AN INVESTIGATION INTO CAUSES, EFFECTS

AND CURES FOR EXTERNAL DEBT

DISTRESS - A MODEL BASED ON CASE
STUDY FOR INDIA
Deepa J. Gupta and Arvind G. Jadhav
Symbiosis International University, Pune, India and
University of Dallas, Irving, TX USA
deepa.gupta@ssbm.edu.in and ajadhav@udallas.edu

Abstract
With a trend towards lowering tariff barriers, trade between nations
has gained added impetus. One of the consequences of this
development is increased imbalance in Balance of Trade for a
number of nations. This imbalance is then made up through flow of
external capital to nations with sustained current account deficits. In
a number of cases, nations have accumulated external debt beyond
their ability to repay principal and interest. This debt distress, which
cannot be reduced through a foreseeable improvement in the trade
account, is relieved through grants from donor nations, increased
concessional terms on loans, and intervention from World Bank and
IMF.

A number of recent studies have tried to trace causes of current

account deficit to a number of economic factors but the main
emphasis appears to be to on its relationship with fiscal deficit. A few
studies have produced opposite results on causal direction between
these two deficits.

This paper attempts to investigate and isolate key causes of external

debt distress, effect of unsustainable external debt level on an
economy, and identify potential policy measures that can reduce the
distress level. The causes of trade deficit investigated in this article
also include factors like foreign exchange reserves, real GDP growth,
inflation rate, degree of openness of economy, etc. The causation is
evaluated through VAR model. Although the analysis will be focused
on external debt situation in India, the objective is to develop a model
that can be applied to nations with severe imbalance on current
account. If the model can make a breakthrough in determining a
sustainable level of external debt for a nation based on causative
factors, it could make a contribution by identifying country specific
policy measures that can lower the distress level to or below a
sustainable level of external debt. The model can also be used to
undertake intertemporal dimension of international trade where
goods and services imported this year can be balanced by exports in
later year.

Keywords – Innovation, Technology, Research projects

JEL : F34;H63;H62

NEED FOR EXTERNAL DEBT

Electronic copy available at: http://ssrn.com/abstract=2187767

External debt fuels internal growth when either internal investment
level is inadequate and/or exports are lower than imports over a
sustained period. In a number of cases external debt implies
importation of new technology that is vital for improving productivity
of domestic economy. Such an import should be viewed as seeding
for future exports. Vital imports such as raw materials and basic
consumption goods are not discretionary items. Japanese economy
could not grow without importing raw materials. As a limitation, a
number of products and services with demand from other nations
may not be exported for the purpose of meeting existing domestic
needs or maintaining reserves for expected future shortages at
home. A nation may not want to export a specific raw material but
may want to export the finished product. A case in point is China’s
recent ban on export of raw materials such as bauxite and yellow
phosphorus to Europe and the U.S. which has lead to a complaint to
WTO by affected nations. A number of advanced economies utilize
cheaper imports to keep domestic price level low even though this
action incurs adverse trade balance. Domestic agricultural subsidies
have been an ongoing cause of friction between a few nations
because of its adverse impact on international trade. The U.S. uses
external debt to finance fiscal deficits, to maintain a lower rate of
interest and also to maintain lower rate of inflation within the country.

There is no single definition or indicator of sustainability of level of

current and future external debt. External debt sustainability is
defined by the World Bank and IMF [1]as “if it (a nation) can meet its
current and future external debt service obligations in full, without
recourse to debt rescheduling or the accumulation of arrears and
without compromising growth.” This definition does not cover fiscal
deficit, composition of debt, uses to which external debt is put or
other policy issues impacting external debt by authors’ own
admission. It is desirable to start with a generally accepted definition
and proceed through a process of enhancements. A number of
indices are introduced to measure the sustainability of external debt.
These include ratio of total outstanding external debt to exports in a
year, ratio of NPV of external debt to annual fiscal revenues, ratio of
total outstanding external debt to GDP; and ratio of external debt
service payments to exports in a year. The notion of establishing
one numerical standard for measuring status of different nations,
each with unique set of situations, has come under criticism as
arbitrary and static. Nevertheless, the indices can be interpreted as
benchmarks that trigger remedial actions. A later model developed
by the World Bank [2], Revised Minimum Standards Model (RMSM-X
and XX) divides nation into five domestic sectors of economy plus a
foreign sector. The markets are segmented in domestic, import,
export, money market, credit market, a quasi-market for Central Bank
Credit, and a foreign asset market. The RMSM-X model estimates
external borrowing capacity of a nation based on a model that
requires minimum inputs, uses static production function and
introduces no or minimum time lags in variables. No matter how
sustainability is defined and the reasons thereof, external debt has to
be managed so that it does not become an unsustainable burden to
the debtor nation. A good process for managing external debt is
given in a World Bank publication on the subject. [3]

Unsustainable external debt burden is often referred to as external

debt stress situation. The Contingent Credit Line (CCL) launched by
IMF was expected to offer a precautionary measure against shortfalls
in trade account but it expired in November 2003 due to lack of
takers. The World Bank has classified a number of countries as
Heavily Indebted Poor Countries (HIPC). The dividing line is not
based up on an absolute level of external debt but debt in
comparison to resources available to repay the principle and interest.

Electronic copy available at: http://ssrn.com/abstract=2187767

HIPC initiative has been hampered by inadequacy of resources. The
default is, however, not limited to HIPC group. A number of cases in
recent history suggest that borderline nations are also exposed to the
risk of default. A recent NBER paper [4] lists nations like Germany
(1932), Russia (1998) and Pakistan (1998) with their year of default
in parenthesis. It should be noted that default on external debt in
reality ends up with restructuring of the debt. This escape valve
reduces the urgency of need to manage external debt and undertake
policy reforms by nations on the verge of unsustainable level of
external debt.

LITERATURE REVIEW
Recent analysis of current account deficit places considerable
emphasis on investigating its association with fiscal deficit in the
context of ‘Twin Deficits’ concept. From a sovereign point of view,
fiscal deficit is a domestic shortfall as compared trade deficit which is
international imbalance. A number of scholars have evaluated
causal relationship between the two deficits [5]. A few authors have
shown causality from an increase in fiscal expenditures, irrespective
of the financing method, to increased trade deficits [5b], [6] [7], while
others contend a reverse relationship between the two deficits [8].
As refinement of this hypothesis continues, other significant
explanatory variables are being introduced to explain the factors
contributing to the trade deficit. The major new variables being
included is the degree of openness of an economy to international
trade [9].

While tracing the relationship between the two deficits is a perfectly

logical intellectual pursuit, it is likely that fiscal deficit may be a proxy
variable for a plethora of endogenous explanatory variables such as
level of budgetary expenses, changes in tax structure, domestic
inflation rate, money supply, domestic interest rate, exchange rate,
growth of real GDP, growth of population with particular emphasis on
the age pyramid, and irregular expenses like wars and natural
disasters. Granted that a few of these variables could have
multicolinearity, it may be worthwhile that the analysis is conducted
with these second tier aggregates. A shock from one or more of
these variables could produce a significant change in fiscal deficit.
Thus association of aggregate or macro level deficits may mask the
real factor(s) that could explain the level of trade deficit.

It should be noted that fiscal deficit is in reality a deferred tax. The

accumulated deficit and interest thereon has to be repaid in future.
Hence it is a generational theft. In a similar vein, trade deficit could
be viewed as deferred exports. Thus both deficits present an
intertemporal dimension, which is not inherently self correcting.
Hence the necessity for policy induced corrections for both deficits.

The above list of potential explanatory variables suggests that fiscal

deficit and monetary or financial activities of the central bank are
interrelated. Let us trace the impact of an increase in money supply
on the trade deficit through Keynesian approach. An increase in
money supply, holding real GDP constant, will lead to a reduction in
interest rate. A reduction in interest rate will lower the savings rate
and will increase consumption. An increase in consumption, when
domestic production is constant (or at a minimum growth), will entail
increased consumption of imported goods and services. This will, in
turn, affect trade account adversely. Thus an imbalance in monetary
market can also impact trade deficit.

A number of studies relate trade imbalance to explanatory variables

contemporaneously. An intertemporal approach can explain
precautionary steps taken by a few countries to smooth out impact of
expected shocks on domestic consumption. India has banned wheat
exports during 2009 in anticipation of wheat shortage to avoid future
increases in trade deficits. Intertemporal balance is not automatically
achievable over a reasonably short period. Mohanty and Joshi [7]
who conducted an empirical study on fiscal and trade deficits in India
have concluded that concentrating on reduction on trade deficits
through reduction in fiscal deficits alone may bring at the most
medium term benefits but will not be effective in the long run.
Another empirical study of Sri Lanka’s borrowing capacity [12]
concluded that a prudent management of foreign exchange rate
along with other measures such as controlling fiscal deficit can
improve sustainable foreign debt. Hence, a multipronged approach
that encompasses policy corrections and financial restructuring by
nations involved with full participation by international organizations
such and IMF and the World Bank has a potential to maintain trade
deficit at sustainable or better level. Thus trade deficit is not
necessarily a bad situation as long as it is not perpetual, its causes
can be determined and corrective actions can be initiated.

ANALYTICAL APPROACH
Prior analysis of external debt has concentrated exclusively on
accumulated past debt and its servicing requirements. Although total
past debt is the critical issue, this paper attempts to suggest a
separate treatment for new external debt so as not to exasperate an
existing situation.

Let us begin with defining criteria for new external borrowing. Unless
the loan is for humanitarian purpose, the objective in seeking
external debt (ED) is to increase the growth of GDP for the benefit of
citizens of the debtor nation.

ED = GDP – GDP = GDP ( - 1)

Where,  is coefficient of ED’s contribution to GDP (>0) and  is

growth multiplier to GDP (>1) as a result of stimulus from ED.
Levels of  and  will depend on the extent of productive content of
ED. For a non-productive use of external debt,  will be closer or
equal to zero and  will be closer or equal to 1.

Designating ‘t’ for term of the loan, and ‘r’ for rate of annual interest
on the loan; net marginal contribution from external debt (i.e., after
deducting debt servicing requirements) to GDP can be stated as:

Net [GDP( - 1)] = ED – (ED/t + rED) ………… Equation 1

Where, ED/t stands for annual principal payments during the term ‘t’
of the loan and rED denotes annual interest payments on new
external debt. The parenthesis on the right hand side gives debt
servicing requirements. Debt stress can be defined as a point where
the term in parenthesis on the right hand side of the equation
exceeds ED to an unsustainable level. Since it is imperative that
>1, unless ED is for humanitarian purposes, this formulation
enables development of a minimum critical condition for new external
debt as:

ED > (ED/t + rED) …………………………………….… Equation 2

Enforcement of this rule is likely to introduce a point of inflection in
total external debt servicing curve leading to a change in the slope of
the curve and improvement in solvency of the debtor nation in
international capital markets. The change in slope will depend on
relative size of new debt as compared to accumulated past debt.
Similar changes in the curves can also be observed when past debt
is converted into concessional loans and grants; however, such
change is preceded by a stigma of default. Additional structural
hurdles such as prior default or existing level of debt far exceeding
sustainable amount could also inhibit issuance of new debt.

Since the new debt rule cannot be applied to past accumulated

external debt, this papers attempts to determine causes and sources
for servicing past debt separately through development of a
disaggregated VAR model. The logic leading to the proposed two
models dealing with existing external debt is outlined in the following
paragraphs.

Following Keynesian terminology:

Y = C + I + G + (X – M) and also

Y=C+S+T

Where Y is GDP, C is consumption, I is investment, G is government

spending, X – M gives trade balance, S is savings of household
sector; and T represents taxes.

Rewriting the equations, trade balance will equate to:

(X – M) = (S – I) + (T – G)

Where (T – G) represents fiscal balance. (S – I) describes difference

between domestic savings and total investment needs for both public
as well as private sectors [10]. Thus presence of trade deficit
suggests that developing countries have more investment
opportunities than can be met by domestic savings. The logic of twin
deficits suggests that at optimum level of Y, if fiscal deficit (T – G)
increases or is significantly negative, (S – I) must become
significantly positive to bring about equilibrium between trade and
fiscal deficits. This does not necessarily imply that all capital flows
originate in developed nations and end in developing nations.
Private capital flows have shown reverse direction as evidenced in
empirical data for the United States due to its dismal domestic

Therefore, linkage of trade deficit with domestic savings and

investment balance should be considered in the analysis as the third
deficit, (S – I). However, insertion of domestic savings and
investment balance is inhibited in this analysis due to paucity of
consistent data series for these variables for India. The authors are
planning to test the three deficit hypothesis for another country,
where data is available, in cooperation with IMF. The above
formulation also suggests that M1 or money supply could act as an
instrumental variable or proxy for a number of monetary variables.
Further refinements can be introduced by dichotomizing the
exchange rate into fixed and floating since their impact on trade
balance will be different. [11] The IMF paper quoted in [10] also
mentions that there is no obvious connection between protectionism
and savings or investment. This paper assumes conduct of
international trade on floating or managed floating exchange rate,
with a glaring exception of China. A number of studies use exports
as per cent of GDP as a measure of openness of economy. [9] The
level and significance of trade deficit can be directly related to
participation of nation in international trade. In an extreme case of a
completely closed economy, trade balance given by (X – M) will be
zero. Growth of world trade as a consequence of globalization is
bound to increase openness of economies of nation s. This paper
assumes that ‘openness’ is a less important variable in the long run.

Collapsing and elaborating the functional relationships enumerated

above into a single equation will enable development of the final
specification of the model through a ‘test down’ approach. The test
down VAR model employed in this study starts with an economic
hypothesis that utilizes as many logical linkages as possible to arrive
at a statistically valid model. Care is exercised in retaining the final
set of explanatory variables that could be influenced through policy
decisions. Policy variables could further be dichotomized into
domestic and international market driven. A country could exercise
control over domestic policy measures. Involvement of institutions
such as IMF, World Bank, and WTO will be necessary for dealing
with international measures. Therefore, this evaluations starts with
the hypothesis, that fiscal deficit plays a prominent and independent
role in both models. The starting hypothesis for trade deficit is:

(X – M) = f(fiscal deficit, foreign exchange reserves, domestic

inflation rate, domestic interest rate, exchange rate, exports as % of
GDP, and growth of real GDP)

The second hypothesis relates external debt to explanatory variables

on the basis of the following hypothesis.

External Debt = f(trade deficit, fiscal deficit and foreign exchange

reserves)

It should be noted that inclusion of fiscal deficit in both hypothesis

does not violate any statistical rule because the equations are
computed on a standalone or mutually exclusive basis.

Formal specification of the final model derived through ‘test down’

methodology is stated in statistical terms. The model is based on
SVAR technique and is derived in two stages.

The first sets of equations explain the relationship between current

trade deficit and the three explanatory variables as a result of ‘test
down’ approach – fiscal deficit, openness of the economy, and
money supply.

y1t = 1y1t-p + 1x1t-p + 2x2t-p +e1t - q

x1t = 11y1t-p + 12x1t-p + 13x2t-p + e2t,
x2t = 21y1t-p + 22x1t-p + 23x2t-p + e3t
where E(e1t), E(e2t), and E(e3t) are equal to zero.

The symbol y1t stands for international trade balance in period t, X1t
is for fiscal deficit in period t, X2t is for money supply in period t; and
‘p’ and ‘q’ (= 3) represent number of lags.

The second set of equations determines the impact of trade balance,

fiscal deficit and foreign exchange reserves on external debt. It
should be noted that the two models are computed independently of
each other. This is done to gauge the impact of policy variables on
both trade deficit separately and then on external debt jointly with
trade deficit and fiscal deficit.

ed1t = 1ed1t-p + 1y1t-p + 2fx2t-p + 3fd3t-p + t-q

y1t = 11ed1t-p + 12y1t-p + 13fx2t-p + 14fd3t-p + t
fx2t = 21ed1t-p + 22y1t-p + 23fx2t-p + 24fd3t-p + t
fd3t = 31ed1t-p + 32y1t-p + 33fx2t-p + 34fd3t-p + t
Where E(1t), E(2t), E(3t), and E(4t), are equal to zero.

External debt ed1t is dependent up on y1t, the international trade

balance; ‘fx2t’ represents foreign exchange reserves, and ‘fd3t’
stands for fiscal deficit for period t.

The choice of explanatory variables in the final model is based on

sound economic hypothesis supported by highly significant statistical
values of model statistics given in Attachment 1. Results of impact
analysis are included in pertinent paragraphs under Conclusions.
Explanatory variables are deliberately chosen to be subject to
domestic and international policy influence. For instance, fiscal
deficit is a combined result of tax receipts and budget expenditure.
Even if total tax receipts are held constant, the composition of tax
receipts would have different impact on income distribution and
incentives. A few studies have traced the circular relationship
between reduction of fiscal deficit to increase in growth rate of GDP
leading to increased tax revenues and back to further lowering of
fiscal deficit. [13] Similarly, government expenditures will result in
different income multipliers depending on the portion spent on
productive endeavors, transfer income, etc. The level of fiscal deficit
along with money supply will determine price level, interest rate, and
preference between domestic savings and consumption. The
analysis, therefore, concentrates on using both fiscal deficit and
money supply as proxies or instrumental variables for a number of
underlying variables. The importance of money supply as a key
policy variable in international trade with floating exchange rate is
emphasized by Prof. J. Marcus Fleming in IMF Staff Papers. [11]

The VAR results reinforce the conclusion that fiscal deficit is a

significant causative contributor to trade deficit as well as external
debt per hypothesis proven in a number of studies referred to in this
paper. Finally, an increase in money supply without any change in
transaction demand for money would lower the rate of interest,
encourage consumption, and discourage investment. An increase in
consumptions, not accompanied by an increase in domestic
production, will encourage imports and could adversely affect trade
deficit. Thus positive sign of coefficient for money is consistent with
theoretical contention. The above analysis assumes a common
underlying trend of increase in openness in international trade with
reduced dispersion in rate of openness between trading nations.
Thus openness of an economy under globalization scenario can be
treated as a non-distinguishing variable for international comparison.

The second stage VAR analysis is for confirmation of an identity

which states that external debt is composed of fiscal deficit, domestic
savings gap in comparison to investment requirements, and
availability of foreign exchange reserves to service the external debt.
It should be noted that foreign exchange reserves are of strategic
value to a country beyond the need to service external debt. This is
where the identity becomes a cause and effect equation with
overriding policy factors playing a role. On the negative side, non-
availability of foreign exchange reserves could lead to default of
external debt. The fluctuations in level of foreign exchange reserves
brings into play intertemporal dimension of analysis.

Prior to dealing with debt stress, it is desirable to address the issue of

debt sustainability. Debt sustainability, as defined by IMF and the
World Bank [14] can be attained by bringing the net present value of
external public debt down to about 150 per cent of a country’s
exports or 250 per cent of a country’s revenues. These values were
later reduced to account for international market shocks on which an
individual country has no control. Currently, there is no single rule or
indicator to determine if a country has reached level of debt
sustainability or is on the path of external debt distress.

The VAR analysis conducted in this paper brings us to the underlying

issue: can the external debt stress be reduced through appropriate
policy measures? External debt stress is inability to service external
debt from domestically available funds in current and future periods
without recourse to additional external debt or rescheduling of
existing debt. [14] The second stage analysis relating external debt to
its causative components gives the extent of such debt stress at a
point in time. Debt servicing includes principle payment plus interest
on cumulated external debt in temporal sequence. The domestic
policy decisions necessary to correct the situation may not be
adequate to reduce the stress since the flow of FII also depends on
international market forces. Within a short four month period from
end of March 2008 to the first week in August 2008, there has been
an erosion of US$ 9.47 in global foreign exchange reserves because
of external events on which no single nation has any control. [15]

Repeating the nomenclature mentioned in Equation 1, where

cumulated external debt is given by ED, ‘t’ giving average term of
external debt, and ‘r’ as average rate of interest on cumulated
external debt; debt servicing requirements can be stated as:

External debt servicing requirements = ED/t + rED

The sources of funds to meet the above debt servicing requirements

are included in second stage VAR analysis mentioned in previous
sections. Conceptually, requirements and sources can be
graphically described as follows:

Debt Servicing
Funds

requirements
Available
Funds

Equilibrium Distress Point Years

Foreign debt equilibrium is that condition where available funds for

debt servicing are equal to debt servicing requirements
contemporaneously or graphically where the two curves intersect.
However, this equilibrium is inherently unstable. Any change in
available funds curve, given constancy of debt servicing
requirements and vice versa, will bring about a change in equilibrium
position. The position to the left of equilibrium represents surplus of
available funds while the zone to the right is potential default situation
on a temporal basis. On an intertemporal basis, a portion of surplus
accumulated in the past can be available for servicing the debt in a
later time period thus reducing the debt stress. It is for this reason
the debt distress point lies to the right of equilibrium. On an
intertemporal basis, a portion of surplus accumulated in the past can
be available for servicing the debt in a later time period thus reducing
the debt stress. This analysis of external debt sustainability needs to
be modified for two components of external debt appearing in capital
account – portfolio investment by foreign institutional investors and
short term trade credits in current account. These two elements
often account for up to 50 per cent of external liabilities and are
subject to variations in value. Further external forces, such as
exchange rates, [16] international price of oil and gold also
contributes to the fluctuations in foreign exchange assets. Thus the
reported level of foreign debt and foreign exchange coverage are
often biased. [17]

CONCLUSIONS
External debt stress point is not necessarily at the equilibrium of the
two but could extend to a later time period depending up on
intertemporal adjustments. This equilibrium is the trigger point for
undertaking preventive policy actions. Early warning indicators of the
stress point include unsustainable increase in fiscal deficit, an
increase in money supply and erosion of foreign exchange reserves.

Among domestic policy tools available, fiscal deficit is the key policy
variable in determining level of trade imbalance as well as level of
external debt. Impact analysis suggests that 1 per cent increase in
fiscal deficit brings about a 0.92 per cent increase in external debt.
When cumulative fiscal deficit exceeds a level where it appropriates
a substantial portion of government revenues for servicing the deficit,
a country reaches a point of no return in its fiscal balance. This point
has to be determined by each country and precautionary measures
should be instituted promptly.

Money supply is second most important domestic policy variable that

influences balance of trade. Higher money supply lowers interest
rate and encourages domestic consumption. An increase in money
supply is often accompanied by increased fiscal spending and should
be kept in check because it could start an inflationary spiral.

Balance of trade or trade deficit in turn impacts external debt. For

every 1 per cent of increase in trade deficit, external debt goes up by
0.49 per cent.

A decline of 1 per cent in foreign reserves increases requirement for

external debt by 0.35 per cent. Draft on foreign exchange reserves
for defense or emergency purposes is non-discretionary. It is,
therefore, necessary that only a portion of foreign exchange should
be included in resources available for servicing external debt.

Policy variables that are not under the control of a country are
subject to international market forces and actions of organizations
such as IMF, World Bank, and WTO. The ways in which a country
can exercise partial control on these forces are described in the
following paragraphs.

A country can exercise some control on the exchange rate through

the process of revaluation of its currency. Another non-market (or
non-floating) approach is to peg the exchange rate similar to actions
by China. By pegging the exchange rate for favorable results, China
has been able to accumulate $2 trillion in foreign exchange reserves.
If pegging avenue is utilized, it is better to peg an interval or a range
of rates rather than a specific rate for a limited time with the approval
of IMF and World Bank. Market forces will set the exchange rate
within this range indicating the direction the rate ought to be
prevailing in international exchange market. These options are
intended to reduce imports, increase exports and bring about a
favorable trade balance. The adverse consequence of such
unilateral actions is undervaluation of foreign exchange reserves in
terms of international currencies. A country should seriously analyze
the net impact of these actions on trade balance as well as foreign
exchange reserves in the context of degree of debt stress, prior to
initiating any such action that interferes with international market
forces. IMF and World Bank should monitor the situation and advise
the country about the desirability and duration of such actions.
These international bodies will in turn weigh the cost of relieving debt
stress in comparison to temporary distortions caused by unilateral
actions by the country.

The world oil price is not entirely market driven. The process
involves some degree of speculative activity that is not subject to
legal or regulatory oversight. The price of oil is also related to the
value of currency in which it is quoted. Thus a decrease in the value
of US$ will increase the price of oil without any significant change in
demand or supply. The best method of approaching this issue is to
take a three prong approach. First, reduce oil based energy use by
consuming less of it. This will have a negative impact on quantity of
oil consumed. Consuming less does not necessarily mean reduction
in standard of living if oil based energy output is used efficiently.
Governments can give impetus by increasing tax on oil and oil
derivatives which will reduce demand for oil. Second, a country
should explore new domestic source and improve domestic supply of
oil. It is desirable that this action does not negate consumption
reduction objective enunciated in first action but is designed only to
meet demand from new consumption units. Third, a country could
explore and utilize alternative sources of energy to reduce demand
for oil. As long as per unit cost of alternative sources of energy is
higher than comparative cost of oil, this option is not economically
feasible. To achieve this, a short term government subsidy for
exploration of alternative sources of energy can be effective.
Solutions mentioned in second and third approaches are long term
solutions and will not have any immediate impact.

The other variable could be the international gold prices. The

Washington Agreement on Gold (WAG), signed in September 1999,
limits gold sales by its members (Europe, United States, Japan,
Australia, Bank for International Settlements and the International
Monetary Fund) to less than 400 tons a year. During the recent past,
central banks and official organizations have held up to 20 per cent
of all stock of gold as official gold reserves. The demand for gold
and its price have increased during the period of economic
uncertainty. As it is for foreign exchange reserves, gold prices are
subject to fluctuations in the value of currency in which they are held.
A country can exercise limited control on international price of gold.

In international policy area, gold price may prove to be the most

difficult policy variable to manipulate. Oil prices will respond with a
time lag and exchange rates will require some international
cooperation. The influence of each policy variables on external debt
is limited individually but significant collectively. Thus, the policy
response for relief from debt stress or to prevent impending debt
stress will involve a combination of policy measures.

Although the conclusions are based on an analysis of data for India,

they are applicable to a number of other countries. A country should
develop a portfolio of policy packages that can be initiated when it
reaches equilibrium in external debt servicing requirements and
internal servicing sources. It is imperative that every country
develops these packages in cooperation with world organizations.
Such cooperation should not be viewed as relinquishing sovereignty;
it should be considered an extension of domestic policy in an
increasingly open world economy.
 ATTACHMENT 1 – VAR STATISTICS
Balance of Trade External debt
Fiscal Money Fiscal Trade FOREX
Lags in ( ) deficit supply Lags in ( ) deficit deficit reserves
Fiscal deficit (-1) Fiscal deficit (-1)
Coefficient -0.968 0.270 Coefficient 0.324 0.439 0.289
Standard error -0.109 -0.249 Standard error -0.324 -0.583 -1.259
t- statistics -8.900 1.088 t- statistics 0.999 0.754 0.230
Fiscal deficit (-2) Fiscal deficit (-2)
Coefficient -0.900 -0.183 Coefficient -0.118 -0.589 -0.048
Standard error -0.117 -0.267 Standard error -0.312 -0.561 -1.259
t- statistics -7.719 -0.687 t- statistics -0.377
Fiscal deficit (-3) Fiscal deficit (-3)
Coefficient -0.841 -0.030 Coefficient 0.464 -0.512 -0.768
Standard error -0.135 -0.309 Standard error -0.325 -0.585 -1.264
t- statistics -6.232 -0.097 t- statistics 1.426 -0.875 -0.608
Money supply (-1) Trade deficit (-1)
Coefficient -0.083 -0.633 Coefficient 0.070 0.407 -2.095
Standard error -0.078 -0.178 Standard error -0.196 -0.351 -0.760
t- statistics -1.339 3.564 t- statistics 0.358 1.157 -2.757
Money supply (-2) Trade deficit (-2)
Coefficient 0.128 -0.090 Coefficient 0.487 0.171 -1.112
Standard error -0.096 -0.219 Standard error -0.219 -0.394 -0.851
t- statistics 1.339 -0.413 t- statistics 2.222 0.433 -1.307
Money supply (-3) Trade deficit (-3)
Coefficient -0.011 0.539 Coefficient 0.540 -0.612 -2.175
Standard error -0.079 -0.181 Standard error -0.258 -0.464 -1.003
t- statistics -0.139 2.978 t- statistics 2.093 -1.319 -2.168
Constant FOREX reserv (-1)
Coefficient -20.084 -2.272 Coefficient 0.019 0.115 0.660
Standard error -14.927 -34.113 Standard error -0.108 -0.195 -0.421
t- statistics -0.939 -0.067 t- statistics 0.173 0.590 1.568
Balance of Trade FOREX reserv (-2)
Coefficient -0.314 0.959 Coefficient -0.120 1.299 0.445
Standard error -0.334 -0.764 Standard error -0.298 -0.535 -1.156
t- statistics -0.939 1.255 t- statistics -0.403 2.427 0.385
FOREX reserv (-3)
Coefficient 0.081 -1.167 1.647
Standard error -0.346 -0.622 -1.346
t- statistics 0.233 -1.874 1.224
Constant
Coefficient 1552.160 14870.990 32005.330
Standard error -28799.67 -10595.00 -22904.60
t- statistics 0.263 1.404 1.397
External debt
Coefficient 0.035 0.040 0.186
Standard error -0.059 -0.105 -0.228
t- statistics 0.605 0.375 0.817

R - squared 0.792 0.962 R - squared 0.987 0.959 0.989

F - statistic 15.249 101.422 F - statistic 82.622 25.409 97.314
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