While Greek debt restructuring programs have been dominating the headlines in financial newspapers and fueling debate for over a year, those involving low-income countries (LICs)—admittedly less significant in terms of volume but just as crucial for the countries concerned—are taking place far from the media spotlight. The most recent example dates from last month. On December 20, 2012, the IMF and the World Bank announced that the Union of the Comoros had fully complied with the structural adjustment programs imposed on it and that, as a result, the African archipelago would receive a reduction in its external debt of $176 million, representing 59% of its total external debt (or 28% of its gross domestic product). This debt reduction took place within the framework of the Heavily Indebted Poor Countries (HIPC) debt cancellation programs and also through the Multilateral Debt Relief Initiative (MDRI), both of which are supported by the Bretton Woods institutions.
In order to raise public awareness of the debt problems faced by LDCs, we felt it was necessary to use this recent event to first outline these two programs, which today represent a major lever in development financing policies. However, the most skeptical will undoubtedly be less enthusiastic about the effectiveness of these initiatives. That is why we will attempt, in a second step, to answer the central question raised by these programs: Are they simply a gift (or more concretely, a « shot in the dark ») from the international community to LICs, or can they, on the contrary, be considered a real tool for development?
What are the « Heavily Indebted Poor Countries (HIPC) » and « Multilateral Debt Relief Initiative (MDRI) » initiatives?
The HIPC and MDRI initiatives are the result of a partnership between four major international financial institutions( the IMF, the World Bank, the African Development Bank, and the Inter-American Development Bank) and were launched in 1996 and 2005, respectively. In a nutshell, these programs mainly aim to cancel part of the external debt of low-income countries in order to make it sustainable and thus avoid a monopolization of domestic resources by debt servicing.
The process of implementing these initiatives can be broken down into three stages:
– once a country is declared eligible for the debt reduction initiative (i.e., it meets the criteria for entering the program[3]), the IFIs grant it debt cancellation conditional on the implementation of structural adjustment programs (PRSP and PRGF[4]) aimed at restoring the country’s macroeconomic stability, moderating its debt process, and promoting so-called « poverty-reducing » spending.
– Following the implementation of the economic stabilization process, the beneficiary country receives another conditional debt reduction, this time for larger amounts. The IFIs then continue to carefully monitor the implementation of development policies and convergence towards the target objectives. This interim period of reform implementation generally lasts between three and five years.
– Once the IFIs deem that the economic policies implemented are satisfactory and that the target objectives have been achieved, they definitively and irreversibly cancel the amount of external debt that they and the debtor country had previously agreed upon. This final stage, also known as the « Completion Point, » marks the end of the debt reduction program and, since 2005, has been accompanied by the total cancellation of the remaining multilateral debt.
Today, of the 40 or so countries that have participated in these initiatives (39 to be exact, including 33 from sub-Saharan Africa), 35 have passed the completion point, one is in the interim phase, and three are before the decision point (see table at the end of the article).
Source: Paris Club, IMF, BS-i.
Debt Cancellation: A Waste of Time or Support for Development?
The HIPC and MDRI programs have therefore become essential in the field of development financing. However, the benefits they bring are still far from being fully identified.
These initiatives are based on a central theory of development macroeconomics introduced by Krugman and Sachs in the 1980s and generally known as « debt overhang. » According to this theory, a country in a situation of excessive debt would be better off not repaying its debt. Knowing this, the creditor country would be better off granting the debtor country a partial debt cancellation if it hopes to receive anything from the debtor country. In addition to this negotiation game aimed at reducing potential losses for lenders, the « debt overhang » theory is accompanied by so-called burden effects, induced by unsustainable debt and commonly referred to as the » real burden » and » virtual burden » of debt.
The effect of the real burden of debt is entirely intuitive and lies in the fact that excessive debt generates debt servicing costs that consume the vast majority of domestic resources. As a result, government resources initially earmarked for public development spending aimed at promoting the emergence of social structures (education, health, etc.) are reallocated to debt servicing. Excessive public debt therefore undoubtedly tends to delay the implementation of development policies necessary for poverty reduction and economic catch-up in these countries (crowding-out effect).
The so-called virtual burden effect stems from the fact that unsustainable debt leads to future tax increases, which are necessary to finance debt servicing. As a result, both domestic and foreign investors, seeing their capital income more heavily taxed, become less inclined to invest in such countries, which ultimately tends to reduce the level of private investment.
Debt cancellation programs have therefore been mainly motivated by the international community’s desire to promote both public and private investment in heavily indebted poor countries. Nevertheless, within the economic literature, some voices have been raised against these programs, pointing out their disincentive effect in terms of debt management (Easterly [2002], Leo [2009])Indeed, it would be tempting to think that these initiatives generate significant moral hazard: what would be the incentive for a poor country to make significant fiscal and budgetary efforts to repay its debt, knowing that at any time it could potentially benefit from debt cancellation? Several arguments refute this intuition.
First, countries that join HIPC and MDRI programs have been subject to IMF programs aimed at « monitoring » their public finances for many years. HIPC and MDRI programs therefore come only after numerous attempts to manage debt and public deficits. Similarly, once a country has exited the debt cancellation agreement, the IFIs continue to « keep an eye » on the financial situation of these countries simply because they face prohibitive rates on the international markets and can therefore only borrow from them (and in particular from the concessional arm of the World Bank – IDA).
Finally, these agreements relate exclusively to a predetermined amount of debt within the Paris Club, which does not include outstanding debt recorded beyond a cut-off date set by the IFIs and the country concerned. Debt reduction is therefore only applied to debt incurred before the cut-off date, which excludes any restructuring of future debt and therefore obliges countries to manage their public finances properly once the cancellation has been received.
Other critics also believe that the HIPC and MDRI programs do not promote growth sufficiently and offer nothing to beneficiary countries other than the right not to repay their debt. Nevertheless, some research papers attempt to highlight the benefits of these programs. If we follow the debt overhang theory and the resulting burden effects, it would be tempting to think that debt cancellation promotes national investment by reallocating domestic resources initially earmarked for debt servicing. Debt cancellation programs are therefore supposed to free up sufficient fiscal space to promote development spending such as investment in infrastructure (schools, hospitals, tax offices, etc.). It is on the basis of this idea of « fiscal space » that several authors have tested the impact of debt cancellation, in the form of savings on debt service payments (see graph below), on various budgetary variables such as public investment and domestic revenue (tax revenue).
Source: Cassimon, Ferry, Raffinot, Van Campenhout [2013], « Dynamic Fiscal Impacts of the Debt Relief Initiatives on African Heavily Indebted Poor Countries (HIPCs) ». DIAL, Working Paper/2013-01. Translation BS-i.
The work of Tsakak Temah [2009], Cassimon & Van Campenhout [2006, 2007] and Cassimon, Ferry, Raffinot & Van Campenhout [2013] agree that the savings and gains resulting from debt cancellation promote health spending, public investment, and tax mobilization in beneficiary countries. It would therefore be risky, to say the least, to consider these initiatives completely useless in light of the evidence provided by this rapidly expanding literature.
Finally, many economic actors also point out that the gains resulting from LDC debt cancellation (particularly debt service savings) should not be considered as reported in IFI analysis reports, because their measurement assumes that, in the absence of debt reduction programs, beneficiary countries would have actually repaid the debt service owed. This last point is more debatable and would require further reflection on the question of the real value of LDCs’ debt. Nevertheless, empirical results and observations tend to show that these two initiatives are far from useless.
For example, the Republic of Uganda recently took advantage of the gains from the cancellation of a large portion of its external debt to build a public hospital to care for the poorest people in the Kampala region. This investment, which will promote development by improving the health of the population, would not have been possible without the emergence of this « fiscal space » created by the reduction in debt servicing.
The HIPC and MDRI initiatives therefore represent significant development policies for poor countries facing significant debt constraints. Studies and analyses of these programs have generally confirmed that they promote the financing of social and economic structures necessary for these countries to catch up. Although efforts still need to be made to define the gains from these policies and to provide post-program support to beneficiary countries (particularly in terms of improving the quality of institutions) it is clear that the HIPC and MDRI initiatives, which benefited the Union of the Comoros last December and will benefit Eritrea, Sudan, and Somalia, will help accelerate their development process.
Bibliography
Cassimon, D., Ferry M., Raffinot M., and Van Campenhout B. [2013], “Dynamic Fiscal Impacts of the Debt Relief Initiatives on African Heavily Indebted Poor Countries (HIPCs).” DIAL, Working Paper/2013-01
Cassimon, D. and Van Campenhout, B. (2006). Aid Effectiveness, Debt Relief and Public Finance Response: Evidence from a Panel of HIPC Countries. Working Paper, University of Antwerp, Institute of Development Policy and Management (IOB).
Cassimon, D. and Van Campenhout, B. (2007). Aid Effectiveness, Debt Relief and Public Finance Response: Evidence from a Panel of HIPC Countries, Review of World Economics, Vol.143, No.4, 742-763.
Cohen, D. (2000). The HIPC Initiative: True and False Promises. Working Paper No. 166, OECD Development Center.
Easterly, W. (2002). How Did Heavily Indebted Poor Countries Become Heavily Indebted? Reviewing Two Decades of Debt Relief. World Development Vol. 30, No. 10, pp. 1677-1696, Elsevier Science.
Idlemouden, K and Raffinot, M. (2005). The Virtual Burden of External Debt. EURISCO Research Papers No. 2005-03, Paris-Dauphine University.
IMF, Heavily Indebted Poor Countries (HIPC) Initiative: Status of Implementation. International Monetary Fund and International Development Association.
Tsafack Temah, C. (2009). Does Debt Relief Increase Health Expenditures? Evidence from Sub-Saharan HIPCs. Research Report – United Nations Economic Commission for Africa.
Notes:
[1]IFIs.
[2]In 1999, the HIPC Initiative increased the amounts of multilateral debt canceled, earning it the name Enhanced HIPC Initiative.
[3]Per capita income below $380, and external debt (net present value)/exports ratio above 250%.
[4]Poverty Reduction Strategy Paper (PRSP) and Poverty Reduction and Growth Facility (PRGF).
[5] The Paris Club is the institution within which creditors (bilateral and multilateral—public) and debtors meet to negotiate debt cancellation and rescheduling amounts.
