Economic Development and Globalisation: Question 9

Worked solution

Part (a): Bilateral versus multilateral aid

Bilateral aid is aid given directly by the government of one country to the government of another, on a government-to-government basis, for example, a grant or loan given directly by a wealthy donor country’s government straight to Meridor’s government.

Multilateral aid is aid channelled through an international organisation, such as the World Bank or the International Monetary Fund (IMF), which pools contributions from many different donor countries and then distributes the combined funds to recipient countries such as Meridor.

Part (b): The debt service ratio

The debt service ratio measures debt-service payments as a percentage of export earnings:

$\text{Debt service ratio} = \frac{\text{Debt service payments}}{\text{Export earnings}} \times 100 = \frac{0.9}{4.5}\times100 = 20\%$

A debt service ratio of $20\%$ is generally regarded as a heavy burden: it means that a full fifth of everything Meridor earns from selling goods and services abroad has to be set aside just to keep up with interest and principal repayments on its existing debt, rather than being available to pay for imports of capital goods, machinery, or spending on development priorities such as health and education.

Part (c): A cause and a consequence of Meridor’s high external debt

Cause: Countries such as Meridor often build up large external debts by borrowing heavily, frequently at variable interest rates, to finance infrastructure projects (roads, power stations, ports) that are expected to support future growth, or simply to cover persistent budget or current account deficits. If global interest rates subsequently rise, or if Meridor’s export revenues (for example, from a key commodity) fall, the cost of servicing this already-large stock of debt increases sharply relative to the foreign currency Meridor actually earns, even without any new borrowing.

Consequence: If the debt burden keeps growing, an ever-larger share of Meridor’s foreign currency earnings and government revenue must be diverted to debt-service payments. This creates a significant opportunity cost: resources that could otherwise fund health, education, or infrastructure investment are instead used to service past borrowing, which can slow the very development that the original borrowing was meant to support, and may eventually force Meridor into a debt crisis requiring emergency support (often with attached conditions).

Part (d): Is more aid necessarily the best solution?

Case for aid helping: Additional aid, particularly in the form of grants (which do not need to be repaid), could directly ease Meridor’s foreign currency constraints without adding to its debt stock, potentially freeing up domestic resources that would otherwise go towards debt service.

Case against aid being the best/only solution:

• Aid flows are often small relative to the scale of debt-service payments a country like Meridor faces, so aid alone may not resolve the underlying burden.
• A significant share of aid is provided as loans rather than grants. This itself adds to external debt rather than reducing it, potentially worsening the very problem it is meant to solve.
• Aid can come with conditions attached, or be undermined by governance problems (corruption, weak institutions) in the recipient country, reducing its effectiveness.
• Aid dependency can also reduce the recipient government’s incentive to pursue reforms that would address the debt burden more sustainably.

Judgement: Alternatives such as formal debt relief or restructuring (writing off or rescheduling existing debt) or policies to boost Meridor’s own export earnings (raising the denominator of the debt service ratio directly) may tackle the debt burden more directly than aid alone. Overall, whether more aid helps depends heavily on its form, grants are far more likely to ease the debt burden than loans, so aid is not necessarily the best solution, even though well-designed aid can play a useful supporting role.

Final answers

• (a) Bilateral aid = government-to-government; multilateral aid = channelled through an international organisation (e.g. World Bank, IMF) pooling many donors
• (b) Debt service ratio $=$ 20%, a heavy burden on Meridor’s export earnings
• (c) Cause: past borrowing (often at variable rates) for infrastructure/deficits, worsened by rising interest rates or falling export revenue; consequence: debt service crowds out health/education/infrastructure spending
• (d) Not necessarily, depends on whether aid is grants (helps) or loans (adds to debt), conditions attached, and whether alternatives like debt relief or export growth are also pursued