8 Debt Relief for Heavily Indebted Poor Countries: Lessons from the Debt Crisis of the 1980s
- Zubair Iqbal, and S. Kanbur
- Published Date:
- September 1997
The official financial community has adopted in principle a historic Initiative to forgive a large portion of the debt owed by the most severely indebted of the heavily indebted poor countries. This essay considers the proper directions for this undertaking in light of international experience in resolving the debt crisis of the 1980s, which primarily involved middle-income countries, especially in Latin America.
At the outset, it is useful to consider the possible limits of relevant lessons from that experience because of the differences between the two groups of countries. Perhaps the most important difference is that in the 1980s crisis the bulk of the debt was in the form of claims owed to the private sector, primarily syndicated loans from commercial banks, whereas the bulk of HIPC debt is owed to public sector creditors, both bilateral and multilateral. Numerous contrasts flow from this difference.
At the institutional level, the HIPC debt problem involves the thorny issue of whether and how to reduce claims owed to multilateral official institutions. Preferred creditor status has made them exempt from forgiveness in the past, but they account for a far larger share of the debt of HIPCs and their claims are thus more difficult to exclude from the solution. Similarly, bilateral creditors largely escaped forgiveness in the Latin American debt crisis, but they have already been the principal source of debt relief for HIPCs.
Aside from the inexorable linkage between principal creditors and principal debt alleviators, the official as opposed to private nature of claims on HIPCs introduces a second major difference from the 1980s experience. Political as opposed to commercial considerations affect not only debtor decisions but also creditor decisions. The main case where this was also true in the 1980s experience was that of Poland, where politically driven forgiveness on behalf of bilateral claims set the pace for the unusually deep forgiveness subsequently extended by the banks.
At the economic level, a major difference derives from the crucial role that revival of private market expectations was able to play in the resolution of the debt crisis of the 1980s. As discussed below, it seems unlikely that this capital market revival effect can be as significant for HIPC debt relief.
The third difference is simply that HIPCs are poorer than the Latin American debtors that owed the bulk of the debt in the 1980s. This difference provides a basis for a greater element of concessionality in the workout.
The primacy of policy reform is a salient lesson of the 1980s experience that applies squarely to HIPC debt relief. There is general agreement that the debt crisis of the 1980s stemmed from the combination of international economic shocks (high international interest rates, global recession) with preexisting internal policy imbalances. The most severe imbalances were typically fiscal deficits and overvalued exchange rates.
Most observers would agree that the fundamental reason for the resolution of the Latin American debt crisis was that there was a sweeping process of policy reform that set the stage for more sustainable economic performance. Partial debt forgiveness may have played some part in facilitating this policy regime shift, but could have contributed very little to the outcome without it. Thus, it is difficult to believe that forgiving Peruvian debt during the populist regime of Alain Garcia would have provided a sustainable basis for economic recovery, whereas the subsequent Fujimori reforms cleared the way for a final debt workout. The economic reason why policy was more important than debt forgiveness was that the direct relief on debt was too small to afford the luxury of continuation of distorted policies, but large enough to play a catalytic role in private expectations once reformed policies were in place.
The HIPC Debt Initiative developed in recent months, in part through the leadership of the Group of Seven, the IMF, and the World Bank, appropriately places policy reform at the center of debt resolution. Indeed, it does so to a degree that involves a relatively elaborate and lengthy sequencing of conditional steps. In a first three-year period, bilateral creditors are to apply annually phased Naples debt relief terms, provided that the country adheres to an economic adjustment program monitored by the official international agencies. Bilateral and commercial creditors would reschedule two-thirds of principal and interest coming due during the three years, and at the end of the period with successful adherence to country conditionality, they would forgive two-thirds of the stock of claims. If at the end of three years the country’s debt indicators remain above what is considered sustainable, stock reduction would be postponed, and during a second three-year period the bilateral and commercial creditors would boost rescheduling from 67 to 80 percent of the flow of principal and interest payments. At the end of this second tranche of three years’ successful adherence to conditionality, they would forgive 80 percent of the stock of debt. If even that did not suffice, the multilateral creditors would then undertake indirect debt relief that would bring the burden down to a sustainable level.
Given the primacy of good economic policies, it is difficult to fault this basic approach. The only question is whether it is so drawn out that there could be disadvantageous side effects that could erode the benefits of assuring continuity in policy reform.
A Fresh Start
A potential source of such erosion concerns the role of the favorable expectations shock in the benefits of debt reduction. In the Latin American case, the boost to economic conditions from Brady Plan debt forgiveness tended to exceed substantially what could have been expected as the impact of direct savings on debt servicing (Claessens, Oks, and van Wijnbergen, 1993; Cline, 1995). In Mexico, the Brady agreement of late 1989–early 1990 was largely responsible for a drop in domestic interest rates from more than 50 percent to less than 35 percent, as the resolution of the debt conflict assured investors there would be no collapse of the exchange rate. More generally, there was an impressive surge to new highs for private capital flows to Latin America in the early 1990s, and in each major country there was a clear link in the timing of this reversal to achievement of agreement of Brady restructuring.
It seems likely that HIPC debt relief will also provide important induced macroeconomic gains that add to direct savings on debt obligations. However, the role of private capital markets is much smaller in these countries, so expectational effects seem likely to be relatively smaller.
There is a trade-off between greater assurance of policy reform through a stretching out of the period of conditionality, on the one hand, and the extent of the positive expectational shock from a debt restructuring agreement, on the other. A long conditional period means that investors remain uncertain whether the country will fall out of compliance and the agreement will lapse. Where there is a record of repeated policy distortions, and in view of the likely smaller relative role of the expectational effect, it is probably judicious to adopt the type of phasing-in now planned for the HIPC Initiative, However, where the policy reform record is already strong, there could be an important payoff from truncating the length of the conditional period. The proposed strategy appears to have some latitude for this approach by giving some credit for time already successfully spent in adjustment programs.
Another reason for expediting completion of the debt relief where performance seems favorable is that in the political context associated with concessional assistance, the menu of items for conditionality can become cumbersome and invite noncompliance. Except perhaps where there are extreme noneconomic factors, such as pervasive human rights violations or civil war, it would seem better to focus conditionality on the principal macroeconomic variables central to sustained growth, and thereby improve the chances of an early realization of the favorable expectational shock of debt resolution.
Truth in Accounting
An important lesson from the debt crisis of the 1980s is that accounting—as well as economic reality—can matter. A crucial turning point in the evolution of the debt strategy occurred in 1987, when the major international banks began to set aside large loan-loss provisions for their claims on debtor countries. These provisions placed the banks in a more comfortable position to conduct debt-equity swaps, buy-backs, and other such transactions. The bolstered capital and loss-reserve position of the banks also facilitated the transition from the Baker Plan for refinancing and new money to the Brady Plan for securitization and forgiveness in exchange for official guarantees.
I suspect that an analogous shift in public sector accounting would help realize HIPC debt relief. The World Bank has examined which HIPCs are likely to need official debt relief beyond existing Naples terms for bilateral claims (67 percent forgiveness of present value), based on a rule of thumb of remaining present value of external debt at no more than 200–250 percent of exports. It would make sense for donor aid agencies and bilateral export credit agencies to take a relatively uniform approach in setting aside loan-loss reserves for the amounts of their claims on these countries that are likely to exceed the viable remaining debt by this (or some other appropriate) benchmark.
Writing down the claims would not be equivalent to forgiving the debtor obligation to pay. In the 1980s crisis, loan-loss reserves did not translate into immediate forgiveness. However, the accounting change would ease the eventual economic change, as was the case in the 1980s. Specifically, donor governments could tell legislatures that debt to be forgiven had already been reserved against and therefore did not require any new appropriations of budgetary funds.
The U.S. government already moved in this direction by its credit reform legislation of 1992, which provided that official agencies had to set aside loss reserves on new loans to questionable debtors according to an array of risk categories. However, for some other major donor governments, there may remain substantial amounts of underprovisioning for potential losses on claims owed by HIPCs. Full provisioning would seem likely to facilitate the subsequent implementation of relief.
Whatever its influence on legislative or other donor decisions, truth in accounting would seem necessary simply from the standpoint of honest reporting to taxpayers. Consider the claims on Sudan. This nation owes about $18 billion, about 30 times its export base. Of this amount, $7 billion is in principal arrears on long-term debt, and $6 billion is in interest arrears (World Bank, 1996), so the bulk of debt has arisen from the accumulation of back payments the country failed to make. Regulators would force any domestic financial institution holding such a claim to write off all or most of it, for purposes of evaluating the institution’s soundness. Any official entity holding these claims that has not already done so has in effect failed to tell the taxpayers how large their fiscal deficit was in past years.
Peter or Paul?
Perhaps the most important institutional obstacle in the area of truth in accounting is the artificial division within the public sector that has so far largely stymied HIPC debt relief: the demarcation between multilateral and bilateral. The principal argument against the rescheduling, let alone forgiveness, of multilateral claims is well known: preferred creditor status for these institutions permits them to obtain lower-cost borrowing on capital markets. As noted above, however, the larger the creditor, the more dubious its economic feasibility of retaining seniority. The international discussion on HIPC debt relief now acknowledges the prospective need for de facto multilateral forgiveness, but it respects the preferred creditor status consideration by seeking mechanisms that provide the resources to make the multilaterals whole, essentially granting resources that enable the country to repay its debt to the multilateral institution. The issue, however, is: Who pays for these resources?
It is here that truth in accounting suffers. Some major donors insist that the multilaterals themselves must somehow come up with the resources. The highest-profile variant of this demand is that the IMF sell some gold so that at least the earnings from the proceeds could be used for the resource requirement to pay off multilateral debt. Where accounting veracity suffers in such demands is in the failure to recognize that the principal shareholders mandating such a loss are themselves the ones who will suffer it through their own positions in their subsidiary, the multilateral institution. It is simply misleading for major governments to portray to their domestic publics the notion that the multilaterals are “them” as distinct from the national “us.”
More explicitly, true accounting should show some claim of the industrial country upon the multilateral institution; indeed “capital” contributions are justified to legislatures as costless because they are acquisitions of such a claim, and thus mere reshufflings of assets. So if the industrial country successfully forces the multilateral to raid its reserves to consummate a de facto forgiveness, the industrial country will have experienced a loss on its (true) book of claims in the multilateral. Abstracting from differences between donors’ capital subscription shares and their shares in outstanding debt in particular countries, this type of operation imposes an indirect loss on the industrial country that is equivalent to the direct loss it would have to report in the budget if there were an appropriation of moneys to provide a corresponding grant for direct use to repay the multilateral debt. Peter is being robbed to pay Paul. Correspondingly, to the extent that the United States (for example) has already implemented truth in accounting in its bilateral claims, it has not yet done so in its shareholder position regarding multilateral claims.
With a partial exception: the International Monetary Fund already has established a Special Contingency Account built up in recent years against growing arrears from HIPC and other debtors. It would make sense to tap this source at least initially, and subsequently if necessary to address the remaining need for the rich countries to make direct appropriations to grants for use in repaying multilaterals. Those countries that have booked their share of the accumulated assets in the Special Contingency Account would have to book the loss as it is drawn down; those that have not done so essentially have a hidden reserve that would sensibly be used before the more painful recourse to new appropriations. The main point, however, is that the principle of truth in accounting strongly suggests that the AIphonse-Gaston delays in HIPC debt relief stemming from the institutional rigidity of separation between the multilaterals and their donor country shareholders are an unfortunate real cost of what is essentially a red herring.
Politics and Pattern Bargaining
A major lesson from the debt crisis of the 1980s is that debtor politics can matter as much as the underlying economic burden of the debt. Chile’s relative debt burden was higher than Peru’s through most of the 1980s, yet Chile did not go into arrears and eschewed Brady forgiveness whereas Peru did the opposite. The fall in oil prices hurt Mexico and helped Brazil, but Brazil found it attractive to take advantage of comparable Brady relief.
Pattern bargaining was an outcome of this ambiguous mixture of subjective political and objective economic considerations (or, of willingness and ability to pay). Typically Mexico would set the initial pattern, and then other debtors would eventually secure debt restructurings that closely resembled the Mexican pattern, with only moderate variation to reflect differing economic conditions. This was so with the remarkable choice of exactly 13/16 of a percentage point as the spread above the LIBOR for the new money deals of the mid-1980s, and it was so with the approximately 35 percent debt forgiveness of the Brady deals.
In contrast, the multilateral HIPC debt relief proposal aspires to a more scientific determination of the extent of debt forgiveness in individual cases, based on what is necessary to bring down the prospective debt-exports ratio to a target level (at least in the second phase after the initial 67 percent bilateral cut). It will be a challenge to keep this objective from being turned into a more subjective, political outcome.
One example of the likely pitfalls is that some debtor countries will argue that the debt-exports ratio does not reveal the internal transfer burden of mobilizing resources from the private economy to permit public sector servicing of debt, but instead only considers the external transfer burden of mobilizing export earnings to carry out this servicing. However, the internal transfer argument has always suffered from the problem that it implicitly assumes that external creditors are residual rather than proportionate claimants on budget revenue. Moreover, because donors continue to provide net resource transfers to HIPCs, the question is not whether there should be a net budget drain to service debt but whether the donors should be more generous and pay for an even larger share of HIPC government expenditure.
The debt-exports ratios used for the cutoffs are probably on the generous side, because much of the debt is concessional (at below-market interest rates) so that face value of its principal overstates the corresponding economic value, especially if the new lending can be expected to cover amortization so that all that matters is the interest burden.1 On the basis of the 200–250 percent ratio for present value of debt relative to exports2 and 20–25 percent for the debt-service ratio, analysts at the World Bank and the International Monetary Fund have simulated prospective balance of payments and debt over a decade and identified as “unsustainable” the debt of countries that at the end of this period are likely still to have debt ratios in excess of these ranges. “Sustainable” cases have debt ratios below the lower end of this range within five years, and the rest are “possibly stressed.”
Experience from the 1980s suggests that there will be political pressure for many countries to be shifted from “possibly stressed” to “unsustainable.” This would considerably widen the relief envisioned. IMF and World Bank analysts have identified 8 countries as having unsustainable debt, and another 12 with possibly stressed debt.3 The incremental costs beyond Naples terms relief amount in present value to $5.6 to $7.7 billion, with the higher figure for a scenario with lower export growth, and with the estimates excluding the largest “unsustainable” debtor involved (Sudan). Of the baseline $5.6 billion, the costs would be divided as follows: Paris Club, $1.9 billion; other bilateral, $0.4 billion; commercial creditors, $0.1 billion; World Bank, $1.1 billion; IMF, $0.8 billion; and other multilateral, $1.3 billion.
All these figures would be higher if the political process shifted more countries into unsustainable treatment, and perhaps some other HIPCs from sustainable to possibly stressed. Note further that these estimates are for costs above and beyond the 67 percent Naples forgiveness, so they presume about another $15 billion in bilateral and commercial debt forgiveness in the first three-year tranche before multilateral forgiveness comes into play. Once again, much or most of this loss should be seen as an accounting rather than an economic loss.
The combined population of the unsustainable group is about 80 million (of which Zaïre has about half). Debt forgiven for this group including the first “Naples” tranche would amount to about $15 billion, or about $200 per capita. The transfer would amount to about $20 per capita for OECD donors, small whether viewed as an economic burden or as an accounting correction. Even if the overall forgiveness were to double because of debtor politics, this transfer would remain small.4
The principal contribution of Brady Plan debt forgiveness in Latin America at the turn of the decade was that it cleared the way for a resurgence of private capital inflows. Although private capital is a far smaller part of the debt in HIPCs, and although debt restructuring seems unlikely to achieve more than a modest level of new private capital inflows, it is important that policy design foster rather than impede the possible future gains in private flows.
Private debt reduction has already gone a long way in HIPCs. In sub-Saharan Africa, the two countries with the largest debt to private creditors have received Brady Plan reductions. In 1992, the London Club banks agreed to a package (primarily buybacks) that effectively reduced claims on Nigeria by about 60 percent. In November 1996, CÔte d’lvoire announced an agreement with foreign banks that represented reduction by about 80 percent of the present value of claims (Emerging Markets Debt Report, December 2, 1996). The latter restructuring conferred greater relief than the Naples terms for bilaterals, especially considering that Paris Club relief sets cutoff dates that exclude subsequently contracted debt.
The new official HIPC Initiative stresses that commercial creditors (and non-Paris Club bilateral creditors) should confer comparable relief to the Naples terms to be extended by Paris Club lenders in the first three-year phase of relief, and that the commercial creditors should once again be subject to comparability in a second phase if a country turns out to need further debt reduction. In a broad context, however, the private sector might be seen already to have stored up a large credit toward comparability from its past forgiveness through the earlier Brady Plan operations that emerged from the debt crisis of the 1980s. In that workout, private banks forgave the equivalent of more than $60 billion (Cline, 1995, p. 235). In contrast, for the public sector the debt-forgiveness-equivalent so far in the 1990s is on the order of only about $30 billion.5
Even if one accepts forward-looking comparability for private creditor relief to HIPC debtors, it would seem important to maximize the chances of a favorable reaction in private sector expectations by collapsing forgiveness into once-for-all operations, rather than stretching it out over a period of six years or more. As noted above, IMF and World Bank estimates of the private sector component of the new HIPC Debt Initiative amount to only about $100 million out of the $5.6 billion cost estimated for beyond-Naples relief to countries with unsustainable or possibly stressed debt. It would be likely that the cloud of uncertainty that would hang over private sector claims for a six-year period under the phased-in, two-stage HIPC Initiative could well discourage new private flows by more than enough to warrant forgoing this private sector contribution to relief in the plan’s second phase.
The new HIPC Initiative has incorporated some important lessons from the 1980s debt crisis, but may have failed to recognize others. Perhaps the most important lesson, that domestic economic policies are paramount, is given heavy weight in the Initiative by its short-leash approach, which extends conditionality over as much as six years. This structure is more likely to err on the side of overkill than inadequate policy review, especially where donor politics could expand the range of conditionality to more difficult noneconomic areas. The implication is that the program should provide as much flexibility as possible for telescoping relief into a shorter period where countries have convincing policy track records.
A major lesson of the 1980s experience is that a positive expectational shock that revives private capital flows is the key outcome of debt restructuring. In this regard, the HIPC Initiative may cause an unnecessary impediment by posing extended uncertainty for private creditors (as potential liability for a second round of forgiveness remains for the second three-year period of the program) rather than collapsing private creditor workouts into once-for-all operations early in the horizon. Another key lesson of the 1980s experience is that institutional and especially accounting practices should not obstruct a workout desirable on economic grounds, as shown by the catalytic role played by the loan-loss provisioning undertaken by major banks in the late 1980s. Application of this lesson to the HIPC Initiative would counsel that official creditors not allow accounting practices to be a roadblock to effective relief, whether in appropriations of bilateral assistance or in the thorny question of multilateral as opposed to bilateral forgiveness.
Finally, the lesson of the tendency toward political rather than technocratic solutions in the 1980s suggests that the initial estimates of costs of HIPC relief premised on debt-exports ratios may fail to capture political pressures for wider relief. Nonetheless, even with allowance for some political amplification, the amounts are small on a global historical scale, especially when much of what is involved should be seen as a truthful recalculation of accounts rather than a new unilateral transfer.
ClaessensStijnDanielOks and Sweder vanWijnbergen1993“Interest Rates, Growth, and External Debt: the Macroeconomic Impact of Mexico’s Brady Deal,”Policy Research Working Paper No. 1147 (Washington: World Bank).
ClineWilliam R.1995International Debt Reexamined (Washington: Institute for International Economics).