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This paper analyzes the borrowing behavior of a small open economy of a Less Developed Country (LDC) that relies heavily on imports for its capital formation and faces an upward sloping supply function of foreign loans, in an environment where decision makers face uncertainty about the longevity of external shocks. First, a dynamic general equilibrium model is developed which replicates fairly well the business cycle properties of the LDC data. Second, it is shown that uncertainty concerning the longevity of shocks (a relevant type of uncertainty, especially for LDCs) generates forecast errors that are autocorrelated in a way that is similar to Bayesian learning in the “peso problem.” This autocorrelated forecast errors can generate substantial debt accumulation. Third, it is shown that the assumption of an upward sloping supply function of foreign loans, which is a more realistic assumption for LDCs than the usual perfectly elastic one, offers an alternative to the Uzawa-type utility function for the analysis of asset accumulation in the small open economy framework.

In policy debates it is often argued that the foreign debt build-up by developing countries was essentially the result of their overborrowing and private banks over lending.1 If this argument is true, it remains to be shown why developing countries and private banks exhibited this excessive behavior. The usual supply-side explanation is that overborrowing during the 1970s was the result of very large OPEC surpluses searching for investment opportunities. The usual demand-side explanation is that overborrowing resulted from developing countries’ high growth, improving terms of trade, and low world interest rates. It is also widely believed that developing countries borrowed heavily on international financial markets based on the perception that this favorable external environment would last.2 But, the commodity price booms of the mid- and late 1970s were short-lived and the period of low interest rates ended by the early 1980s. To what extent did uncertainty about the external environment contribute to developing countries’ debt accumulation? It is reasonable to believe that their borrowing behavior will depend crucially on the perceived longevity of shocks. This paper analyzes the borrowing behavior of a small open economy that is subject to terms of trade and world interest rate shocks in an environment where policy makers face uncertainty about the longevity of shocks. In particular, the analysis focuses on the conditions under which an optimistic view (that is alleged to have prevailed among developing countries during the debt accumulation period) about the longevity of external shocks, leading to overestimating the longevity of positive external shocks or underestimating the longevity of negative external shocks, can lead to significant debt accumulation. It is found that this optimistic view is compatible with rational behavior and can generate persistent overborrowing, making debt accumulation likely. The paper does not argue that debt accumulation is non-optimal. In fact, it is shown that debt accumulation may arise as a rational response to uncertainty in international markets. However, debt accumulation increases the vulnerability of the debtor to interest rate fluctuations, as was documented dramatically during the debt crisis. The paper also does not argue that uncertainty was the main cause of debt accumulation in developing countries. Rather, it may have been simply a contributing factor. The justification for focusing on terms of trade and world interest rate shocks is twofold. First, the terms of trade determine the purchasing power of developing countries’ exports. Scarce foreign exchange is essential for development because developing countries rely on imports of investment goods for their capital formation. Second, world interest rates determine both the cost of new borrowing and the cost of servicing the debt outstanding. The framework used is a stochastic dynamic general equilibrium model that captures some important characteristics of developing economies. The stylized developing economy relies heavily on imports for capital formation and has imperfect access to international financial markets in the sense that the economy faces an upward-sloping supply function of foreign loans. This assumption has strong empirical support. It also offers an interesting alternative to the Uzawa-type utility function for analyzing asset accumulation in a small open economy. Finally, the model economy is characterized by an imperfect information structure where decision makers are uncertain about the longevity of external shocks. The contribution of this paper is threefold. First, a dynamic general equilibrium model is developed that replicates fairly well the business cycle properties of the developing countries’ data. Second, it is shown that uncertainty concerning the longevity of shocks (which is a very relevant type of uncertainty, especially for developing countries) generates forecast errors that are autocorrelated in a way that is similar to Bayesian learning in the “peso problem” (Lewis, 1989). These autocorrelated errors can generate substantial debt accumulation. Third, it is not possible to analyze foreign asset accumulation with a variable interest rate within the standard small open economy framework. Under the usual assumption of a fixed discount factor, and given that the world interest rate is exogenous to the small open economy, the rate of time preference must equal the world interest rate to ensure the existence of a stationary equilibrium.3 Obstfeld (1982), followingUzawa (1968), solved this problem by endogenizing the time preference parameter, making it a function of the utility level. More recently, Mendoza (1995) used this approach in the context of a real business cycle model of a small open economy. The approach implies that the steady-state utility level is exogenously determined, leading to a saving target, that is, regardless of the nature and size of the exogenous shock, the economy will save enough to achieve the fixed steady-state utility level. Another approach, attributed to Blanchard (1985) and applied in the context of a small open economy by Cardia (1991), is to assume a finite probability of death. Then, the world interest rate and the subjective discount rate do not necessarily have to be equal, and the difference between them becomes a function of financial wealth. This paper explores an alternative approach. Instead of making the time preference vary in order to generate well-defined dynamics around a stationary equilibrium, it is the domestic interest rate that adjusts so as to equalize the time preference and the marginal cost of borrowing in equilibrium. This adjustment will be achieved by assuming an upward-sloping supply function of foreign loans, which is a more realistic assumption for developing countries than the usual perfectly elastic alternative. “. . . developing countries typically face an upward-rising supply curve of capital funds.” Harberger (1985, p. 236). The remainder of the paper is organized as follows. Section 2 develops the model. Section 3 describes briefly the solution procedure and the model calibration, and Section 4 presents the results. Some concluding observations are contained in the final sections.

This paper analyzes the borrowing behavior of a small open economy that relies heavily on imports for its capital formation and faces an upward-sloping supply function of foreign loans, in an environment where decision-makers face uncertainty about the longevity of external shocks. The model replicates fairly well the business cycle properties of developing countries’ data. It is shown that uncertainty concerning the longevity of shocks generates forecast errors that are autocorrelated even when decision makers use rationally all the information available. These autocorrelated forecast errors can generate substantial debt accumulation. In particular, decision makers tend to overborrow during periods of negative, permanent external shocks (permanent declines in the terms of trade and permanent increases in the world interest rate) and during periods of positive transitory external shocks, even under the rationality paradigm. Furthermore, this overborrowing behavior can be relatively persistent, generating debt accumulation especially if shocks are highly unpredictable. This finding supports the view that the short-lived commodity booms of the 1970s may have done more harm than good by encouraging some developing countries to overborrow, contributing to their debt accumulation and, hence, increased their vulnerability to the exceptionally high interest rates of the early 1980s. Using estimates of the transitory terms of trade shocks in 1974 and 1977, the model yields an overborrowing effect of 32 percent of GDP. Finally, it is worth stressing that other mechanisms can lead to overborrowing, uncertainty about the longevity of external shocks is only one of them. This is especially true if one is ready to depart from the full rationality of all agents. For example, the explicit or implicit government guarantee of foreign debt has certainly contributed to debt accumulation in many countries.