Sabine Sylvia Altendorf Student ID 322077 MSc Development Economics

International Economics II 15PECC019 Course lecturer: Prof Jane Harrigan Assignment No 1

Discuss the evolution of international policies designed to address indebtedness in low-income countries and outline the strengths and weaknesses of the different approaches. Word Count: 3564

INTRODUCTION Debt continues to place a heavy burden on the fiscal space of many low-income countries and hence restrains economic growth, development and poverty alleviation. Since the late 1970s, creditors have implemented debt relief measures of various degrees to provide an exit from the rapidly growing debt. Nevertheless, total external debt of low-income countries increased from US$125 billion in 1980 to US$419 billion in 1990 and in fact continued to build up until about 2000 (Gunter 2002). In sub-Saharan countries, which account for the largest share of the total debt burden, external debt increased approximately 8 times between 1970 and 1995 (Moss 2006). In line with this increase, debt service payments also rose significantly during this period and outgrew government spending on health and education in many countries. This paper outlines the evolution of the debt relief initiatives implemented by both bilateral and multilateral creditors since the late 1970s, notably the Paris Club initiatives, the Heavily-Indebted-Poor-Countries (HIPC) I and II initiatives and the Millennium Debt Relief Initiative (MDRI). Main focus is on the HIPC and MDRI initiatives, which have the most recent impact on indebtedness of low-income countries. The terms and conditions of the individual initiatives are discussed and critically assessed regarding their strengths and weaknesses. Throughout the paper a critical eye will be kept on the question why debt continued to rise despite the debt relief initiatives. With this question in mind, the conclusion provides a brief summary of the findings and suggests an alternative approach.

DEBT RELIEF POLICIES The first attempts to relieve the debt burden of least developed countries (LDCs) were launched in the late 1970s, when official creditors wrote off US$6 billion in debt to 45 poor countries following the UNCTAD meetings of 1977-1979 (Easterly 2002). This first initiative focussed on an elimination of interest payments, the rescheduling of debt servicing and the provision of new loans to reimburse old debts (Easterly 2002). However, considering that total debt of LDCs amounted to US$125 billion in 1980 (Moss 2006), the scale of this debt relief initiative was very small. Furthermore, the fact that the initiative included new lending meant that countries were bound to get deeper into debt. Despite widespread discussions about debt related problems faced by LDCs, it was not until the initiatives of the Paris Club in the late 1980s that larger debt relief was again considered. A significant problem with LDC debt was that the bulk of it was owed to multilateral donors, mainly the IMF and the World Bank, and not to private banks, as was the case with debt in middle-income countries. Most LDC debt had resulted from previous aid flows from multilateral and bilateral donors, who had given aid in the form of concessional loans as opposed to 100% grants. Hence the debt differed from commercial debt in two ways. Firstly, there was no automatic market correction mechanism as is usually the case with commercial debt, which is typically sold at a discount in secondary markets with the discount reflecting the chances that the debt will be repaid. Secondly, although many LDCs were heavily indebted in relation to their own economies, their debt only accounted for less than 10% of total global debt and hence did not threaten the global financial system. This meant that while the international community had a vital interest in controlling indebtedness of middleincome countries, LDC debt was largely ignored. Towards the end of the 1980s, it became clear that high levels of LDC debt not only had devastating effects on the social structures and poverty levels in heavily indebted countries, but also had adverse effects on the creditors. Krugman (1988) and Sachs (1989) identified the debt overhang problem, namely that while loans would initially enhance economic growth, high levels of debt in LDCs would eventually reduce investment and hence growth since debt service payments could be seen as some form of tax on future investment returns and would therefore act as a strong investment disincentive. Similarly, governments were found to be more reluctant to implement reforms because the prospect of future yields of the reforms being taken up 3

by debt repayments acted as a disincentive. It was acknowledged that countries often got caught in debt traps, where new loans were needed to overcome the heavy and disruptive burden of the old debt a vicious circle that could repeat itself perpetually. Creditors furthermore realized that once countries had reached the point of unsustainable debt they were unlikely to meet their debt servicing obligations and that it was hence in creditors interest to reduce the face value of debt via debt relief since this would increase debt repayments (Corden 1988). As a result of these considerations an informal group of 19 bilateral creditors known as the Paris Club agreed on four ad hoc initiatives between 1988 and 1994, which involved the rescheduling of debt, i.e. extending the terms of repayment, and even partial debt relief. However, these ad hoc initiatives were usually tied to two conditions designed to restore economic growth and secure debt servicing capacity (ODI 1995): new loans from the IMF and World Bank had to be taken up and structural adjustment programmes from both institutions had to be followed. Again, this conditionality implied that LDCs had to take up new debt to finance the old debt and were virtually drawn into a debt spiral. By the mid 1990s Paris club members and other bilateral creditors had increased the speed of debt forgiveness and debt indicators such as the debt-GDP ratio or the debt-exports ratio started to improve for many LDCs. However, since the Paris Club initiatives were ad hoc, there were several problems: there was no official framework to support the initiatives and all excluded the debt of the multilaterals, especially the IMF and the World Bank, who argued that their constitutions prevented them from providing debt relief. Given that debt owed to multilateral donors had increased to over 30% by the late 1990s, in part as a result of the new lending conditionality attached to the Paris Club initiatives, the fact that the multilateral donors excluded themselves from debt relief initiatives significantly hindered a successful outcome. The Paris Club initiatives furthermore faced a number of additional shortcomings. Firstly, there was the problem of potential free riders that some but not all creditors would offer debt relief and that those who refused to participate would still gain from debt relief in the sense that they would receive a larger share of debt servicing. Secondly, there was the problem that debt relief would lower the ceiling or level of debt ultimately repaid, i.e. even in the case that an economy would pick up again, a country would not have to repay the debt that it had previously 4

been relieved of. Thirdly, there was a moral hazard problem concerning future loans, namely that receiving countries may get tempted to borrow irresponsibly knowing that any debt would eventually be relieved. By the mid 1990s it was accepted that debt overhang was creating devastating economic and social problems for many of the LDCs and that some heavily indebted countries may never be able to repay their debts. In an attempt to help poor countries reach sustainable debt levels the Heavily-Indebted-Poor-Country (HIPC) initiative was launched by the IMF and the World Bank in 1996. Rather than providing a constant re-scheduling of debt, the idea of the HIPC initiative was to reduce debt to sustainable levels, and unlike previous debt relief initiatives, the HIPC initiative for the first time included multilaterals. Debt sustainability was identified as having a net present value debt-to-export ratio of less than 250%. The HIPC initiative was a much more comprehensive approach to debt relief since the IMF and the World Bank tried to involve as many creditors as possible to overcome the free rider problem. Furthermore, in an attempt to overcome the moral hazard problem, debt relief under the HIPC initiative was tied to the condition that a country implement reform programmes. Originally 41 countries were classified as HIPC, which meant that they were deemed to be unlikely to reduce their debt through the debt relief mechanisms of the Paris Club. As outlined by an IMF factsheet, the qualification process of HIPC consisted of two stages, the decision point and the completion point (IMF 2011). In order to reach the decision point, the country had to be eligible for aid from the World Banks International Development Association (IDA), face an unsustainable debt burden, and have implemented an IMF and World Bank approved reform programme for at least 3 years. To reach the completion point the country had to have established a further track record of good performance under programs supported by loans from the IMF and the World Bank (IMF 2011), and implemented reforms agreed at the decision point for at least three years. Debt relief was only granted after a country had reached the completion point, which in most cases such as in Zambia took significantly more than 5 years (Weeks 2006), and the extent of the debt relief was aimed only at reducing debt to sustainable levels, i.e. below the sustainability threshold of a net present value debt-to-export ratio of less than 250%. As a result of public campaigns pressing for debt relief for the benefit of poverty reduction by organisations such as Oxfam and the Jubilee 2000 Campaign, the original HIPC initiative was reformed in 1999 to the HIPC II or enhanced HIPC 5

initiative. For the first time the debt relief process was linked to poverty reduction. As Gunter (2002) analyses, HIPC II provided much broader and faster debt relief than HIPC I because the ratios regarding the measurement of debt sustainability were lowered significantly, the fixed three-year period between decision and completion points was replaced by a floating completion point, and interim relief could be provided between the decision and the completion point. HIPC II could hence be regarded as a significant step forward in the alleviation of debt related problems in LDCs. However, to classify as eligible a country had to satisfy even more conditions than under HIPC I: in addition to the HIPC I conditions it also had to draught a socalled poverty reduction strategy paper (PRSP), which entailed that some of the debt relief would have to be spent on poverty reduction. These imposed quite stringent conditions before a country could become eligible for HIPC II debt relief. According to IMF figures, 32 countries had reached the completion point by 2010 and four had reached the decision point (IMF 2011). They had in total been given about US$75 billion in debt relief. In those 36 countries, the IMF observed increases in health and education spending, which point to a success of the HIPC initiative. However, debt relief was largely concentrated on four countries Nicaragua, Mozambique, Tanzania, Zambia which up until 2003 accounted for a half of all debt relief, revealing some of the shortcomings of the initiative in providing widespread poverty reduction. Although the HIPC initiatives provided greater debt relief than previous initiatives, they were still far from eradicating debt problems completely. The strict eligibility criteria excluded many heavily indebted poor countries, especially countries that were deemed to have poor governance or were stricken by civil war. Some countries were included but not deemed eligible for debt relief as they just marginally missed the debt sustainability criteria, as was the case with Kenya, whose debt-export ratio was 148% instead of the 150% required to qualify for HIPC II (Sachs 2000). With large countries such as Bangladesh or India excluded from HIPC debt relief, the number of poor people living in non-eligible countries outnumbered those living in HIPC eligible countries. This led some critics to argue that the IDA only condition was purely designed to exclude certain countries, such as Nigeria because debt was too high there (Morrissey 2002). Sachs (2000) argued that the debt sustainability criteria were inappropriate as they were too high and based on economic rather than social criteria. Purely reducing debt levels to below the sustainability threshold may still leave fiscally unsustainable 6

debt, which would hinder growth and development, and debt relief would hence need to be supported by aid and development assistance if poverty were to be reduced. This was supported by Gunters (2002) observation that according to a World Bank report, at least 4 countries (Guinea, Mauritania, Niger and Zambia) will continue to pay more than 20% of government revenues as external debt service [] after enhanced HIPC debt relief. Stiglitz (2005) furthermore argued that the focus on increasing GDP through debt relief ignored problems of uneven distribution, leaving the majority of the population still impoverished, while a few wealthy people would benefit. Stiglitz hence argued that the initiatives should rather target sustainable increases in standards of living and the promotion of democratic and equitable development in order to achieve poverty reduction. Killick (2000) also argued that over optimistic growth and export projections were often used and that possible exogenous shocks which a country might suffer in the future were ignored. Gunter (2002) commented on how over-optimistic growth rates could indicate unrealistic long-term debt sustainability through overestimations of exports [] and underestimations of future financing needs. This was for example the case in Zambia, where the IMF based the relief programme on the false predictions of significantly overestimated export growth for copper and underestimations of inflation (Weeks 2006). Gunter (2002) furthermore criticised the HIPC II initiative for putting a heavy burden on the countrys administration in the design of the PRSP. While the World Bank assumed that governments could produce acceptable PRSPs within two years, in the best case of Uganda it took five years. Gunter (2002) hence argued that the PRSP requirement would either delay debt relief or lead to a lower level/quality of country ownership and civil society participation. The fact that countries continued to need to borrow in the interim in order to fulfil their old debt obligations and sometimes even to implement the PRSPs imposed a significant weight on the debt burden as in many cases it meant that some countries such as Zambia, Bolivia, Chad and Uganda were even more indebted when reaching the completion point than before (Weeks 2006, Stiglitz 2005). Moreover, the free rider problem persisted under HIPC since the initiative was not enforced by law while debtors could be punished for not paying, there was no international law that prevented creditors from not offering debt relief. There was furthermore disagreement on whether the cost of the debt relief should be an additional resource or should be taken out of creditors normal budgets. While the World Bank was in favour of 7

declaring debt relief as an additional resource, some countries like Japan were opposed to this and preferred debt relief to be taken out of further lending. Gunter (2002) criticised that although some bilateral creditors were HIPCs themselves, there was no attempt to exempt those from the burden-sharing of the initiative. Gunter (2002) also pointed out that the adoption of the HIPC II framework was unilaterally decided by the developed creditor nations and that developing countries, and especially debtor countries, were hardly at all involved in this decision. This proved particularly problematic since some developing countries like China acted as major creditors to HIPCs. Furthermore, Gunter (2002) argued that the HIPC initiative was designed around what debt reduction is needed according to inappropriate debt sustainability indicators, instead of what debt reduction is needed for sustainable development. In his analysis of debt relief in Zambia, Weeks (2006) analysed that HIPC debt relief created marginally less fiscal space rather than more due to restrictive policy conditions including the reduction of civil service employment and the deregulation of the maize markets, which left the Zambian government little space for development policy. Weeks (2006) highlights the restraining nature of the conditions, adherence to which was strictly monitored and at times punished with the cancellation of further lending agreements, which increased the debt burden on the Zambian economy further and restricted the governments ability to implement development programmes. As Fine (2006) pointed out, the macroeconomic models employed by the World Bank and the IMF for stabilisation policy and poverty reduction are merely concealed and even simplified neo classical IS/LM/BP frameworks originally designed to analyse industrialised economies and hence unsuitable for application to developing countries. This is not least because these models had already been dismissed for the use in developed countries at the time the World Bank and the IMF started to implement them for developing countries. A similar view was expressed by Stiglitz (2005), who argued that the externalities so typical to developing countries such as restricted access to water or pollution were not considered in those models but instead perfect capital markets were assumed. The Multilateral Debt Relief Initiative (MDRI) was implemented by the World Bank, the IMF and the African Development Bank (AfDB) in 2005 to help accelerate progress toward the United Nations Millennium Development Goals (IMF 8

2011), essentially because it was acknowledged that debt relief under the HIPC initiative did not suffice. The MDRI was the first initiative that moved towards full debt relief from its three founding organisations and remains in place at present. As of December 2010, 32 countries, which had reached the HIPC II completion point plus 2 non-HIPC countries, had benefited from the MDRI. The IMF estimates that so far they spent about US$3.4 billion on MDRI debt relief. MDRI debt relief covers the whole stock of debt that has been outstanding since the end of 2004. Debt accumulated after 2004 does not qualify for debt relief. Eligible for 100% debt relief are those countries that have reached the completion point of the HIPC initiative. Herein lies the first flaw of the MDRI countries still have to go through the longwinded, exclusive HIPC selection process, and while full debt relief will mean a significant improvement for eligible countries, many others, which are desperately in need of debt relief, will continue to be excluded. In fact the MDRI introduces even stricter conditions to access not only debt relief, but also World Bank aid flows. Under IDA and IMF conditionality, countries have to demonstrate good performance in macroeconomic policies, public expenditure management and poverty reduction strategies (IMF 2011), which is measured through a so-called Country Policy and Institutional Assessments (CPIA) score. The CPIA score has been undertaken by the World Bank since 1997 but details of the ratings were not published until 2005. The ratings are based on 16 indicators on economic management, structural policies, policies for social inclusion and public sector management and institutions (Bretton Woods Project 2006). Critics argued that the CPIA is unable to distinguish between countries and over time (Bretton Woods Project 2006) and according to van Waeyenberge (2008) the CPIA score was merely used to support the Banks move to an even stricter selection process for both aid and debt relief. The MDRI brought about a shift away from financial gap analysis in the allocation of aid towards a focus on complementing domestic resources and foreign capital flows through bridging institutional gaps. This shift is supported by the idea that business friendly environments will attract international finance and investments, which are meant to fill finance gaps. Donors hence aim at improving the institutional framework of LDCs, e.g. through securing property rights, in order to facilitate transparent, stable and predictable conditions for domestic and foreign investors. The reform programmes attached to World Bank and IMF loans hence include economic liberalisation and privatisation packages. However, as Stiglitz (2005) pointed out, 9

privatisations are often marred by corruption and monopoly power, which significantly drive up consumer prices and often lead to increased inequality, as was the case in the former Soviet Union. Debt relief furthermore moved from what can be called ex ante conditionality, meaning that relief would be given with reform conditions attached, to an ex post conditionality, meaning that relief will only be given if reforms have already been implemented.

CONCLUSION The obstacles hindering effective debt relief, which would facilitate poverty alleviation, can be summarized as follows: for a long time, the scale of debt relief was small compared to total debt and in addition debt relief was tied to new loans from the World Bank and the IMF. Both institutions joined the debt relief initiatives too late, and when they finally joined, they applied too strict a selection process, which excluded many countries. The HIPC initiatives, whilst a significant step forward, entailed a complicated and lengthy qualification process, delaying much needed debt relief. HIPC conditions for reforms and economic policies are stringent and leave governments little space to implement reforms appropriate for poverty reduction in their countries. Debt sustainability thresholds continue to be too high, and purely reducing debt below those levels has proven to not be enough. Widespread poverty reduction has not been achieved because HIPC debt relief has focused only on a handful of countries and distributional problems were ignored. The fact that countries at times even need to borrow to implement the PRSPs proves particularly problematic considering that debt reduction is the goal of the HIPC initiative. While the MDRI has the noble incentive of cancelling 100% of the debt of eligible countries, its selection criteria is even more exclusive and appears almost dubious. These increasingly strict conditions can be seen as the main reason why debt relief, despite having provided extensive financial means, has not made substantial progress in poverty alleviation. Privatisation and economic liberalisation have benefitted private investors and creditors more than the indebted countries themselves. This has led some to argue that the policies tied to debt relief were purely designed to ensure as much debt as possible will be repaid. What may be needed is something like an international debt ombudsman, who designs and monitors debt relief programmes according to a countrys needs, identifies the need for further aid

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and provides individually tailored development assistance to ensure that the funds made available by debt relief are used in the best possible way to alleviate poverty in the long term.

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Morrissey, O. (2002), Making Debt Relief Conditionality Pro-Poor, United Nations University, World Institute for Development Economics Research, Discussion Paper No. 2002/04 Moss, Todd (2006), Will Debt Relief make a Difference? Impact and Expectation of the Multilateral Debt Relief Initiative, Centre for Global Development, Working Paper no. 88 Nunnenkamp, P. (1986), The International Debt Crisis of the Third World, Brighton: Wheatsheaf IMF (2011), The Multilateral Debt Relief Initiative Factsheet IMF (2010), The Multilateral Debt Relief Initiative: Questions and Answers IMF (2011), Debt Relief Under the Heavily Indebted Poor Countries (HIPC) Initiative Factsheet Jubilee Debt Campaign (2006) The Multilateral Debt Relief Initiative: the good, the bad and the ugly, June, available at: http://www.debtireland.org/resources/JDCon-MDRI.pdf. Overseas Development Institute (ODI) (1995), Poor Country Debt: A Never Ending Story, Briefing Paper No. 1. Sachs, J. (1989), The Debt Overhang of Developing Countries, in: J. de Macedo and R. Findlay (eds), Debt, Growth and Stabilisation: Essays in Memory of Carlos Diaz Aljandro. Oxford: Blackwell Sachs, J. (2000), The Charade of Debt Sustainability, Financial Times, 25 September 2000 Stiglitz, J. E. (2005), Post Washington Consensus Consensus, Initiative for Policy Dialogue, Columbia University

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Van Waeyenberge, Elisa, (2008), After structural adjustment, then what? Lending selectivity by the World Bank, Development Viewpoint Weeks, J. and McKinley, T. (2006), Does Debt Relief Increase Fiscal Space in Zambia? The MDG Implications, UNDP International Poverty Centre, Country Study No. 5

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