Debt Sustainability in Low-Income Countries

World BankEconomic Policy and Debt Department

May 2006

Debt and Debt Relief in the World Bank

“Sector Units”

Finance, Private Sector, Infrastructure

Environment and Socially Sustainable

DevelopmentHuman

Development

Poverty Reduction and Economic Management

Economic Policy and Debt

2

Outline

1. Why is debt relief a global issue?

3. How did the international community respond?

4. How can we avoid debt distress in future?

2. What led to debt distress in the 1990s?

Why is debt relief to low-income countries a global issue?

Despite access to highly concessional financing, many low-income countries have needed significant debt relief

The need to meet the MDGs has led many to question why the poorest countries should pay debt service to rich creditors

4

The Main Arguments for Debt Relief*

Moral argument

Financing argument

Debt overhang or growth argument

“Evergreening” or efficient lending argument

5

* Acknowledgement: the following 8 slides are adapted from work by Christina Daseking; all views expressed are those of the current presenter and should not be attributed to the IMF, its Executive Board, or its management.

The Moral Argument

Poor countries should not devote scarce resources to pay rich creditors

But... No debt service means no borrowing Smaller overall aid envelope How pessimistic should we be?

6

Are poor countries doomed to stay poor?

Per Capita Income in U.S. dollars

Ghana

Thailand

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

7

The Financing Argument

Debt relief generates additional predictable resources in support of the MDGs

But... Additionality cannot be taken for granted There may be better ways to provide MDG

financing, as debt relief is: Backloaded Allocated based on past lending decisions Small relative to new development assistance

8

Debt Service and ODA for 28 Post-Decision-Point HIPCs, 1999-2003

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

Total OfficialDevelopment

Assistance($68 billions)

Total Debt Service($14 billion)

9

The Debt Overhang or Growth Argument

As a high debt burden weakens incentives to invest, debt relief will foster growth

But... Growth effect beyond financing controversial: Is high

debt ratio cause or symptom of low growth? HIPC Initiative has already removed large portion of

debt Other factors are likely to be much more important

(trade deal, policies, institutions)

10

The “Evergreening” orEfficient Lending Argument

Debt relief removes roll-over concerns, allowing creditors to allocate new resources more efficiently

But... Allocation of debt relief resources itself benefits

heavy borrowers Performance-based lending already possible Debt relief may create incentive problems of its

own by raising expectations for more

11

“Caveat Emptor”

All arguments for debt relief have some appeal and merit…

… but none is without caveats

Bottom line: don’t expect too much!

Debt relief generates predictable aid, but it cannot generate sustainable growth

12

What led to debt problems in the 1990s?

Debt burdens in some low-income countries rose dramatically from 1973 to 1993

14

0%

50%

100%

150%

200%

250%

1970 1974 1978 1982 1986 1990 1994 1998 2002

HIPC Countries

Low-Income Countries

The Share of External Debt to GDP (in NPV terms)

Low Growth is the Main Cause of Debt Distress

Note: Source: World Bank Global Development Finance Statistics. The graph shows the actual unweighted average of debt-to-GDP ratios across LICs versus the simulated ratio had all countries grown at 5% in dollar terms, a performance achieved by just over one in three LICs during the period. 15

Average External Public Dyanamics, 1980-2002(NPV, percent of GDP)

0

20

40

60

80

100

120

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Actual

Simulated 5% growth

Developing countries are dependent on commodities

Commodities’ Share of Exports

Commodities’Share of GDP

Major Commodity

Zambia 99.8% 23.4% Copper

Mauritania 99.5% 39.4% Iron Ore

Guinea Bissau 97.7% 23.7% Cashew Nuts

Benin 93.7% 16.1% Cotton

Uganda 90.5% 11.1% Coffee

0

50

100

150

200

250

300

350

400

1970 1975 1980 1985 1990 1995 2000

Crude oil

Cotton

Copper

Coffee

0

50

100

150

200

250

300

350

400

1970 1975 1980 1985 1990 1995 2000

Crude oil

Cotton

Copper

Coffee

Commodity Price Trends

16

Other factors played a part…

Waste of resources due to weak institutions, poorly designed projects, corruption

Poor debt management and unrestrained non-concessional borrowing; “loan pushing” by creditors

Wars, civil strife, conflict

17

How did the international community respond?

Bilateral creditors have forgiven increasing amounts of debts owed to them

50%

67%80%

33%

90%

Toronto (1988)

London (1991)

Naples (1994)

Lyon (1996)

Cologne (1999)

Proportion of Grant Element in Paris Club Forgiveness

Note: The forgiveness listed is the reduction in the NPV of the rescheduled debts owed to the Paris Club members.19

Traditional debt relief reduced bilateral and commercial debt; not multilateral debt

0%

5%

10%

15%

20%

25%

30%

35%

40%

1970 1974 1978 1982 1986 1990 1994 1998 2002

Note: “Traditional Debt Relief” includes that of the Paris Club (bilateral debt owed to donor governments) and the London Club (commercial debt). Source: World Bank Global Development Finance 2005.

Share of Multilateral Debt of Overall External Debt

20

HIPC Was the First Comprehensive Global Debt Reduction Initiative to Include Multilateral Debt

Objectives Reduce external debts owed by HIPC governments Finance increase in government spending on poor people

Design Eligibility is based on external debts and income per

capita Requires government to formulate a poverty reduction

strategy paper (PRSP) through local consultation Requires satisfactory performance based on an IMF

program Then irrevocably provides debt relief – up to a pre-defined

threshold

21

Multilateral Institutions Have Provided Half of All HIPC Debt Relief Committed

Total Amount of Debt Forgiven (USD bn)

Note: The figures of committed debt relief are current as of April 2005 measured in end-2004 NPV terms, and include 38 HIPCs as of 2005. 22

13.8

3.6

0.93.0

7.69.2

Paris Club Other Bilaterals Commercial World Bank IMF OtherMultilaterals

Irrevocab

le d

eb

t relie

fThe HIPC Process

Decision Point

Determination of:- NPV of debt - Debt Relief- Triggers

Country fulfills HIPC

Eligibility

Criteria

- Meeting triggers

Completion Point

Interim period

- Satisfactory Performance under PRGF- Implementation of PRSP for one year

PreliminaryDiscussion

23

March 2006: 29 Countries are receiving debt relief, nine countries had yet to benefit…

Zambia

Post-HIPC

Uganda

Tanzania

Senegal

Rwanda

Niger

Nicaragua

Mauritania

Madagascar

Guyana

Ethiopia

Bolivia

Mozambique

Mali

Honduras

Ghana

Burkina Faso

Benin18

Interim-HIPC

Sierra Leone

São Tomé & Principe

Malawi

Guinea-Bissau

Guinea

The Gambia

Chad

Congo, Dem. Rep.

Cameroon

11

Pre-HIPC

Togo

Sudan

Somalia

Myanmar

Liberia

Lao PDR

Congo, Rep.

Comoros

Côte d’Ivoire

Central African Rep.9

Causes Conflict Arrears Weak governance

24

Burundi

May 2006: “Ring-Fencing” has identified four potentially eligible countries that may opt in…

Zambia

Post-HIPC

Uganda

Tanzania

Senegal

Rwanda

Niger

Nicaragua

Mauritania

Madagascar

Guyana

Ethiopia

Bolivia

Mozambique

Mali

Honduras

Ghana

Burkina Faso

Benin19

Interim-HIPC

Sierra Leone

São Tomé & Principe

Malawi

Guinea-Bissau

Guinea

The Gambia

Chad

Congo, Dem. Rep.

Cameroon

10

Pre-HIPC

Togo

Sudan

Somalia

Liberia

Congo, Rep.

Comoros

Côte d’Ivoire

Central African Rep.

11?

25

Burundi

Eritrea

Haiti

Kyrgyz Rep.

Nepal

HIPC has substantially reduced debts and pro-poor spending has increased

Notes: 1) Debt stocks of 28 decision point countries, USD billion 2004 NPV terms. 2) Projected debt service obligations of 28 decision point countries. 3) Debt service to government revenue for 28 decision point countries. 4) Ratio of poverty-reducing expenditures to government revenue. 26

Debts have been reduced1…

30

84Before Traditional Relief

After Add. Bilateral Debt Relief

and so have payments to creditors2…

1

2

3

4

5

6

2001 2002 2003 2004 2005 2006

USD

Billio

ns

Before HIPC Relief

After HIPC Relief

and increasing pro-poor spending4.

40.9%47.6%

1999 2003

reducing budget spent on debt payments3…

21.8%

13.4%

1999 2003

Pre-Conditions for Effective Debt Relief

Priority Sectors MDGs

HIPCCreditors

Gov’tBudget

Donors

Debt ServiceAid In

flows

1. Additional toaid inflows

2. Beyond arrears clearance

Debt in Arre

ars3.

Economically significant

HIPC Initiative

MDRI

Preliminary Results: Debt Relief and Priority Sector Spending

Debt Relief vs. Education (top) and Health (bottom) Expenditures

y = 0.292x + 0.0349

R2 = 0.1711

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%

ED

UC

/GD

P

Debt Relief vs. Poverty-Reducing Expenditures(IMF definition)

y = 0.9989x + 0.0501

R2 = 0.2329

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%DR/GDP

PR

E/G

DP

DR/GDP

y = 0.2073x + 0.0158

R2 = 0.2097

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%

HEA

LTH

/GD

POther measures of poverty-reducing expenditures are also increasing with debt relief

Institutions and policies are better in countries that have gone through HIPC

Note: Post, interim and pre-HIPC refer to the countries that are at the pre-decision point (10 countries), decision point (10 countries) and completion point (18 countries) as of end 2005. The first bars refer to 1998, the second bars to 2003. 29

HIPCs: Evolution of CPIA ratings (1998 and 2003)

2.00

2.20

2.40

2.60

2.80

3.00

3.20

3.40

3.60

3.80

Post-HIPC Interim-HIPC Pre-HIPC

CP

IA r

ati

ng

s

Further Debt Cancellation for HIPCs

30

1

2

3

HIPCs will receive 100 percent debt cancellation from IDA, AfDF and the IMF under Multilateral Debt Relief Initiative

Debt relief is to be provided at HIPC completion point

Average debt/export ratios in post-completion point HIPCs would fall from about 140 percent to 50 percent in present value terms

Donors will compensate IDA and AfDF for reflows lost due to debt relief. This should result in approximately $50 billion in additional flows to low-income countries

4

MDRI significantly reduces debt stock ratios in HIPCs(18 CPs: NPV of Debt to Exports, Post MDRI)

0

50

100

150

200

250

300

Ugand

a

Burki

na F

aso

Mau

rita

nia

Benin

Zam

bia

Moz

ambi

que

Nig

er

Rwan

da

Ethi

opia

Tanz

ania

Mad

agas

car

Mal

i

Sene

gal

Ghana

Boliv

ia

Nicar

agua

Hon

dura

s

Guyan

a

Prior to MDRIPost MDRI

31

Debt service reduction due to MDRI

(18 completion point HIPCs)

0.0

0.5

1.0

2006 2011 2016 2021 2026 2031 2036 2041

$ billions

AfDF

IMF

IDA

32

How MDRI Affects IDA Allocations

Source: IDA staff estimates

Composition of IDA Assistance to 18 completion point HIPCs, FY07-FY26 (SDR Million)

0

100

200

300

400

500

600

700

800

900

1000

FY07FY09

FY11FY13

FY15FY17

FY19FY21

FY23FY25

Tota

l d

eb

t re

lief

1500

1550

1600

1650

1700

1750

1800

1850

1900

Tota

l N

ew

ID

A c

om

mit

men

t

Total debt relief

Total new IDA commitments

33

How do we avoid future debt problems?

Low debt ratios in HIPCs could result in “free riding” by

commercial creditors Debt Burden Indicators - Post MDRI Debt Relief:

18 CP HIPCs vs. Selected Lower Middle Income Countries

HondurasMauritania

Guyana

BoliviaNicaragua

Syria

Guatemala

China

Jordan

EcuadorBrazil

Peru

Thailand

Philippines

0

50

100

150

200

250

300

350

400

0 10 20 30 40 50 60 70 80 90 100

NPV of debt-to-GDP

NP

V o

f d

eb

t-to

-Exp

ort

s

18 CP HIPCsLower Middle Income Countries

35

Reaching the MDGs must not create a new debt problem

The Debt Sustainability Framework for Low-Income Countries (DSF) tries to ensure that countries receive financing on terms that are commensurate with their ability to service debt

The DSF determines up front the mix of World Bank (IDA) loans and grants Countries with high risk of a debt crisis only receive grants Over 40 low-income countries will now receive either 100% or

50% of their World Bank finance in the form of grants Countries with low debts receive more resources

The DSF is an “ex-ante” tool for addressing issues related to debt sustainability.

36

Notes: Thresholds apply to public and publicly guaranteed (PPG) external debt, only. The Country Policy and Institutional Assessment (CPIA) assesses the quality of a country’s present policy and institutional framework. “Quality” means how conducive that framework is to fostering sustainable, poverty-reducing growth and the effective use of development assistance.

Institutional strength and quality of policies

Weak

CPIA<3.25

Medium

3.25<CPIA<3.75

Strong

CPIA>3.75

NPV of debt-to-GDP 30 40 50

NPV of debt-to-exports 100 150 200

NPV of debt-to-revenue 200 250 300

Debt service-to-exports 15 20 25

Debt service-to-revenue 25 30 35

Sustainable levels of debt burden depend on a country’s institutions and policies

37

+10%

-10%

Threshold

High Risk100% Grants

Medium Risk50% Grants

Low Risk100% Soft Loans

Debt burdens determine the mix of world bank loans and grants

38

From July 2006, grants will be based on debt sustainability analyses under the LIC DSF

Accurate debt data Macroeconomic and

financing assumptions Baseline scenario and

standardized stress tests Staff judgment

NPV of debt-to-GDP ratio

0

10

20

30

40

50

60

70

80

2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026

Baseline

Historical scenario

Most extreme stress test

Threshold

NPV of debt-to-exports ratio

0

50

100

150

200

250

2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026

Baseline

Historical scenario

Most extreme stress test

Threshold

Debt service-to-exports ratio

0

5

10

15

20

25

30

35

40

2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026

Baseline

Historical scenario

Most extreme stress test

Threshold

39

Conclusions

1

3

4

Debt reduction under the HIPC Initiative has reduced external debts (multilateral and other) by two-thirds. It has helped increase pro-poor spending and promoted economic reform

Debt cancellation under the Multilateral Debt Relief Initiative will have a beneficial impact on HIPC debt ratios and provide additional resources for all IDA-only borrowers

Low-income countries experienced debt repayment difficulties due to a variety of factors, both exogenous and endogenous

Going forward, the World Bank has adopted an ex-ante frameworkto promote debt sustainability in low-income countries

5

40

Debt relief is only one part of the solution to financing needs and policy dialogue: expectations should be realistic about what it can deliver

2

A wealth of information is available on the World Bank website

http://www.worldbank.org/debt

41

Q & A