Sources of Debt Accumulation in a Small Open Economy

In policy debates it is often argued that the foreign debt build-up by developing countries was essentially the result of their overborrowing and private banks over lending.2 If this argument is true, we must understand why developing countries and private banks exhibited this excessive behavior. The usual supply-side explanation is that overborrowing during the 1970s was the result of very large OPEC surpluses searching for investment opportunities. The usual demand-side explanation is that overborrowing resulted from developing countries' high growth, improving terms of trade, and low world interest rates. It is also widely believed that developing countries borrowed heavily on international financial markets based on the perception that this favorable external environment would last.3 But, the commodity price booms of the mid- and late 1970s were short-lived and the period of low interest rates ended by the early 1980s.