Debt Relief. Economics 426

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1 Debt Relief Economics 426 1

2 Sources: S. Arslanalp and P.B. Henry (2006) Debt relief. Journal of Economic Perspectives 20:1, N.D. Chauvin, N.D. and A. Kraay (2005) What has 100 billion dollars worth of debt relief done for low-income countries? economics working paper archive W. Easterly (2001) The Elusive Quest for Growth. MIT Press, chapter 7. 2

3 Debt relief involves forgiving/cancelling sovereign debts. Relief usually should be coordinated, for reasons we have seen. For many countries, debt is owed to international agencies such as the World Bank and IMF, not to private banks. 3

4 How can debt relief help? (a) It could free up public-sector resources. (b) It could improve private incentives. e.g. Debt overhang may discourage investment. The tax on project earnings, needed to raise revenue to pay interest on debt, might prevent projects from being started. 4

5 Debt relief is not new. Here are some recent episodes: (a) Brady Plan, 1989: middle-income countries (b) HIPC Plan, 1996 and after: low-income countries (c) Gleneagles Plan, 2005 and after: low-income countries 5

6 Arslanalp and Henry (2006) predict little effect of the Gleneagles proposal. Why? Net Resource Transfer = New Lending + Grants Portfolio Equity + Foreign Direct Investment - Debt Service but for the poorest countries there are few private capital flows and most flows go to the public sector: Net Resource Transfer = New Lending + Grants - Debt Service 6

7 Forgiving $55b of debt eliminates interest payments of roughly $2b year (that is the flow burden to the debtor countries). (a) Small as a share of G7 GDP: roughly 0.01 percent (b) Larger as a share of borrower GDP: roughly 2-3 percent (c) But, gross lending is much larger so there still is a positive transfer ongoing. 7

8 For averages... Net Resource Transfer = New Lending + Grants - Debt Service In billions of USD: 17.7 = or in percentages of HIPC GDP: 12.2 =

9 Reducing the debt service cost would have a small effect on the positive, net resource transfer. In the past, grants sometimes have changed in the opposite direction, so focus on the net transfer. The net transfer may not be much larger after debt relief. 9

10 Either way, there are positive net resource transfers, so no debt overhang. For HIPCs there is little sign of private flows, and the response of other public flows is not driven by debt overhang/taxes The poor countries in today s plan have never attracted much private capital; it is unlikely debt relief will affect that. 10

11 Has debt relief ever succeeded? In the Brady Plan private flows responded and the net transfer became positive. Physical capital investment and growth after the plan were higher than.. (a) before the plan (b) in a control group of countries. 11

12 Chauvin and Kraay examine the HIPC initiative after 1996 using the same approach to evaluate the progam: difference in differences They find little effect of debt relief on public spending in poor countries, or on growth, or on investment in physical capital. 12

13 Easterly goes further. High-debt countries: (a) Did not experience more bad luck in the form of war or a fall in their export prices... (b) and receive debt relief: so repeated debt relief creates an incentive for high debt. 13

14 Debt relief: (a) predicts additional new borrowing; (b) is also associated with faster extraction of non-renewable resources (suggests discounting the future i.e. low β) 14

15 Conclusion: This evidence suggests that debt is a symptom not a cause. 15

16 Addendum How does this story of net capital inflows fit with the view that the North is exploiting the South? Answer: They are consistent.

17 Suppose that Glencore (based in Switzerland) receives a licence to mine copper in Zambia. Also suppose it uses transfer pricing to charge a high price to its Zambian subsidiary for the services it provides (or equivalently to pay a low price for the copper it buys). Monitoring such practices is expensive and requires experience.

18 Think about national accounts for Zambia. It will have a large negative NFP as profits earned there flow out due to foreign ownership. Thus it will have a current-account deficit. This may be one reason why it requires a capital inflow.

19 Another way to see the same accounting: With low reported profits from the subsidiary in Zambia, tax and royalty income to the government will be low. It may need foreign aid to meet its budget.

20 This story could partly explain how such a country became indebted in the first place. Tax revenue and the CA balance were not as large as they should have been. Lesson 1: It is good to know both national and business accounting. Lesson 2: There may be special governance issues for resource-rich emerging economies, where technical assistance can help.

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