AFRICA: Debt-relief rationales belie limited impact

Analysis

Debt relief is among the most favoured instruments for helping low-income countries. The Paris Club of major official creditors has been meeting since the 1950s to negotiate debt reschedulings and reductions, and has to date reached 391 agreements with 80 debtor countries. However, in the 1980s, anti-poverty activists focused their attention on the debt issue and their efforts accelerated in the 1990s.

In 1996, in the face of growing public pressure, the World Bank and International Monetary Fund (IMF) launched the Heavily Indebted Poor Countries (HIPC) initiative. In 1999, the programme was enhanced further and has so far benefited 27 countries (see AFRICA: Long-term benefits of debt relief elusive - November 19, 2004). On June 11, the G8 announced it would deepen HIPC again, including write-downs of the remaining multilateral debt for qualifying countries (see INTERNATIONAL: Aid key to debt-relief deal impact - June 13, 2005).

Costs of high debt. Although many of the campaigners' appeals are emotionally based, there are thought to be several 'costs' of large external debt obligations that might justify reductions:

1. Resource diversion. The standard claim of activists and politicians is that debt service diverts limited resources. It is often claimed, for instance, that a country spends more on debt service than it does on a particular social service.

2. Economic growth. Economists have sought to assess whether high levels of debt affect economic growth. The empirical evidence is still unclear, but several potential channels for such an effect have been suggested:

   • Debt overhang. Debt levels may dampen incentives to invest because of expectations that taxes on returns to capital will be imposed in the future to service the debt or because of heightened uncertainty over future macroeconomic stability linked to government actions to repay.
   • Liquidity constraints. Debt service payments may deprive the country of foreign exchange needed for importing capital goods.
   • Fiscal effect. High debt service could reduce growth as governments cut back on public investment and/or run large budget deficits.
   • Productivity suppression. The uncertainty generated by high debt could bias investment towards short-term returns, discouraging the longer-term investments necessary to improve productivity growth.

3. Policy distortion. The mere fact that a country has difficulties servicing its debts -- particularly low-income countries which may have received loans on extremely soft terms -- suggests that there are policy deficiencies. However, the presence of high debt levels is also thought to affect policy by encouraging a short-term orientation and undermining the credibility of policy reforms. For the donor/creditor countries, high debt can undercut conditionality and selectivity by forcing them into 'defensive lending'.

4. Institutional development. Low-income countries are concerned about limited 'capacity' and its impact on the effectiveness of the civil service. It is thought that high levels of debt, and especially the administrative burden of managing the debt, may strain limited public sector management capacity. This may be exacerbated by, in a typical poor country, a large number of creditors, obligations in multiple currencies and the drain on officials from repeated negotiations with the IMF and the Paris Club.

The poverty rationale. The financing of social services and other anti-poverty expenditure have been the most politically effective justification for obtaining debt relief. For many of the small and poor countries without major economic or security interests for the creditors -- which covers most countries within HIPC -- this appears to be the primary rationale. The IMF, in a recent update, therefore boasted that 'poverty reducing expenditures' in the 27 countries in HIPC have been raised on average to 7.9% of GDP in 2004, from 6.4% five years ago -- a change which is attributed to the debt relief granted under HIPC. Overall, this is claimed (even before the latest multilateral debt initiative) to be about four times the level spent on debt service.

Strategic reasons. Debt relief is also being used for strategic purposes. Reducing debt is viewed as an important tool to bolster countries coming out of conflict or undergoing a major transition, such as democratisation or market liberalisation. Creditors therefore use debt relief both to transfer resources and to remove the potential blockage of progress by the debt itself. Based on this rationale, countries such as Iraq and the Democratic Republic of Congo have recently been granted substantial debt relief (see IRAQ: Debt relief comes with conditions - December 21, 2004), while Nigeria may soon receive a similar deal (see NIGERIA: Paris Club debt deal would strengthen reforms - June 17, 2005).

Shortcomings. Although debt relief is increasingly popular for both of these reasons, there is decreasing scope to use debt relief in the future as creditors grow weary of the continual lend-and-forgive cycle. In the long term, debt relief may undermine the establishment of a 'credit culture' and delay countries' eventual access to private capital markets.

Furthermore, there is a real risk that the benefits of debt relief are being oversold. Debt service was never as important a resource constraint as claimed since all of the HIPC countries receive strongly positive net flows from donors. To the extent that extra cashflow is available from debt relief, it is also not clear that resources are the major barrier to economic and political progress in most of the affected countries.

For example, Uganda paid 57 million dollars in total debt service in 2004, of which 30 million was to the World Bank's International Development Association (IDA). That 30 million will presumably be forgiven next year because of the new debt deal. However, Uganda also received 247 million dollars in IDA credits and a total of 959 million in aid, in the context of which 30 million dollars in relief appears minor. Moreover, under the G8 deal, the 30 million in relief will be balanced out by a matching reduction in Uganda's new IDA credits. While the IDA's funds will be replenished by the donor community, they are not earmarked for Uganda and will be distributed via the normal allocation system.