External Shocks and the Demand for Adjustment Finance

When a country experiences a long-term adverse external shock, resulting in a balance of payments deficit unsustainable in the medium term, how quickly should it adjust? Because time is required for movement of productive factors and consumptive patterns, the short-term effect of the shock will be a large increase in the value of foreign exchange. It then pays to borrow abroad during the first years of the transition against those years when full resource and demand reallocations have taken place. To allow this adjustment path, the market exchange rate should follow the shadow exchange rate. This article uses a simple traded/nontraded sector model with lagged responses and optimal borrowing theory to derive a quantitative relationship between the magnitude of the shock and the optimal amount of borrowing, the speed at which the original shortfall of foreign currency should be closed, and the required currency depreciation during the borrowing and repayment period.