chapter v DEBT RELIEF, NEW AID FLOWS, AND THE CHALLENGE OF MAINTAINING EXTERNAL DEBT SUSTAINABILITY
- International Monetary Fund
- Published Date:
- March 2004
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).
|Developing countries average 20012||Non-HIPC low-income countries 2001||Before enhanced HIPC relief3||Debt indicators for 2001||Debt indicators for 2002||After enhanced HIPC relief at the completion point|
|NPV of debt-to-experts ratio4||120||143||274||275||214||1285|
|NPV of debt-to-GDP ratio||33||39||61||65||60||305|
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
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.
|Life Expectancy||Life Expectancy||Infant|
|GDP per capita||0.25***||0.24***||–1.05***||–1.46***|
|Nominal debt to GDP||–0.06**||0.33**|
|NPV of debt to GDP||0.28**|
|Debt service to exports||–0.05**|
|Observations||309||297||308||287|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
Excluding Cameroon, which is projected to have the largest remaining debt (about
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
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.