debt relief for low income countries: is it effective and efficient?

Debt Relief for Low Income

Countries: Is it Effective and

Efficient?

Graham Bird and Alistair Milne

1. INTRODUCTION

I N recent years religious bodies, campaigning groups and parts of the mediahave made a strong moral case for debt relief, accusing creditors of

imposing an excessive burden of debt on low income countries and therebyforcing them to cut back in other areas of government expenditure such aseducation and health, with deleterious effects on poverty reduction and economicgrowth. The case for debt relief is also made from the other side of the politicalspectrum, most notably in the recent report of the International FinancialInstitution Advisory Commission sponsored by the US Congress (the ‘Meltzer’report) which amongst other measures called for complete debt cancellation bythe IMF and other IFIs.

Donors have responded with a series of measures, beginning witharrangements for debt relief under the Paris Club Toronto terms of October1988 culminating in the current enhanced Highly Indebted Poor Country (HIPC)initiative for the reduction of external debt.1 These measures have attractedincreasingly generous promises of funding from donors. Yet it is far from clearthat even complete debt forgiveness, let alone the much more modest degree ofdebt relief offered through the HIPC initiatives, will transform the economicsituation in low income countries in the way that campaigners for debt relief seemto expect.

ß Blackwell Publishing Ltd 2003, 9600 Garsington Road, Oxford OX4 2DQ, UK and350 Main Street, Malden, MA 02148, USA 43

GRAHAM BIRD is with the Surrey Centre for International Economic Studies, University ofSurrey, Guildford, UK and ALISTAIR MILNE is with the Faculty of Finance, City UniversityBusiness School, London, UK. Comments from Walter Elkan and an anonymous referee aregratefully acknowledged.1 A good overview of debt relief for low income countries may be found in Daseking and Powell

(1999). A comprehensive description of the HIPC initiative is Boote and Thugge (1999). Thisprovides a very useful summary of the institutional details that we omit from this paper.

Discussionhastendedto getcarriedawayby therhetoricof debtrelief withouttroublingto analysemorecarefully its implicationsfor resourcetransfersandtheconductof economicpolicy in poor countries.Suchanalysismustconfront twofundamentalquestions.First, shoulddevelopmentassistancebe offered to poorcountries,andif so,second,shouldthisassistancebeprovidedin theform of debtrelief or in someother way? It is, in principle, possibleto favour the idea ofprovidingdevelopmentassistanceandyet beunenthusiasticaboutdebtrelief asamodality for organisingit.

This paperimplicitly assumesthat thereis a role for developmentassistanceandit haslittle to sayaboutthe first question.Instead,it focuseson the secondquestionandsystematicallyexploresthe key issuessurroundingdebt relief asaway of providing developmentassistance.2 Throughout,an attemptis madetokeepa sharpdistinctionbetweenrhetoricandreality. Again,muchof thepopulardiscussionsurroundingdebtrelief mixesthemup.While this maybring attentionto theissue,in thelong run it doesnot assistin designingappropriatepolicy. Theultimateobjectivesof developmentassistanceareto help bring abouteconomic,social and human developmentin poor countries by encouraginglong-termeconomic growth and poverty reduction. This paper investigateswhetherassistanceoffered in the form of debt relief canhelp to deliver theseobjectivesand whether it can deliver them better than conventionalforeign aid. Is debtrelief, in other words, more effective and efficient? Our aim is to provide ameasuredassessmentof the issuessurroundingdebtrelief ratherthanto adoptaparticularpoint of view.

It is tempting to try and short-circuit careful analysisby arguing that debtrelief, in theform of theBradyPlan,waseffectivein alleviatingthedebtcrisis inLatin Americaat theendof the1980s,allowingcountriesin theregionto achieverapideconomicgrowthin thefirst half of the1990s,andthatit will similarly helpin thecontextof low-incomecountries,suchasthosein Sub-SaharanAfrica. Thisapproachis illegitimate. Apart from the scopefor a reasonabledebateabouttheroleof debtrelief in Latin America’seconomicrecovery,therearealsoreasonstosuggest that low-income countries are analytically different. The principalcreditorsof low incomecountries,unlike the caseof the major Latin Americandebtors,arebilateralandmultilateraldonors,not banks.Almost all the severelyindebtedlow incomecountries,againunlike theLatin Americancase,continuetoreceivesubstantialnetresourcesfrom their majorcreditors.It cannotbeassumed,therefore,that policy cansimply be exportedfrom Latin America to Africa.

Thelayoutof thepaperis asfollows. Section2 examinestheavailabledataondebtstocksandresourceflows. Section3 considersthe resourceimplicationsof

2 For attemptsto placedebtrelief in the contextof otherpoliciesfor dealingwith indebtedness,seeBird (1989)andBird andSnowden(1997).An overviewof theeconomicsof debtrelief in thecontextof the Third World debtcrisis in the 1980smay be found in Williamson (1988).

44 GRAHAM BIRD AND ALISTAIR MILNE

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debt relief. Section 4 considersthe economic consequencesof transferringresourcesthroughdebt relief, ratherthan throughnew lendingor grants,takingaccountof issuessuchasdebtoverhangandmoralhazard.Section5 offersa fewconcludingremarks.

2. THE DATA ON DEBT

Table1 presentsdataon thedebtstockandassociatedflows for fifty eight lowincomecountries.While this is standarddata,our presentationis novel in onerespect;distinguishing stocks and flows from official sources(such as themultilateral andbilateraldonors)andprivatesources(suchasbanks).3

The figures for total debt confirm that both debt stocks and debt servicepaymentsarehigh, with total 1998debtservicepaymentsfor exampleaveraging3.4 per cent of GNP. The majority of this debt is held by official creditorsbutprivatesectorcreditorshold aroundonethird of the long termdebtstock.Privatecreditorsalsoaccountfor nearlyhalf of debtservicepayments,becauseofficialcreditorsoffer loansat lessthanmarketratesof interest.However,debtservicepaymentscan be a misleadingindicator of the burdenof debt. In 1998 newlending(column4) wasa major offsettinginflow, reducingthe overall resourceoutflow on total low incomecountrydebt(debtserviceminusnewlending)to 1.6per cent of GNP. Other significant resourceinflows in 1998 to thesecountriesweregrantsandforeigndirect investment.Theeffectof addingtheseis to reversethe sign of total resourceflows, resultingin total net resourceinflows from allsourcesof just over threeper centof GNP in 1998.

The final two rows of Table 1 distinguishdebt stocksand resourceflowsassociatedwith official sourcesfrom debtstocksandresourceflows derivedfromprivatesources.In 1998therewerepositiveresourceinflows from both officialand,to a greaterextent,from privatesources.New lendingfrom official sources(1.9 per cent of GNP in 1998) and grants(0.6 per cent of GNP in 1998) weremore than enoughto offset debt serviceto official creditors.In the caseof theprivatesector,while netlendingwasnegative,substantialflows of FDI alsoled toa positivenet resourceinflow.

3 Thereis a technicaldifficulty in makingthisdistinctionusingtheWorld Bankdataonwhich thistable is based.This datacontainsa categoryof other public sectorand publicly guaranteedlongterm lending (the row in Table 1 labelled ‘other guaranteed’)which cannotbe clearly dividedbetweenofficial andprivatesources.We understandthat this dataincludesa largecomponentofsuppliercredit supportedby export credit guaranteesand we havethereforeallocatedthis as anofficial ratherthana privatesourceof finance.Thealternativeof allocatingit asa privatesourceoffinancewould not significantly alter the conclusionsdrawnfrom eitherTable1 or Table2.

DEBT RELIEF FOR LOW INCOME COUNTRIES 45


Table2 hasthesameform asTable1, but is restrictedto the29 mostseverelyindebtedlow incomecountries.4 This categoryincludesall thosecountriesthatare eligible for debt relief under the current HIPC initiative. For the severelyindebtedcountriesstocksof debtareof coursemuchhigher,nearly threetimeshigherin relationto GNP,thanfor low incomecountriesasa whole.But mostofthis additionaldebthasresultedfrom concessionallendingby the official sectorandconsequentlydebtservicepaymentsarelessthanhalf ashigh againat 4.9percentof GNP.Privatesectordebtstocksaresomewhathigherandprivatesectorresourceinflows somewhatlower thanfor all low incomecountries.

TABLE 1ExternalDebt andResourceFlows of Low IncomeCountries1

Stock Interest Amortisation New Net Debt ResourceLending Lending Service2 Inflow

% GNP 1998 (1) (2) (3) (4) (5) = (4)ÿ(3) (6) = (2)+(3) (7) = (5)ÿ(2)

Total debt3 39.6 1.4 ÿ0.1 ÿ3.4 ÿ1.6Long term4 33.4 1.2 2.1 2.5 0.4 ÿ3.3 ÿ0.8Multilateral 9.2 0.2 0.3 0.8 0.5 ÿ0.6 0.2Bilateral 11.1 0.2 0.5 0.6 0.1 ÿ0.7 ÿ0.1G’teedbank/bond5 5.5 0.3 0.4 0.7 0.3 ÿ0.7 0.0Otherguaranteed6 2.1 0.1 0.3 0.1 ÿ0.2 ÿ0.4 ÿ0.3Non-guaranteed7 5.5 0.2 0.6 0.3 ÿ0.3 ÿ0.9 ÿ0.6

IMF 1.1 0.0 0.1 0.4 0.3 ÿ0.1 0.3Short term 5.0 0.2 ÿ0.9 ÿ1.1

Grants8 0.6FDI9 3.0Portfolio10 0.1

Summary (excludingshort term)Official sources11 23.5 0.6 1.2 1.9 0.7 ÿ1.8 0.7Privatesources12 11.0 0.5 1.1 1.0 0.0 ÿ1.6 2.5

Notes:1 Statisticsfor 58 low incomecountriesreportingto the World Bank (sourceGlobal DevelopmentFinance

2000on CD-Rom).2 Including the interestbut not the amortisationof short term debt.The latter dataareunavailable.3 Total debt= long term + IMF credit + short term.4 Long term = multilateral+ bilateral+ suppliercredits+ otherpublicly guaranteed+ non-guaranteed.5 ‘G’teed bank/bond’is lending to the public sectorand to publicly guaranteed privatesectorborrowersvia

banklendingor bondissue.6 ‘Other guaranteed’ is all other lending by private creditors either to public sector or to private sector

borrowerssupportedby a public sectorguarantee(typically exportcredit guarantee).7 Non-guaranteed is debt finance from private sourcesto private sectorborrowerswithout supportof any

public sectorguarantee.8 Grantsareofficial developmentgrantsexcludingtechnicalco-operation.9 FDI is net foreign direct investment.

10 Portfolio is net portfolio investment(purchaseof equitiesandlocally tradedbonds).11 Official sources= multilateral+ bilateral+ otherguaranteed+ IMF + grants.12 Privatesources= g’teedbank/bond+ non-guaranteed+ FDI + portfolio.

4 OtherthanIndonesia.Indonesiais a largeeconomyonly recentlyreclassifiedfrom middleto lowincomeandwith a very differentdebtstructurethanotherseverelyindebtedlow incomecountries.Its inclusionwould greatlydistort the conclusionsdrawnfrom Table2.



Table 2 also highlights the fact that severelyindebtedlow incomecountriesreceivemuchgreaterlevelsof newlendingfrom official sourcesandmuchhigherlevels of developmentgrants,relative to other low income countries.In 1998thesefavouredcountriesreceivednew loansfrom official sourcesamountingto4.5 percentof GNPandgrantsof over four percentof GNP.Themostseverelyindebtedlow incomecountriesreceivednearly$3 in new lendingandgrantsforevery $1 of debt servicepaymentsand were thereforethe beneficiariesof netdevelopmental aid inflows amountingto nearly six per cent of GNP. Officialcreditorsin effectprovidedtheresourcesto servicetheir own claimsfor themostseverelyindebtedlow incomecountries.

Themostseverelyindebtedcountriestendto attractthelargestinflows of newlendingandgrants.Figure2A comparesstocksof debt from official sourcesin1995with theaveragenet inflow of resourcesover theyears1996–1998(officialgrants + new lending ÿ debt service payments)for the severely indebtedcountries.5 The only severelyindebtedcountry receiving negativenet officialresourcetransfersover this period was Nigeria.6 A small number(Cameroon,DemocraticRepublicof Congo,Cote D’Ivoire, Indonesiaand Sudan)received

TABLE 2ExternalDebt andResourceFlows for SeverelyIndebtedLow IncomeCountries1

Stock Interest Amortisation New Net Debt ResourceLending Lending Service2 Inflow

% GNP 1998 (1) (2) (3) (4) (5) = (4)ÿ(3) (6) = (2)+(3) (7) = (5)ÿ(2)

Total debt3 128.2 2.1 1.2 ÿ4.9 ÿ0.8Long term4 111.3 1.8 2.9 4.7 1.9 ÿ4.6 0.1Multilateral 29.3 0.5 0.9 1.9 1.1 ÿ1.4 0.6Bilateral 57.1 0.5 0.6 0.8 0.2 ÿ1.1 ÿ0.3G’teedbank/bond5 16.2 0.6 1.0 0.5 ÿ0.5 ÿ1.6 ÿ1.1Otherguaranteed6 5.6 0.1 0.2 1.5 1.3 ÿ0.3 1.2Non-guaranteed7 3.1 0.1 0.2 0.1 ÿ0.2 ÿ0.3 ÿ0.3

IMF 3.7 0.0 0.3 0.4 0.1 ÿ0.3 0.1Short term 18.8 0.3 ÿ0.7 ÿ1.0

Grants8 4.2FDI9 2.8Portfolio10 0.0

Summary (excludingshort term)Official sources11 95.7 1.1 1.9 4.5 2.6 ÿ3.0 5.7Privatesources12 19.3 0.7 1.2 0.5 ÿ0.7 ÿ1.9 1.5

Notes:1 Statisticsfor 29 low income countries– all thosedefined as ‘severely indebted’ in Global DevelopmentFinance.2–12 SeeTable1.

5 The allocation of debt and net resourceflows betweenofficial and private sourcesusedforFigures2A and2B is madeon exactlythe samebasisasfor the final two rowsof Tables1 and2.6 The refusal to provide resourceinflows was presumablya conseqenceof the international

opprobriumof the SunniAbacharegime.



net transfersof less than two per cent of GNP. The remaining twenty threeseverelyindebtedcountriesall receivedpositivenettransfersin excessof two percent of GNP. As the regressionline in this figure suggests,from amongsttheseverelyindebtedlow incomecountriesit is thosewith thehighestlevelsof debtstockwhich typically obtainthelargestnetofficial resourceinflows. It seemsthatit paysto beindebtedto official creditors.Figure2B, comparingthestockof debtwith net new lending, revealsa very different picture for debt owed to privatecreditors.7 New lending is typically less than debt service,so net inflows arenegativeandthereis no clearrelationshipbetweenindebtednessandnet inflows.

To summarise:low incomecountriesarecarryinglargestocksof externaldebtto GNP, with especiallylarge amountsowed to official creditorsby the mostseverelyindebtedcountries.Debtservicepayments,relativeto the magnitudeof

FIGURE 1Debt StockandDebt Servicein the 20 Most SeverelyIndebtedLow IncomeCountries

Notes:Figure 1 comparesdebt stock and debt servicefor the twenty most severelyindebtedlow incomecountries,thosewith ratios of externaldebt to GNP in excessof 100 per cent. Given their limited tax capacity,thesecountrieswould certainlybe unableto servicesuchhigh debtstockson commercial terms.But in fact, whiledebtservicepayments(interestplus amortisationof principal) area significantproportionof exportsof goodsandservices(XGS),theyarelow relativeto themagnitudeof thedebt,andthereis noclearrelationshipbetweendebtstockandthe amountof debtservicepayments.

7 The net inflow in Figure2 excludesforeign direct investment.



FIGURE 2AOfficial Debt Stocks(1995)andNet Inflow of Official Resources(1996–1998)

FIGURE 2BPrivateDebt Stocks(1995)andNet Inflow of PrivateDebt (1996–1998)



debtstocks,aremuchhigher for borrowingfrom privatecreditors,comparedtoborrowing from official creditors.Finally and perhapssurprisingly, given thewidespreadperceptionthat low incomecountriescarry a substantialburdenofdebt service, inflows of official resourcesnet of debt service paymentsaresubstantialand positive for virtually all the severely indebted low incomecountries.The largestinflows go to thosecountrieswith the higheststocksofofficial debt.High debt stocksare a reflection of pastaid dependency,but notindicative of any requirementto transferborrowedresourcesback to officialdonors.

3. DEBT RELIEF AND NET RESOURCETRANSFERS

Having looked at the dataon debt, we may now examinethe casefor debtrelief in termsof its impacton net resourcetransfers.It is sometimessuggestedthatdebtrelief canreleaseadditionalresourcesfor low incomecountrieswithoutplacinganyadditionalburdenon thetaxpayersof donorcountries.8 This positioncanbe quickly dismissed.The new resourceshaveto be found from somewhereand, in the caseof official debt relief, this can ultimately only be either byborrowing,the saleof assetsby donors,or by increasedtaxation.

To explorethe flow of resourcesarising from debt relief morecarefully it ishelpful to examine two accounting identities; one for the evolution ofindebtednessandtheotherfor the fiscal constraintof an indebtedcountry.Thus:

�D � �Sÿ P� � �LÿW� �1�where �D is the change in indebtedness,S is the contracteddebt servicepayments,P is actualdebtservicepayments,andL is newlending.Debt relief isrepresentedby W, althoughit will alsoreduceS.

As far asthe fiscal constraintis concerned:

G� I � N � T � �Lÿ P� � A: �2�Here we distinguish between government expenditure on developmentalexpenditures, including infrastructure, health, and education �I � and amiscellaneouscategory�N�. Tax revenue�T� is augmentedby net new lending�Lÿ P� anddevelopmentgrants-in-aid from abroad�A�.

From these expressionswe can see that the only direct impact of debtforgivenessis to reducethe stockof debt.The fiscal implicationsarise,if at all,only indirectly via the effects on P, L and A. It is quite possible for debtforgivenessto haveno resourceimpact.Forexamplein thecasewheresomedebt

8 The suggestionthat debt relief mustautomaticallyreleaseresourcesfor health,education,andother developmentalexpendituresis madeto seemplausibleby campaignswhich focus on theoutflow of grossdebtservicepaymentsratherthanon net resourcetransfers.



servicewas not being paid prior to the granting of relief, and the relief onlyappliesto thisshortfall,i.e. thedifferencebetweenSandP, Sis nowreduceduntilit equalsP. Debtrelief of this sortwill reducethecontractualstockof debt,but itwill not strengthenthe recipient’sfiscal stance,unlessit leadsto new lendingormoreaid.

What if debtrelief goesbeyondthis essentiallycosmeticexerciseandreducesbothSandP? If therecipientwaspreviouslymakingall contractualdebtservicepayments,suchthat S� P, then,other thingsbeingequal,debt relief will relaxthebudgetconstraintto thefull extentof thefall in S. If, however,P< S, thenthefiscal impactwill bereducedaccordingly,andwill only occurto theextentof thefall in P (which will now clearly be lessthanthe fall in S).

But, other thingsmay not remainconstant.If donorswork to a targetbudgetfor thefinancialsupportof poorcountries,thefall in Swill beoffsetby a fall in Lor A. Dependingon the relative size of the fall in P, L and A, real resourcetransfersmight not riseat all andmight evenfall. Fromexpression(2), it maybeseenthat if A andL togetherfall by morethanP, thenthebudgetarysituationofthe recipientwill actuallyweakenratherthanstrengthen.

Assuming the most negative possible accounting treatment,under whichforgivenessof stocksof debtmustbe ‘financed’ out of currentaid budgets,thenthe immediateresourceimpact could be much worse than this. Supposethatdonorsforgive say$100million of debtandthis mustbeentirely financedout ofthecurrentaidbudget.How will currentresourceflows to a recipientbeaffected?Assumingan interestrateof threeper centandan amortisationrateof two percent,thefirst-yearresourcegainfrom debtrelief will be$5m.But the immediateresourceloss from reducedaid inflow will be $100m. Thus in this casetheforgivenessof a stockof debtis financedentirely out of the currentflow of aid,therewill actuallybe a declinein net resourcetransfersduring the first yearof$95m.It is truethat,becausethedebtis no longerbeingserviced,thisdeclinewillbe offset by increasednet resourcetransfersin future years.But this examplemakesclearthat whereeconomicdevelopmentis constrainedby the availabilityof externalresources,thefinancingof debtrelief out of currentaid budgetscouldhavea significantly adverseeffect on the ultimate objectivesarticulatedat theoutsetof this paper.

This potentialimpactof debtrelief hasbeenrecognisedin the framing of theHIPC initiatives,which incorporatea principleof ‘additionality’: i.e. thatall debtforgivenessshould be financedout of funds that are additional to current aidbudgets.Theneedto do this reflectsthebasicresourceconstraint;anyadditiontonet resourceflows resulting from debt relief must be financed,ultimately bytaxpayersin developedcountries.

To theextentthatdebtrelief crowdsout conventionalaid, from amongstlow-incomecountriestherewill begainersandlosersfrom aninitiative suchasHIPC.The issuethen becomeswhether financial assistancechannelledthrough debt



relief is distributedin a way that is in somesensepreferableto thedistributionofaid.Therearesoundreasonsfor believingexactlytheopposite.Wheredebtreliefgoesto countrieswith amountsof debtthat aredeemedunsustainable,resourcesmay in effect be directed towards countries with a history of economicmismanagement. To finance the debt relief, aid may be withdrawn from otherlow-incomecountrieswith greater‘need’ anda bettertrack recordof economicmanagement.To counter this problem HIPC eligibility is subject to strictconditionality in termsof the conductof economicpolicy.

Anotherway of makingthe samebasicpoints is by noting that:

F � L� Aÿ P �3�whereF standsfor total net resourcetransfersto anindebtedpoorcountry.A fallin P will only leadto additionaltransfersif L andA remainthesame.If A andLtogetherfall by the sameamountas the fall in P, then from a resourcetransferpoint of view, as well as from a fiscal point of view, the recipientof the debtrelief will beno betteroff. Furthermore,an increasein A andL equivalentto thedebt relief shown by the fall in P would have resultedin additional resourcetransfersanda relaxationin the fiscal constraint.

Expression(3) alsoallows us to draw an importantdistinction betweenlow-incomecountriesandmiddle-incomecountries.At the endof the 1980s,andforthe latter group of countries, P> L� A, and F was negative. Debt relief,providedthroughthe Brady PlanconversionsandothermechanismsreducedP,hadrelatively little effecton L� A, andthereforetendedto havea positiveeffecton F. In the Brady Plan ‘additionality’ was automatically provided by thereductionin interestincomeacceptedby bankcreditors.

As we haveseen,in the caseof almostall low-incomecountrieson the otherhand, P< L� A, and F is positive. Without additional resources,debtforgivenessfinancedout of currentaid budgets,i.e. out of reductionsin L� A,will leadto an immediatedeclinein F which will takemanyyearsto offset.

In summary,whatdoesthisanalysistell us?It saysthatit is illegitimatesimplyto assumethat debtforgivenessor evenfull debtcancellationwill automaticallystrengthenthebudgetarypositionof recipientsor their net resourceposition.Thecrucial issueis the impact of debt relief on other flows. It is possiblethat debtforgivenesswill leavethepoorcountriesthatreceiveit nobetteroff. Indeedto theextent that aid flows to all low-income countries are used to finance debtforgiveness, those countries that receive aid but are not beneficiaries ofmeaningfuldebt forgivenessmay well be left worseoff.

One may arguethat if additionalresourcesare availablefor transferto low-income countries, then the more efficient way of providing them is asconventionalaid ratherthan debt relief. This is becauseconventionalaid hasamore high-poweredshort-runeffect and also, as will be discussedin the nextsection,conventionalaid may createbetterincentivesfor recipientcountriesto



conductpolicies which achievethe ultimate objectivesof growth and povertyreduction.

4. EFFICIENCY ARGUMENTS FOR DEBT RELIEF

The casefor debt relief cannotbe basedon increasedresourceavailability,since,aswe haveseen,no increasein resourceswill automaticallyaccrueto therecipientcountriesfrom the relief of debtunlessthe donor/creditor countriesarepreparedto increasenet resourcetransfers.And suchan increasecould equallywell bechannelledthroughincreasedgrantsor newlending.The justification fordebt relief must instead be that, independentlyof any impact on resourcetransfers,it helpsachievethe ultimateobjectivesof improving growth ratesandrelieving poverty in low incomecountries.

Oneefficiency argumentfor debtrelief which hasfeaturedsignficantlyin theframingof theHIPC initiatives is thedesirabilityof reducingdebtto sustainablelevels. If debtservicebecomesunsustainable– i.e. if thedebtorcountryis unableto mobilise a sufficient proportionof externalresourcesto serviceits externaldebt – then the consequencewill be a shortageof international liquidity, adisruption of trade flows, and a consequentdeterioration in economicperformance. Debt relief can avoid both these costs and the associatedtransactionscostsof debt renegotiationand restructuring.9 But is sustainabilityreally a relevantissuein relation to the debtof low incomecountries?10

It might be claimedthat the high level of debt servicein the most severelyindebtedcountriesshownin Figure1, sometimesashigh as40 percentof exportearnings,are indeedbeyondthe paymentcapacityof debtorcountries.But thistakesno accountof the flow of developmentgrants.Specific measuresof debtsustainabilitythereforeonly makesensein thecontextof someparticularlevel ofaid flows.

If, asseemsto be the casefor virtually all the severelyindebtedlow incomecountries,debtorscancounton somegivenpositivelevel of net resourceinflowsF thentherewould seemto beno effectivelimit on thesustainablelevel of debt.Debt servicepaymentsrising to 50 per cent of total exportsor more could bematchedby a correspondingincreasein grants, and hencecould always befinanced.If thereis no netburdenof debtservice,thenanyabsolutelevel of debtis sustainable.Liquidity problemsmay emerge,but this will be becausedonorsset limits on the total level of net resourcetransfer that they are willing toprovide,not becausedebtstocksareunsustainablyhigh.

9 Therearevery few attemptsin theliteratureto assessthecostsof debtrelief to creditors.Foronesuchattempt,seeDasekingandPowell (1999).10 For an attemptto modeldebtsustainabilityin the contextof low incomecountries,seeCohen(1996).



An alternativeefficiency argumentfor the provision of debt relief relatestodebtoverhang; the ideathat the stockof debtactsasa disincentiveto economicreform,sinceindebtedcountriesperceivecreditorsto be the major beneficiariesfrom it while they – the debtors– carry the costsof economicadjustment.Debtactsasa tax on adjustmentandinvestment.11

Of course,servicinganyamountof debtinvolvesanopportunitycostsincetherelatedresourceswill beunavailablefor otherpurposes.But debtoverhanggoesfurther than this. While additional capital inflows may defray the costs ofservicingexisting debt, they will also lead to further accumulationof debt andwill thereforeincreasethe claimsof externalcreditorson an indebtedcountry’sfutureresources.It is in thenatureof debtoverhangthatit is thestockof debtthatneedsto be reduced.By reducingthe stock of debt, foreign claims on futureincomeareloweredandthis encouragesdomesticinvestmentandgrowth.This iswheredebt relief fits into the picture.

But doesofficial debt,whichdominatesthedebtstockof theseverelyindebtedlow incomecountries,really inducedebt overhang?This would only be true ifhigher levels of debt stock mean that debtorsanticipate lower levels of netresourcetransfersfrom donorsin the future. But aswe haveseenin Section2,higherlevelsof outstandingdebtareassociatedwith higher,not lower, levelsofnet resourcetransfersfrom official sources.

Onceagainthe key point is that it is not so muchdebt stocksthat matterasexpectedlevelsof net resourcetransfers.If thesearegreatestfor thosecountrieswith lowestpercapitaincome,thencountrieswhich aresuccessfulin movingoutof povertywill find that their shareof limited aid budgetsdeclines.This createsan obviousdisincentiveto pursuinggrowth and development.12 The extent towhich this ‘tax on development’alterspolicy choicesin the poorestcountriesisunclear.But unlessexpectationsof net resourceflows arealtered,reductionsinthe stock of debt will have little effect on incentivesto engagein economicreform.

A relatedpoint, alsoof limited relevanceto low incomecountries,is the so-called ‘debt relief Laffer curve’. If thereis a debtoverhangthendebt relief, byenhancingthe domestic incentive to pursueeconomic reform and economicgrowth,canleadto a rise both in the secondarymarketprice of debtandin thepresentvalueof expecteddebtrepayments.13 In this way creditorsmaygainfromdebt relief even though they have forfeited the option of full and completerepayment.In sucha casedebtorsareto theright of thetop of theLaffer curve.Itwasthe conceptsof debtoverhangandthe debtrelief Laffer curvethat were,in

11 Theinitial ideaof a debtoverhangis usuallyattributedto Sachs(1984).Otherusefuldiscussionsof the idea, inter alia, areKrugman(1988),Corden(1989)andSachs(1990).12 Analogousto the disincentiveeffectsarsingfrom welfarepaymentsto low incomehouseholds.13 Thedebtrelief Laffer curveis thoroughlydiscussedin Williamson(1989);butalsoseeKrugman(1988).For an attemptto test for its existence,seeClaessens(1990).



largemeasure,usedto justify debtrelief in thecontextof theLatin Americandebtcrisis. But clearly if there is no equivalent debt overhangfor low incomecountries,therecanbe no equivalentdebt relief Laffer curve.14

Whatabouttheefficiencyargumentsmadeagainsttheprovisionof debtrelief?Themostcommonargumentagainstrelief of privatesectordebtis thatof moralhazard. If private creditorsexpectthat public funds, in the form of debt relief,will be usedto bail out debtorsin the eventof their accumulatingunsustainabledebt,privatecapitalmarketswill be encouragedto over-lend.As a consequencedebtrepaymentcriseswill becomemorelikely. But thismoralhazardargumentisa weakonewhenappliedto debtrelief for low incomecountries.Relativelylittleof their debt comes from private sector creditors and current initiatives aredesignedfor the relief of official debt.

Thereis anotherandsomewhatdifferentargument,confusinglyalsoreferredtoasmoral hazardsometimesusedto opposetherelief of official debt.This is thatcountries, rather like an individual anticipating escapefrom repaymentbyenteringbankruptcyproceedingsand racking up large and unsustainablecreditcard bills, will deliberatelybuild up unsustainablelevels of debt from officialcreditorsin orderto subsequentlybenefit from any additionalresourcesflowingfrom official debt relief.15 Thereare flaws with applying this argumentto lowincomecountries.The analogywith an individual borrowingon a credit card isimperfectin that countriesarenot offereda large line of credit, which they canthen utilise freely for whateverpurposesthey choose.In fact new lending istightly controlledby donorsandis usuallyconditionalon the borrowerpursuingappropriatepolicies. In any casealtering debt stocks,as alreadydiscussed,haslittle impact on expectednet resourceflows so there are no obvious resourcebenefitsto over-borrowingin this way.

A final issue in the debateabout debt relief concernsconditionality. Anargumentthat may in principle be madeagainstrelief of official debt is that, tothe extent that it allows debtor countriesrenewedaccessto borrowing fromprivatecreditors,it mayallow themto escapefrom the conditionalityassociatedwith official new lending and grants.Although the escapemay well only betemporary,since they are likely eventually to exhausttheir accessto privatesourcesof credit, in the meantimepoliciesmay be adoptedthat makeeconomic

14 Claessens(1990)estimatesa debtLaffer curveusingcrosssectiondatafrom 1986to 1989fortwentynine countries.He concludesthat only Bolivia, Sudan,Peru,NicaraguaandZambiaareonthe ‘wrong side’ of the curve.However,methodologicallythereareproblemswith the studysincethereare difficulties in measuringthe ‘price’ of debt for poor countries.Cohen(1990) finds nosupportfor a debtLaffer curve.Subsequentwork by Samter(2000)againfinds little supportfor adebtLaffer curvein Sub-Saharancountriesover1990–94.He doesfind, however,that the ratio ofdebtservicepaymentsto obligationsis positively relatedto aid per capita,suggestingthat aid hasenabledlow incomecountriesto meettheir debtobligations.15 Although suchbehaviourmight be regardedas immoral, this is not moral hazardin the sensedevelopedin the literatureon insurancecontractsunderasymmetricinformation.



growth and poverty reduction less likely in the long run. This assumesthatconditionality disciplines countries to pursue policies that assist economicdevelopmentin the long run.

This argumentdoesnot apply to the currentHIPC initiative, sincethe degreeof debt relief on offer hasnot beensufficient to allow low incomecountriestogain accessto private sectorcredit. Nonethelessit is true, in principle, that asufficiently generousreductionof debtstockscouldleadto a weakeningof donorconditionalityaftertheexpirationof thedebtrelief scheme.To theextentthattheobjectivesof donorsandof debtorgovernmentsarein conflict, thentheremaybea casefrom thedonors’perspectivefor keepingdebtorson a ‘tight leash’throughmaintaininga sufficiently high level of debt to precludeaccessto privatesectorlending. Concerns about a loosening of conditionality also explain whyqualification for HIPC is itself subject to strict criteria on debtor governmentpoliciesandreform.

There is only one further economicargumentto be considered.If virtuallycompleteforgivenessof official debtwereon offer, thenaccessto privatesectorborrowingmight allow debtorsto escapefrom theconditionalityassociatedwithcurrentdevelopmentalaid flows. If thisconditionalityis inappropriatelydesignedand discourages the development of relevant domestic institutions andgovernments,avoiding it could be a benefit. But if debtorcountriescannotbetrustedto settheirowneconomicpoliciesandwork towardsdevelopmentalgoals,then this would be an undesirableoutcome.The attraction of escapingfromconditionalitydependson its costsandbenefits.

Overall we canconcludethat the efficiency argumentsfor debt relief in lowincome countries, just like the resource transfer arguments, have beenoverplayed.Sustainabilityof low incomecountries’official debt is not an issuein an economicsense.Sincedebtrelief is unlikely to affect anticipatedresourcetransfers,it will conferlittle benefitvia debtoverhangandthe debtrelief Laffercurve.But neitherdoesit createany moral hazard.The conditionalityargumentcould cut both ways.In the final analysisofficial debtrelief might appearto belittle more than a book-keepingexercise,and largely irrelevant from both theperspectiveof resourcetransfersandeconomicefficiency.

5. CONCLUDING REMARKS

It is understandablethat picturesof poverty and starvationin Sub-SaharanAfrica combinedwith discussionof the ‘burdenof debt’ andexpressionsof thesize of this burdenrelative to expenditureson healthand educationlead to theapparentlynaturalconclusionthat debt relief will help poor countries.

However,carefulanalysisof the budgetaryandresourceimplicationsof debtrelief revealstheweaknessof this kind of argument.Net resourceflows, i.e. new



lendinganddevelopmentgrantslessdebtservice,aresubstantiallypositivefor allthe most indebted low income countries.The fact is that the world’s mostseverelyindebtedlow incomecountriesreceiveonaveragenearlythreedollarsofnew money from official creditors, for every one dollar of debt service.Moreover,as we haveemphasised,debt relief on its own doesnot createnewresources.Theseresourceshave to come from somewhereand it is an openquestionas to whethernew resourcesare best applied to the cancellationofofficial debtor to the moreconventionalform of new lendinganddevelopmentgrants.

If it crowdsout otherformsof aid, conclusionsaboutdebtrelief will hingeonits relativemeritsanddemeritsin comparisonto aid. This will involve questionsof cost,conditionalityanddistribution.

The principal economicargumentfor forgivenessin the form of debt reliefratherthanfinancingin the form of newinflows is debtoverhang.This hasbeenusedin thepastto justify debtrelief for middle incomecountries.But it turnsoutthat this argumentis largely irrelevant to low incomecountries,for the simplereasonthat relief of their substantialstocksof official debtwill havelittle impactonexpectedfutureresourceflows. However,andby thesametoken,theopposingmoralhazardargumentsmayalsofail to applyto therelief of low incomecountryofficial debt.

There could be undesirabledistributional effects with somepoor countrieslosing out. Highly indebtedcountriesneednot necessarilybe able to makethestrongestclaimsfor assistanceon eitherhumanitariangroundsor on thegroundsof economicmanagement.Political pressuresto offer debtrelief may distort theallocationof resources.Moreover,a completerelief of debt could result in anundesirablerelaxationin donorconditionality.While perhapsa usefultidying upaccountingexercise,from an economicperspectivedebt relief may be largelyirrelevantto the goalsof growth andpoverty reduction.

If the economicbenefitsof debt relief are minimal, why has it receivedsomuch attention?There are a numberof considerations.First, even where thebenefitsare cosmeticin economicterms,they may be real in a political sense.Donorandrecipientgovernmentsmaywish to beableto claim thatsomethingisbeing doneabout the extremepoverty found in the world’s poorestcountries.Announcementsof debt relief are an effective way for finance ministersandofficials to grab the headlines,and appeargenerous,at little real economicorpolitical cost. High profile initiatives suchas HIPC imply that action is beingtaken.Indeedif donorsare fundamentallyuncommittedto increasingresourcetransfersaninitiative that impliesa lot anddeliversonly a little maybeattractiveto them.

Second,and in contrast,the powerful symbolismof debt relief may createapolitical commitmentin developedcountriesto increaseresourcetransfersto lowincomecountries.Evenif thetransferof resourcesthroughconventionalaid is in



fact a more efficient economicmechanism,providing resourcetransfersvia aprogrammeof debt relief may be neededin order to mobilise theseadditionalresourcesin the first place.

Third, and with some justification, debtors perceive that they have lostsovereigntyoverthedesignof domesticeconomicpolicy. A largescalereductionof debtstockscouldallow themto escapefrom whattheyseeastheintrusivenessof IMF and World Bank conditionality. While conditionality may, in the shortrun, promotesounderpolicies,it is not obviouslyconduciveto the developmentof domesticinstitutions and the practiseof good governance.Over the longerterm, developmentand poverty reductionmay thereforebe better servedby atransfer of sovereignty back to the governmentsof low income countries,facilitating political as well as economicdevelopment.But this would requiremuch larger scale forgiveness of debt to official creditors than is beingcontemplatedunderthe HIPC initiative.16

For as long as low income countriesare unable to accessprivate capitalmarkets,they will remaindependentuponaid which is conditionalandlikely toremainso. Debt relief cannotthereforebe expectedto restorecontrol into thehandsof domesticgovernments.The rhetoric surroundingdebt relief remainsunmatchedby the reality.

REFERENCES

Bird, G. (1989),‘StrategicPlansor Muddling Through:TheGenericsof Third World DebtPolicy’,in G. Bird (ed.),Third World Debt: TheSearchfor a Solution(Aldershot,EdwardElgar).

Bird, G. andN. Snowden(1997),‘From Banksto Bonds:A ProblemResolved?A Perspectivefromthe LDC Debt Literature’, Journal of InternationalDevelopment, 9, 2, 207–20.

Boote,A. R. andK. Thugge(1999),Debt Relief for Low IncomeCountries:TheHIPC Initiative,PamphletSeries,51 (WashingtonDC, IMF).

Claessens,S. (1990),‘The Debt Laffer Curve:SomeEstimates’,World Development, 18, 12.Cohen,D. (1990),‘Debt Relief: Implicationsof SecondaryMarketDiscountsandDebtOverhangs’,

World BankEconomicReview, 4, 1.Cohen,D. (1996), ‘The Sustainabilityof African Debt’, Policy ResearchWorking Paper,1621

(WashingtonDC, World Bank).Corden,W. M. (1989),‘Debt Relief andAdjustmentIncentives’,in J.A. Frenkel,M. P.Dooleyand

P. Wickham(eds.),Analytical Issuesin Debt (WashingtonDC, IMF), 242–57.Daseking,C. andR. Powell(1999),‘From TorontoTermsto theHIPCInitiative: A Brief Historyof

Debt Relief for Low Income Countries’, IMF Working Paper,WP/99/142(WashingtonDC,IMF).

16 Completedebtforgivenesscould leadto a relatedandgenuineresourcesaving.Releasedfromthe costsof debtnegotiationsandconstantreschedulingand,perhapsmorepertinentlywith theirbalance sheetsgreatly shrunk, the IMF and World Bank, for example, could be forced tosubstantiallyreducetheir operatingcostsandpassthis benefiton to poor countries.To the extentthatthetransactioncostsof debtreschedulingarehigh thebenefitsof debtrelief couldbeexpressedin termsof avoiding thesecosts.



Krugman, P. (1988), ‘Financing vs. Forgiving a Debt Overhang’, Journal of DevelopmentEconomics, 29, 253–68.

Sachs,J. (1984),‘TheoreticalIssuesin InternationalBorrowing’, PrincetonStudiesin InternationalFinance, 54.

Sachs,J. (1990), ‘Introduction’, in J. D. Sachs(ed.), DevelopingCountry Debt and EconomicPerformance,Vol. 2 (Chicago:ChicagoUniversity Press/NBER).

Samter, P. (2000), ‘Debt Overhang and Debt Relief in Africa: A Case Study of Zambia’(mimeographed).

Williamson, J. (1988), ‘Voluntary Approachesto Debt Relief’, Policy Analysesin InternationalEconomics, 25 (WashingtonDC, Institute for InternationalEconomics).



debt relief for low income countries: is it effective and efficient?

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