Due to their growing national debt and widening trade deficit, several emerging countries, including Pakistan, have found themselves in a debt trap. These nations gave up some of their sovereignty to their lenders since they had no choice but to use lenders’ funds to pay their trade deficit.
In order to keep emerging economies in debt, the IMF and World Bank have both been accused of using predatory lending practices. These practices include requiring structural adjustment programs as a condition of loans, frequently to governments that view these loans as a last resort, pushing for privatization, and improperly influencing central banks.
“The World Bank and the IMF have routinely offered loans to States as a means of influencing their policies,” the Committee for the Abolition of Illegitimate Debt stated. The IMF has chosen which nations received loans based on geopolitical factors rather than just economic circumstances. During the Trump presidency, the phrase “debt trap diplomacy” first appeared in US government documents. The 2020 Department of State study “The Elements of the China Challenge” is one of many U.S. official papers that mention it.
Because Beijing is now Islamabad’s biggest creditor, China has significantly increased its power to influence Pakistan’s economy in recent years. Only 9.3 percent of Pakistan’s entire public and publicly guaranteed external debt, which was $44.35 billion in June 2013, was owed to China, according to documents made public by the finance ministry of Pakistan.
The International Monetary Fund estimates that by April 2021, this external debt had grown to $90.12 billion, with $24.7 billion ($27.4 percent) of Pakistan’s total external debt owed to China (IMF). However, China has yet to exert direct control over Pakistan’s economic decisions. The World Bank, the Asian Development Bank (ADB), and the IMF are still the primary decision-makers when it comes to the fiscal policies that are pursued in Islamabad, as seen by the ongoing IMF loan program.
We must comprehend some macroeconomic models that describe the balance of trade and capital influx in order to comprehend the origin and causes of the debt trap. The primary macroeconomic distinction between an open economy and a closed economy is that an open economy does not require that a nation’s expenditure in any given year match its output of goods and services. A nation has two options: it can borrow from abroad to cover its surplus spending, or it can borrow less and lend the remainder to foreigners.
Net Exports and Trade Balance
The national income account’s identity shows that net capital outflow always equals the trade balance. That is,
Net Capital Outflow = Trade Balance
S – I = NX
We will see how this equation is derived.
To expand this equation, we need to start with National Income Identity,
Y = C + I + G + NX
Y is National output or GDP
C is the total consumption
I is Investment
G is Government purchases
NX is Export – Imports
To arrive at this identity, we need to look into
This identity (Y = C + I + G + NX) is derived Y = Cd + Id + Gd + X
The first three terms Cd + Id + Gd combine to represent domestic spending on goods and services. Foreign spending on domestic goods and services is the fourth term, X.
The total amount of domestic spending on goods and services equals the sum of domestic spending on domestic goods and services plus domestic spending on international goods and services.
Thus, total consumption C is equal to the sum of the consumption of local products and services (Cd) and the consumption of goods and services from other countries (Cf). The total investment I is equal to domestic investment in goods and services plus foreign investment in goods and services. if; and total government purchases G equal the sum of the government’s purchases of goods and services domestically (Gd) and abroad (Gf). Thus,
C = Cd + Cf also Cd = C – Cf
I = Id + If, also Id = I – If
G = Gd + Gf, also Gd = G – Gf
We substitute these three equations into the identity Y = Cd + Id + Gd + X:
Y = (C – Cf) + (I – If) + (G – Gf) + X
We can rearrange to obtain Y = C + I + G + X – (Cf + If + Gf)
Spending on imports is calculated as the total of domestic purchases of foreign goods and services (Cf + If + Gf) (IM). The national income accounts identity can thus be written as
Y = C + I + G + X – IM.
This calculation subtracts import spending because it is part of domestic spending (C + I + G) and because foreign-imported goods and services are not included in a nation’s output. Net exports are defined as exports minus imports (NX = X – IM), and the identity is
Y = C + I + G + NX
With some manipulation we get,
Y – C – G = I + NX
Y – C – G is national saving S, which equals the sum of private saving, Y – T – C, and public saving, T – G, where T stands for taxes. Private Saving + Public Saving = Y – T – C + T – G: T cancel out, Therefore, S (total national saving) = Y – C – G
Therefore, S = I – NX or
NX = S – I
Trade Balance = Net Capital Flow
This table shows the three outcomes that an open economy can experience.
Exports > Imports
Exports = Imports
Exports < Imports
Net Exports > 0
Net Exports = 0
Net Exports < 0
Y > C + I + G
Y = C + I + G
Y < C + I + G
Saving > Investment
Saving = Investment
Saving < Investment
Net Capital Outflow > 0
Net Capital Outflow = 0
Net Capital Outflow < 0
By definition, a debt trap is when a creditor country gives a debtor country an excessive amount of credit to get political or economic concessions later on when the debtor country is unable to make repayments. Without going into specifics to comprehend the intentions of Pakistan’s lenders (such as major lenders China, the IMF, KSA, UAE, etc.), we will draw attention to the fact that the government of Pakistan’s revenues—both tax and nontax—are not even enough to pay for debt repayment and defense spending.
As a result, borrowings are used to fund all ministries of the Government of Pakistan (GOP), the Public Sector Development Program (PSDP), debt repayment, and defense.
Let’s begin by reading the following table of Pakistan’s national income in order to better grasp the jigsaw puzzle of the trade balance and its relationship with the budget (fiscal measures) and GDP.
|Trade Deficit & Components of Pakistan’s GDP|
The trade deficit is shown by net exports, which are expanding from 2017 to 2022.
Household final consumption expenditure
A transaction of the national account’s usage of the income account, which represents consumer spending, is the household’s final consumption expenditure. It comprises the money spent by residing households on personal consumption products and services, even those offered at marginally profitable pricing.
It also contains a variety of imputed expenses, the most significant of which is typically the imputed rent for owner-occupied housing services. In addition to people who live in traditional homes, the household sector also includes those who reside in communal settings like nursing homes, boarding houses, and jails.
The definition of HFCE provided above covers both domestic and international spending by resident households (outbound tourists) but does not include any domestic spending by non-resident families (inbound tourists).
The household final consumption expenditure according to the domestic concept, which includes household expenditures made on the domestic territory by residents and inbound tourists but excludes residents’ expenditures made abroad, can be distinguished from this national definition of consumption expenditure.
Final consumption expenditure of non-profit institutions serving households (NPISH)
NGOs and membership organizations make up Non-Profit Institutions Serving Households (NPISHs). The total consumption expenditure of NPISHs is equal to their operating expenses and is always of an individual type. For the first time, the final consumption expenditure of NPISH was estimated separately through the known output values in the 2015–16 rebasing.
Due to its non-market nature, the output of NPISH has been estimated using data on fixed capital consumption, employee compensation, and intermediate consumption expenditures reported by NGOs for the base year survey and membership organizations. For the new base estimates, the NPISH’s output from the base year, or Rs. 296.7 billion, has been considered as its final consumption expenditure, accounting for 0.91 percent of the GDP.
Household final consumption expenditure + NPISH = C
General government final consumption expenditure
The total of employee compensation, purchases by the government of materials and other intermediate consumption items, consumption of fixed capital, purchases of goods and services by the government for the benefit of households, other production taxes, and non-miscellaneous taxes on production equals the final consumption expenditure by the government, which is equal to its cost.
It is compiled through the federal, provincial, and local government budget documents and broken down in accordance with the classification of the functions of government (COFOG).
General government final consumption expenditure = G
Gross Fixed Capital Formation (GFCF).
Assets can be divided into two categories: financial (cash, stocks, etc.) and non-financial. The capital stock of a nation is made up of physical non-financial assets that are employed as a factor of production to produce GDP. Non-financial assets can be broadly divided into produced assets, which arise as byproducts of production processes, and non-produced assets, such as natural resources, contracts, leases, and licenses, as well as goodwill and marketing assets.
Fixed assets, inventory, and valuables are the three primary categories of generated assets. Fixed assets and inventories are both assets that are only retained by producers for production-related purposes. Any institutional entity may have valuables, which are primarily kept as stores of worth.
Fixed assets that are generated and used regularly or continuously in industrial processes for longer than a year is of interest to GFCF. The total value of a producer’s acquisitions during the accounting period, fewer disposals of fixed assets, plus a specific amount spent on services that raise the value of non-produced assets, is used to calculate GFCF.
GFCF can also take the form of enhancing existing fixed assets, including structures or software, to boost their productivity, lengthen their useful life, or both.
Gross Fixed Capital Formation (GFCF) = I
Why Doesn’t capital flow to poor countries and why does it flow to advance an economy like the U.S.A.?
Let’s start by understanding the balance of trade, trade deficit, and net capital flow. As you can see in the following graph, Pakistan and the United States are noticeably farther away from China in terms of gross capital expenditure, household consumption expenditure, government expenditure, and net exports.
The main distinction between the United States and Pakistan is that the former enjoys the advantage of attracting the surplus of its trading partners into its financial assets (bonds & stocks), while the latter does not.
Pakistan must emulate China’s success by increasing exports and raising its national income through Gross capital formation (formerly gross domestic investment).
Where Gross capital formation according to the World Bank is made up of expenditures for augmentations to the economy’s fixed assets as well as net changes in the level of inventories. Purchasing plants, machinery, and equipment; building roads, railways, and similar structures; and building schools, offices, hospitals, private residences, commercial, and industrial structures are all fixed assets.
Fixed assets also include land improvements (fences, ditches, drains, and so forth). Stocks of items kept by businesses as “work in progress” and to cover brief or unforeseen swings in production or sales are known as inventories. Net acquisitions of valuables are also regarded as capital formation in accordance with the 1993 SNA.
|The trade deficit of Pakistan last 5 years|
Even though the United States has a trade imbalance, the rest of the world continues to invest in its economy. Capital has primarily come from nations that have trade surpluses with the United States of America. In 2013, this category comprised a number of countries like China, Nigeria, Venezuela, and Vietnam that were far less developed than the United States. Savings outpaced domestic capital investment in these countries.
These nations were sending money to nations like the United States, where domestic capital investment outpaced saving.
The direction of global money flows seems paradoxical from one angle. There, we demonstrated that the Cobb-Douglas form is a production function that is experimentally realistic:
F (K, L) = A KαL1-α,
where K is capital, L is labor, A is a variable representing the state of technology, and a is a parameter that determines capital’s share of total income. For this production function, the marginal product of capital is
MPK = α A(K/L) α-1
How much additional production an additional unit of capital might produce is shown by the marginal product of capital (MPK). A must be less than 1, since it represents the capital’s portion, hence – 1 0. Thus, a rise in K/L results in a fall in MPK. In other words, the more capital a country possesses, the less valuable each additional unit of capital is, all other things being equal. According to the declining marginal product phenomenon, capital ought to be more valuable in areas where it is scarce. For instance,
MPK = 0.5 (100) (0.5)0.5-1 = 70.71
MPK = 0.5 (100) (1)0.5-1 = 50
MPK = 0.5 (100) (1.5)0.5-1 = 40.82
MPK = 0.5 (100) (2)0.5-1 = 35.36
However, this projection appears to conflict with the global capital movement that a trade deficit implies. It appears that capital does not move to the countries where it should have the greatest value.
We frequently see the opposite, with capital-rich nations like the US lending to capital-poor nations. How come? One explanation is that countries differ significantly in ways other than just how much cash they have amassed. Poor countries have poorer levels of production capacity in addition to lower levels of capital accumulation per worker (measured by K/L) (represented by the variable A).
Poor countries may, for instance, have less access to cutting-edge technology, lower levels of education (or human capital), or less effective economic policies than rich countries.
Such variations can result in reduced output for a given level of labor and capital input; in the Cobb-Douglas production function, this is represented by a lower value for parameter A. If so, despite the fact that capital is scarce, capital need not be more valued in poorer countries.
The widespread piracy and frequent non-enforcement of intellectual property rights are further factors that may prevent finance from reaching developing countries. Governments frequently fail in their obligations, expropriation of wealth is more widespread, and revolutions, coups, and corruption are all more rampant.
Therefore, despite the fact that capital is more valuable in developing countries, foreigners may be reluctant to put their money there for fear of losing it. Additionally, similar incentives exist for regional investment. If you were to live in a poor country and be fortunate enough to have some money to invest, you could conclude that it is best to do so in a safe nation like the United States, even though capital is worth less there than it is in your own.
Whichever of these two explanations is true, poor countries including Pakistan must figure out how to change the situation. The flow of international capital would probably change direction if these countries provided the same levels of production efficiency and legal protections as the American economy.
Capital would flow to these developing countries, and the trade deficit with the United States would turn into a trade surplus. A shift like that would aid in the emancipation of the world’s impoverished.