Debt Relief for the Poorest

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1 Debt Relief for the Poorest Panacea or Placebo? Andrea F. Presbitero E mail: Pagina web: sites.google.com/site/presbitero/ 1 Università Politecnica delle Marche Money and Finance Research group (MoFiR) School of International Studies Università di Trento May, 3 rd 11 Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 1 /

2 The HIPC and the MDR Initiatives For decades, concessional lending has been an important element of international assistance to developing countries. Despite these favorable terms, many poor countries have had increasing difficulty making payments on their debts, having not grown as rapidly as hoped because of internal and external shocks. After several debt reschedulings, in the 199s the Paris Club started to negotiate debt reduction programs. Under political pressure, in 199, the World Bank and the IMF launched the Heavily Indebted Poor Countries (HIPC) Initiative: debt relief is delivered in two stages (decision and completion points) with some conditionality. In June, the G-8 proposed a 1% write off of multilateral debt (MDRI) for countries reaching the CP under the HIPC Initiative. Currently, the HIPC and the MDR Initiatives target countries, mainly African, with a total population of more than million people, affected by widespread poverty and hunger and poor education and health conditions. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

3 The external debt build-up External debt (% exports) 3 MDRI External debt (% GDP) HIPC E HIPC PPG External Debt over Exports (weighted) PPG External Debt over GDP (weighted) Source: World Development Indicators 1 (The World Bank) Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 3 /

4 The HIPC Initiative Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

5 The debt-growth nexus in poor countries The large costs of debt relief programs (the HIPC + MDRI cost about USD 1 billion) require sound evidence on the growth effect of debt reduction. Recent research raised some concerns on high debt being a real constraint to economic growth and social expenditures in poor countries. The rationale for a negative correlation between external debt and economic growth is related to: 1 debt overhang (Krugman 1988; Sachs 1989), even if: net positive resource transfers reduce the disincentive effect of debt (Bird and Milne 3) and weak economic institutions and infrastructure represent the major hindrance to investment in HIPCs (Arslanalp and Henry ) macroeconomic uncertainty which generates a misallocation of resources (short-termism and waiting option), fosters capital flight, increases the size of the informal sector, and reduces the efficiency and productivity of capital. 3 disincentive on investments in human capital and on the government s willingness to adopt structural reforms (Sachs, Vamvakidis 7). Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

6 The debt-growth nexus in poor countries: the empirical evidence The evidence on debt overhang lacks robustness (Chauvin and Kraay ): Earlier papers show that the debt-growth relationship follows a Debt-Laffer curve (Pattillo et al. ). Debt irrelevance above a certain (country-specific) debt threshold (Cordella et al. 1). The negative relationship between debt and growth could be driven by omitted time invariant country characteristics (Imbs and Ranciere 8). Institutions matter for the debt-growth nexus The debt Laffer curve looses significance when policies are taken into account, suggesting that institutional quality could be a common determinant of both low growth and high debt. Large debts reduce GDP growth only in countries with sound policies and institutions (Presbitero 8). Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

7 The debt-growth nexus and institutional quality Weak institutions Medium institutions ln(npv ExDebt/GDP) 3 Strong institutions Total Real per capita GDP growth rate (unexplained part) ln(npv ExDebt/GDP) Linear fit Graphs by Institutional quality Notes: Different panels refer to countries with weak (CPIA 3.), medium (3. < CPIA < 3.7) and strong (CPIA 3.7) policies and institutions, and to the overall sample. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 7 /

8 The rationale for debt relief Debt overhang and crowding out are two arguments in favor of debt relief, even if the empirical evidence is inconclusive (Rajan ). But debt relief could not necessarily trigger growth and development because: 1 debt relief curse: aid dependence could undermine institutional quality (Knack 1; Moss et al ; and, in contrast, Kanbur ), debt relief has a minimal impact on HIPCs net resource transfers (Arslanalp and Henry ), 3 large external debt might be a signal of a high (and stable over time) discount rate against the future (Easterly ). Multilateral debt relief could partially overcome these problems and debt relief would become more effective with time (learning by doing). Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 8 /

9 The determinants of debt relief: main results 1 Debt relief is path dependent (Michaelowa 3). Donors grant debt relief to countries which are most in need and with low repayment capacity. 3 The increased influence of the IMF and the World Bank is partially diverting donors decisions from political considerations (Dollar and Levin ). With the HIPC Initiative, donors changed behavior, choosing the eligible countries on the basis of the quality of policies and institutions, rewarding the countries with better governance. To what extent donors debt relief policies are associated with subsequent improvements in the institutional framework? Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 9 /

10 Debt relief delivered: an assessment The HIPC and the MDR Initiatives have been successful in relaxing the budget balance and increasing poverty reduction expenditures, even if the the situation at country level is heterogeneous. More resources and poverty reduction expenditures are not necessarily correlated with improvements in the welfare of the poor (Gomanee et al ) and HIPCs are still far away from the achievements of the MDGs (UNCTAD ) Expectations should be realistic: Tanzania, Ghana and Uganda need around 1% of GDP in external financing to fund the MDGs (Sachs et al ), while debt relief counts for less than 3%. There is weak evidence so far supporting a positive impact on public and social spending, investment and growth (Depetris Chauvin and Kraay ; Presbitero 9; Johansson 1). Since late 199s, debt relief is associated with increasing domestic financing in HIPCs. The 1% MDRI debt cancellation could be more effective than traditional debt relief in helping countries escaping a situation of aid dependence. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 1 /

11 Debt service and poverty reduction expenditures in selected HIPCs Debt service (% GDP) Poverty reduction expenditures (% GDP) Congo, Rep. Guyana Guinea Bissau Mozambique Gambia Tanzania Guinea Bolivia Bolivia Ethiopia Sao Tome and Principe Nicaragua Guyana Rwanda Nicaragua Chad Mali Malawi Honduras Madagascar Ghana Sao Tome and Principe Chad Burundi Senegal Zambia Sierra Leone Ghana Haiti Senegal Congo, Dem. Rep. Niger Burkina Faso Mauritania Burundi Mali Zambia Congo, Rep. Mauritania Honduras Benin Cameroon Niger Gambia Mozambique Burkina Faso Malawi Uganda Ethiopia Guinea Bissau Rwanda Benin Madagascar Guinea Decision Point Cameroon Uganda Congo, Dem. Rep. Sierra Leone Decision Point 7 Tanzania Haiti Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), /

12 MDRI and (the lack of) growth AFG BDI BEN BFA BOL CAF CMR COG ETH GHA GMB GUY Real GDP growth rate HND HTI LBR MDG MLI MOZ MRT MWI NER NIC RWA SEN SLE STP TZA UGA ZAR ZMB Number of years pre and post MDRI (year ) Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 1 /

13 The impossibility principle Because debt sustainability is a forward-looking concept, it cannot be assessed with certainty. In that sense, debt sustainability analysis [... ] is impossible. At best, [... ] one can make educated guesses but it is important to recognize at the outset that these are just guesses, no matter how sophisticated they may be Charles Wyplosz (7) But to reach the most educated guesses as possible something can be (and it has been) done. I propose four main issues for discussion: 1 LICs vulnerability Domestic debt and crowding out 3 Optimistic projections Threshold approach Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), /

14 The Debt Sustainability Framework The DSF is based on three main pillars: 1 country-specific debt and debt-service thresholds, depending on policies and institutional quality, the evaluation of the impact on debt of external shock under a forward looking analysis of debt and debt service dynamics, and 3 the formulation of an appropriate borrowing and lending strategy that contains the risk of debt distress. HIPCs are classified as low/medium/high risk or in debt distress and they will receive the a specific grant/loan mix in future IDA allocations. PV of debt in percent of Debt service in percent of Exports GDP Revenues Exports Revenue Weak Policy (CPIA < 3.) Medium Policy (3. < CPIA < 3.7) 1 3 Strong Policy (CPIA > 3.7) 3 3 Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 1 /

15 Institutions and policies are not the only things that matter Structural vulnerability (EVI) rather than governance (CPIA) is a suitable predictor of debt distress episodes in LICs (Ferrarini 9): contingent DSF: focus on exogenous BOP shocks and on a contingent credit line Domestic debt is the missing link explaining external default and high inflation (Reinhart & Rogoff 9). It is not only debt overhang, crowding out can be a binding investment constraint. The DSF should be based on the estimation of the Kraay and Nehru () model on a broader set of determinants of debt distress episodes. Table: Debt distress, public debt, policies and vulnerability DSF Risk Rating Public debt (% GDP) Interest (% GDP) CPIA EVI low moderate high in debt distress Data at 9 refer to the sample of HIPCs, excluding AFG, KGZ, MRT, SLE and SOM because of missing data. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 1 /

16 External debt relief... but increasing domestic debt The HIPC and MDRI programs have brought inflation under control in many HIPC, reducing seigniorage and expanding the budget deficit of the public sector. However, the fiscal adjustment has not been equally successful. Limited access to international capital markets a condition required by the WB and IMF concessional lending programs and insufficient concessional lending forced many governments to tap domestic markets to finance their primary deficits. This effect has been aggravated by a loose tax collection capacity and the unfeasibility of tight policies in countries with widespread poverty. The shift towards domestic securities, and the associated increase in the real cost of financing (Christensen ) can be considered an unintended consequence of the HIPC Initiative (Arnone & Presbitero 1). The unfavorable evolution of domestic debt could be worsened by a reduction in foreign lending and aid assistance following the global crisis (Dabla Norris et al. 1). Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 1 /

17 The unintended consequence : rising domestic debt Data on the debt structure underline the weaknesses of the domestic debt build-up: 1 maturities are severely biased towards short-term instruments, the banking sector remains the main holder of government securities. Share of domestic in total public debt (%) Interest payments (% GDP) Share of domestic in total public debt Interests on domestic debt Interests on external debt Notes: elaboration on data drawn from IMF country reports and national sources. Data are unweighted averages for 1 HIPCs. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), /

18 The crowding out effects of domestic debt Costs of domestic debt outweight benefits if some prerequisites (a sound macroeconomic and legal framework and a broad investor participation) are not satisfied, as in several LICs. Government borrowing could crowd out lending to the private sector, especially to SMEs and rural borrowers, and debt service could crowd out public investment. The DSF and subsequent changes make important step forwards, but inspect the black box of domestic debt: 1 maturities are biased towards short-term instruments; the banking sector remains the main holder of government securities.... monitor the (productive) destination of public financing. A great effort should be done in collecting and disseminating data on domestic debt and public investment Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), /

19 Rising interest payments and lower investment: the case of Malawi 1 8 Public investment (% GDP) Interest payments (% GDP) 8 1 Public investment Interests on domestic public debt Interests on total public debt Elaboration on data drawn from IMF country reports Malawi s domestic debt market is still underdeveloped: it is dominated (9%) by Treasury Bills (91, 18 and 73 days) and the Reserve Bank of Malawi is the main holder. Similar pictures emerge in Zambia, Senegal, Ghana and Kenya (Afrodad) Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), /

20 Is the framework overly-optimistic? The DSA is based on overly optimistic projections, especially for HIPCs (Leo 9) and on defensive forecasting (Dreher, Marchesi & Vreeland 8). Downward revisions in exports and GDP growth rates in the wake of the global crisis are associated with severe deterioration of debt dynamics in several LICs (Presbitero 1; IMF 1): Vietnam PPG external debt in 1 was projected at 7% in the 7 DSA, while is now projected at 3% of GDP. Proposals: lending conditions based on existing debt sustainability level; extend the sensitivity analysis with multiple shocks and feedback effects. Table: Accuracy of 1-year WEO GDP growth projections Category 1 3 Average Low-Income Countries HIPCs Non-HIPCs Source: Leo (9), calculation based on the IMF WEO Database. Negative figures indicate growth exceeded projections. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

21 Debt sustainability requires limited deficits and strong growth, but... Poor institutions, weak policies, and economic vulnerabilities still put several LICs at risk of debt distress and impair growth (Depetris Chauvin & Kraay ). Out of 3 post-cp countries where a comparison over a -yrs window around MDRI is possible: 1 no growth accelerations: only show a statistically significant increase in the average GDP growth, while exhibit lower growth rates no fiscal consolidation: 7 show significant improvements in government financing, but 3 a significant worsening budget balance No downward trend in total financing after MDRI (Leo 9). If growth is fragile (Arbache & Page 9), budget deficits appear sustainable: (non-concessional) loans may be too risky, disentangle between long-term sustainable growth and exogenous shocks. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 1 /

22 Critical issues on the DSF threshold approach The framework is of little help for countries far away from thresholds: provide a more severe guidance on government spending: (counter-cyclical) budget deficit thresholds; focus on the links between debt, investment, growth and institutions to mitigate debt overhang, crowding out and output and policy volatility (Cordella, Ricci & Ruiz-Arranz 1; Malone 1) Perverse incentives? Improvements in the DSF increases the size of IDA allocation but also the loan share: weak incentives to improve institutions. Linking thresholds (and the size and term of lending) to economic vulnerability makes the process more exogenous. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

23 Summing-up and issues for assessing sustainability Shift from a debt threshold paradigm good to deal with the emergency of a debt crisis to a new one for tranquil times: flexible and country-tailored to specific vulnerabilities and constraints to infrastructure investment; based on simple rules on debt stocks and flows and on budget deficits to preserve sustainability, growth-enhancing, focused on reducing vulnerabilities and improving policies and institutions: how to insulate good-performers LICs with a nonzero limit to nonconcessional borrowing from external shocks? considering in an integrated way all sources of government financing: grants, (concessional and commercial) external and domestic debt, remittances. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 3 /

24 Vulture funds, responsible lending & donors coordination Recent data show that there are ongoing litigations by commercial creditors against 11 HIPCs, for an estimated value of $ 1. bn. Vulture funds are specialized asset management funds that buy the distressed commercial debt of the poorest and most indebted countries to then suit them in the courts of rich nations. While they generally improve the efficiency of secondary debt markets, in LICs they undermine debt relief efforts. In 7 the High Court in London ruled that Zambia must pay $ 1. mil to Donegal International (this sum is half of debt relief). Donegal bought the debt from the Romanian Government for less than $ mil, but had sued Zambia for a total claim of more than $ mil. The emergence of vulture funds is a symptom of a other bigger problems of debt relief initiative: the difficult coordination among donors and the so-called creditor moral hazard in the post-mdri lending. Legal assistance and more resources are required to support commercial external debt buy-back. Donors should commit themselves to avoid selling their claims to creditors who do not intend to provide debt relief (Charter for Responsible Lending). Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

25 Policy implications Adoption of a growth-diagnostic approach to debt relief policies, which should be country-specific and targeted exclusively to countries where public debt is a real constraint to growth and investment. The emphasis should shift from the original paradigm external debt - debt overhang to a new one based on total public debt and on the evaluation of stock and flows effects, to avoid the crowding out due to domestic and commercial borrowing. Targeting debt relief to countries with sound institutions and making the eligibility criteria measurable, realistic and public ex-ante, would be not only economically efficient maximizing the benefits of debt reduction in times of shrinking aid budgets, but will also provide the right incentives. In this spirit, debt relief can work as an incentive-based pull mechanism to improve policy and institutional framework. Finally, donors support to the other heavily indebted countries should be oriented to promote governance reforms and to identify and ease their actual constraints to economic growth. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

26 Current and future research Estimation of the long-run effect of debt on growth over the full sample of industrialized and developing countries taking advantage of a brand-new dataset: thresholds and debt effects should be heterogeneous according to the country s level of development and institutional setting; institutions could overshadow the negative debt effect in poor countries (debt irrelevance). Creation of a broad and complete dataset on HIPC and MDRI debt relief, plus Paris Club debt cancellations: determinants of debt relief allocation: does politics matter? fully-fledged ex-post evaluation of the last 1 years debt relief efforts. Presbitero (Univpm) Debt Relief for the Poorest Trento (SIS), 11 /

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