An Investigation into Causes, Effects and Cures for External Debt Distress - A Model Based on Case Study for India

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