Global Policy Forum

The Rough Guide to Debt

February 2002

At the G8 summits in Cologne in 1999 and Birmingham in 1998 tens of thousands of people from all walks of life, especially from the churches, joined hands to support debt cancellation for the world's poorest countries. On the eve of the new millennium, Jubilee 2000 debt campaigners handed over to the heads of government of the richest countries the world's largest petition: it called for the cancellation of the "unpayable debts of the world's most impoverished countries by the year 2000". Not since the anti-apartheid demonstrations of the 1970s and 1980s has an overseas issue so galvanised global public opinion.

This briefing looks at the origins of the debt crisis for poor countries, the official policies intended to address the problem and the proposed alternatives.

· The origins of the debt crisis
· A humanitarian disaster
· Debt relief begins
· Debt relief continues - the HIPC initiative
· How much debt has been cancelled?
· What's wrong with HIPC?
· Debt and poverty
· Will more aid solve the problem?
· The way forward
· Fair and transparent arbitration
· Further information from CAFOD
The origins of the debt crisis

The debt crisis of the very poorest countries differs from the recurrent debt crises in Latin America. The poorest countries' debts are primarily owed to official lenders - northern governments, the World Bank and the International Monetary Fund (IMF).

The Latin American debt crises are primarily owed to the private sector and arise from unrealistic, or mistaken, expectations on the part of both borrowers and lenders. In the 1980s, middle-income debtor countries, led by Mexico, threatened to default on their repayments to large western banks. Because the banks were owed such large amounts, the threat of default rang alarm bells in northern capitals and financial markets.

After much procrastination and efforts at crisis management, the crisis was resolved (temporarily, at least) by the Brady Plan. This allowed the states concerned to reduce the value of their debts to commercial banks in exchange for free-market financial and economic reforms.

The Brady Plan, however, allowed Latin American governments to court global capital markets once again by removing restrictions on the flow of capital. They ran up new kinds of debts, for example by selling government bonds to private and institutional investors. Asian countries such as Korea and Thailand also joined the borrowing spree. Such new lending proved even less reliable than that of banks or governments because much of it was invested in short-term assets and booming property markets. Spectacular crashes ensued in Mexico (1994/5), Asia, Russia and Brazil (1998) and Argentina (2002).

However, the Latin American and Asian rollercoaster of booms and busts eclipsed another debt crisis - one less threatening to the international financial community, but with stark consequences for the world's most impoverished people.

A humanitarian disaster

The 1970s started out with a great deal of promise for the Third World, for Africa in particular. Commodity prices were buoyant and growth prospects good. But oil price hikes in 1973 and 1979 led to hyperinflation in industrialised countries, whose response included steep rises in interest rates. The net effect in the North was economic recession and a slump in demand for commodity exports from the South. So southern governments borrowed to make up for their revenue shortfalls on the assumption that the economic downturn would be short-lived. And they took on loans at floating interest rates, borrowing initially at a low rate and then having to service their debts at rates four or five times higher.

These new debts also had to be repaid in US dollars. With interest rates rising in the North and a slump in exports in the South, debtor governments saw their export revenue dwindle. At the same time, their debt grew daily as the dollar increased in value and interest rates soared even higher.

By the late 1970s and 1980s, the accumulation of the poorest countries' debts had become unsustainable.

The deteriorating global economy was one factor in the debt crisis, but many debtor governments share some of the responsibility. Most were wedded to a centralised model of economic management. There were bottlenecks in production, private indigenous enterprise was discouraged, exports shrank and economic growth was stifled. Many governments borrowed for glamorous, but ultimately unproductive, large-scale projects.

Creditor governments were also to blame. They wanted to create employment at home, so they lent southern governments the money to buy goods from their own countries. They also lent to their Cold War allies in the Third World: some of the more corrupt governments, such as that of President Mobutu in Zaire, received loans from western governments, the IMF and World Bank. Irresponsible lending and borrowing was also common among Soviet bloc allies. Proliferating Cold War conflicts also encouraged political lending on both sides - the priority was to win friends and influence, regardless of the economic value of the loans.

The spiralling costs of debt repayment and servicing, combined with contracting economies, led the most heavily indebted and poorest countries to default on their debts. Eventually this produced an unpayable mountain of arrears. By the mid-1980s, debt and deepening poverty constituted a humanitarian disaster for many of the poorest countries. During the past two decades the world's most heavily indebted continent, Africa, has experienced falling incomes and investment, falling life expectancies and rising infant and maternal mortality rates. Debt has become not only an economic issue, but a matter of life and death.

The world's poorest countries were in effect bankrupt. But the international economic order does not allow countries to sue for insolvency and start again. Governments were largely content to ignore the plight of the poorest in faraway countries. It was only the efforts of debt campaigners the world over that challenged the reasoning of creditors.

Debt relief begins

Throughout the late 1980s and early 1990s, creditor governments, the IMF and the World Bank argued that the problem of debtor countries was one of short-term financing and that the debts were not an obstacle to poverty reduction.

The IMF and World Bank said the outflow of resources in the form of debt repayments was offset by a larger inflow in the form of aid or new loans. In other words, donors and creditors were keeping debtor governments afloat with regular top-ups of new aid and lending.

In the late 1980s, richer governments conceded that poorer countries needed some debt relief. Creditor governments, grouped in the so-called Paris Club, devised a series of concessions named after the cities where they met: London dealt with commercial debts; Toronto, Houston, Lyon, and Naples eventually offered relief on up to 67 per cent of debt. But this debt relief was limited in scope. Naples terms offered to write off 67 per cent of the debt owed to governments at the time the debtor country first approached the Paris Club for relief - the so-called cut-off date. Any new borrowing, to pay off interest on old debts or to buy essential imports, would have to be repaid in full.

This piecemeal approach failed to address the growing mountain of debt owed to the World Bank and IMF. A single framework was needed to deal comprehensively with all creditors.

Debt relief continues - the HIPC initiative

Aid agencies, and later the Jubilee 2000 campaign, argued that the debt problem was not merely a narrow issue of countries defaulting on their debts. It was, and still is, a problem of social justice. The agencies argued that it was unacceptable that those who could afford the least were paying - literally with their lives - those who already had the most.

In 1996, the creditors responded to public pressure with the Heavily Indebted Poor Country (HIPC) initiative. In response to the Jubilee 2000 campaign's impatience with the meagre results, in 1999 they made marginal improvements in the form of an "enhanced HIPC initiative".

For the first time the world's poorest countries were promised debt cancellation so that they could achieve "a robust exit from the burden of unsustainable debts".

Moreover, in 1999 the G8 Summit in Cologne acknowledged that unsustainable or unpayable debt was a serious obstacle to poverty reduction.

From then on, all creditors were to share equally the cost of writing off the debts of qualifying countries. And their debts were to be reduced until they became "sustainable".

How much debt has been cancelled?

Calculating how much debt relief debtor countries have received is not an exact science. There are various ways of determining the amount a country owes - the value of the debts when they were first taken out, or their value in debt markets, or their value at current prices when interest has been added. On the last measure, most commentators agree that writing off the debts of the 24 countries that have gone through the HIPC process will cost creditors about US$36 billion.

This sounds impressive. But from the point of view of debtor countries, it seems far less generous. Because most debtor governments did not, and could not, keep up their repayments, most of the US$36 billion consists of interest and principal they had not been repaying and were never going to repay. On average, the initiative will cut the HIPCs' expenditure on debt servicing by one third.

For example, Mozambique was paying about US$120 million a year in interest and principal. After debt reduction, the country will continue to spend more than US$70 million a year in debt service. The reduction in Tanzania's annual debt service will only be about ten per cent. Cameroon and Zambia, where one in every five children does not live to see their fifth birthday and their parents earn less than 60 cents a day each, will be left with a combined debt stock of nearly US$5 billion.

What's wrong with HIPC?

The generous view is that the enhanced HIPC initiative has simply failed to meet both of its objectives - to reduce debt to sustainable levels and to produce sufficient additional finance to reduce poverty. In reality, the rules governing the application of the HIPC initiative are often broken and inconsistently applied.

The system is supposed to be transparent about who qualifies for debt reduction and how much they will get. But two countries that do not meet the eligibility criteria - Bolivia and Honduras - are in. And some that do meet the requirements - Cambodia, Georgia, Haiti and Afghanistan - are out. Others that have been excluded - for example, Nigeria - have no prospect of developing without debt reduction. Pakistan received debt relief in return for assisting the US and its allies after 11 September 2001, although it is clearly ineligible under both Paris Club and HIPC rules.

Also, the calculation of how much debt relief countries should get is elastic. Before 1999, debt reduction was given if total debt was more than twice a country's export earnings. After lobbying by the Jubilee 2000 campaign, this threshold was reduced to 1.5 times a country's export earnings.

At first, IMF officials argued that there was "absolutely no analytical justification" for this reduction. When reminded of this position in meetings, they justified the extra debt relief as a "cushion effect" in case a country's export earnings fell after it received debt relief.

Other problems with the HIPC initiative include:

· Some bilateral creditors write off only the debts acquired before HIPCs first approached their creditors for debt relief. Some countries first appealed for help in the mid-1980s. Twenty years later, they are being offered 100 per cent relief on those original sums only, but not on any subsequent borrowing. So headlines of "100 per cent debt relief!" can be misleading.
· The World Bank and IMF decide how much debt should be cancelled. But the figures they use for their calculations depend on hopelessly optimistic forecasts about future export earnings, growth and aid inflows. This significantly reduces the relief given and countries have to return to the negotiating table when the figures are proved wrong.
· After receiving debt relief, HIPCs need to continue borrowing to keep up their debt servicing obligations and to cover their foreign exchange outgoings - purchase of essential imports, for example. So even by the definition of "sustainability" used by the World Bank and the IMF, their debts are unpayable.
· To qualify for HIPC debt relief, governments must adopt economic policies prescribed by the creditors. This works against poor people, because governments are required to cut subsidies and other spending that benefits the poor. As one Zambian finance ministry official put it: "We introduced the economic reforms and reduced inflation quicker than the Nazis and still our poverty levels are rising." In theory, free-market reforms will eventually lead to increased economic growth, but the poor have yet to experience any benefit.

Debt and poverty

The fundamental weakness of the HIPC initiative is that it uses narrow financial criteria to judge how much debt to write off, and ignores poverty indicators. Assessing whether a country can afford to pay its debts by looking only at its export earnings is wholly inappropriate for low-income countries. For economies that are dependent on one or two export commodities, such as coffee or cocoa, and are prone to droughts that can drastically decrease their export income, gauging debt sustainability from projections of export revenue is foolhardy, misguided and usually wrong.

This is not only an unreliable way of predicting the sustainability of debt. It is also at odds with the requirement that debtor governments should draw up poverty reduction plans to show how they will use the resources freed by debt relief to tackle poverty. The amount of debt relief a country receives has nothing to do with the cost of those plans or the levels of poverty it has to tackle.

In defence of the HIPC initiative, creditors have argued both ways. On the one hand, they maintain that its purpose is to fund poverty reduction. On the other, they assert that the purpose of the initiative is to make debt sustainable in the more narrow financial sense. In reality, it fails in both.

Will more aid solve the problem?

When this failure is pointed out, creditors argue that new aid will finance poverty reduction. But this argument has serious flaws.

· In practice, donors avoid coordinating with each other. As a result, recipient country civil servants are left negotiating, reporting and conducting audits on a range of programmes when their time would be better spent improving their own administration. Tanzania, for instance, has to produce more than 800 reports each quarter to over 50 donors.
· Often donors shape their aid programmes according to their own strategic interests rather than the recipient countries' needs. France, for instance, is willing to spend large amounts of "aid" money promoting French culture. The US prefers to give to allies - Egypt, Poland and Israel - rather than to the poorest countries. Japan prefers to give aid that boosts its exports. In 2001 Britain provided export credit guarantees for a £28 million military radar system for Tanzania, when a £7 million civil aviation radar system would have served just as well. This appears more effective at sustaining jobs in the UK than at meeting needs in Tanzania.
· All donors - except the United States - have agreed to increase their aid spending to 0.7 per cent of Gross National Product (GNP). In more than 30 years since the UN adopted this target, aid expenditure - as a proportion of donor country incomes - has declined steeply.
· Unlike debt relief, aid flows are highly unpredictable and often hamper governments' efforts at medium-term planning.

Debt relief, unlike aid, immediately reduces the outflow of funds, and, by bolstering governments' budgets, supports their spending on poverty reduction. And there is growing evidence that debt relief immediately benefits economic growth.

The way forward

According to Catholic Social Teaching, economic policy-making should have at its centre the needs and rights of the least advantaged in society. So far, creditors have approached debt relief on the basis of what they are willing to pay, rather than what debtor countries need.

CAFOD argues that governments must prioritise poverty reduction and basic human development. Only when such programmes are fully funded - from tax revenues, development aid and the proceeds of debt reduction - should any remaining resources be allocated to debt service.

If the international community is serious about achieving the internationally agreed development goal of halving global poverty by 2015, it must rethink its policies on debt. A significant group of countries, mostly in Africa, is likely to miss the 2015 development targets because of a lack of finance. The amount of debt that can be repaid by each country should be judged according to the additional finance required to achieve these targets. For many, this will mean 100 per cent cancellation of their outstanding debts by the rich-country governments, the World Bank and the IMF.

The world's poorest countries are pushing for this human development approach to calculating debt sustainability. They want the criteria for assessing the extent of debt relief to focus on poverty levels. In the UN and the World Bank, they have called for debt reduction that will provide the financial resources they need to reduce poverty.

But the richest creditors are using their majority shareholding in the World Bank and the IMF to resist this demand. Is it fair that global institutions make their decisions in this way?

Fair and transparent arbitration

The debt crisis has lasted for more than 25 years at enormous cost to the lives of the poorest and most vulnerable people. Creditors have long taken a half-hearted approach to the problem, and then only after pressure from debt campaigners. Even though most independent commentators agree that the HIPC initiative is not solving the problem, the global financial authorities, controlled by the richest countries, are refusing to budge.

Currently, creditors control the pace, amount and criteria for relief. Because creditors act as prosecutor, judge and jury in assessing how much debt relief should be made available, campaigners argue, the results will always be unfair or inadequate.

They argue that a fair and transparent arbitration process should be developed to decide how much debt relief countries need. All stakeholders, and in particular the civil society representatives of the affected countries, have a right to be heard. And to protect the basic needs of the poor in debtor countries, there should be an automatic stay of debt servicing once a country asks for debt relief.

According to CAFOD's partner in Zambia, Mulima Kufekisa Akapelwa:

"If the people in the heavily indebted poor countries are always going to be excluded from the talks which determine their future, then we are doubtful that the decisions taken on their behalf will be just ones.

"We are now saying the people of the South must be included in the discussions that decide their fate."

More Information on Debt Relief

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FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.