Preventing unsustainable debt

According to the latest Debt Sustainability Analysis of the IMF, around a third of low-income countries are heavily indebted. Classed among them are a number of countries that have already been granted substantial debt relief under the Heavily Indebted Poor Countries (HIPC) Initiative and the Multilateral Debt Relief Initiative. They include Burkina Faso, Burundi, Gambia, Haiti and São Tomé and Príncipe. Moreover, recent IMF and World Bank calculations indicate that another five graduated HIPC countries are in danger of falling into a debt trap again.

To prevent that, two conflicting goals must be achieved. On the one hand, donors must plug financing gaps with credit and grants, while on the other hand, the capa­city of developing countries to bear the debt burden must not be over-stretched.

Guaranteeing debt sustainability in the world’s poorest countries is fundamentally about prudent lending and borrowing. Loans have to be highly concessional. Because of fiscal constraints in the rich world, outright grants are only feasible to a limited extent. Moreover, the debt situation of the poorest countries needs to be closely monitored.

Among the multinational donors, the IMF and World Bank were particularly fast to respond to the crisis. The IMF has ploughed an additional $ 17 billion into its concessional loan programme through to 2014. It has also suspended interest payments on outstanding concessional loans to all low-income countries up to the end of 2011.

Reform was necessary to adapt the IMF toolbox to the needs of tackling the current financial crisis. Earlier, the Fund lacked a flexible short-term financing facility for concessional use as well as a flexible emergency credit. The reform of the facilities therefore made good sense, it served to appropriately improve the IMF’s scope of action.

The World Bank has also adapted its tools to the new situation and has started to fast-track $ 2 billion of IDA, the World Bank branch which gives concessional loans to low-income countries. However, the total volume of IDA-15 – $ 42 billion – will not rise.

At the G20 summit in Pittsburgh, World Bank President Robert Zoellick proposed creating a “Crisis Response Facility” for low-income countries. It would provide fast and effective financial assistance to low-income countries and become a permanent IDA facility. No decision, however, was taken yet.

Another important tool for monitoring and analysing the debt situation is the Debt Sustainability Framework of the IMF and World Bank. Its purpose is to give early warning of critical states of debt matters in low-income countries, thus helping both creditors and debtors to assess requirements and risks for future loans.

The current financial crisis has shown that adequate instruments allow governments to absorb shocks. These instruments need to be flexible and be used in a counter-cyclical manner. For two years, Agence Française de Développement has been working with an innovative financial tool it calls “Counter-Cyclical Loan”. It is designed to prevent high indebtedness in low-income countries by linking terms of repayment to export performance. Empirical evidence shows that falling export revenues often play a major role in causing debt crises in low-income countries. To make sure that the instrument’s effect is indeed anti-cyclical, timely export data are needed.

Innovative debt swaps

Debt swaps are another tool for tackling – and preventing – indebtedness. In a debt swap, the creditor country cancels a part of the outstanding debt, and the debtor in return invests part of the cancelled amount in pre-defined development projects. Debtors use domestic currency for this purpose. From 1993 to 2008, the German government pledged € 1.36 billion for debt swaps in 19 countries. The advantage of debt swaps is that additional domestic funds are mobilised for development purposes.

Debt swaps can be used innovatively under a three-way agreement. The Federal Ministry of Economic Cooperation and Development (BMZ) cancelled FC debts worth € 50 million for Indonesia and € 40 million for ­Pakistan. In return, the two countries paid half of the amount cancelled into the Global Fund to Fight AIDS, Tuberculosis and Malaria. The Global Fund has a system of controlled evaluation mechanisms, so it is easier to check whether a government would have made the relevant payment even without the debt swap. Like the Counter-Cyclical Loan, individual donor debt swaps have little impact on indebtedness as a whole, but they nonetheless make the debt situation better manageable.

In the course of the current financial crisis, UNCTAD Secretary-General Supachai Panitchpakdi proposed a moratorium on public-sector debt-service payments for all low income countries as a short-term measure to reduce debts. A moratorium gives a debtor time to improve liquidity; on the other hand, it breaches one of the fundamental principles of contracts – the observance of contractual conditions. Furthermore, there is a risk of moral hazard on the part of debtors. Therefore, a moratorium can only be an emergency solution in an exceptional case; it should not be used across the board for all developing countries.

In addition, an international insolvency procedure for sovereign states is needed to resolve debt crises in low-income countries. Within such a framework, foreign debt would be restructured in keeping with given rules and on the basis of a majority creditor decision that would have binding force for minorities. One important reason for the introduction of an international insolvency procedure is that today’s lengthy ad-hoc – and therefore unregulated – proceedings permit no rapid re-scheduling, as was seen in the case of Argentina. This state of affairs is expensive for creditors and debtors alike.

Last but not least, the developing countries themselves play an important role in preventing and managing debt crises. To plug financial gaps, they need to mobilise domestic resources more effectively. Domestic savings need to be generated and harnessed for productive investment. This concerns both the public and the private sector. The public sector must mobilise domestic resources through taxes and public revenues – such as through investment. The private sector must mobilise household and corporate savings through financial intermediaries – such as banks – which channel the resources into productive investments. Equally important, developing countries must manage their debts prudently with a view to future trends.