Chapter

chapter v DEBT RELIEF, NEW AID FLOWS, AND THE CHALLENGE OF MAINTAINING EXTERNAL DEBT SUSTAINABILITY

Author(s):
International Monetary Fund
Published Date:
March 2004
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Debt Relief Under the HIPC Initiative

Excessively high levels of external debt have been a serious obstacle to economic growth and poverty alleviation in heavily indebted poor countries. A high external debt-service burden can directly reduce resources available for social expenditures and adversely affect economic growth, hence indirectly leading to increases in poverty (Box 5.1). The HIPC Initiative, launched in 1996 and enhanced in 1999, aims to reduce heavily indebted poor countries’ external debt to sustainable levels, removing this obstacle to poverty reduction and growth in these countries.

The enhanced HIPC Initiative, building on debt reduction in the context of the Paris Club over the last decade or so, has already provided substantial debt relief to qualifying countries (Table 5.1). At the end of November 2003, 27 countries were benefiting from debt relief under the enhanced HIPC Initiative, of which 8 had reached their completion points, rendering them eligible to receive unconditional and irrevocable debt relief. Most of the 19 countries between their decision and completion points are receiving interim relief from their major creditors. Combined with traditional debt relief mechanisms and other debt relief initiatives, debt relief under the HIPC Initiative is estimated to reduce the overall debt stock of these 27 countries by about two-thirds in NPV terms (see Appendix II).

Table 5.1.Debt Indicators for Developing Countries and HIPCs(In percent, weighted averages)
Developing CountriesHIPCs1
Developing countries average 20012Non-HIPC low-income countries 2001Before enhanced HIPC relief3Debt indicators for 2001Debt indicators for 2002After enhanced HIPC relief at the completion point
NPV of debt-to-experts ratio41201432742752141285
NPV of debt-to-GDP ratio3339616560305
Debt service-to-exports61915167101085
Sources: World Bank, Global Development Finance; International Monetary Fund and World Bank (2003a and 2003b); HIPC country documents; and staff estimates. Liberia, Somalia, Turkmenistan, and the Federal Republic of Yugoslavia have been excluded because of incomplete data.

Beyond the HIPC Initiative: New Aid Flows Versus Debt Relief

Although HIPC relief is substantial and provides a sound basis for maintaining long-term external debt sustainability, its magnitude is relatively modest when compared to net resource transfers needed by these countries. Historically, net resource flows to the 27 HIPCs, including loans, grants, and funding for technical assistance, have been sizable—they averaged

5.9 billion annually during the 1980s (12.6 percent of GNP) and
8.8 billion (13.7 percent of GNP) during the 1990s. Annual savings from HIPC relief, in contrast, are estimated at about
1.2 billion or ½ percent of GNP for the period 2001–05.

Looking forward, low-income countries, including HIPCs, will need significant external financing inflows if they are to meet the MDGs. Debt relief, while critical in removing the burden of existing debt, can only realistically be expected to contribute a small share of the financing needed by these countries. The bulk of the external financing will have to come from new flows. This is especially true for HIPCs where there is little scope for further debt relief by official bilateral and commercial creditors after the HIPC Initiative. Additional debt relief from multilateral creditors—the main sources of new financing to HIPCs—essentially boils down to the need for new aid flows from bilateral donors to recapitalize these institutions (Box 5.2). Moreover, repeated debt relief may discourage creditors from lending even for good projects and could have a detrimental effect on the creation of credit culture in low-income countries. Thus, it is critically important that HIPCs pursue sound economic policies and practice good governance in order to attract adequate external financing, especially non-debt-creating capital inflows (e.g., grants and foreign direct investment), while avoiding the accumulation of unsustainable debt.

The Challenge of Maintaining External Sustainability in Developing Countries

The sharp fluctuations in financing flows to developing countries and the ensuing financial crises in recent years underscore the importance of increasing these countries’ resilience to external shocks. Better monitoring and assessment of countries’ debt sustainability outlooks and efforts to address financial and structural vulnerabilities would need to be key elements of any framework that would support countries’ effort to maintain external sustainability. As part of its work on surveillance and financial assistance, the IMF has adopted recently a strengthened framework for assessing debt sustainability in emerging market economies (see Appendix III).

Box 5.1.The Impact of External Indebtedness on Poverty in Low-Income Countries

High debt service can directly reduce resources that are available for expenditures on health, education, and other social areas such as social safety nets. Based on the debt overhang theory, high indebtedness can also indirectly affect poverty through its effect on investment and hence growth. A recent study by IMF staff estimated both the direct and indirect links, focusing on the relationship between per capita GDP, nonincome poverty indicators, and debt indicators.1 The study confirmed that (1) higher real GDP per capita is associated with longer life expectancy and a lower infant mortality rate, and (2) external debt indicators are negatively correlated with per capita GDP and life expectancy and positively correlated with the infant mortality rate.

The estimation used annual data for 67 low-income countries over the period 1985–99. The study used two standard human development indicators to measure poverty—life expectancy at birth and the infant mortality rate—as dependent variables. Several studies have shown that these indicators can be used to measure variations in physical well-being (World Bank, 2002), and that, in many countries, health indicators are worse for the income-poor than for the income-nonpoor. Per capita GDP corrected for purchasing power parity, and five different external debt indicators (nominal debt-to-GDP ratio, NPV of debt-to-GDP ratio, NPV of debt-to-exports ratio, debt service-to-GDP ratio, and debt service-to-exports ratio) were used as explanatory variables.

Using panel data and generalized method of moments to simultaneously address the problems of endogeneity and omitted-variable bias, the estimations show that the impact of external debt on poverty is largely indirect, and occurs mainly through income or per capita GDP (see table below). The estimation results suggest that a 5 percent increase in real per capita GDP could lead to a 1 percent increase in life expectancy, while a 20 percent increase in the debt-service-to-export ratio could lead to a 1 percent decline in life expectancy at birth. The results imply that, along with its effect through income, high indebtedness can also directly affect life expectancy, notably through its effect on relevant social expenditures. Ratios of nominal debt to GDP and NPV of debt to GDP were found to correspond positively with the infant mortality rate.

While the above results suggest that high indebtedness adversely affects key poverty indicators, it is important to note that the purposes for which the initial indebtedness was incurred can have an important effect on the results. Debt incurred for extra poverty-reducing spending may mitigate some of the adverse outcomes associated with higher indebtedness to an improvement of poverty indicators.

Empirical Evidence on Measures of Nonincome Poverty and External Indebtedness
Life ExpectancyLife ExpectancyInfant

Mortality Rate
Infant

Mortality Rate
GDP per capita0.25***0.24***–1.05***–1.46***
Nominal debt to GDP–0.06**0.33**
NPV of debt to GDP0.28**
Debt service to exports–0.05**
Observations309297308287
Note. ** significant at 5 percent and *** significant at 1 percent levels.Source: Loko and others (2003).
1Loko and others (2003).

Box 5.2.New Aid Flows Versus Debt Relief: Beyond the Enhanced HIPC Initiative

As reported in recent IMF-World Bank HIPC Initiative progress reports.1 most industrial country creditors (Paris Club creditors excluding Russia) have provided or committed to provide additional debt relief above and beyond the HIPC Initiative. This additional bilateral debt forgiveness implies that almost all debt owed by HIPCs to these creditors would be forgiven. For the 26 countries that have reached their decision points under the enhanced HIPC framework, their total external debt, after HIPC relief and additional bilateral debt forgiveness, is estimated at

22 billion in NPV terms. Of this amount, roughly about 70 percent would be owed to multilateral creditors, 16 percent (about
3.5 billion) to Paris Club creditors, and the remaining 14 percent to non-Paris Club official bilateral and commercial creditors. These estimates do not take into account new borrowing by these countries after the decision point. Taking into account new borrowing—which has been mostly from multilateral creditors–these creditors’ share would be much higher.2

Excluding Cameroon, which is projected to have the largest remaining debt (about

1.6 billion) to Paris Club creditors, each of the other 25 HIPCs would have very little or no debt to industrial country creditors (on average less than
100 million a country) after the completion point.3 This analysis indicates clearly that the scope for more debt relief by industrial country creditors after HIPC and associated debt relief initiatives is very limited. Similarly, non-Paris Club creditors are unlikely to be willing to provide additional debt relief, especially as many of them are reluctant to participate in the HIPC Initiative.

Therefore, additional debt relief beyond the HIPC Initiative would have to come primarily from multilateral creditors. However, the provision of debt relief by these creditors would require donor funding in order to preserve the integrity of these institutions’ balance sheets and safeguard their capacity to provide financial support to low-income countries including the HIPCs. Thus, additional debt relief by multilateral creditors boils down to the need for new flows from donors to these creditors/institutions.

Given the limited scope for additional debt relief, and the very large financing needs for achieving the MDGs (estimated at

50 billion a year through 2015), external financial support for low-income countries would have to be in the form of new concessional loans or grants. Efforts should also be made to increase aid efficiency to ensure that recipient countries do not fall back into a situation of unsustainable debt.

1International Monetary Fund and World Bank (2002b).2Multilateral creditors are estimated to account for 89 percent of the remaining debt for the 8 countries projected to have external debt to exports ratio exceeding the HIPC Initiative threshold at the completion point (see International Monetary Fund and World Bank (2002c).3Cameroon’s annual exports, including oil products, amounted to 2 billion in the last few years.

Low-income countries, particularly heavily indebted poor countries, will need to strengthen their ability to cope with exogenous shocks, especially since many of them rely heavily on commodity production and exports—the prices of which have been very volatile in world markets. Studies by the IMF and World Bank staffs indicate that the recent global economic slowdown, coupled with a significant decline in commodity prices, weakened HIPCs’ growth and export performance in 2000–01 and led to a deterioration of the external debt indicators in many of these countries.27 There are considerable differences in the evolution of the debt indicators among the HIPCs, reflecting their individual exposure to shocks and differences in macroeconomic management, including external borrowing policies.

With limited access to international capital markets, most low-income countries—particularly HIPCs—will continue to rely on external financing from official sources in their efforts to achieve the MDGs. Maintaining external debt sustainability over the longer term in these countries is, therefore, a challenge for both the debtors and their international supporters. For low-income countries, meeting this challenge will require prudent borrowing policies and the implementation of reforms to increase the effectiveness of external financing. However, even if countries design borrowing policies on the basis of reform scenarios, their vulnerability to external shocks can quickly lead to deteriorations in their debt indicators. Thus, stress testing would be a useful tool for examining the path of a country’s debt indicators in the face of external shocks. For creditors and donors, adequate financing on terms consistent with low-income countries’ capacity to repay, including grants where warranted, will no doubt improve recipient country’s debt sustainability prospects while still providing the financing needed to meet the MDGs. Perhaps most important, increased market access for low-income countries’ exports will encourage export diversification in these countries.

International Monetary Fund and World Bank (2002b and 2002c).

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