Should the West Lend to the East?
Lessons from Developing Countries

At a lunchtime meeting on 11 October, Daniel Cohen presented the results of his recent research into the implications of Western lending to the Third World for the new market economies of Eastern Europe and the Soviet Union. Cohen is Professor of Economics at the Université de Paris I (Panthéon-Sorbonne) and CoDirector of the International Macroeconomics programme of the Centre for Economic Policy Research. The meeting formed part of CEPR's research programme on Economic Transformation in Eastern Europe, supported by the Commission of the European Communities under its SPES and ACE programmes and by the Ford Foundation. His remarks were based in part on his CEPR Discussion Paper No. 539, `The Solvency of Eastern Europe' , which was prepared with financial support from the Commission of the European Communities within the framework of the PHARE programme to assist the countries of Central and Eastern Europe, and which is also available in Special edition no. 2 of European Economy, `The Path of Reform in Central and Eastern Europe', July 1991. The views expressed by Professor Cohen were his own, however, and not those of the above organizations nor of CEPR, which takes no institutional policy positions.
Cohen focused initially on the proposition that foreign finance may act as a spur to developing countries' growth. Both East European and developing economies may seek to remedy their shortages of indigenous physical capital with imports from the industrialized world if external finance is available, but they differ markedly in other respects. Private agents in LDCs have considerable practice of operating in a market environment despite severe distortions since they have long traditions of owning private property. On the other hand, according to all the traditional indicators, East European countries have much higher literacy rates and better endowments of human capital than almost all Third World countries.
In the developing countries during 1973-90, growth was generally lower in countries that borrowed than in those that did not, largely as a result of the interest rate shocks the high debtors suffered in the 1980s. Even data for the 1970s indicate, however, that the borrowers' growth rates were only marginally higher than the nonborrowers'; so it is far from clear that access to foreign capital acted as a spur to their growth. Both general and specifically earmarked lending are highly prone to leakage, and estimates indicate that only one-third of total investment lending to the Third World over this period was in fact used for that purpose.
Cohen noted that developing countries' `growth catch-up' has been remarkably small relative to the predictions of traditional growth theory: that the productivity of capital should be high where it is scarce. This finding challenges the traditional view that capital is most productive in poor countries, and it at least suggests the alternative hypothesis that an abundance of productive capital is associated with a wide variety of goods and qualified labour. This implies in turn that the developing countries will never catch up with the income levels of the industrialized West; but the empirical evidence remains mixed.
Cohen reported the results of applying this `new' growth theory, focusing on levels of income and education, to the East European economies to project the pattern of their future development. Assuming that their growth during 1990-2015 replicates the patterns that an economy with similar initial factor endowments would have followed during 1965-90, he found that Eastern Europe will attain in 2015 an average level of development similar to that of Belgium in 1990.
Cohen then applied various measures to assess the solvency of the East European economies. Hungary is the region's biggest per capita debtor in per capita terms by a wide margin, with a 1989 per capita debt of $4,261 some 50% greater than either Bulgaria or Poland. Calculations of a `growth-adjusted' measure of the East European countries' 1989 debt burden (in terms of the `debt per capita equivalent' for the USA in 1980 and corrected for growth prospects) also indicate that Hungary is the most highly indebted, with a growth-adjusted per capita debt of $3,041 comparable to that of the Ivory Coast. Poland and Bulgaria, with figures of $1,704 and $1,573 respectively, are also large debtors according to this measure broadly comparable to Argentina or Venezuela.
Cohen also reported an econometric study of the secondary market in East European debt, in which he found that if Hungary behaved as a typical debtor towards the international financial system its debt should be traded at a discount of some 70%. This result is surprising, since Hungary is viewed on the secondary markets as one of Eastern Europe's better risks, essentially because it has never rescheduled its debt. Nevertheless, these results imply that the key issue is not whether the West should embark on a new round of lending to the East, but rather whether it should forgive Eastern Europe's existing debt.
Cohen noted in conclusion that differences in developing countries' economic growth have been largely determined by their rates of domestic saving. Investing 1% of GDP typically adds 0.15% to developing countries' annual growth rates; so LDCs that typically invest some 20% of their income have grown at 3%, while Korea, by investing some 40%, has grown by about 6% per annum. In relation to these figures, foreign lending has had only negligible effects. East European countries should therefore learn from the developing countries' experience and limit their use of external debt to smoothing the cycles resulting from fluctuations in the terms of trade.