Foreign Exchange Gap. An LDC suffers a foreign exchange gap when its current account deficit is greater than the value of its capital inflows. Basically, it does not have enough foreign currency coming in to spend on imports necessary for growth and development.
Maybe export revenues are low because of declining terms of trade, debt servicing or capital flight.
A foreign exchange gap constrains development because:
1) Limits Vital Imports. LDC export revenues become insufficient to fund the growing need for importing large amounts of capital goods and raw materials that are required for development but not available domestically. So the economy’s investment and productivity is constrained.
2) Default on Foreign Debt. The economy may not have enough foreign currency reserves to repay its international debt.
3) Famine. The LDC may run out of foreign exchange reserves that could be used to buy food for the domestic population, so living standards fall and poverty may increase as people starve.
However, a foreign exchange gap may not be a major constraint on development because:
- LDCs could seek foreign aid to plug their foreign exchange gap. Maybe LDCs could seek assistance from the World Bank for foreign loans.
- LDCs could receive humanitarian aid if they are suffering from a famine due to a lack of food imports.
- Maybe other factors are more important development constraints.