Inflation, terms of trade, and debt capacity

Abstract

The optimal level of debt for an economic entity is a function of, among other things, the variability of its cash flows. Since real and inflationary shocks which cause the variability may not influence various components of the cash flows by equal proportions, a project's financial risk, and hence its debt capacity, will depend upon the correlation between its cash inflows and outflows. A developing country's external debt capacity depends upon cash flows arising from its foreign trade. In this research, we analyze the impact of inflation on the foreign currency cash flows of developing countries and find that inflation affects very few countries in a symmetrical manner. Results indicate that an assumption that unexpected inflation has a neutral impact on the debt capacity of a borrower is supportable neither in theory nor in practice.