Foreign borrowing benefits a developing country by promoting growth and helping the economy to adjust to internal and external shocks. In recent years foreign borrowing has been used in several distinct ways. From the mid-1960s to the early 1970s, financing was predominantly from official sources for specific investments. It resulted in accelerated economic growth, thus maintaining or improving capacity to service the rising debt. Borrowing for balance of payments purposes was limited. Between 1973 and 1978, although a high proportion of borrowed resources continued to flow into investment, the low cost of financing led to the rechannelling of some borrowing to finance of balance of payments and fiscal deficits. This had the effect of diminishing the potential gains. The use of borrowing for balance of payments and fiscally related finance increased from 1979 to 1982, often primarily to postpone, rather than buy time for, structural adjustment, thus contributing little to growth. Since 1982, net capital flows have diminished considerably and become linked to debt-servicing and balance of payments difficulties.
Although a developing country's economic policy is the basic determinant for the level of capital inflow, how efficiently it is used and how readily the debt can be serviced, failure in economic policy is only one cause for debt-servicing problems. Neither sound macroeconomic policies nor less borrowing could have avoided all the difficulties which arose in the early 1980s at a time of unusually severe recession and rising interest rates. But the effects of even the most severe external shocks can be cushioned if policy-making and economic structures are flexible to changing demands. An inflexible economy with a modest debt service ratio may be more prone to crisis than one with a higher ratio but with a government that takes rapid corrective action when growth and exports are threatened.
Each country has to make its individual decision on borrowing policy which will depend on the external environment that it faces in world trade and capital markets, its natural and human resources and its economic and political structures. Economic policies which result in large budget deficits and overvalued exchange rates, and which discourage domestic savings, may unintentionally bias an economy toward relying on borrowing from abroad. By consciously avoided big fiscal deficits and distortions of prices and exchange rates a country can avoid this problem. Sharp changes in terms of trade can also cause macroeconomic imbalances. For example, many countries resorted to foreign borrowing in the 1970s to finance what was expected to be an only temporary large external resource gap.
Since not all developing countries have access to all types of foreign capital their borrowing experiences and the current size and composition of their debt will vary. As a country's economy progresses its opportunity to borrow commercially grows; the greater the per capita income the greater the access to private sources of finance as opposed to reliance on concessional funds. But external factors are important too. In a commodity boom such as the 1970s, many middle-income and even low-income countries find they can borrow from foreign banks, the loans often being only marginally related to project viability. The result is that projects run into difficulty, commodity prices fall and the banks stop lending. Available financing is currently often linked with debt-servicing and balance of payments difficulties and is more closely tied to programmes of structural adjustment. This has meant a positive contribution to establishing a basis for recovery in growth, especially among the largest borrowing countries. New commercial finance now only available for trade and project-related purposes and only to the few developing countries that have managed to maintain a high standard of creditworthiness.
Borrowing has many potential disadvantages. Loans can be wasted on inefficient investment or promote delay in essential economic reforms. As debt accumulates the economy becomes more vulnerable to financial pressures from the world economy.