed that foreign aid is essential for resources mobilization and economic growth and
development. According to Qudsia (1998) foreign aid promotes a culture of dependency instead
of encouraging the recipients countries to explore their own indigenous resources. Pakistan and
many countries of the Africa are the prime example. Richard and Robert (1973) concluded that
rapid inflows of foreign capital in shape of aid, grant, loan and project assistance can pose
numerous problems for developing countries. Foreign aid is a political success; it is an economic
and social failure. By increasing government power, destroying economic incentives, promoting
unprofitable enterprises, and subsidizing misguided policies, foreign aid increases Third World
poverty.
Research scholars and economists are also differing in their opinions on the influences of foreign
aid at macro and micro levels of development of the recipients countries. Official development
assistance in shape of foreign aid between 1960 and 1985 varied between 1.9 per cent of the
GDP of developing countries in 1961 and 1962 and 0.8 per cent in 1985. But with an end of the
mutual struggle of supremacy between U.S.A and former USSR the rate of foreign aid has
declined (World Bank, 1986)
Foreign aid brought many multidimensional benefits to many countries of the global. Botswana
and the Republic of Korea in the 1960s, Indonesia in the 1970s, Bolivia and Ghana in the late
1980s, and Uganda and Vietnam in the 1990s are all examples of countries that have gone from
crisis to rapid development due to the contribution of foreign aid from donors countries and
agencies (Mosley, 1987, April 17). Foreign aid played a significant role in each transformation,
contributing ideas about development policy, and training for public policymakers, and finance
to support reform and an expansion of public services. Foreign aid has also transformed entire
sectors. The agricultural innovations, investments, and policies that created the green revolution
improving the lives of millions of poor people around the world-were financed, supported, and
disseminated through alliances of bilateral and multilateral donors (World Bank, 1995).
Foreign aid is also is an unmitigated failure in many countries of the Africa and some countries
of the Asia and Latin America. There are many integrated reasons for that inefficacy of the
foreign aid. These are corruption, ill intentions of the governing elite, political instability, ethnic
violence, dictatorship and inability to command over all the related social, economic and
financial issues. In many cases the continuous flows of foreign aid put the burden of massive
debt on the host countries and the ratios of debt servicing increases all the time (Bovard, 1986
January 31). The tied loans given to developing country tends to increase the inflation rate,
increase the unwanted political exploitation and unsuited economic conditionality within the
country. The removal of subsidiaries from health, education, utilities, public services,
downsizing of the employees, privatization of many state owned enterprises and corporations,
imposition of general sale tax are the some but very strict measures that Government of Pakistan
has to take in order to fulfill the conditions imposed by World Bank and IMF (Hassan, Nation)
Many rulers of the Africa like former Zaire’s Mobuto Sese Seko, is just one of several examples
where a steady flow of aid ignored. Foreign aid in different times and different places has thus
been highly effective, totally ineffective, and everything in between. The checkered history of
assistance has already led to improvements in foreign aid, and there is scope for further reform.
The development experience of India provides a classic example of the failure of foreign aid.
India receives more aggregate aid than any other developing nation on earth. It received a total of
55 billion U.S. dollars over a 43-year period (Kamath, 1995).
Many international economists and prominent international financial analysts demand the greater
flows of foreign assistance to deprived regions of the world like Rwanda, Somalia, Zaire, Bosnia,
Chechnya; Bangladesh, and the Haiti because all these countries are facing daunting problems of
extreme poverty, over-population, under-education, environmental degradation, disease, civil
disorder, and crumbling public infrastructures (The Economist, 1994 May 7).
The Foreign Assistance Comes In Three Ways

---FOREIGN GRANTS------FOREIGN LOANS------FOREIGN INVESTMENT---

a. Foreign Grants: The Foreign Grants are free and are not to be returned. These can be in the
form of goods or economic grants.

b. Foreign Loans: The Foreign Loans are to be returned. There are two types of loans Soft Loans
and Hard Loans. Loans can be bilateral and multilateral.
a) Soft Loans: In soft loans Interest Rate is very low and Time period to return loan is long and
also there are no strict instructions interims of usage of these loans.
b) Hard Loans: Where as on the other hand in hard loans The Interest Rate is very high, time to
return the loan is short and there are strict policies on the usage of loan.

c. Foreign Investment: The Foreign Investment is brought in to a country for business purposes.
Foreign Investment can be Direct and Indirect and it can also be Public Investment and Private
Investment.

a) Direct Investment: In Direct Investment the control over the capital lays in the hands of
investor.
b) Indirect Investment: Where as in Indirect Investment the investor just has some shares, just
like a sleeping partner.

a) Public Investment: In Public Investment the investment is done while considering the needs of
the peoples. It is important in accelerating economic development.
b) Private Investment: In Private Investment the investors invest in the fields which they think
can yield maximum profit, irrespective of how this investment is going to affect the peoples.

BNEFITS and COSTS FOREIGN AID

Prominent economists and research scholars share different opinions about the impact of foreign
aid to host country’s macro and micro policies. According to White (1992), Mosley (1987) and
Cassen (1986) foreign aid plays very important role at the micro levels policies of the host
countries however, at the macro level the evidence is much more ambiguous. According to
Sargent, Thomas (1993), Gang and Khan (1986, 1991), and Khan (1994, 1996), foreign aid plays
very little impact on the macroeconomics policies due to the complexity and constraints facing
by the host countries.
Foreign aid plays very important role in the development of a country and its benefits are given
below:
• According to Chenery and Bruno (1962) and Chenery and Strout (1966) foreign loans and
assistances bridge saving gap. Foreign aid/loans supplement domestic saving and help in
bridging the resources gap.
• According to Lance Taylor (1993), Bacha (1984) foreign aid pals pivotal role to fulfill internal
and external balances.
• Heller (1975) Taylor 1993, pp. 11-12). Increase productivity of various economic sectors
• Cashel-Cordo and Craig, 1986; Booth, (1988) Increase in tax collection Binh, Tran-Nam and
Mark McGillivray, (1993). The foreign assistance helps in the establishment of industrialization
in the country. The flows of technical knowledge improve the quantity and quality of
manufactured goods and makes them available at lower prices to the domestic consumers.
• Foreign aid helps in increasing marginal productivity of labour in the recipient country. The
real wages of the workers are increased by the induction of foreign aid.
• Foreign aid stimulates domestic enterprises. The firms avail of the benefits of external
economies like that of training of labour, introduction of new technology, new machinery
Foreign aid plays very important role in the reduction of poverty and other socio-economic
problems and efficient economic institutions and macro economic and fiscal policies in the
developing world are the key to utilize the flows of foreign aid properly. Good governance and
quality economic policies may increase the chances of bright future the future that will be free
from poverty, economic dependency, political exploitation, and scarcity of the resources
(Richard, & Robert, 1973).
The Cost of Foreign Aid to Recipient Country
The cost of foreign aid is very heavy on the recipient country if it is not utilized properly. It has
been observed that most of the most of the developing countries including Pakistan are not fully
utilizing the foreign aid.
• The burden of debt servicing increases all the time.
• The tied loans given to developing country tends to increase the inflation rate
• Increase the unwanted political exploitation
• Unsuited economic conditionality (Kamath, 1995).
Role of Foreign Aid in the Development of Pakistan
Pakistan has been a recipient of foreign aid since its existence. This aid has been in the form of
grants, tied aid, project aid and huge inflows intended to keep the foreign exchange reserves at a
safe level to cope with industrialization related liberal import policy. Foreign aid has played very
important role in the economic development of Pakistan. In the beginning Pakistan received very
small aid from the rest of the world and international monetary agencies like World Bank and
IMF. Industrialization process began in Pakistan after the late 50s and to fulfill the demand of
intense development activity, increased reliance on foreign resources became virtually inevitable.
In the economic history of Pakistan five-year planning scenario is also responsible for foreign
aid. Government of Pakistan had to request for the foreign aid for the completion of the five
years targets and the volume of foreign aid increased with the introduction of every five-year
plan.
Many economists share the same views about the foreign aid and economic development. Many
third world countries received substantial foreign aid from the developed countries for the
economic stability and development but political considerations strategic alliances has been
partly responsible for the level of aid flows to different countries at different points of time.
Due to geo-political developments around its borders Pakistan received liberal assistance
packages during the decade of 60’s and 80’s. Pakistan has been closed ally of western world in
order to stop the onward march of communist menace. There was lavish foreign aid and military
assistance to Pakistan due war in Afghanistan. The inflows of generous foreign aid reached its
climax in the ear of Zia. With the end of war in Afghanistan, policy of isolation and lesser
interests of God Fathers Pakistan could not have economic and materialized aid on softer terms
(Kardar, 1995). The composition and terms of foreign aid has changed considerably from grants
and grant like assistance to hard term loans over the years. The share of grants and grant like
assistance in the total commitments was 80% during the first five-year plan (1955-60). It was
dropped to 46% during the second five year plan (1960-65) and continued to decline thereafter,
averaging 31% during the third five year plan (1965-70) and 10% in the fourth five year plan
(1970-75). There were many geo-political aspects for that down ward trend in foreign aid in
shape of grant or grant like (Abbas, Brecher, 1992).
Foreign aid in shape of loans, and credit has been granted on easier conditions during the 1960s
and the 1970s. During the 1980s and the first eight years of the 1990s (1990-98) the source and
availability of foreign aid has made very harder and difficult for Pakistan. The rate of interest of
foreign aid has been on the move during the last 50 years. Furthermore, the repayment period of
loans/credit has been reduced by the international monetary agencies and western world
(Qureshi, 1997).

Main Merits and fields of Foreign Loan:

1) Accelerates Economic Development.
2) Helps in setting up Industry.
3) Helps in Capital Formation.
4) Employment Opportunities Increase.
5) Transfer of Technology & Knowledge takes place.
6) Peoples Purchasing Power Increases.
7) Helps in Industrialization.
8) Helps in Building Economic & Social...

Effect of Foreign Debt

a developing nation has to use all the available and possible resources to raise funds for the
implementation of its development plans. it hs to utilized surplus revenues, tax revenues,seek for external
aid and borrow in addition. public borrowing can be domestic or foreign.in LDC's savings are too low,
therefore the Govt. has to borrow from abroad.Foreign debt has two dimensions, on one hand it is helpful
in development process and on other hand, excessive borrowings can cause many serious problems.
on th first instance, foreign loans help to bridge up the gap between govt. expenditures and revenues
which may not be covered by domestic savings. secondly, foreign debt help the economu to import the
capital goods which is mostly impossible for LDC's without foreign aid. thirdly, foreign dabt can be used
for export promotuion. on the other hand, external debt transfer wealth when the loans are repaid with
interest.

Effects on consumption and spending:

foreign debt has two sides effects on consumption and spending. on one hand , govt. of debtor country
spends more to complete its projects. more money means more income and more income means more
consumption. if the aggerate supply is not enough to satisfy the increased aggregate demand, it will
create inflation in the country. on the other hand it has indirect negative effect on consumption. we know
that debt is the burden that requires higher taxes to meet indirect payments; therefore more taxes leave
less disposeable income which will reduce the consumption too.

Effects on Saving:
effects of foreign debt again depends on use of debt. if the debt is used to finance the investment which
will further increase the income of the people, then saving will increase out of increased income. on the
other hand, if it is used on non-productive projects, it will depress saving by increasing aggregate demand
and creating inflation.

Effects on investment:
if foreign debt is used for capital investment, it will further increase the priovate domestic investment
because increased aggregate supply will balance the increased aggregate demand, caused by increased
income. on the other hand, increased expenditure on non productive projects will cause highere interest
rates which will depress incentives for investment.

Effects on monitory policy:

if the borrowed money is used on non productive issues,the new expenditure will shift the IS curve
upword, increasing the dificite and higher interest rates with reduced investments. therefore centeral bank
will increase the money supply therefore LM curve move forward causing new equilibrium with interest
rates at its initial levels but at higher income and output level. if centeral bank does not increase the
money supply, additional demand created by increased expenditure will cause inflation.

In summary, in eddition to the efects on saving, consumption, in vestment and monetary system, foreign
debts has far reaching effects on the financial system. if the cash flows available to the countries is
interrupted for any reason the some of the LDC's find no other way but to default in their debt obligations.
therefoe they will be forced to reduce the demand for goods & services causing serious recession.

RECOMENDATION

Many of the LDC's have learned experience from default countries and have started improving their debt
situation but still a lot is needed to be done on this issue to avoid the future crises. following are some of
the policy solutions which can help in reducing the debt problem.

Elimination of federal budget deficit:

federal budget is the major source of foreign debt. therefore, if a govt. really wants to halt the high growth
of debt, the first is to eleminate the bidget deficit. this step will keep the domestic savings free for the
investment purposes which can further genrate foreign exchange to keep the economy out of the "debt
trap" in the future. this can be done by reduction in spending.

Foreign Exchange shortages:

the second issue in adjusting to debt regards the fact that the country need to earn foreign exchange not
their own currency. in other words, it needs to genrate the trade surplus. in LDC's much of the foriegn
debt is used to build non -productive projects. if the same capital is used in productive projects, the debt
burden will be less. because the new investment will create or save enough foreign exchange to make the
future payments without creating the additional tax burden on the community or society.

Revision of the tax policies:

Some of the LDC's yax policies encourage the loan because it is exampted from tax. such policiec should
be eliminated.

Reversial of capital flight:

because of the unfavourable investments climate and political instability in the country, there is a huge
capital flight in the country. reversing these capital flights would make it almost possible to pay off the
external debt. positive real stable interest rates will help a lot in this regard.

Need for international cooperation & coordination:

developed countries can play a key role in the developing countries. international banks should change
their policies while lending to LDC's. they should borrow according to their needs and on low interest
rates. IMF should help LDC's in accomodating their balance of payments. IMF plays a good role to assist
rich industrial nations of the world but it is reluctant to help LDC's. large and develpped nations should
help LDC's to perform industrial reforms in LDC's economies.

Debt-Equity swaps:
another solution that is finding a lot of favour in the financial community is the system of debt-equity
swaps. in this system an invester of a creditor nation purchases in the second hand market the debt of the
debtor nation at a 30% discount. this debt then is presented to the debtor nation's federal bank for
redumption at par into their currency units at a premium prevailing in the arket. that amount is then spent
on purchasing some assets being liquidated by the public sector. when the accounts are done, the
external debt is reduced. it may be an exopensive way to clean up the balance sheet. but it will promote
foreign investment, both direst and portfolio investment.