OPTIMAL MACROECONOMIC POLICY RESPONSES TO AN INCIPIENT EXTERNAL DEBT CRISIS: THE CASE OF THE PHILIPPINES (OPTIMAL CONTROL, INTERNATIONAL FINANCE, DEVELOPING COUNTRIES)

The boom in commercial bank lending to less developed countries (LDCs) in the past ten years, which was seen as a timely response to oil price shocks and industrial recessions, has culminated in external debt crises in several major LDCs. This outcome suggests the need to identify an appropriate role for external debt among other macroeconomic policy responses for confronting external financial shocks. This study attempts to define such a role, using dynamic and optimal control simulations of a macroeconometric model of the Philippines. A large-scale disaggregated model was estimated, with full articulation of Philippine commodity sectors, the interaction of international financial flows with domestic monetary aggregates, and the external debt accounts. The study also clarified conceptual issues for measuring debt capacity, and defined measures for the sustainability of the debt situation. Dynamic simulations show that given an external financial shock, recourse to short-term external debt without the accompanying set of coordinated fiscal and monetary policies to distribute the burden of adjustment among the various macroeconomic goals, would likely result in an unsustainable debt situation. Dynamic simulations also evaluate institutional responses such as debt restructuring, rescheduling, and debt cancellation. Optimal control simulations derive a pattern of policy responses that avoid an unsustainable debt situation, given the same external financial shock. The optimal package assigns an important role to official compensatory financing to de-fuse an incipient debt crisis, and highlight the importance of determining whether the shock is temporary or is a permanent revision of the external balance position. The optimal package includes fiscal and monetary policies that encourage provate sector investment and autonomous portfolio capital inflows. This prescription is difficult to implement because in a period of uncertainty, the private sector could not usually be the leading growth sector. These and other real world constraints on the optimal solution suggest the need for other macro policy actions on the part of industrial countries for a satisfactory solution to the debt problem. Dynamic simulations measure the multiplier effect of such actions on the debt situation in the case of the Philippines