1 4 • F O R E I G N A S S I S TA N C E , A I D , D E B T A N D D E V E L O P M E N T 417

exchange i , to achieve a aster rate o growth and development, the gap between oreign
exchange earnings rom exports and necessary imports is larger than the domestic investment–
savings gap, and domestic and oreign resources are not easily substitutable or one another.
Foreign borrowing must ll the larger o the two gaps i the target growth rate is to be achieved.
Te historical sequence o experience originally suggested by Chenery was that countries in the
pre-take-of stage o development would have a dominant investment–savings gap, ollowed by
a dominant oreign exchange gap, with the possibility o a skill constraint at any stage. Most o
today’s developing countries, apart rom China and the oil-exporting countries, have a dominant
oreign exchange gap, which mani ests itsel in a chronic balance o payments de cit on the
current account, while domestic resources lie idle. Tese de cits require nancing not only in the
interests o the countries themselves, but or the sake o the growth momentum o the whole
world economy. Tere is an interdependence in the world economic system because countries
are linked through trade. Te alternative to the nancing o de cits is adjustment by de ation to
reduce imports, which means slower growth in the world economy as a whole.
I the historical experience o developed countries is considered, in cases where borrowing
took place (mainly rom Britain as the major creditor), the borrowing was ultimately converted
into an export surplus, which enabled the borrowing country to repay its debt and become a net
creditor. Te condition or this to happen is that the marginal savings ratio should exceed the
average savings ratio in order to eliminate the investment–savings gap, i that is the dominant
constraint, or that the marginal propensity to export should exceed the marginal propensity to
import i oreign exchange is the dominant constraint. For most developing countries today, there
is little evidence that they have either the desire or the option to reduce the level o net resource
in ows without a major disruption o their economies. Te need or resources is as acute as ever,
because o a dominant oreign exchange gap to meet development requirements and to pay inter-
est and amortization on past borrowing. Developing countries nd it di cult to convert domes-
tic resources into oreign exchange in adequate quantities, not only cyclically when the world
economy is depressed, but also secularly owing to their economic structure; that is, they produce
goods whose demand tends to be both price and income inelastic in world trade.
In the rst edition o this textbook (Tirlwall, 1972), I predicted that:

unless something is done the debt-servicing problem arising rom mounting resource ows
may well become unmanageable in the not too distant uture. It will certainly be a long time
be ore these countries become net exporters o capital even in the absence o an investment–
savings gap.

Tis has turned out to be true. Developing countries continue to borrow extensively; their debt
now stands at over $5,000 billion, and over $250 billion ows out o developing countries each
year to service the debts.

Dual-gap analysis and oreign borrowing

In national income accounting, an excess o investment over domestic saving is equivalent to a
surplus o imports over exports. Te national income equation can be written rom the expend-
iture side as:

Income 5 Consumption 1 Investment 1 Exports 2 Imports

418 FINANCING ECONOMIC DEVELOPMEN

Since saving is equal to income minus consumption, we have:

Saving 5 Investment 1 Exports 2 Imports

or:

Investment 2 Savings 5 Imports 2 Exports

A surplus o imports over exports nanced by oreign borrowing allows a country to spend more
than it produces or to invest more than it saves.
Note that, in accounting terms, the amount o oreign borrowing required to supplement domes-
tic savings is the same whether the need is just or more resources or capital ormation or or imports
as well. Te identity between the two gaps, the investment–savings (I − S) gap and the import–
export (M − X) gap, ollows rom the nature o the accounting procedures. It is a matter o arithmetic
that i a country invests more than it saves, this will show up in the national accounts as a balance o
payments de cit. Or, to put it another way, an excess o imports over exports necessarily implies an
excess o the resources used by an economy over the resources supplied by it, or an excess o invest-
ment over saving. Tere is no reason in principle, however, why the two gaps should be equal ex ante
(in a planned sense); that is, that plans to invest in excess o planned saving should exactly equal plans
to import in excess o plans to export. Tis is the starting point o dual-gap analysis.
Be ore going into dual-gap analysis in more detail, a reminder o elementary growth theory is in
order. Growth requires investment goods, which may be provided domestically or purchased rom
abroad. Te domestic provision requires saving; the oreign provision requires oreign exchange.
I it is assumed that some investment goods or growth can be provided only rom abroad, a
minimum amount o oreign exchange is always required to sustain the growth process. In the
Harrod model o growth (see Chapter 4), the relation between growth and saving is given by the
incremental capital–output ratio (c), which is the reciprocal o the productivity o capital (p),
that is, g 5 s/c or g 5 sp, where g is the growth rate and s is the saving ratio. Likewise, the growth
rate can be expressed as the product o the incremental output–import ratio (DY/M 5 m’)
and the ratio o investment-good imports to income ([M/Y] 5 i), that is, g 5 imr.
I there is a lack o substitutability between domestic and oreign resources, growth will be con-
strained by whatever actor is the most limiting – domestic saving or oreign exchange. Suppose,
or example, that the growth rate permitted by domestic saving is less than the growth rate per-
mitted by the availability o oreign exchange. In this case, growth will be savings-limited and i
the constraint is not li ted, a proportion o oreign exchange will go unused. For example, sup-
pose that the product o the savings ratio (s) and the productivity o capital (p) gives a permis-
sible growth rate o 5%, and the product o the import ratio (i) and the productivity o imports
(m9) gives a permissible growth rate o 6%. Growth is constrained to 5%, and or a given m9, a
proportion o the oreign exchange available cannot be absorbed (at least or the purposes o
growth). Some oil-exporting countries all into this category; they cannot use all their oreign
exchange. Conversely, suppose that the growth rate permitted by domestic savings is higher than
that permitted by the availability o oreign exchange. In this case, the country will be oreign
exchange-constrained and a proportion o domestic saving will go unused. Most developing
countries all into this category. Te policy implications are clear: there will be resource waste as
long as one resource constraint is dominant. I oreign exchange is the dominant constraint, ways
must be ound o using unused domestic resources to earn more oreign exchange and/or raise
the productivity o imports. I domestic saving is the dominant constraint, ways must be ound
 1 4 • F O R E I G N A S S I S TA N C E , A I D , D E B T A N D D E V E L O P M E N T 419

o using oreign exchange to augment domestic saving and/or raise the productivity o domes-
tic resources (by relaxing a skill constraint, or example). (I there were complete substitutability
between imports and domestic resources, any surplus o domestic resources could be immedi-
ately converted into oreign exchange, and any surplus o oreign exchange could be immediately
converted into domestic resources, and there could only be one gap, ex ante, as well as ex post.)
Suppose now a country sets a target rate o growth, r. From our simple growth equations
(identities), the required savings ratio (s*) to achieve the target is s* 5 rc, and the required import
ratio (i*) is i* 5 r/m9. I domestic saving is calculated to be less than the level required to achieve
the target rate o growth, an investment–savings gap is said to exist equal at time t to:

It 2 St 5 s*Yt 2 sYt 5 (rc)Yt 2 sYt (14.1)

Similarly, i minimum import requirements to achieve the growth target are calculated to be
greater than the maximum level o export earnings available or investment purposes, there is
said to exist an import–export gap, or oreign exchange gap, equal at time t to:

Mt 2 Xt 5 i*Yt 2 iYt 5 (r/ m')Yt 2 iYt , (14.2)

where i is the ratio o imports to output that is permitted by export earnings. I the target growth
rate is to be achieved, oreign capital ows must ll the larger o the two gaps. Te two gaps are
not additive. I the import–export gap is the larger, then oreign borrowing to ll it will also ll the
investment–savings gap. I the investment–savings gap is the larger, oreign borrowing to ll it will
obviously cover the smaller oreign exchange gap.
Te distinctive contribution o dual-gap analysis to development theory is that i oreign
exchange is the dominant constraint, it points to the dual role o oreign borrowing in supple-
menting not only de cient domestic saving but also oreign exchange. Dual-gap theory thus
per orms the valuable service o emphasizing the role o imports and oreign exchange in the
development process. It synthesizes traditional and more modern views concerning aid, trade and
development. On the one hand, it embraces the traditional view o oreign assistance as merely
a boost to domestic saving; on the other hand, it takes the more modern view that many o the
goods necessary or development cannot be produced by the developing countries themselves
and must there ore be imported with the aid o oreign assistance. Indeed, i oreign exchange
is truly the dominant constraint, it can be argued that dual-gap analysis also presents a more
relevant theory o trade or developing countries that justi es selective protection and import
substitution. I growth is constrained by a lack o oreign exchange, ree trade cannot guarantee
simultaneous internal and external equilibrium, and the e ciency gains rom trade may be ofset
by the underutilization o domestic resources. We shall take up this matter in Chapter 15.

A practical example o dual-gap analysis

Now let us give a practical example o how dual-gap analysis may be applied to a country. We
shall be applying equation (14.1) to estimate the investment–savings gap, and equation (14.2) to
estimate the import–export gap. Suppose that the target rate o growth (r) set by the government
over a ve-year planning period 2015–20 is 5% per annum and the capital–output ratio is 3. Te
investment requirements in time t may be written as:

It 5 crYt 5 cDY 5 3DY