on the sustainability of external debt: is debt relief enough?

Cambridge Journal of Economics 2014, 38, 1155–1169doi:10.1093/cje/bet039Advance Access publication 4 December 2013

© The Author 2013. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.

On the sustainability of external debt: is debt relief enough?

Gianni Vaggi* and Annalisa Prizzon**

Elaborating on Pasinetti (1998), the ‘geometry of debt sustainability’ (GDS) represents an analytical tool for the analysis of the long term sustainability of foreign debt. The paper focuses on debt sustainability in low-income countries, which face several major challenges simultaneously: achieving economic growth, consolidating human devel-opment goals and meeting regular debt service payments. The GDS reveals how the ‘structural’ aspect of debt sustainability—as indicated by trends in the non-interest cur-rent account—is closely interlinked with sustainability from a ‘financial’ point of view—as indicated by the relationship between the growth and the interest rate. The GDS shows why both debt cancellation and additional aid are necessary to give indebted low-income economies a chance to improve their long term economic viability.

Key words: Debt relief, External debt sustainability, Development finance, AidJEL classifications: E60, H60, O11

1. Introduction

Since the end of the 1980s, heavily indebted low-income countries (LICs) have been ben-efiting from debt relief measures that range from the rescheduling of interest payments to partial or total debt stock forgiveness. Among the most well-known measures are the Heavily Indebted Poor Countries (HIPC) Initiative of 1996 (enhanced in 1999) and the Multilateral Debt Relief Initiative (MDRI)1 of 2005. Notwithstanding these initiatives and the overall financial improvements that they have contributed to bringing about, many countries still face daunting challenges: they must service foreign debt every year, while at the same time they are supposed to achieve the Millennium Development Goals (MDGs). Moreover, it is not yet clear whether the debt story of the 1980s and 1990s is finally over or whether some countries are still at risk of falling again into a debt trap. The financial crisis that originated in 2007 has exacerbated the situation; recession and reduced aid in some

Manuscript received 6 July 2009; final version received 6 May 2013.Address for correspondence: Gianni Vaggi Department of Economics and Management, University of Pavia,

via S. Felice 5, 27100 Pavia, Italy; email: [email protected]

* Department of Economics and Management, University of Pavia, via S. Felice 7, 27100 Pavia, [email protected]

** Overseas Development Institute, 203 Blackfriars Road, London SE1 8NJ [email protected]. The authors are grateful to Amit Bhaduri, Amitava Dutt, Andrew Mold, to three referees and to the editors for their constructive comments. The authors alone are responsible for any remaining errors. The views expressed herein are solely those of the authors and do not necessarily represent the views of the ODI.

1 On HIPC Initiative and MDRI see IDA and IMF (1999) and IDA (2005), respectively.

at University of W

ashington on Decem

ber 3, 2014http://cje.oxfordjournals.org/

Dow

nloaded from

mailto:[email protected]?subject=




http://cje.oxfordjournals.org/

1156 G. Vaggi and A. Prizzon

OECD economies plus the contraction of international trade and the rising risk of protec-tionism do not help to solve the foreign debt problem of the poorest developing countries.2

In the context of the criteria for integration within the European Union, Pasinetti (1998) discusses the conditions for the stabilisation3 of the debt ratio, considering the implicit relationship between the debt ratio—i.e. the debt-to-GDP ratio—and either the total or the primary surplus (deficit). Pasinetti (1998) shows that the debt and deficit ratios defined in the Maastricht Treaty represent only one possible combination of these two variables such that the debt ratio stabilises.

We build on Pasinetti’s (1998) approach to present a simple tool for evaluating the sustainability of external debt that we call the ‘geometry of debt sustainability’ (GDS). In particular we extend the model to the case of LICs and to their external debt. We show that there is a precise relationship between the non-interest current account (NICA)-to-GDP ratio4 and the debt-to-GDP ratio such that the debt ratio does not increase. This stable level of the debt ratio depends on the relationship between the interest rate and growth rate and on the level of the NICA-to-GDP ratio, which has been negative in the case of most LICs for decades. The GDS combines both the financial dimension of sus-tainability, captured by the difference between the GDP growth rate and the interest rate, and the structural dimension, described by an improvement in NICA and by the achieve-ment of a NICA surplus. In this way the GDS shows how the financial and structural aspects of debt sustainability are interlinked. While traditional sustainability analyses tend to focus on the financial element, GDS highlights the role of structural improvements in NICA for the long term sustainability of foreign debt.5 In particular, the GDS framework shows that in the case of an indebted LIC, even debt cancellation may not be a sufficient condition to avoid a new external debt crisis. Cancellation or other forms of debt relief give some space to try to improve growth performance and the trade balance in particular. Other component of the current account, such as grants and remittances, may help to improve the NICA in the short and medium term, but in order to achieve long term debt sustainability the country has to undertake a process of structural change in her export–import composition, a major challenge that requires investments and time. All the more so if government expenditure is required to support social policies.

Most LICs lack domestic savings and need foreign financing. The average interest rate is very low due to loan concessionality and is generally lower than the GDP growth rate. Most LICs run NICA deficits. Last, but not least, LICs suffer from low levels of human development, which could be overcome in part by freeing up resources from the debt burden. However, the GDS framework can be easily adapted to the macro-economic features of emerging economies.

Section 2 of the paper describes the basic analytical framework and the building of the GDS. The effects of debt forgiveness on debt stabilisation are discussed in Section 3. Section 4 evaluates the role of aid in the GDS framework and provides a

2 The financial crisis brings to the fore the issue of the sustainability of foreign debt of high-income econo-mies, which could easily be explored with the tool presented in this paper. Some recent work from CADTM shows that the problem of developing country foreign debt is far from being solved (see Millet et al., 2012).

3 Henceforth, we use the term stabilisation to indicate a debt ratio that remains constant or decreases.4 The NICA is the equivalent to primary surplus in the case of domestic public debt.

5 Long term sustainability can be expressed by lim( )t

tt

D

i→∞ +=

10 , where Dt is the debt stock at time t and

i is the nominal interest rate (see Cohen, 1985). This links up with the so-called transversality condition, according to which in the long term a debt must go to zero, i.e. it must be entirely repaid.

at University of W

ashington on Decem


Dow

nloaded from


Sustainability of external debt 1157

new rationale for a policy of synchronised debt cancellation and additional aid, what we call ‘positive shock therapy’. Section 5 discusses some policy implications and indi-cates other possible applications of the GDS framework.

2. The analytical framework

Fiscal sustainability analysis usually focuses on the primary surplus.6 Nevertheless, in an open economy the overall surplus, i.e. the current account, is usually adopted instead of the NICA. This is because the current account measures changes in the net exter-nal position with the rest of the world: a current account deficit indicates an increase in net foreign liabilities. We prefer the NICA as it does not include interest payments, thus providing a better indicator of the long term external debt sustainability. Indeed, a positive NICA is the source out of which foreign debt can be repaid in the long term.

Consider a net external debtor country. Each variable is expressed at current prices and in domestic currency, as if the exchange rate were fixed and equal to one.7 The capital account includes only debt-related flows, so it measures changes in net foreign liabilities, D . The equilibrium of the balance of payments corresponds to

− + − =C iD 0D (1)

where C is the NICA, i the nominal interest and D the debt stock; thus iD indicates interest payments.

Scaling by GDP, Y, and multiplying the last term on the left-hand side of equation

(1) by DD

, we obtain

− + ∗ − ∗ =CY

iDY

DD

DY

0 (2)

which can be expressed as

c i d= ( )− θ (3)

where c = CY

, d = DY

and θ is the growth rate of the debt stock.

The growth rate of the debt stock is equivalent to

θ = −icd

(4)

A non-increasing debt ratio requires the GDP growth rate, g, to be equal to or higher than the debt stock growth rate θ, θ ≤ g , which is from now on what we call the stability condition. This condition is met if

c i g d≥ ( )– (5)

Equation (5) can be described in a diagram whose vertical axis represents the NICA-to-GDP ratio, c, and the horizontal axis is the debt-to-GDP ratio, d (see the

6 See, e.g., Agénor and Montiel (1996), Chalk and Hemming (2000) and Burnside (2005).7 GDS can easily take into account flexible exchange rates and the case of partly foreign and partly

domestic-owned debt.

at University of W

ashington on Decem


Dow

nloaded from



upper panel of Figure 1). Here we assume a country with a NICA deficit and with i < g: these conditions are typical of most LICs.

Pasinetti’s model helps us to divide the space into two areas, one characterised by a sustainable debt ratio and the other by an increasing debt ratio. A country can find itself in one of three different positions, depending on the actual values of c and d.

First, when the country is on the boundary between the two areas which indicates all the combinations of c and d such that d = 0; the debt ratio is stable, i.e. θ = g.

Second, when the country finds itself above the boundary line, the debt ratio is decreasing ( d < 0), because c > (i – g)d, with θ < g. We denominate sustainability area the area above the boundary relation, including the boundary relation itself.

Third, when the country locates below the boundary relation, the debt ratio is increasing ( d > 0) as c < (i – g)d, with θ > g the stability condition is violated.

The debt story of the LICs goes back to the early 1980s and for many of them is not yet clear whether or not the external debt is on a sustainable path, even after the differ-ent measures undertaken, such as the HIPC initiative and MDRI. It is clear that we are examining a long term phenomenon and not only a temporary liquidity problem. The analysis of the changes in the debt ratio from one year to the other is of course very impor-tant, but one cannot avoid the investigation of the long term conditions of external debt

′

Fig. 1. The Framework of the ‘geometry of debt sustainability’.

at University of W

ashington on Decem


Dow

nloaded from



sustainability. Therefore it is necessary to take into account the magnitudes and the forces that can influence the evolution of the debt ratio in the medium and long term.

As is well known, the variation of the debt ratio through time is normally expressed as follows:

dd

DD

YY

g= − = −θ (6)

By inserting equation (4) into equation (6) we obtain the following relation, which we call ‘state equation (7)’:

d c i g d= − + −( ) (7)

which is depicted in the lower panel of Figure 1.8

Given the initial value of d, if d = 0, the equilibrium value d* is ci g−

, which cor-

responds to point A in Figure 1. d* is an equilibrium value in the sense that is the value of the debt ratio that does not change, given the values of i, g and c.

The boundary relation, equation (3), and ‘state equation (7)’, can be represented in the same diagram: the first is in the upper panel of Figure 1 and the latter is in the lower panel. We denominate this comprehensive framework the GDS. In order to bet-ter understand the main features of the long term external debt sustainability of LICs, it is necessary to consider both panels of the GDS.

Clearly, equations (3) and (7) lead to similar results in terms of the stabilisation of the debt ratio. In ‘state equation (7)’, c is the NICA-to-GDP ratio of the country and its value is seen on the vertical axis of the lower panel of Figure 1. Notice that NICA deficits, i.e. negative values of c, are represented by the function intercept of the vertical axis in the lower panel of Figure 1.9

Of course a country can be located only along ‘state equation (7)’ at a point that depends on the actual debt ratio. If a country is at point A, where ‘state equation (7)’ crosses the horizontal axis in the lower panel, then in the upper panel of the diagram it will lay at the corresponding point A′ of the boundary relation.

When i > g, both the boundary relation and ‘state equation (7)’ slope upwards. In this case even a positive NICA may not be enough to achieve a stable debt ratio and this ratio does not converge to any stable point. If the country’s initial position is out-side the sustainability area, ceteris paribus, the debt ratio increases indefinitely through time; if the country is already inside the sustainability area, then d goes to zero.10

If i < g, even a NICA deficit could be compatible with a sustainable debt ratio. For a given set of stable parameters i, g and a negative c, the debt ratio will always converge to a stable level, whatever its initial level.

8 In his comment to Pasinetti (1998), Harck (2000) uses a differential equation to describe the evolution of the debt ratio through time. Harck’s analysis is limited to the case of public debt and does not discuss the role of the NICA.

9 We analyse indebted LICs with i < g and NICA deficits; therefore, in the lower panel, c is always negative.

10 Notice that if the country is on the boundary relation then the debt ratio does not change, but this is an unstable equilibrium value and a ‘knife-edge’ problem (we owe this comment to a referee). In many ways the case of i > g is quite challenging, but here we analyse the typical condition of an LIC.

at University of W

ashington on Decem


Dow

nloaded from



However, given the values of i, g and c, the probability of a country being located inside the sustainability area increases with the debt ratio.11 This sort of paradox derives directly from the accounting perspective on which GDS is built and can be explained by the fact that for given values of i, g and c, and with i < g, the system unconditionally converges—both from the left and the right—to a stable level of d (see the lower panel of Figure 1).

On this point, consider the following example. Two countries, 1 and 2, differ only in terms of the values of their initial debt stock, such that d2 < d1, but i, g and c are the same, which implies that they have the same stable equilibrium, point A in the lower panel of Figure 1.

Country 1 presents a decreasing debt ratio, d1 < 0, in the lower panel of Figure 1: the increase in the numerator, the debt stock, is due only to the rollover of interest payments and is lower than the increase in the denominator, the GDP. Thus the debt ratio decreases and this effect is larger the higher the debt ratio. Country 1 progres-sively reduces its foreign liabilities (D) vis-à-vis its GDP and will not enter into the area below the boundary relation.

Country 2 has an increasing debt ratio, d2 > 0 in the lower panel of Figure 1, but the growth rate of the debt ratio progressively decreases until it reaches the stable value at point A. Notice that with unchanged i, g and c, country 2 will move to the boundary line of the sustainability area, but without entering inside it, and debt accumulation will stop at point A′ in the upper panel of Figure 1.

It must be emphasised that these results derive from the fact we have adopted an accounting framework that is quite binding. Moreover, the stabilisation of the debt ratio is a long term phenomenon: point A corresponds to a steady state that is theo-retically attained after repeated rounds of interest payments. Notice that in GDS we consider i, g and c as parameters: this is particularly relevant in the use of a differential equation, our ‘state equation (7)’, which highlights the long term dynamics of the debt ratio. Of course, in reality, g, i and c do change over time, thus modifying the time path of the debt ratio, in which case both the boundary relation and the state equation do change.12 The GDS highlights the internal dynamics of foreign debt. With an initial d0 and assuming stable values of i, g and c, there is an inbuilt tendency for the debt ratio to move towards its stable value, at point A in Figure 1.13

We want to underline the special role of a NICA deficit in setting the country on dif-ferent trajectories. In ‘state equation (7)’, c is the intercept on the vertical axis. If i and g are unchanged, the slope does not change. However, an improvement (worsening) of c may drastically reduce (increase) the level of the stable debt ratio (A). This point is

11 We could have a non-linear boundary relation in two cases: first, in the case of a ‘debt overhang’ effect, in which there is an inverse relationship between the growth rate and the debt ratio; and, second, if the interest rate increases as the debt stock grows. In both cases the higher the debt ratio, the smaller the sus-tainability area.

12 As for the three variables, one must notice that in the case of LICs i is highly concessional, refers to long term obligations and could really be taken as given, while of course both g and c could change. Moreover, changes in the debt ratio might affect the growth rate (see footnote 11). In particular Rowthorn and Wells (1987) have examined the issue of debt sustainability allowing the trade deficit ratio to vary over time. Following Bhaduri (1987), Gram (1992) examines the relationship between external debt sustainability and an endogenous growth rate in an open economy of the Harrod–Domar type.

13 In the GDS framework we start with an initially given debt ratio d0, but of course in the long term countries could either undertake more debts or repay part of them; hence d0 could also change over time, but for reasons different from those implied in the values of i, g and c.

at University of W

ashington on Decem


Dow

nloaded from



particularly significant because we refer to countries that have experienced structural deficits over decades.

We conclude this section with four considerations.First, the GDS shows the analytical relation between the financial and structural

dimensions of debt sustainability. The former points to the relationship between i and g; if i < g, the debt ratio can be stabilised, in the sense of bringing it onto a non-increas-ing path, even in a country with a NICA deficit. The structural dimension is captured by the ratio of NICA to GDP, c, which of course affects the stabilisation of the debt ratio in the short term, but above all only a permanent improvement of NICA, which at least brings it to zero, can guarantee that the debt will ever be repaid. Of course improvements in the growth rate, such as those that took place in sub-Saharan African countries between 2000 and 2012, are most welcome. In a low-income economy with undiversified exports, improving a negative NICA might take time. Moving from a NICA deficit to a NICA surplus would be even more difficult and would imply a pro-cess of structural change in the composition of exports and possibly also of imports, which is much more complicated than achieving a higher growth rate for a few years. The Asian growth experiences have shown that sustained high average growth rates for decades are the results of a continuous process of export diversification, which requires the economies to move up the global value chain.

Second, debt is a typical phenomenon for which the short term and long term are closely interlinked. A decrease in the debt ratio, d, from one year to the next one will improve the liquidity conditions of the country in the short term. However, as we shall see in the next section, this decrease might have very little impact on the ability of the country to repay its debt in the long term and hence on its creditworthiness. The GDS shows the relationships between the two timescales, but emphasises the essential role of NICA in the overall assessment of debt sustainability. An improvement of the NICA not only reduces the stable level of the debt ratio in the long term; it also gives an important signal for the improvement of the creditworthiness of the country in the short term.

Third, the GDS highlights the important difference between the case of domes-tic public debt—as in Pasinetti (1998)—and that of foreign debt. The notions of pri-mary and NICA deficits play a similar analytical role in the GDS, but the economic and policy implications are completely different. Of course it is painful, but a country can reduce its primary deficit by cutting expenditures and increasing taxes and rev-enues, and this adjustment can take place even in the short term.14 On the other hand, improvements in net trade may take much more time and, above all, the evolution of the NICA is not under the complete control of each country, all the more so when the country is an LIC with an undiversified composition of exports.

Fourth, in the case of LICs an unsustainable debt arises not only when the debt ratio is increasing, but also when the stable debt ratio is either (i) above a certain threshold considered as the maximum acceptable level by the international markets or (ii) so high as to discourage investments and growth, or quite simply the debt ratio is unbear-able for a low-income economy (see also footnote 11). These were the conditions of many indebted countries in the 1980s and 1990s, conditions that eventually led to the HIPC initiatives of 1996 and 1999.

14 This is precisely the experience of some economies in the eurozone during the period 2009–12 in the aftermath of the financial crisis.

at University of W

ashington on Decem


Dow

nloaded from



We do not indicate any specific threshold for the stable debt ratio, but clearly c plays a fundamental role in setting the stable debt ratio, d*. A very high level of d* and a large and structurally negative NICA imply that the country will not be able to repay its debt, even if at some point the debt ratio will cease to increase. For this reason, in the next sections we will discuss cases of debt cancellation and of more aid.

3. Debt forgiveness

Most analyses of debt sustainability focus on the relationship between i and g and on the value of the primary surplus in the case of public debt. The initial value of the debt ratio does not influence the final and stable level of the debt ratio over time, which only depends on the values of i, g and c as parameters. In the GDS framework the initial debt ratio sets the country on a certain point along the horizontal axis of the upper panel of Figure 1, for example d1, and together with c defines whether or not the coun-try is inside the sustainability area, given i and g.

Multilateral debt cancellation for the poorest countries was first conceived in the 1996 HIPC initiative and later appeared in the 2005 MDRI and in some bilateral initiatives of debt relief. After many years of ‘reschedulings’, the period of the so-called ‘buying time’ and ‘muddling through’ in the debt jargon, it became clear that, notwithstanding the very low interest rates, many LICs would never have been able to repay their debts entirely. Making use of the GDS framework, this means that the international commu-nity had realised that the indebted LICs were facing three equally difficult situations:

(i)the stable debt ratio would have been unacceptably high (see the end of Section 2);(ii)the whole process of moving from the initial debt ratio to a stable one would have

been too long; and(iii)both situations (a) and (b).15

The GDS can easily describe what should happen after debt cancellation in order to avoid the country falling again into a debt trap. By itself, debt forgiveness does not formally affect either i, g or c (however, see footnote 11). The only immediate conse-quence is that of moving the country from right to left, from d1 to d2, in the upper panel of Figure 2.16 In the case of a country characterised by a NICA deficit and by i < g, debt forgiveness might take the country away from the sustainability area. This appar-ent paradox reveals very simple evidence: by reducing the debt ratio, debt cancellation creates more space for debt accumulation in a way that is consistent, according to the GDS scheme, with the given values of i, g and c.

In the case i > g, the boundary relation slopes upwards and debt cancellation could be very effective because it might bring the country inside the sustainability area, pro-vided that the country has a NICA surplus. However, if there was a NICA deficit, the debt ratio would still be on an explosive path.17

15 Debt forgiveness is justified also because it helps to reduce the ‘debt overhang’ effect and the crowding out of debt service on poverty reduction expenditures.

16 If in Figure 2 we should use the current account-to-GDP ratio instead of the NICA-to-GDP ratio, the debt stock reduction would move the country to the left of the initial debt ratio but also up, because the current account would improve due to lower interest payments.

17 Think of Greece, whose debt has been partly cancelled; a measure that hopefully should give Greece the time and fiscal space required to try to improve her trade balance and primary deficit in a smoother way.

at University of W

ashington on Decem


Dow

nloaded from



Let us go back to our case of an LIC, with i < g, which benefits from debt cancel-lation. The GDS indicates which are the challenges facing a developing country after debt cancellation and what should happen for the country to take advantage of this opportunity. There are four possible cases.

First, after debt forgiveness a country fails to improve both g and c; therefore it will start accumulating foreign liabilities again and might repeat its past debt history.

Second, the country succeeds in increasing g. Then, both the boundary relation and ‘state equation (7)’ rotate downwards; the sustainability area expands and the stable debt ratio lowers from A to A* as indicated in the lower panel of Figure 2A (bold lines in Figure 2A).

Third, if the NICA deficit improves from c1 = c2 to c3, the state equation shifts down-wards (the dash dotted line in Figure 2B), thus reducing the value of the stable debt ratio from A to A** in the lower panel of Figure 2B.

Fourth, in the most favourable case both g and c improve (along the dashed line in Figure 2C). The stable debt ratio lowers from A to A*** in the lower panel of Figure 2C.

Fig. 2. Debt forgiveness, the growth rate and NICA.

However in the short term only a complete restructuring of the debt stock, with much longer maturities and very concessional interest rates, could help to reduce the still very large difference between i and g. The GDS could be more extensively used to illustrate this case.

at University of W

ashington on Decem


Dow

nloaded from



Notice that in all four cases we examine the impact of a once-and-for-all change in parameters g and c; of course they could change again in the future, thus eventually modifying the actual stable debt ratio.

The GDS shows that even in the case of total cancellation, a ‘fresh start’ (Sachs, 2002), a country that fails to improve both g and c would simply accumulate new debt stocks again. A high growth rate is a very useful condition, but the improvement of NICA is equally important to guarantee the long term sustainability of foreign bor-rowing of an LIC.

However, NICA improvements require profound structural changes in the export–import composition and indeed in the production structure of an LIC.18 This process of structural change is a long term objective and requires investment in new sectors of the economy. From this point of view, debt cancellation is a way to allow the debtor country more time and more financial resources to go through the process of structural change needed to boost its external accounts.

Let us discuss in more detail case four above (see Figure 2C). Consider a country with an initial debt ratio d1. Thanks to cancellation, the debt ratio decreases to d2 and

18 See UNCTAD (2004) and UNCTAD (2006). Bhaduri (1987) highlights the importance of appropri-ate changes in the import and export propensities for the sustainability of external debt.

Fig. 2. Continued.

at University of W

ashington on Decem


Dow

nloaded from



the country moves from point 1 to point 2 to the left of the boundary relation. Now the country is outside the sustainability area, but it has a lower foreign exchange constraint. Thanks to a smaller ‘debt overhang’ effect, the country may attract new funds, including debt-creating funds, and therefore the debt ratio increases again, all the more so if the country still keeps a negative NICA. However, an efficient use of the new finance is such that the growth rate increases; the new boundary relation is represented by the bold line in the upper panel of Figure 2C. Thus the country moves to the right of point 2, but this movement would result in a stable debt ratio A* (see Figure 2A) lower than the initial A. However, this very favourable scenario assumes that the NICA also improves to c3; ‘state equation (7)’ shifts downwards (the dashed line in Figure 2C) and the stable debt ratio is now A***, lower than A* and A** in the lower panel of the figure.

The GDS shows the different roles of the growth rate and of the NICA-to-GDP ratio in improving the debt path of the country; the importance of NICA improvements in debt ratio stabilisation can be seen on the basis of ‘state equation (7)’ and its intercept on the vertical axis. The crucial point is not whether the country will end up in A*, A** or A*** in the very long term; as we have already noted, the parameters g and c, and even i, could change thus leading to a different stable debt ratio. The key issue here is that different stability points correspond to different debt paths and these debt trajecto-ries highlight the challenges that a country will have to face in the years following debt cancellation. In general, an improvement of the NICA puts the country on a better debt sustainability path compared only to improved growth performance measured by g.19

4. Additional aid

The GDS diagram, see Figure 3, brings to the fore a point that is often overlooked: other things being equal, increased aid flows and debt cancellation have very dif-ferent effects on debt stabilisation. Aid represents a flow variable and additional aid—if kept constant each year—is similar to a permanent improvement of the NICA:20 ‘state equation (7)’ shifts downwards. Debt cancellation influences a stock variable—the debt stock—and its effect is that of moving the debt ratio to the left.21

Take an LIC that is at point 1 in the upper panel of Figure 3, clearly outside the sus-tainability area; additional aid may help to stabilise the debt ratio. Thanks to increased aid NICA improves and coeteris paribus, the state equation moves downwards, see the bold line in the lower panel of Figure 3. The value of the stable debt ratio decreases

19 The GDS framework could also be extended to the case of middle-income countries, which usually access financial markets. In recent years there has been a revival of interest in indexed instruments for the financing of low- and middle-income countries—the idea being that the interest rate on foreign debt is linked to the economic performance of the debtor country. This economic performance may be measured by the GDP growth rate, by other relevant magnitudes, such as net exports, or by the price of some primary commodities if they represent an important item in the country’s exports. These financial instruments are designed to limit the vulnerability of the country to either cyclical or sudden shocks (Griffith-Jones and Sharma, 2006). In particular Borensztein and Mauro (2004) suggest that GDP-indexed bonds contribute to debt ratio stabilisation.

20 Here ‘aid’ means grants and appears in the current-account side of the balance of payments. The addi-tional aid strategy means that the aid-to-GDP ratio increases from year 0 to year 1 and that this higher level of the ratio is kept in each following year.

21 More foreign direct investments and more portfolio equity inflows have an impact similar to that of debt cancellation, because they appear in the capital-account side of the balance of payments. Of course changes in the different components of the balance of payments will have different macroeconomic impacts, but their analysis is beyond the scope of this paper.

at University of W

ashington on Decem


Dow

nloaded from



from A to A′, which coincides with d1. In the upper panel of Figure 3, the country moves from 1 to 1* because the increased aid flows are just enough to reduce c1 to a value, call it ctarget, which stabilises the debt-to-GDP ratio at its existing level d1. The value of the stable debt ratio decreases from A to A′ in the lower panel and coincides with d1. For a given c, the amount of additional aid is precisely what is needed to pre-vent further increases in the debt ratio and to bring the country onto the boundary relation, i.e. inside the sustainability area, we can call this the weak hypothesis.

Of course in this case the additional aid is used to limit the increase of the debt, which might not be its best utilisation in an LIC.

If donors are so generous to provide a volume of aid large enough to cover the entire NICA deficit, the post-aid value of c is zero, we can label it the strong hypothesis. In the lower panel of Figure 3, the state equation shifts downwards (see the dashed line) and the stable debt ratio coincides with the origin. In the upper panel of Figure 3, the boundary relation is unchanged; however, the position of the country initially shifts from 1 to d1, but now the country is on a decreasing debt ratio path and eventually it moves from d1 to zero.22

′

target

target

Fig. 3. Effects of aid flows.

22 The positive outcomes deriving from the additional aid depend on the aid-to-GDP ratio being kept at the new and higher level in the future. If aid is reduced and the country has not improved either g, c or both, debt stocks will accumulate again.

at University of W

ashington on Decem


Dow

nloaded from



To consider increasing aid in a period in which OECD countries are dealing with their own budgetary problems is probably too optimistic; but for an indebted LIC there are not that many alternatives to additional aid, at least in the short term. It would be much better to have higher remittances, which in the GDS scheme have an impact similar to that of a permanently higher aid-to-GDP ratio: they shift ‘state equation (7)’ downwards. A permanent improvement in the net trade position of the country would be even better. However, as we have already noted, major improvements in the trade account require time and investments, both domestic and foreign, and are difficult to achieve in the short term. Suppose the country will make the best possible use of some new foreign funds different from aid. The GDS shows that during the period while the country is trying to improve its net trade position, the inbuilt dynamics of foreign debt continues to operate, thus subtracting resources either to investment, human develop-ment expenditures or both, thus endangering the process of structural change.

The GDS is based on a very tight accounting perspective, but precisely for this reason it shows some very important policy implications for an indebted LIC. In the short term only an appropriate mix of debt cancellation and increased aid can bring the country onto a sustainable debt path, leading to a new level of the stable debt ratio, a level that is sufficiently low as to remove the negative impacts of the ‘debt over-hang’. One can think of a ‘positive shock therapy’ according to which debt relief and increased aid are simultaneously applied.

5. Conclusions

The GDS is a simple and versatile tool for the analysis of foreign debt sustainability and can easily be adapted to different types of countries with different macroeconomic performances. In the case of LICs the GDS brings to the fore some rather neglected aspects of debt sustainability and highlights the real macroeconomic challenges facing these countries. Let us summarise the major points.

First, in the case of LICs most of the foreign debt is at very concessional interest rates and condition g > i is often verified. Of course this is quite positive, but this con-dition does not fully describe the problem of sustainability because it concentrates only on the financial side of the problem. The GDS shows that in order for debt forgiveness to be really effective and to avoid the country falling again into a debt trap, the NICA must permanently improve and eventually it should either balance or become posi-tive. Of course a country could go on with a very high debt ratio; however she must find investors willing to lend her money, but it is difficult to regard this as a stronger position in her external finances. The improvement of the NICA can also be due to additional aid flows and increased remittances, but again it is hard to regard these facts as the most appropriate solution to the sustainability of external debt. Here we should focus on part of the NICA, i.e. the balance of goods and services (or trade balance), which in any case usually accounts for the largest share of the NICA.

Second, improvements in the NICA and in particular in the trade balance imply major changes in the production and export structure of a developing country; above all, the process of structural change and export diversification takes time and needs significant investments. Financial resources are needed and this may imply a mixture of grants, remittances, foreign direct investments and also foreign borrowing. GDS helps to set the borrowing process on more realistic grounds. The GDS shows why a ‘positive shock therapy’, which combines debt cancellation and increased aid, may be

at University of W

ashington on Decem


Dow

nloaded from



a necessary policy to give the indebted LICs a real chance to strengthen their interna-tional position in a permanent way.

In summary, debt sustainability is mainly a long term issue, but in the case of LICs both the short term and long term must be taken into consideration. Certainly, poor countries must make the most efficient use of aid and debt forgiveness, but two points must be kept in mind because of their policy relevance.

First, the size of aid and the size and terms of foreign borrowing must be appropriate to the difficulty of the tasks and challenges facing LICs. In a period of low growth of OECD countries, a combination of debt cancellation and increased official development assistance may be a challenging task; however in the short term these are important tools to help LIC countries improve the MDGs and achieve a less fragile financial position.

Second, in the GDS framework g, i and c are taken as parameters because we want to show the different ways in which they affect debt sustainability. The improvement of the NICA is a difficult long term objective that we cannot discuss in this paper, but a few considerations are needed. The process of product and export diversification must be supported by coherent international trade relations. Forgiving the debt does not con-tribute to debt sustainability if the existing trade relations damage LICs’ net exports; this is the well-known issue of coherence between the different policies of international institutions and in particular of the largest economic blocs, such as the USA and the European Union.23 Above all, it is well known that it is very difficult for LICs to change the composition of their exports and improve their trade performances; therefore they should not be prevented from adopting industrial policies that favour the establishment of new industries and strengthen the few activities they have in the manufacturing sec-tor.24 The GDS shows why and how the efficacy of debt relief measures depends on a coherent set of aid, lending and trade policies, which should be complementary instru-ments to reach the same goal: the long term sustainable development of LICs.

Finally, the GDS framework might be used to explore other aspects of foreign debt sustainability going beyond the analysis of financial and economic magnitudes. As a matter of fact, one should take into account the development challenges facing an LIC, such as the need to improve human development, to increase expenditures in education and health and to try to achieve the MDGs. Since the 1990s there has been a debate about what is considered an affordable25 foreign debt and many authors have underlined the trade-off that has often materialised between the repayment of foreign debt and the need to increase the budget for social development expenditures.26 The GDS could be adapted to take into account these aspects, thus putting the view of foreign debt and sustainability within a more realistic framework, which could describe the real constraints confronting an indebted LIC.

23 For an example of the lack of policy coherence, see the long-standing issue of the European Partnership Agreements, which are part of the Cotonou Partnership Agreement of June 2000 between the European Union and the African, Caribbean and Pacific countries (see Evans and Vaggi, 2007). The problem of policy coherence should apply also to the so-called ‘new donors’: see, e.g., the impact of China’s trade and lend-ing policies in sub-Saharan Africa, which is still quite ambiguous (see Reisen and Ndoye, 2008; Brautigam, 2010).

24 See Chang (2002).25 On the notion of affordability see, e.g., Northover et al. (1998), Birdsall and Williamson (2002),

Seshamani (2003) and Bhattacharya (2003). For an approach that takes into account the possible trade-off between debt service and human development expenditures see also Vaggi (1993).

26 See also the so called negative net transfer problem due to foreign debt and the use of the three-gaps model to analyse it (see, e.g., Bacha, 1990).

at University of W

ashington on Decem


Dow

nloaded from



Bibliography

Agénor, P. and Montiel, P. 1996. Development Macroeconomics, Princeton, Princeton University Press

Bacha, E. 1990. A three-gap model of foreign transfer and the GDP growth rate in developing countries, Journal of Development Economics, vol. 32, 279–96

Bhaduri, A. 1987. Dependent and self-reliant growth with foreign borrowing, Cambridge Journal of Economics, vol. 11, no. 3, 269–73

Bhattacharya, A. 2003. From Debt Relief to Achieving the MDGs, Annual World Bank Conference on Development Economics, Oslo

Birdsall, N. and Williamson, J. 2002. Delivering on Debt Relief: From IMF Gold to a New Aid Architecture, Washington, DC, Center for Global Development

Borensztein, E. and Mauro, P. 2004. The case for GDP-indexed bonds, Economic Policy, vol. 19, no. 38, 165–216

Brautigam, D. 2010. The Dragon’s Gift: The Real Story of China in Africa, Oxford, Oxford University Press

Burnside, C. 2005. Fiscal Sustainability in Theory and Practice: A Handbook, Washington, DC, World Bank

Chalk, N. and Hemming, R. 2000. ‘Assessing Fiscal Sustainability in Theory and Practice’, IMF Working Paper no. 81

Chang, H.-J. 2002. Kicking Away the Ladder, London, Anthem PressCohen, D. 1985. How to evaluate the solvency of an indebted nation, Economic Policy, vol. 1,

no. 1, 139–67Evans, A. and Vaggi, G. (eds) 2007. Visions of Europe and Africa in the 21st Century, Pavia,

CICOPSGram, H. 1992. Dependent and self-reliant growth with foreign borrowing: a comment,

Cambridge Journal of Economics, vol. 16, no. 1, 91–9Griffith-Jones, S. and Sharma, K. 2006. ‘GDP-Indexed Bonds: Making It Happen’, Working

Paper no. 21, UNDESA, New YorkHarck, S. 2000. On the sustainability area as a simplifying didactic device, Cambridge Journal of

Economics, vol. 24, no. 4, 505–8IDA. 2005. The Multilateral Debt Relief Initiative: Implementation Modalities for IDA, Washington,

DC, World BankIDA and IMF. 1999. Modifications to the Heavily Indebted Poor Countries (HIPC) Initiative,

Washington, DC, World Bank and International Monetary FundMillet, D., Munevar, D. and Toussaint, E. 2012. 2012 World Debt Figures, CADTM, http://cadtm.org/Northover, H., Joyner, K. and Woodward, D. 1998. A Human Development Approach to Debt

Relief for the World’s Poor, London, CAFODPasinetti, L. 1998. The myth (or folly) of the 3 percent deficit/GDP Maastricht parameter,

Cambridge Journal of Economics, vol. 22, no. 1, 103–16Reisen, H. and Ndoye, S. 2008. ‘Prudent versus Imprudent Lending to Africa: From Debt Relief

to Emerging Lenders’, OECD Development Centre Working Paper no. 268Rowthorn, R. and Wells, J. 1987. De-industrialisation and Foreign Trade, Cambridge, Cambridge

University PressSachs, J. 2002. Resolving the debt crises of low-income countries, Brookings Papers on Economic

Activity, vol. 33, no. 1, 257–86Seshamani, V. 2003. Towards a Human Development Approach to Debt Sustainability: Some

Observations, Annual World Bank Conference on Development Economics, OsloUNCTAD. 2004. Least Developed Countries Report: Linking International Trade with Poverty

Reduction, Geneva, United Nations Conference for Trade and DevelopmentUNCTAD. 2006. Least Developed Countries Report: Developing Productive Capacity, Geneva,

United Nations Conference for Trade and DevelopmentVaggi, G. 1993. Sustainable debt and the human factor, pp. 117–51 in Vaggi, G. (ed.), From

the Debt Crisis to Sustainable Development: Changing Perspectives on North–South Relations, Basingstoke, Macmillan

at University of W

ashington on Decem


Dow

nloaded from

http://cadtm.org/


on the sustainability of external debt: is debt relief enough?

Documents