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Class 13 and class 14 three analytical themes on development finance 2018

Development Finance, MPP, VJU

Prof. Koji Fujimoto

Class 13 and Class 14 Three Analytical Themes on Development Finance
Financing development can be partly understood by analyzing particular themes to which
development practitioners might have been seeking answers. In our present lecture, three
such themes are briefly analyzed below.
The themes are:
> Measuring Investment Needs for the Economic Growth of the Developing Country,
> Relationship between the Development Budget and the Balance of Payments for
Foreign Debt Management, and
> International Capital Needs/Availability for Economic Development of the Third
World.
The following analyses simply ‘scratch’ the surface. On the other hand, such analyses
suggest that they would become excellent research themes for future theses and
dissertations, once analytical methods are further elaborated and empirical analyses are
carried out after collecting statistical data.
1. Measuring Investment Needs for Economic Growth of the Developing Country
(1) Economic Growth and ICOR
The relationship between economic growth and ICOR is, in its simplest form,

expressed in the equation as follows,
∆Y/Y = I/Y ÷ I/∆Y (or ∆K/∆Y) ---------------------------------------------- (1)
where ∆Y/Y is Economic Growth Rate, I/Y is Investment Ratio and I/∆Y
(or ∆K/∆Y) is ICOR.
This equation implies that ICOR as well as the investment ratio play an important
role in promoting economic growth. The higher the ICOR becomes (other things
being equal), the lower the economic growth rate becomes. And, the higher the
investment ratio becomes, the higher the economic growth rate becomes (other
things being equal).
In developing countries, considerable attention and importance is given to ICOR
when analyzing economic growth. There are at least two major reasons. One is that
scarce capital is often the determinant of economic growth while labor tends to be
supplied in excess (on the contrary, in developed countries labor sometimes
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Development Finance, MPP, VJU

Prof. Koji Fujimoto

becomes the restrictive factor in determining economic growth because of
population decrease). The second reason is that it is often quite difficult to analyze
the production function where three factors of production (capital, labor and TFP)
are involved, as reliable data are not available.
The view above suggests how important it is to investigate investment in
analyzing economic development in developing countries. Let us, then, analyze a
specific investment need to attain a certain level of economic growth by a simple
case study by manipulating the equation (1).
The equation (1) is re-written by introducing a time-lag factor as follows.
(Yt – Yt-1)/(Yt-1) = (It)/(Yt-1) ÷ (It)/(Yt – Yt-1) ------------------------ (2)
Let us further assume that GDP in the year of t-1 is US$120 billion. In order
to attain an economic growth rate of 6% {Gt = (Yt – Yt-1)/Yt-1}, namely to attain
$127.2 billion, on condition that ICOR does not change from the previous year at
4.5, investment has to reach $32.4 billion (therefore, the investment ratio in the year
of t is 27%) in the year t.
Similarly, if an economic growth of 6.5% in the year of t+1 with ICOR of 4.5 is
desired, investment in the year of t+1 has to reach US$37.21 billion (the investment
ratio is 29.3%). The fact that ICOR stays constant at 4.5 and the economic growth
rate increases from 6% to 6.5% implies that a considerable increase in investment
is needed. Further, if we want to achieve an economic growth rate of 6.5%, in the


year of t+2 with ICOR {It+2/(Yt+2 – Yt+1)} of 4.2 (improved from previous 4.5 to
4.2), investment in the year of t+2 has to reach US$36.98 billion (a decrease of
US$0.2 billion, and the investment ratio 27.30%). The fact that ICOR is improved
from 4.5 to 4.2, while the aimed economic growth rate remains constant at 6.5%,
suggests that investment does not always need to be increased. As a matter of fact,
the amount of investment in year t+2 decreased slightly from that of year t+1 owing
to the improvement of ICOR.
The above equation (2) enables us to project economic growth rates and trends
based on past economic performances. In other words, once the GDP, investment
and ICOR are obtained on the basis of past economic performances, we can project
future economic growth for economic development planning. Table 1 below shows
what is discussed above more comprehensively over 4 years.
(Read Reference 1 Singer, H.W. “Is Development Economics Still Relevant ?”, and
comment on its contents.)
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Development Finance, MPP, VJU

Prof. Koji Fujimoto

Table 1 Economic Growth and Investment
G (%)
Year t–1

Y

Unit:$billion

∆Y

I

I/Y (%)

120.00

ICOR
4.5

Year t

6.0

127.20

7.20

32.40

27.3

4.5

Year t+1

6.5

135.47

8.27

37.21

29.3

4.5

Year t+2

6.5

144.27

8.81

36.98

27.3

4.2

(2) Public Sector Investment and Funding
Investment is broadly divided into two kinds; public investment and private
investment. The equations above include both public investment and private
investment. In other words, “I” denotes the total investment of both public and
private. As far as public investment is concerned, the government determines its
level when the budget is prepared on the basis of the economic growth target and
the assumed division of labor in investment. The simplest way of setting a level of
public investment is to divide the country’s required annual investment on a pro rata
and historical trend basis.
Once a level of public investment is determined, the government needs to secure
its sources. The government generally finances its investment expenditure
domestically through tax revenues and domestic government borrowing. If these
two measures suffice the investment expenditure requirement, the need to procure
funds from abroad both or either in the form of loan and/or grants does not exist.
Generally speaking, however, developing countries plan ambitiously to attain a high
economic growth in spite of budgetary constraints. They then turn around to request
industrialized countries and multilateral aid organizations to supplement their
financial shortages through ODA, OOF and PF. The developing countries, as a
matter of course, prefer and seek softer conditioned funds from abroad such as ODA.
In addition, it should be noted that a large number of developing countries have
long made it a rule to integrate foreign financial assistance into annual budgetary
procedures.
(3) The Case of REPELITA VI and Its Economic Growth Targets (Economic Growth
Rate, ICOR and Investment Ratio)
The Government of Indonesia set forth economic growth targets in the REPELITA
VI (1994~1998) plan as shown in table 2. Those targets suggest that the Indonesian
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Development Finance, MPP, VJU

Prof. Koji Fujimoto

Government, in an attempt to attain the economic growth rate of 6.2%, put special
emphasis on maintaining its investment ratio at a 27% or 28% level and to improve
investment efficiency by reducing ICOR from 4.5 (1994) to 4.3 (1998).
High economic growth and the stabilization of the external balance of payments
are twin macroeconomic objectives. However, if the economic structure remains
unchanged, these objectives are antinomic to each other. High economic growth
requires high investment and high investment results in considerable foreign
borrowing, which in turn deteriorates the external balance of payments. It is evident
that REPELITA VI tried to avoid this antinomy by improving investment efficiency
through a more efficient economic structural change.
It is, however, generally evidenced that ICOR deteriorates (increases)
temporality at the stage of “the pre-conditions for take-off into self-sustaining
growth” as public investment in new and renewal economic infrastructure
considerably increases. In order to decrease ICOR, the government has to continue
its policy reform efforts to create a more efficient economic structure through
deregulation, market liberalization and so on.
Table 2 REPELITA VI and Macroeconomic Targets
ICOR

Investment
Ratio (%)

Economic Growth
Rate (%)

1994

4.5

27.0

6.0

1995

4.5

27.0

6.0

1996

4.4

27.3

6.2

1997

4.4

28.2

6.4

1998

4.3

28.4

6.6

2. Relationship between the Development Budget and the Balance of Payments for
Foreign Debt Management
(1) Foreign Borrowing in the National Budget and Debt Repayment (Debt Service)
(i) State Budget System of the Developing Countries
The budget system in developing countries often consists of the “Development
Budget” and the “Routine (or Recurrent) Budget.” Needless to say, the budget
system has two sides for each budget, revenue and expenditure. There are, of course,
many developing countries whose budget system is characterized as one united
budget, not two types of budgets. This is increasingly true recently as the mid-term
expenditure review methodology has been widely introduced in developing
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Development Finance, MPP, VJU

Prof. Koji Fujimoto

countries. Indonesia, too, abandoned the traditional two-budget-system several
years ago. Even for the budget system which is not divided into two, we can
conceptually sort out the above discussion as shown in figure 1 below.
The domestic routine expenditure is intended to be used for the fixed annual
expenses and, therefore, it has to be spent every year, while the development
expenditure (domestic development expenditure and project aid expenditure) is
intended to be used for investment on the part of the government (public investment)
to achieve, say, 6% of country’s economic growth. As figure 1 below indicates, the
project aid expenditure, which is equal to the project aid revenue, is foreign capital
inflow (loans and grants) that is to supplement the domestic development
expenditure which aims to attain, for example, an economic growth of 6%. (Refer
to the Two Gap Model)
Figure 1 Structure of Budget System of Developing Country

Routine Budget

Revenue

Expenditure

Domestic Revenue

Domestic Routine
Expenditure

Domestic Revenue

Domestic Deveopment
Expenditure

Development Revenue
(Project Aid)

Project Aid
Expenditure

Development
Budget

(ii) State Revenue and Development Revenue ~ with an Interest in Indonesia~
The breakdown of state revenues of Indonesia in 1997/98 is shown below.
Revenues (in billion rupiah)
a. Domestic Revenues
① Oil and gas revenues
② Non-oil and gas revenues
 Income tax
 Value added tax
 Import duties
 Excise

Rp. 88,069.7
Rp. 14,871.1
Rp. 73,198.6
Rp. 29,117.1
Rp. 24,601.4
Rp. 3,321.7
Rp. 4,436.3
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Development Finance, MPP, VJU

Prof. Koji Fujimoto







Export tax
Land and building tax
Other taxes
Non-tax revenue
Net oil profit

Rp. 100.0
Rp. 2,505.0
Rp. 632.0
Rp. 8,225.8
Rp. 249.2

b. Development Revenue
Project Aid (Loans and Grants)

Rp. 13,026.0
Rp. 13,026.0

Generally speaking, in developing countries the government revenue tends to
fall short of the required routine and development expenditure. In order to
supplement the shortage, governments can issue government bonds (denominated
in domestic currency) and sovereign bonds (denominated in foreign currencies), or
borrow from foreign governments and MDBs in the form of ODA and /or OOF. In
the case of Indonesia, the government maintains a balanced budget meaning that
expenditures equal to revenues (including foreign, but not domestic borrowing).
“Project Aid” means, therefore, foreign borrowing. No domestic borrowing is
assumed.
(iii) State Expenditure and Foreign Debt Service
Expenditures (in billion rupiah)
a. Routine Expenditures
① Personnel Expenditures
 Salary and pension
 Rice allowance
 Food allowance
 Other domestic staff
expenditure

Rp. 62,167.8
Rp. 17,084.4
Rp. 1,309.5
Rp. 1,233.7
Rp. 1,009.9

 Other overseas staff
expenditure
② Expenditure on Goods
 Domestic purchases
 Overseas purchases

Rp.

590.5

Rp.
Rp.

8,478.0
417.2

③ Subsidies to Provincial and Local Government
 Personnel expenditure
Rp. 10,967.8
 Non-personnel expenditure
Rp. 568.0
④ Interest and Debt Repayment
 Domestic debt

Rp.
6

334.2


Development Finance, MPP, VJU

Prof. Koji Fujimoto

 Overseas debt

Rp. 19,236.7

⑤ Other Routine Expenditures

Rp.

b. Development Expenditures
① Rupiah Expenditures
② Project Aid

964.9

Rp. 38,927.9
Rp. 25,901.9
Rp. 13,026.0

Over the two oil crises of 1973 and 1978/79, many non-oil producing
developing countries accumulated foreign debt. The serious foreign debt problem
of the Third World prevailed during the ‘80s, which threatened to collapse the
international financial system. Fortunately, owing to enormous efforts by the
lenders of developed countries and borrowers of developing countries, the
international financial system survived. This experience demonstrated to us that
foreign debt management is one of the most important macroeconomic policies.
In other words, the government of developing country must grasp the real time
state of affairs on debt service obligation vis-à-vis their state budget. By doing so,
the government of any developing country can pursue a prudent debt management
policy.
The case of Indonesia above shows us that the foreign debt service shares
21%~22% against domestic revenues (total state revenue). This ratio is quite high,
but is presumably within the sustainable level.
On the other hand, the government needs to secure the development revenues
for development expenditures to attain their economic growth target, regardless
of the foreign debt services.
Another issue to which we have to pay attention to is that the figures of
“Development Expenditures” are shown in gross disbursement terms. Net
disbursement figures (“Project Aid Expenditures” minus “Overseas debt”) are
regularly used in DAC statistics. However, in our present analysis, net figures
proved to be not very useful.
(2) Relationship between Domestic Budget and Balance of Payments
In case that the government of a developing country secures revenues for
development expenditures in the form of project loan aid, figures which appear in
the Capital and Financial Account for the Balance of Payments are in conformity
with figures that appear in the Development Expenditures of the State Budget. To
be more specific, it should be elaborated as follows.
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Development Finance, MPP, VJU

Prof. Koji Fujimoto

 Gross disbursement figures that appear in the “Other Investment (Loan)” of
the “Capital and Financial Account” are equal to the gross disbursement
figures that appear in the “Development Project Aid (Loan)” of the
“Development Expenditures.”
 Gross disbursement figures that appear in the “Capital Account (Grant)” of
the “Capital and Financial Account” are equal to the gross disbursement
figures that appear in “Development Project Aid (Grant)” of the
“Development Expenditures.” As this case deals with grant project aid,
gross disbursement is equal to net disbursement.
From a viewpoint of debt servicing, the following two relationships need to be
pointed out.
 Gross figures of interest payments that appear as “Income” (of “Current
Account”) under the Balance of Payments are equal to figures of interest
payments that appear in the “Overseas debt” (of “Interest and Debt
Payment”) of the “Routine Expenditures.”
 Gross figures of principal repayment that appear as “Other Investment” (of
“Capital and Financial Account”) under the Balance of Payments are equal
to figures of principal repayment that appear as “Overseas debt” (of
“Interest and Debt Repayment”) of the “Routine Expenditures.”
It is difficult to evaluate the relationship between the development budget and
the balance of payments on an ex post basis. However, the kind of analysis shown
above helps to understand the relationship between the budget and the balance of
payments in terms of effective and efficient foreign debt management.
3. International Capital Needs/Availability for Economic Development of the Third
World
There are at least the following five types of capital fund flows into the Third World,
which are deemed to contribute to its economic development. The industrialized
countries should be bound to secure the maximum financial resources on those fronts.
(Read Reference 2 Rt. Hon Simon Upton, “What Should World Leaders Focus on at
the Johannesburg Summit?” 2002, and summarize and comment on its discussion
concisely.)
(1) Official Development Assistance
Since the Pearson Report of ’69, the targeted ODA of 0.7% of GDP of the donor
countries has not been attained. How can we possibly implement this promise and
when we meet this target, how much is available for the Third World?
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Development Finance, MPP, VJU

Prof. Koji Fujimoto

(2) Philanthropy
As a source of development assistance, philanthropy should be encouraged by the
international public or the civil society. How much, then, is available for the Third
World?
(3) Foreign Direct Investment (FDI)
FDI could be a driving force of economic development for developing countries. It
is expected that globalization helps to increase FDI in a more equitable manner. How
can we help promote FDI? How much FDI capital flow would be available for the
Third World?
(4) Trade Liberalization
A variety of trade barriers imposed by developed countries should be lifted. Trade
liberalization on the part of the developed world must give tremendous economic
benefits to the Third World. What would the value of trade liberalization be worth
to developing countries?
(5) Freer Movement of People including Migration
It is well known that expatriate remittances are one of the major foreign exchange
earnings for many developing countries. There are pros and cons on free movement
of people. However, these remittances contribute to economic development
considerably. How much more could developing countries benefit if the restriction
of freer movement of people in developed countries be allowed?


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Development Finance, MPP, VJU

Prof. Koji Fujimoto

(For reference)

Balance of Payments Headings

Current Account
Goods and Services
Trade Balance
Exports
Imports
Services
Income ・・・・・・・・・・・・・・・・・・・・・・・(Interest Payment, Remittance by
migrant workers, etc.)
Current Transfers ・・・・・・・・・・・ (Grants for consumer goods,
Contributions to international
organizations, etc.)
Capital and Financial Account
Financial Account
Direct Investment
Portfolio Investment
Other Investment ・・・・・・・・・・ (Loans, Trade Credits, etc.)
Capital Account ・・・・・・・・・・・・・・・・ (Grants for capital projects, etc.)
Changes in Reserve Assets
Errors and Omission

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