The effect of unsustainable debt on growth

Unsustainable debt levels can affect economic performance through several channels. First, and most directly, the payment of debt service reduces the resources available for investment. This effect is limited for the HIPCs, many of which continue to receive positive net transfers from official creditors (which hold the bulk of HIPC debt). Nevertheless, for a variety of reasons the investment rate in HIPCs is relatively low; in the first half of the 1990s it was only 17 percent of GNP, compared with 26 percent of GNP for other developing countries. Second, even when a country receives a positive net transfer, cumbersome negotiations with creditors over the amount of debt to be rescheduled and the constant dependence on new inflows to cover debt service can impose significant administrative costs and increase uncertainty about government spending on projects (deterring private contractors). Third, the size of future repayments may be seen as the outcome of bargaining between the country and its creditors, with higher economic growth resulting in higher repayments. In these circumstances private agents may be hesitant to invest because of uncertainty over future tax rates (which may rise to finance debt service on old loans). Similarly, the impetus for undertaking difficult adjustment programs will be weakened if governments expect that foreign creditors will claim a large share of the resulting growth in output. Finally, unsustainable debt levels can preclude access to international capital markets, making it more difficult for the private sector to finance trade. Providing an exit from rescheduling by reducing debt to sustainable levels can thus play an important part in removing constraints on growth.

Goals and design of the initiative

The basic goal of the HIPC Debt Initiative, which was endorsed by the Development Committee of the World Bank in September 1996, is to reduce HIPC debt burdens to levels that can be serviced without recourse to further rescheduling, in the context of a sound growth and development program.9 The initiative is intended to provide a permanent exit from debt rescheduling and thus marks an important extension of previous debt initiatives. To qualify for assistance under the initiative, countries must be eligible to borrow from IDA, but not from the IBRD, must be eligible to borrow from the IMF’s Enhanced Structural Adjustment Facility (ESAF), must have established a track record of adjustment and reform supported by the IMF and the World Bank, and must face an unsustainable debt situation even after the full application of existing debt relief mechanisms.

By involving all of a country’s creditors, and for the first time multilateral creditors, the initiative provides an orderly process for allocating the costs of debt relief. And by ultimately removing excessive pressures to refinance debt service, it will help to strengthen the credibility of the adjustment dialogue between donors and countries. In addition, an important consideration in debt relief agreements under the HIPC Debt Initiative has been to establish monitorable programs for macroeconomic and structural reform and for social development policies focused on basic health, primary education, and rural development. Debt management capacity is also assessed, and programs are being put in place to strengthen capacity where necessary to help ensure that debt problems do not reemerge.

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The HIPC Debt Initiative incorporates lessons learned in the 1980s from such efforts as the Brady Plan and builds on existing debt relief mechanisms, including the Paris Club. Countries are considered for eligibility after maintaining a three-year track record of macroeconomic, structural, and social policy reforms, monitored by the World Bank and the IMF. A country’s eligibility for assistance is determined by the Boards of the Bank and the IMF on the basis of a tripartite debt sustainability analysis undertaken by the country’s government and Bank and IMF staff. Toward the end of the three-year performance period required for a country to be considered for a Paris Club stock-of-debt operation (the decision point), an analysis is made of whether this operation, together with at least comparable action by other nonmultilateral creditors, would be enough to achieve debt sustainability after another three years (the completion point). The performance period addresses the potential moral hazard problem that could arise if debt relief were seen as a reward for poor economic policy performance. The requirement of a track record also provides some assurance that debt relief will be provided in a context in which the resources released as a result will be used for sound development purposes.

Under the HIPC Debt Initiative the target ranges for debt sustainability are defined case by case within the range of 200–250 percent for the ratio of debt (on a net present value basis) to exports and 20–25 percent for the ratio of debt service to exports.10 The initiative recognizes the fiscal dimension of external debt; for countries that at the decision point have a ratio of exports to GDP of at least 40 percent and are making a substantial fiscal effort, as reflected in a ratio of fiscal revenue to GDP of at least 20 percent, the target ratio of debt to exports may be further reduced to a level that achieves a ratio of the net present value of debt to revenues of 280 percent at the completion point. The resources to be provided under the HIPC Debt Initiative are based on the target values of these ratios at the completion point, not on their current value.

Countries for which existing debt relief mechanisms would not achieve sustainability in the three years following the decision point would receive enhanced relief under the initiative, adequate to achieve debt sustainability by the end of that period, assuming continued strong policy reform. For borderline cases, where there is uncertainty about the robustness of their ability to reach a sustainable debt position, there are provisions for further monitoring that leave open the possibility of receiving enhanced assistance under the initiative if needed to achieve debt sustainability. The requirement of a six-year performance period is implemented flexibly and case by case; countries receive credit toward the first three years of performance for programs already under way, and in exceptional cases the second three-year stage may be shortened for countries with sustained records of strong performance.

Progress in 1997 and outlook

During 1997 the eligibility of seven countries that had established track records of performance was reviewed by the Boards of the World Bank and the IMF under the HIPC Debt Initiative. Six of these countries were judged to qualify for relief packages that could amount to about $3 billion in net present value terms and debt service relief of $5 billion over time. The debt of these six countries in 1996 was equivalent to about 40 percent of the debt of the 19 HIPCs considered likely to qualify over the life of the initiative, assuming that they establish the necessary track records. Debt relief packages were agreed on for four of the six countries (Bolivia, Burkina Faso, Guyana, and Uganda) by the end of 1997, totaling about $1,155 million in net present value terms (table 3.5).11 For all four countries the normal three-year interim period between the decision point and the completion point was shortened in view of their strong policy performance.

Table 3.5 Countries with a decision point in 1997 under the HIPC Debt Initiative
(millions of U.S. dollars)

a. Net present value of debt relief at the completion point.
b. Nominal debt service relief refers to the cumulative amount of relief over time. It exceeds debt relief in net present value terms, which discounts the nominal debt service relief back to the completion point.
c. Sustainable case.
Source: World Bank and IMF staff estimates.

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The HIPC Debt Initiative is open to countries that begin undertaking Bank- or IMF-supported adjustment programs by September 1998, at which point the initiative will be reviewed and a decision made on whether it should be extended. Although the projections are subject to much uncertainty, preliminary Bank and IMF staff analyses suggest that about 15 additional countries are likely to receive assistance under the initiative, assuming good performance. Of the countries likely to require assistance under the initiative, about three-quarters could qualify with continued good performance in the first three years of the program (that is, by 2000). Nine countries could qualify for assistance in 1998, assuming continued satisfactory performance (Côte d’Ivoire, Ethiopia, Guinea-Bissau, Mali, Mauritania, Mozambique, Senegal, Togo, and Vietnam). Decisions on individual countries will be made by the Boards of the Bank and the IMF at the appropriate time.

Funding

All creditors participate in the debt relief packages under the initiative. Costs are shared broadly in proportion to each creditor’s outstanding claims, expressed in net present value terms at the decision point. Paris Club creditors participate by granting Lyon terms. Each creditor may define the mechanism through which it will participate as long as it achieves the agreed reduction in net present value claims by the completion point. Regular meetings have been established among multilateral creditors to coordinate their participation.

The total cost of assistance under the HIPC Debt Initiative is estimated at about $7.4 billion in net present value terms.12 This relief is in addition to that provided through traditional mechanisms such as Paris Club Naples terms or commercial bank buybacks funded through the IDA Debt Reduction Facility and other donors. The World Bank has established the HIPC Trust Fund to facilitate participation by multilateral institutions. The Bank remains committed to meeting its full share of the costs out of its own resources, and it has transferred $750 million from IBRD net income to the HIPC Trust Fund. Together with the relief provided through IDA grants, these funds are expected to cover the Bank’s share of commitments made in 1997. The HIPC Trust Fund has also received about $170 million in pledges and contributions from 11 bilateral donors to help meet the costs of other multilateral development banks. The IMF has established the ESAF-HIPC Trust for financing special ESAF operations under the initiative, to which up to SDR 250 million (equivalent to about $340 million) can be transferred from the ESAF Trust Reserve Account.

Growth and innovation in official guarantees

As developing countries have greatly expanded their access to private capital markets and foreign direct investment, export credit agencies have responded to the rise in private flows by increasing support through their traditional export guarantee business and through the development of investment insurance. This section argues that:

• Export credit guarantee commitments have increased strongly during the 1990s, in part because of more aggressive export promotion by many countries and the improved financial conditions of export credit agencies. The rapid growth of investment insurance has helped developing countries involve the private sector in the provision of infrastructure and supported the privatization of state enterprises.

Trends in the export credit market

Export credit agencies’ new commitments—the value of new business insured, new lending facilities, and guarantees for new foreign direct investment (but excluding trade finance with maturities of less than one year)—to developing countries increased to an average $110 billion a year in 1990–96, up from $83 billion in the second half of the 1980s (figure 3.3).13/

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Driving this strong expansion in export credit agency activities have been more aggressive export promotion by many countries and, perhaps more important, the changing nature of international financing for developing economies, which has shifted toward project finance and direct investment projects. Roughly half of new export credit agency commitments in recent years have gone to support project financing activities, mainly for large infrastructure projects in power generation, telecommunications, and transport. Project finance, one of the most rapidly growing forms of external finance in the 1990s, typically involves a package of financing arrangements that may include export credit guarantees, commercial bank loans, equity, debt, and different types of contingent liabilities of the host government.

New export credit agency commitments in 1996 totaled $94 billion, well above the average of the late 1980s but 5 percent lower than in 1995. There were modest increases in several major markets (Brazil, Russia, and Turkey) and a big jump in South Africa. But these increases were more than offset by a substantial and widespread decline in Asia (China, Indonesia, Malaysia, the Philippines, and Thailand), which followed a doubling of commitments to this region between 1992 and 1995.

The decline in new export credit commitments in 1996 (and probably in 1997 as well) reflected some contraction in new infrastructure projects and growing concerns over macroeconomic imbalances and financial sector fragility in emerging markets, particularly in Asia. The health of the banking sector in borrowing countries is a particularly important consideration for export credit agencies in deciding on new credits because the prospects for repayment are directly affected by the financial situation of correspondent commercial banks. For some countries the downward trend in new commitments in the past two years reflects increasing competition from private insurers and commercial banks and increased access to international bond issues that require no guarantees from export credit agencies.

New commitments continue to be concentrated in a handful of economies that are viewed as relatively low risk and that are large purchasers of industrial country exports. The top 12 recipients accounted for nearly 70 percent of new commitments in 1996, and the top 20 for more than 80 percent (figure 3.4).

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Export credit agencies’ total exposure to developing countries reached an estimated $463 billion by the end of 1996, or 22 percent of the total external debt owed by developing countries (28 percent of their long-term debt). Export credit agencies are the largest official creditor of developing countries, accounting for 31 percent of their debt to official creditors. But the agencies’ share of countries’ external debt varies considerably. A few countries (such as Algeria, Iran, and Nigeria) owe more than 60 percent of their total debt to export credit agencies as a result of large arrears or rescheduled debt.

Financial performance of export credit agencies

The net cash flow of the 41 export credit agencies that are members of the Berne Union, measured as the difference between receipts (of premiums and recoveries on old claims) and payments (of new claims and operating costs), totaled $1.5 billion in 1996. This was the first surplus since before the debt crisis in the early 1980s, and it compares favorably with the $0.4 billion loss in 1995 and the record loss of $7.1 billion in 1990 (figure 3.5). The improvement in export credit agencies’ financial position in recent years is due largely to increased recoveries from payments of moratorium interest under Paris Club rescheduling agreements, reduced claims owing to generally improved payment performance by debtor countries, and increased premium income reflecting the trend toward more market-oriented risk pricing systems.

Export credit agencies have recently made progress toward harmonizing their export credit policies under the Arrangement on Guidelines for Officially Supported Export Credits, commonly referred to as the OECD Consensus. The consensus was established in 1978, and its most recent modification (intended in part to further reduce the provision of subsidized credits) became effective in 1994. The consensus defines a set of limits on the terms of officially supported export credits, including the minimum cash down payment, maximum repayment period, minimum currency-specific interest rates, and minimum concessionality for mixed credits (which combine aid resources and commercial credits). The consensus has supported much progress in rationalizing the structure of premiums by reducing interest rate subsidies; export credits of more than two years’ maturity are now close to market rates, and this trend is expected to continue. Although the recent developments are not likely to produce fully harmonized premium rates, there is now agreement among the OECD countries on minimum, or floor, premium rates. And after a short transition period there should be much greater convergence in the premium rates charged by agencies.

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Investment insurance and foreign direct investment flows

One of the most notable developments in the export credit market has been the rapid growth in agencies’ provision of investment insurance. The Berne Union member agencies extended a record $15 billion of insurance against foreign direct investment projects in developing countries in 1996, five times more than in 1990. This growth trend has been closely associated with the surge in foreign direct investment flows in the 1990s (figure 3.6). The total investment under cover by member agencies (the outstanding exposure, or stock) rose to $43 billion by the end of 1996, up from $17 billion in 1990. Ranked by the outstanding amount under cover, the Berne Union member agencies active in this market are led by EID/MITI (Japan), OPIC (United States), C&L (Germany), and the Multilateral Investment Guarantee Agency (MIGA) of the World Bank Group. Investment insurance by official agencies has covered about 10–15 percent of the foreign direct investment flows to developing countries.

The strong growth in investment insurance in recent years reflects the rising demand for political risk cover for long-duration projects, often in conjunction with large privatization programs. Unlike export credits, investment insurance by export credit agencies excludes commercial risks and is normally limited to coverage of nationalization or expropriation without compensation, losses on the investment due to war or civil unrest, and inability to convert and transfer or remit profits and dividends. This narrow coverage may limit the expansion of investment insurance, which remains much smaller in amount than export credits. But the relative importance of investment insurance in export credit agencies’ business is expected to grow, given the favorable outlook for sustained foreign direct investment flows to developing countries. The latest data show that insured investment is approaching $20 billion a year.

Multilateral guarantees

Multilateral institutions also have expanded their guarantee activities during the 1990s in response to increasing private sector flows and the growing involvement of the private sector in infrastructure. The World Bank Group, which has issued guarantees for some time (box 3.2), is further expanding its guarantee activity to meet the expected increase in demand for risk mitigation instruments. The Bank’s Development Committee agreed in principle to double MIGA’s capital to $2 billion and urged swift action to finalize the capital increase by the 1998 spring meetings of the World Bank Group and the IMF. The IDA directors approved a pilot program for IDA’s provision of partial risk guarantees to private lenders against country risks. And the Bank’s executive directors approved the use of IBRD partial risk guarantees to support private enclave projects in IDA-only countries.

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Other multilateral institutions also provide guarantees. The Inter-American Development Bank approved its first private sector partial risk guarantee in April 1997. The Asian Development Bank has approved $252 million in guarantees since 1988 for projects in which it has a stake through a direct loan, bond subscription, or equity investment. The European Bank for Reconstruction and Development had approved 14 guarantee operations for a total of Ecu 401 million (approximately $497.2 million) by the end of 1996. Smaller multilateral institutions providing guarantees include the West African Development Bank, the East African Development Bank, and the Islamic Corporation for the Insurance of Investment and Export Credit.

The benefits of expanded guarantee activity for developing countries

The growth and innovation in guarantees have done much to help developing countries expand the role of the private sector and to increase their integration with the global economy. Export credit guarantees help countries access a wider range of finance and obtain improved financing terms. The growth in investment insurance has aided in privatizing state enterprises and increasing the private sector’s involvement in the provision of infrastructure services. Investment guarantees can play a key role in strengthening investor confidence when a government is just beginning to implement economic reforms. But where reforms are more firmly in place, some governments have decided that the private sector should bear the full risk of investments.

Notes

1. About 70 percent of aid is tied to the dollar, so appreciation of the dollar affects the dollar value of 30 percent of aid flows (about $11 billion). Thus the 10 percent appreciation of the dollar in 1997 lowered the dollar value of aid flows by approximately $1.1 billion.
2. Average prices in donor countries expressed in dollars declined by 3 percent in 1996 as the dollar appreciated (particularly against the yen).
3. Part of the decline in the ratio of ODA to GNP in 1997, perhaps 0.2 percentage point, is due to the removal of Israel and a few smaller countries from the DAC’s list of ODA-eligible countries.
4. These perceptions were reported by a study by the Program on International Policy Attitudes, which included a nationwide poll, focus groups, and telephone interviews.
5. However, Levy (1988) found that aid was positively and significantly correlated with investment and economic growth for low-income countries in Sub-Saharan African, without distinguishing between good and bad performers.
6. Excluding the “blend” countries China, India, and Pakistan, which have access either to private capital markets or to official nonconcessional resources.
7. These countries are Angola, Benin, Bolivia, Burkina Faso, Burundi, Cameroon, Central African Republic, Chad, Democratic Republic of the Congo, Republic of Congo, Côte d’Ivoire, Equatorial Guinea, Ethiopia, Ghana, Guinea, Guinea-Bissau, Guyana, Honduras, Kenya, Lao People’s Democratic Republic, Liberia, Madagascar, Mali, Mauritania, Mozambique, Myanmar, Nicaragua, Niger, Nigeria, Rwanda, São Tomé and Principe, Senegal, Sierra Leone, Somalia, Sudan, Tanzania, Togo, Uganda, Vietnam, Republic of Yemen, and Zambia.
8. Many studies have presented empirical evidence showing that high debt levels reduce growth and investment. Studies focusing on Africa, where most of the HIPCs are located, include Hadjimichael and others 1995; Cohen 1996; Oshikoya 1994; and Savvides 1992.
9. The Bank has taken the lead in coordinating multilateral creditors, with contacts involving 20 multilateral institutions. The IMF has taken the lead in contacts with bilateral creditors. The Paris Club has stated its willingness to increase the concessionality of debt rescheduling from 67 percent to up to 80 percent (Lyon terms) in the context of the HIPC Debt Initiative.
10. The experience of the 1980s shows that countries typically reschedule their debt or build up arrears if the ratio of the present value of debt to exports is on the order of 200–250 percent or the ratio of debt service to exports is on the order of 20–25 percent.
11. The IMF and Bank Boards have held preliminary discussions on the eligibility of Côte d’Ivoire and Mozambique, which are expected to reach their decision points in the spring of 1998.
12. This estimate excludes several countries (Liberia, Somalia, and Sudan) because of insufficient data.
13. Export credit commitments are excluded from the data on official development finance.

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