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Country Risk, Foreign Borrowing and the Social Discount Rate in an Open Developing Economy

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  • Sebastian Edwards

Abstract

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.

Suggested Citation

  • Sebastian Edwards, 1985. "Country Risk, Foreign Borrowing and the Social Discount Rate in an Open Developing Economy," NBER Working Papers 1651, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1651 Note: ITI IFM
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    1. Nichols, Alan, 1969. "On the Social Rate of Discount: Comment," American Economic Review, American Economic Association, vol. 59(5), pages 909-911, December.
    2. Jeffrey Sachs & Daniel Cohen, 1982. "LDC Borrowing with Default Risk," NBER Working Papers 0925, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Aizenman, Joshua, 1990. "External debt, planning horizon, and distorted credit markets," Journal of International Money and Finance, Elsevier, vol. 9(2), pages 138-158, June.
    2. Aizenman, Joshua, 1991. "Trade dependency, bargaining and external debt," Journal of International Economics, Elsevier, vol. 31(1-2), pages 101-120, August.
    3. Wang, Alan T. & Yang, Sheng-Yung & Yang, Nien-Tzu, 2013. "Information transmission between sovereign debt CDS and other financial factors – The case of Latin America," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 586-601.
    4. Kent P. Kimbrough & Kent P. Kimbrough, 1988. "Optimal Tax Policy for Balance of Payments Objectives," NBER Chapters,in: International Aspects of Fiscal Policies, pages 309-348 National Bureau of Economic Research, Inc.
    5. Aizenman, Joshua, 1991. "Inward versus Outward Growth Orientation in the Presence of Country Risk," Economica, London School of Economics and Political Science, vol. 58(229), pages 57-77, February.
    6. Karbowski, Adam, 2016. "Discussion on the Social Rate of Discount: from Sen to Behavioural Economics," EconStor Open Access Articles, ZBW - German National Library of Economics, pages 46-60.
    7. Levy, Nadav & Pauzner, Ady, 2014. "Government's credit-rating concerns and the evaluation of public projects," Journal of Public Economics, Elsevier, vol. 115(C), pages 117-130.
    8. Juan Andrés Fontaine, 1994. "Inversiones Extranjeras por Fondos de Pensiones: Efectos sobre la Política Macroeconómica," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 31(93), pages 161-184.
    9. Joshua Aizenman, 1987. "Investment, Openness, and Country Risk," NBER Working Papers 2410, National Bureau of Economic Research, Inc.
    10. Joshua Aizenman, 1986. "Country Risk, Asymmetric Information and Domestic Policies," NBER Working Papers 1880, National Bureau of Economic Research, Inc.

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