Debt Relief for Poor Countries

The debt problem of poor countries has attracted considerable public attention, not least through the well-targeted campaigns of Jubilee 2000 and other non-governmental organizations (NGOs) as well as civil society action in developing countries themselves. Unlike the earlier debt crisis of the 1980s (which mainly affected middle-income countries in Latin America), much of the debt of poor countries in Africa and elsewhere is owed to official creditors including the International Monetary Fund (IMF) and the World Bank, a legacy of donor support to structural adjustment programmes (SAPs) in the 1980s. By the early 1990s, debt service was taking a large and rising share of the public budget in poor countries, and donors came under mounting pressure to resolve the issue. In 1996, the Heavily Indebted Poor Countries (HIPC) Initiative was launched with the aim of cutting debt back to sustainable levels, thereby releasing more resources for development spending, including poverty reduction. After further public pressure, this was followed by the Enhanced HIPC Initiative of late 1999 which raised the amount of relief, accelerated the process and tightened the link between debt relief and the objective of poverty reduction. As of September 2003, eight HIPCs had reached their ‘completion points’ — the point at which they receive their full package of debt relief under the HIPC Initiative process (IMF and World Bank, 2003;World Bank, 2003c).

As the plight of low-income developing countries in the protracted debt crisis has caught the heart of millions, a worldwide campaign by civil society activists and NGOs for more substantial or total debt cancellation is gathering momentum. In response to the growing demand for effective debt relief measures, governments of G7 and multilateral lending institutions have placed much of their credentials in the HIPC I and II Initiatives. Indeed, by the mid-1990s, it had become clear for creditors of official debt that the repeated debt rescheduling, which has been undertaken through the traditional forum of the Paris Club negotiations since the 1970s, was approaching deadlock. The need for radical measures for writing off bilateral and multilateral official debt finally surfaced as an open agenda on the negotiating table in 1996.

A large literature has developed on the country and other factors that influence the effectiveness of aid and the development aid business more generally. Two major findings have emerged (World Bank, 1998). First, aid is more effective when the recipient country’s policy and institutional environment satisfies some minimal criteria. Second, aid and debt relief have not been particularly targeted to countries with adequate policies and institutions.¹ In this chapter, we concentrate on understanding the dynamics behind the second finding. To do so, we analyse the donor and official creditor side of the aid process. Our specific hypothesis is that the growing debt of poor countries since the 1980s and its composition has affected the process of granting new loans and grants by donors and official creditors.

Towards the end of the debt crisis decade, a vast literature on the issue of debt overhang emerged, which significantly influenced policy thinking and decisions concerning debt relief programmes in favour of developing countries. In a nutshell, the argument of this literature was that too heavy a debt burden was creating disincentives in the indebted countries, which in turn impeded adjustment and reform policies. According to this analysis, debt service obligations acted as an implicit taxation on all future returns on investments and reforms, therefore limiting the willingness of governments to implement the appropriate policies needed to promote economic growth. As a consequence, high debt implied low growth and, in the absence of a major debt relief initiative, heavily indebted countries were meant to stay trapped in a low equilibrium.

Unless we understand, and act upon, the causes of the present HIPC problem, its recurrence is almost certain.¹ Poor countries, and poor people, will be condemned to live through repeated cycles of borrowing, default and recession. But this is easier said than done. The voluminous literature on debt relief emphasizes everything from bad policy to terms of trade shocks to political instability to globalization. Depending on one’s personal preferences (and biases) you can ‘pick and mix’ virtually any combination of explanatory factors.

Excessive external indebtedness has plagued numerous developing countries since the 1980s. In the 1980s, a number of middle-income countries — especially in Latin America — experienced high indebtedness, and most of them have since managed to reduce it, partly through international efforts such as the Brady plan. However, in the second half of the 1990s, policy-makers around the world began to recognize that very high large debt levels were a contributing factor to the extreme poverty of many low-income countries, despite the fact that a sizeable share of the lending to these countries had occurred at concessional rates.

The external debt burden of many low- and middle-income developing countries has increased significantly since the 1980s.¹ This prompted the multilateral Paris Club and other official bilateral and commercial creditors to design a framework in 1996 to provide special assistance for heavily indebted poor countries (HIPCs) for whom traditional debt relief mechanisms (provided under the Paris Club’s Naples terms) are not sufficient.² In return, these countries agreed to pursue IMF- and World Bank-supported adjustment and reform programmes and meet specific policy and performance criteria.

The issue of debt relief was hotly debated during the 1990s, and extensive debts have been considered to cripple the growth prospects of particularly the poorest least developed countries (LDCs). The Heavily Indebted Poor Countries (HIPC) Initiative is an attempt to provide comprehensive debt relief to the poorest and most indebted countries. The World Bank and the IMF launched the first version (HIPC I) in 1996. In 1999 it was enhanced following global consultations in Cologne, where it was considered necessary to provide more extensive and faster debt relief with clearer links to poverty reduction (HIPC II).¹

Poverty reduction and investment in human capital are important concerns of the government of Mozambique. Following independence in 1975, substantial expansion of basic education and health services took place. Enrolment rates went up and mortality declined. These gains, however, were soon undermined by war and economic collapse (Tarp and Arndt, 2000). During the 1980s, the Renamo (Resistência Nacional de Moçambique) rebels systematically targeted education and health infrastructure for destruction, and teachers were often killed. The ceasefire in 1992 and peace in 1994 made it possible to turn attention to economic recovery and reconstruction, including the restoration and renewed expansion of basic health, education and economic infrastructure, often with the assistance of foreign donors. Towards the end of the 1990s basic rehabilitation was more or less complete. Macroeconomic stability had also been attained. Nevertheless, poverty remains extremely high, even by African standards. The national poverty headcount ranges from 69 to 82 per cent, depending on the method used (Tarp et al. 2000). With such levels of poverty, little can be achieved from redistribution alone, so the key development challenge faced by Mozambique in the coming years is determining how to move on from stabilization and reconstruction to high, sustained and equitable economic growth.

It is widely asserted that debt relief for heavily indebted poor countries (HIPC) could create and sustain a virtuous circle of poverty reduction and growth, primarily by providing additional fiscal resources for poverty alleviation. Debt relief targeted for human capital accumulation through increased public spending on education is viewed as a critical component of this link.¹ Low overall educational attainment, stagnant school enrolment rates, along with high estimated returns to schooling in many HIPCs, are often cited as justification for increased public investment in education (Table 11.1). As a result, explicit targets for expanding school enrolment rates and other performance criteria for education expenditures have been set in HIPC programmes.

Debt relief is a form of aid, and one that is becoming increasingly important for poor developing countries. From the perspective of donors, funds allocated to debt relief are attributed to the aid budget. From the perspective of developing countries, debt relief reduces debt servicing costs. As with aid, it represents an increase in funds available to government. Furthermore, as with aid, eligibility for debt relief is conditional on implementing specified economic policy reforms. The literature on aid conditionality should therefore be informative regarding the appropriate form of conditionality for debt relief. Furthermore, debt relief is intended to have a poverty-reducing effect. Although relief in itself will not affect poverty, the way in which the government funds that are freed through relief are used can reduce poverty. In other words, and this is the argument of the chapter, it is the funds associated with debt relief that can reduce poverty (if allocated to pro-poor expenditures). The flaw in current debt relief conditionality is that the conditions relate to policies (that should be pro-poor) rather than to the use of these funds, which are released only after the conditions have been met. We argue that pro-poor expenditures can and should be disbursed independently of, and if necessary prior to, full compliance with policy conditions.