5 capital flight exacerbates debt problems because

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5. Capital flight exacerbates debt problems because the government is left holding a greater external debt itself but may be unable to identify and tax the people who bought the central-bank reserves that are the counterpart of the debt, and now hold the money in foreign bank accounts. To service its higher debt, therefore, the government must tax those who did not benefit from the opportunity to move funds out of the country. There is thus a change in the domestic income distribution in favor of people
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182 who are likely to be quite well-off already. Such a regressive change may trigger political problems. 6. There may have been less lending available to private firms than to state-owned firms if lenders felt that state guarantees ensured repayment by state-owned firms. (In some cases, such as that of Chile, however, the government was pressured ex post into taking over the debts even of private borrowers.) Private firms may also have faced more discipline from the market -- their operating losses are unlikely to be covered with public revenues. Private firms would therefore have had to restrict borrowing to investment projects of high quality. 7. By making the economy more open to trade and to trade disruption, liberalization is likely to enhance an developing country's ability to borrow abroad. In effect, the penalty for default is increased. In addition, of course, a higher export level reassures prospective lenders about the country's ability to service its debts in the future. Finally, by choosing policies which international lenders consider sound, such as open markets, countries improve lenders assessment of their credit-worthiness. 8. Cutting investment today will lead to a loss of output tomorrow, so this may be a very short-sighted strategy. Political expediency, however, makes it easier to cut investment than consumption. 9. Peter Kenen first proposed the IDDC plan in 1983, before there was a secondary market for debt. Even with a secondary market, there is scope for the IDDC to help debtor countries since it would alter the terms of their loans and provide some debt relief. There are some potential problems with the IDDC. First, the debt that banks would be willing to sell to the IDDC is that which is least likely to be repaid. Kenen argues that this problem could be avoided by forcing banks to sell baskets of debt, offering some or all of their claims on all participating debtor countries. There is also the so-called moral hazard problem; a debt relief scheme would invite debtors to pursue policies that would increase rather than reduce the size of their debt. Another obstacle is the free-rider problem; if one bank believes that other banks or the IDDC will grant debt relief, which improves the debtor's ability to repay, there is an incentive for that bank to demand a higher price from the IDDC, or to refuse to participate in the IDDC scheme.
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183 10. If Argentina dollarizes its economy, it will buy dollars from the United States with goods, services, and assets. This is, in essence, giving the US Federal Reserve assets for green paper to use as domestic currency. Since Argentina already operates a
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