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Country risk, foreign borrowing, and the social discount rate in an open developing economy

  • Edwards, Sebastian

Most discussions on the social rate of discount have assumed that the economy under consideration is isolated from the rest of the world, and that there are no capital movements. This paper explicitly analyzes the determination of the social rate of discount in a small open developing economy. It is shown that under general conditions, the discount rate will bea weighted average of the marginal return to capital in the private sector(p), the rate of time preference (r), and the marginal cost of foreign indebtedness (n).It is also shown that unless the country faces an upward-sloping supply curve for foreign funds the weights of p and r will be zero. Finally, it is shown that if the country in question faces a foreign borrowing constraint imposed from abroad, the social rate of discount becomes equal to a weighted average of the domestic marginal return to capital and the rate of time preferences. Data for a group of LDCs is then used to show that financial markets have indeed attached a default country risk premium to LDCs. This provides some evidence in favor of the hypothesis that developing countries face an upward-sloping supply curve of foreign funds, and that, in general, the social rate of discount should be a weighted average of p, r and n. Finally,some numerical examples are used to show that ignoring the open economy aspects can result in a substantial overstatement of the social rate of discount.

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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 5 (1986)
Issue (Month): 1, Supplement (March)
Pages: S79-S96

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Handle: RePEc:eee:jimfin:v:5:y:1986:i:1:p:s79-s96
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  1. Sjaastad, Larry A & Wisecarver, Daniel L, 1977. "The Social Cost of Public Finance," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 513-47, June.
  2. Feder, Gershon & Just, Richard E., 1977. "An analysis of credit terms in the eurodollar market," European Economic Review, Elsevier, vol. 9(2), pages 221-243.
  3. Feder, Gershon & Ross, Knud Z, 1982. " Risk Assessments and Risk Premiums in the Eurodollar Market," Journal of Finance, American Finance Association, vol. 37(3), pages 679-91, June.
  4. Sandmo, Agnar & Dreze, Jacques H, 1971. "Discount Rates for Public Investment in Closed and Open Economies," Economica, London School of Economics and Political Science, vol. 38(152), pages 395-412, November.
  5. Findlay, Ronald & Wellisz, Stanislaw, 1976. "Project Evaluation, Shadow Prices, and Trade Policy," Journal of Political Economy, University of Chicago Press, vol. 84(3), pages 543-52, June.
  6. Nichols, Alan, 1969. "On the Social Rate of Discount: Comment," American Economic Review, American Economic Association, vol. 59(5), pages 909-11, December.
  7. Jeffrey Sachs & Daniel Cohen, 1982. "LDC Borrowing with Default Risk," NBER Working Papers 0925, National Bureau of Economic Research, Inc.
  8. Somers, Harold M, 1971. "On the Demise of the Social Discount Rate," Journal of Finance, American Finance Association, vol. 26(2), pages 565-78, May.
  9. Usher, Dan, 1969. "On the Social Rate of Discount: Comment," American Economic Review, American Economic Association, vol. 59(5), pages 925-29, December.
  10. Eduardo Morán & Gert Wagner, 1974. "Estimación de la Tasa de Retorno del Capital," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 11(34), pages 22-32.
  11. Hanson, James A, 1974. "Optimal International Borrowing and Lending," American Economic Review, American Economic Association, vol. 64(4), pages 616-30, September.
  12. Warr, Peter G & Wright, Brian D, 1981. "The Isolation Paradox and the Discount Rate for Benefit-Cost Analysis," The Quarterly Journal of Economics, MIT Press, vol. 96(1), pages 129-45, February.
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