Understanding Debt Relief

ODC Issue Brief


Understanding Debt Relief
Kevin Morrison, ODC

August 1999


The debt initiative announced during the G7 Summit in Cologne in June of this year has received extensive press coverage, yet the casual observer could be forgiven for wondering exactly what is going on. Articles reporting on the Summit have carried headlines like "G7 Agrees to Write Off $ 71bn of Debt Owed by World's Poorest Nations" (Irish Times), "Leaders Approve New Debt Relief Plan Worth $70BN" (The Independent, London), and "Poor Nations To Get Debt Relief, G-7 Agrees to $70 Billion in Reductions" (Chicago Tribune). All of this sounds quite good, so why are so many developing countries and nongovernmental advocates of debt relief unhappy with the Summit plan? This ODC Issue Brief provides some clarification and explanation of the issues involved in the Cologne Debt Initiative (CDI).

The official line from the Summit was catchy and to-the-point: debt relief will be "deeper, faster, and broader."

Nominal vs Net Present Value
There are two ways to measure debt, and figures are reported both ways. "Nominal" is the actual face value of the money owed. "Net present value" (NPV) is the amount of money that would be required to pay off the debt immediately. NPV is the sum of all future debt-service obligations (interest plus principal), discounted at the market interest rate. This is lower than nominal debt when the money has been lent on "concessional" terms (that is, below market rates), as NPV reflects the "grant" element of the loans. It is estimated that NPV is about 54% of nominal debt for the HIPCs.
Deeper: If everything goes well, the CDI would combine with earlier debt relief commitments to relieve up to 70 percent of the approximately $127 billion owed by the highly indebted poor countries (HIPCs). This is roughly $65 billion more in debt relief (in nominal terms–see box) than under the original HIPC Initiative endorsed by the World Bank and International Monetary Fund (IMF) in 1996. About $25 billion of that is relief of bilateral nonconcessional loans and multilateral loans; about $20 billion is bilateral official development assistance (ODA) from members of the Development Assistance Committee (DAC) of the OECD; and about $20 billion is bilateral non-DAC official development assistance.


Faster: In contrast to the earlier HIPC Initiative, in which debt forgiveness was only given after two successfully implemented IMF structural adjustment programs (SAPs), the CDI provides "interim relief" after the first SAP has been implemented. This basically means that debt service payments (as opposed to debt stock-see below) can be reduced after the first SAP. Furthermore, there is now a "floating completion point," which means that debt stock may actually be reduced before the completion of the second SAP if the country does very well in meeting certain "ambitious" targets and policy reforms.

Eligibility Criteria
There were two main criteria for eligibility under the first HIPC initiative: one export-based and one fiscally based. With regard to exports, the most common way to define "debt sustainability," the target debt/exports ratio was in the 200-250% range. The CDI lowers this target ratio to 150%. Under the first HIPC Initiative, the fiscal definition of sustainability was applicable only to countries with certain structural characteristics: an exports/GDP ratio of 40% and a tax revenue/GDP ratio of 30%. For these countries, debt sustainability was defined as having a debt/government revenue ratio of 280%. The CDI has lowered all of these figures. Now the minimum exports/GDP ratio is 20%, and the minimum tax revenue/GDP ratio is 15%. With these criteria, debt sustainability has been lowered to a debt/government revenue ratio of 250%.

Broader: The number of countries that are expected to qualify for the CDI is 33, up from 26 under the original HIPC Initiative. This is due to looser eligibility criteria (see box). Of these HIPCs, under the new Cologne terms, about 24 are expected to have some debt cancellation promised (not necessarily delivered) by the end of the year 2000.

This all sounds fair enough, but the CDI may not end up being as generous as the G7 suggests. For example, it is somewhat misleading for the G7 to say that the CDI will, when added to previous debt reduction commitments, relieve up to "70 percent of the total debts for these countries." First, the $127 billion figure cited by the ministers corresponds to only the 33 countries expected to qualify for the initiative, not the 41 countries defined by the World Bank as HIPCs. Second, the $127 billion figure excludes short-term debt and publicly guaranteed private debt (these are both small in any case). The total debt for the 41 HIPCs is about $207 billion.

It should also be noted that a significant portion (at least $20 billion) of what is being touted as a 70 percent reduction of debt is non-G7 ODA, which the G7 is asking other countries to forgive. It is not clear that this will in fact happen. For example, Eveline Herfkens, Junior Foreign Minister of the Netherlands, said, "The G8 has trailed a string of initiatives for which Dutch financing is essential. But in spite of that we were not involved in the decision-making process. I have since made plain that the Netherlands will no longer finance decisions in which I have not been involved."

But debate about the numbers is only a small part of the debate surrounding debt relief. To understand the problem better, one must understand three key issues: conditionality, debt service vs. debt stock, and financing.

Conditionality

The rationale for debt relief for the poorest countries is that servicing this debt, much of which was incurred many years ago, often by corrupt governments no longer in power, imposes an overwhelming burden on countries already short of resources. Instead of spending more money on much-needed social services, governments must spend large sums of money servicing debts to countries that are, ironically, often giving them aid to support those same social services. Nongovernmental organizations (NGOs) and creditor countries agree that forgiving this debt would theoretically release more funds for education, health, and poverty reduction. Where they disagree is on the question of how to ensure the money made available by debt relief is well spent.

The G7 argues that implementing IMF structural adjustment programs is the best indication of effective policy. In Cologne, they bolstered this with an explicit call for debt relief proceeds to be spent on social expenditures and for civil society assistance in designing how the debt relief is used. This is what they called a "new focus on poverty." NGOs argue, however, that SAPs are too difficult, take too long to implement, and are not focused on poverty reduction themselves. Some NGOs advocate faster debt relief (one to two years), conditional on a government's agreement to spend a significant amount of the resources made available on social spending (an approach Oxfam calls the Human Development Window). Most NGOs also argue for civil society involvement in decisions on terms and conditions of debt relief, including how to spend the money. Therefore, both NGOs and G7 governments want to use debt relief to leverage certain policies in developing countries. The debate is over which policies, and how quickly to give up that leverage.

Debt Stock vs. Debt Service

In addition to the pace of debt relief, there is also debate about what exactly debt relief should target. One of the biggest complaints about the HIPC program was its exclusive focus on debt stock (the total amount of debt owed) as opposed to debt service payments (the amount of the budget actually taken up every year by servicing the debt). The difference is that the debt of many of these countries is so high that they only service part of it (that is, debts to certain donors), and donors acknowledge that much of it will never be repaid. Therefore, "forgiving" it is essentially an accounting exercise. But if debt that is not being serviced is forgiven, debt service payments do not decrease at all. This is one of the reasons that the World Bank and IMF found that, in the initial HIPC program, "for the first seven countries to reach the decision point [that is, finished with their first SAP], estimated scheduled debt service payments after receiving HIPC assistance are not dramatically different from the actual debt service paid for the period prior to the decision point…. In absolute terms, the [HIPC] Initiative may not be significantly reducing debt service from current levels paid." Enter Cologne. The target is still debt stock and not debt service, but the argument is that by simply cutting so much more debt out, payments would be reduced.

However, the presumed connection between debt stock and debt service might not be so direct. As noted above, if the debt stock is not being serviced in the first place, clearing the stock has no effect on debt service payments. Which debt gets forgiven is therefore a key variable. In addition, Jubilee 2000 (an international coalition advocating debt relief by 2000) reported that during the British government briefings in Cologne, the spokesperson said that the degree of debt service reduction depended "crucially" on reducing much of the stock of debt very soon after the completion point. This "front-loading," the spokesperson said, was in turn dependent on how much money ends up in the Millennium Fund, a fund to which the private sector can contribute in order to help finance debt relief. In other words, debt stock reduction does not necessarily equal debt service reduction.

Furthermore, even if debt service payments are reduced, the question is whether or not they are reduced enough. The U.S Treasury has reported that Mozambique's annual debt service payments were $153 million before the first HIPC program and $98 million after. Under the CDI, Mozambique debt service should drop to $73 million. Obviously, these are significant decreases, but $73 million is still more than Mozambique spends on basic health and education services combined. Oxfam and other NGOs believe debt service payments should be lowered to 10% of government revenue.

Financing

Finally, there is the real linchpin of debt relief: funding. As the Finance Ministers' report issued in Cologne said, "these changes will entail significant costs." The Ministers called on the multilateral development banks (MDBs) to continue to "identify and exploit innovative approaches which maximise the use of their own resources." Furthermore, the Ministers will "consider in good faith contributions to an expanded HIPC Trust Fund" (the HIPC Trust Fund was set up to help all MDBs finance debt forgiveness). And there is the Millenium Fund mentioned above, whose size will be determined by private sector generosity. These two latter funding options will be key to lowering debt service payments.

In addition to these funding mechanisms, the G7 agreed to sell up to 10 million ounces of the IMF's gold reserves, invest the proceeds, and then use the interest to finance debt relief. Members of the U.S. Congress have come out against the sales, however, and the United States can effectively veto the sale of the gold by the IMF. Some members of Congress oppose the gold sales on the grounds that they will not only finance debt relief but also help the IMF's Enhanced Structural Adjustment Facility (ESAF) in its transition to self-sustainability. This self-sustainability will make ESAF less accountable to donor governments. Furthermore, there is concern in Congress that the sale of gold reserves will decrease the price of gold on world markets, hurting profits of U.S. gold-mining companies, not to mention a number of gold-exporting developing countries.

The fact is that the money for debt relief has to come from somewhere, and G7 governments hope the IMF gold sales will mean they do not need extra budget allocations to cover it. If gold sales are rejected, the debt initiative will have to be financed directly through government contributions, which will most likely mean one of two things: either it will not be financed at all, or it will be financed at the cost of many governments' normal aid budgets.

Bottom Line

"Concrete proposals" on how to implement the Cologne Debt Initiative are due from the World Bank, IMF, and the Paris Club (the group of leading bilateral donors) by the time of the next Annual Meetings of the IMF and World Bank in September. How they resolve these debates will determine their success. As of now, if it were fully financed and everything went according to plan--e.g., the Millenium Fund received large amounts of money, IMF gold sales were approved, all donors agreed to forgive outstanding official development assistance, and all HIPCs successfully implemented structural adjustment programs--the Cologne Debt Initiative would offer significant debt relief to a number of poor countries. But these are big "ifs."





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Kevin Morrison is a Research Analyst at ODC.