Jubilee for Third World Debt?

The debt crisis in many low-income countries has become a cause celebre for the American media and international charitable organizations for good reason. Countries whose people have difficulty feeding themselves are finding it impossible to spur economic growth despite an infusion of funds from organizations such as the International Monetary Fund and the World Bank. They are barely able to pay the interest on their outstanding loans even using funds that could be better devoted to public health and education programs, or tax cuts.

Take Cìte d'Ivoire, for example. Inhabitants of this small country on Africa's west coast have a declining life expectancy that is already about 15 years below the average for all developing countries, and its literacy rate is 30 percent lower than the average. Its per capita gross national product increased by only $45 in the 1990s. Yet in 1995, World Bank figures indicate, Cìte d'Ivoire spent over eight times as much to service its debt (which was more than double its GNP) as it did on public health and more than double the amount devoted to public education. Despite a joint IMF-World Bank debt relief program, Cìte d'Ivoire's debt remained over one and one-half times its GNP, and debt service payments consumed 14.4 percent of the country's GNP in 1997.

Heavily indebted poor countries (HIPCs) like Cìte d'Ivoire are deteriorating under this increasingly onerous burden of debt service. On average, their debt-to-GNP ratio is 13 percent higher than the average for all developing countries. They spend less on public health and education even though they have lower life expectancies and lower educational levels of attainment. Countries like these need rapid economic growth to overcome this morass and supply the means to meet their basic fiscal needs.

The path from problem to solution is far from clear. For centuries, economists of every ideology (from Adam Smith and Karl Marx to Robert Barro and Joseph Stiglitz) have grappled with the question of what makes economies grow. The central difference in their theories can be reduced to the level of government intervention they believe necessary to maximize a country's economic growth. One point they can agree on is that when a country starts from a low level of economic development, an influx of investment can spark explosive growth if wisely utilized. This observation is the underlying justification for the billions of dollars developing countries have received in loans and grants from multilateral sources such as the IMF and World Bank, as well as bilateral sources.

Unfortunately, providing money to these countries does not automatically translate into economic growth. Poor spending decisions, corruption, and economic policies that undermine opportunities for growth frequently negate the benefits of loans and investment. Well-intentioned, but poorly utilized, assistance compounds the problems in dozens of low-income countries. Indeed, many are as poor as they were before receiving billions in loans, but now also owe millions of dollars in annual loan payments.

The cost of unproductive investment is steep. The 41 poor countries considered heavily indebted by the IMF and the World Bank owed an average of 15.8 percent of their GNP for debt service in 1994. However, on average they paid only 5.3 percent of their GNP in debt service, leaving the arrears and interest to accumulate. In addition to unpaid debt service, borrowing increased. In 1994, net aid flows from multilateral and bilateral sources (loans extended at below market terms, known as "concessional flows," minus debt service) to these 41 countries averaged 8.3 percent of GNP.

According to the U.S. General Accounting Office, these HIPCs nearly doubled their average external debt from $122 billion between 1983 and 1985 to $221 billion between 1993 and 1995. In most cases, this increase outstripped their economic and export growth, hampering their ability to service their debt and forcing many of these countries into arrears or default.

Yet, although most of these countries are not paying enough to service their debt in full, what is paid absorbs a rising portion of the concessional assistance received from the international lenders. Thus, a good portion of their economic assistance is no longer being used to promote economic growth. For instance, World Bank data indicate that:

- The Republic of Congo received official assistance equivalent to 7.3 percent of its GNP in 1995, 22.7 percent in 1996, and 14.7 percent in 1997, yet most of this was never used for development. During the same three years, Congo paid 8.3, 16.7, and 5.1 percent of its GNP, respectively, in debt service on public and publicly guaranteed debt, most of which is owed to official creditors including bilateral aid agencies, the IMF, and the World Bank. Thus, significant amounts of new assistance were required simply to finance past assistance.

- Over the same three-year period, Cameroon received official assistance equivalent to 6.0, 4.9, and 5.9 percent of its GNP, respectively, and paid 4.6, 5.4, and 5.0 percent of its GNP each of those years toward servicing its public and publicly guaranteed debt. As with Congo, new assistance to Cameroon basically financed past assistance.

The failure of traditional debt relief mechanisms to solve the debt problems of poor countries led the IMF and World Bank to create the HIPC Initiative in 1996. The HIPC Initiative offers relief to poor countries by rescheduling their debt when traditional debt relief measures prove insufficient. Multilateral institutions supply 54 percent of total financing for the HIPC Initiative (including 25 percent from the World Bank and 9 percent from the IMF) with the remaining 46 percent coming from bilateral creditors.

In order to be eligible for HIPC relief, a country must qualify for World Bank concessional assistance, have an "unsustainable" debt burden after exhausting all other debt-relief options, and a maintain track record of adherence to IMF and World Bank conditions agreed to in return for loans (referred to as "conditionality").

Forty-one countries were originally deemed eligible for HIPC assistance, but only nine had received assistance through HIPC by 1998 and only Uganda had completed the program. Overall, the HIPC Initiative was expected to provide an 18 percent reduction in debt service due but most countries did not pay their obligations in full. According to the IMF, "in comparison to the debt service paid prior to HIPC debt relief, the reduction is about 2 percent on average and some countries are expected to experience an increase in debt service due even after HIPC assistance."

This relief fell far short of the expectations of debt relief proponents, who subsequently heaped criticism on the HIPC Initiative. As reported in the Financial Times of June 12-13, 1999, the development committee of the British House of Commons characterized the initiative as merely a "rearrangement of accounts," which fails to provide a permanent solution to the HIPC debt problem.

The Debt Relief Debate
The evident failure of the HIPC Initiative to reduce significantly the debt service obligations of eligible countries has inspired a number of competing proposals. The most publicized alternative to HIPC is championed by Jubilee 2000, a coalition of non-governmental organizations founded in 1990. Operating under the premise that debt levels in many developing nations are beyond their ability to service, Jubilee 2000 is urging creditors to forgive the "unpayable" debt in 50 low-income countries by the year 2000.

Jubilee 2000 is highly critical of the debt relief efforts of the IMF and the World Bank, calling "current lending and debt relief fundamentally unjust. International loans are negotiated in secret between local elites and powerful creditors like the IMF, the World Bank and government export credit agencies Debt relief negotiations are always driven by creditors, who are naturally unwilling to write off debts." The efforts of Jubilee 2000 have been very successful and elicited supporters as diverse as rock star Bono of U2, Pope John Paul II and a number of conservative Republicans in the U.S. who have a history of opposing foreign assistance. Their reasons for support range from religious beliefs, as is the case for Rep. Spencer Baucus, R-Ala: "The Bible says it is more blessed to give than to receive. Please help 700 million of your brothers and sisters in the poorest countries," to Bono's humanitarian appeal to help "a billion people living on less than a dollar a day."

Not everyone is enamored of the Jubilee 2000 campaign, however. Economist Steve H. Hanke paints debt relief as rhetoric that "pulls at the heart strings" but cannot stand up to the challenge of "a dose of reality." Even some World Bank employees have doubts about debt forgiveness. David Dollar, co-author of the seminal World Bank report Assessing Aid: What Works, What Doesn't, and Why, worries that there is no provision in the debt relief efforts to prevent a repetition of the current debt crisis, so that "in 15 years you have another debt crisis." On the contrary, countries will likely wind up with unsustainable debt again in the future.

In addition, the intended linkage between debt forgiveness and increases in government expenditures on specific programs (such as education and health) is dubious at best. Since money is fungible, there is no guarantee that the portion of the budget now reserved for interest payments would be set aside for increased health and education spending if the debt were forgiven. Debtor governments can cut spending on social programs even as they comply with creditors' conditionality by allocating debt relief funds to those very same initiatives. Once the creditors forgive debt, they relinquish their influence over a debtor's budgetary decisions. As Hanke observes, "At present, the politicos in poor countries tend to favor military spending, Swiss bank accounts and villas on the Riviera over schools and hospitals."

According to the Rev. Jesse Jackson, "Debt burdens are the new economy's chains of slavery. remove the shackles from a continent, to guarantee life and opportunity to millions of young children." Critics rightfully dismiss such statements as mere rhetoric, and point out that debt is not a problem in and of itself. Government borrowing to finance public expenditures can provide benefits that justify the assumption of debt. If the allocation of borrowed resources is productive, it can generate income or increase productivity sufficient to meet the costs of debt service. The problem arises when debt is not used in ways that contribute to the government's ability to service the debt, such as financing grandiose but essentially pointless construction projects, or by corrupt government officials siphoning off the funds. Thus, the central problem is not the debt burden in poor countries, but poor utilization of past credit and the reluctance of most HIPC countries to adopt economic reform.

A Better Solution
The challenge for policy-makers is to ensure that whatever debt relief proposal is ultimately adopted is more than feel-good rhetoric. The goal should not be debt forgiveness, but maximizing the ability of heavily indebted countries to develop economically and socially. Forgiving debt can facilitate this goal, but will not achieve it without other measures.

Efforts to deflect criticism have led the Group of Seven to endorse a plan to forgive most bilateral debt owed them by poor countries. The IMF and the World Bank have also yielded to public pressure and agreed in September 1999 to lower the threshold above which debt is considered "unsustainable," expand the number of countries eligible for debt relief, and front-load HIPC Initiative debt relief. As for the U.S., soon after the HIPC Initiative reform announcement, President Clinton produced a proposal to forgive all bilateral debt owed the U.S. by 36 poor countries, while Congress is considering legislation to implement debt relief.

Unfortunately, the cogent arguments of Hanke, Dollar and other skeptics of debt forgiveness have not been given equal weight with those urging deeper and broader debt forgiveness, such as Jubilee 2000. As a result, a key element -- measures to ensure that the recipients of debt forgiveness can benefit from debt forgiveness -- is missing from most proposals.

Numerous studies, including The Heritage Foundation's 1999 Index of Economic Freedom, show that the single greatest determinant of future economic growth is a freer market -- not the amount that governments spend. Thus, to be successful, debt forgiveness must be accompanied by means to encourage countries to adopt economic reforms that increase the likelihood of economic development, and measures to prevent a return to unsustainable debt levels through poor investment of borrowed funds.

The most dependable way to ensure that HIPCs adopt economic and institutional reform is to require them to forgo future official credit in return for debt forgiveness. This will:

- Provide a clean slate to allow poor countries to start fresh. Official assistance, while well-intentioned, has fostered dependence on aid and discouraged reform. In fact, foreign assistance has done little more than add to the burden many developing countries face by increasing their overall debt. The proof of this statement lies in the need to forgive poor country debt, which is overwhelmingly economic aid, in the first place -- obviously, the past loans did not generate sufficient economic growth to supply countries with the means to repay them. Forgiving these ill-conceived loans would allow poor countries to focus their resources on development rather than reinforcing past errors in judgment made by officials in bilateral and multilateral aid agencies.

- Create a market check on unwise investment and unsustainable debt levels. Official creditors have weaknesses that the private sector does not. Private creditors require countries to demonstrate an ability to service their debt before they extend additional loans. The exception is when private sector institutions are shielded from the consequences of poor decisions and market discipline, thereby creating a "moral hazard." Even the Latin American debt crisis of the 1980s, which involved private debt primarily, was spurred by implicit and explicit guarantees from domestic regulators (e.g., central banks) and international financing institutions.

If it is not insulated from market discipline, the private sector has a greater incentive to ensure that the borrowing countries can meet their debt obligations than do official institutions because it is their money at risk, not the money of taxpayers to whom aid institutions have limited accountability. Forcing countries to rely on the private sector for investment and credit by cutting them off from official creditors would prevent them from accumulating unsustainable debt through ill-conceived foreign assistance in the future. Analysis of the debt trends for developing countries supports this belief. As the debt burdens of the HIPCs increased, private creditors reduced their exposure in recognition of their decreased ability to service it. (See Figure 1.) This is a stark contrast to the developing countries as a group, who maintained a better capacity to finance debt, for whom private creditors were the main source of credit in 1995. (See Figure 2.) It is obvious from these charts that the primary source of the "unsustainable" debt burden in HIPC countries is their official bilateral and multilateral creditors.

- Encourage economic reform. Because of its emphasis on profits, private investment flows disproportionately toward countries that have economic policies conducive to entrepreneurship. Unfortunately, many heavily indebted countries have a poor record of adopting such economic reforms, using borrowed funds effectively and reliably meeting their debt obligations. Perversely, official assistance undermines the very leverage potential investors and creditors wield -- namely, the ability to withhold credit and investment -- and thus actually perpetuates economic inefficiency.

Restricting official credit and forcing HIPCs to turn to the private sector would thus supply the missing incentive to implement economic reforms. These policies (including protections for private property rights, non-punitive tax and investment regimes, minimal restrictions on repatriation of profits, financial transparency, and strong and fair judicial systems) are also the ones most conducive to economic growth and development.

Proponents of economic assistance obviously will be less than thrilled with requiring countries to forgo future assistance in return for debt relief. The countries requiring debt relief are among the largest recipients of economic assistance. This would be appropriate, if economic assistance had a positive impact on development. Indeed, in response to a Jubilee 2000 criticism of IMF assistance, Bruno J. Mauprivez of the IMF defended concessional aid because "[s]uch borrowing allows these countries to invest to enhance their future income-earning potential, which is important for economic growth and poverty reduction."

Unfortunately, history indicates that foreign assistance has not helped nations develop. Numerous studies have concluded just the opposite, in fact. One example, cited by George Will in a June 1, 1997 article in The Washington Post, is an exhaustive study by the London School of Economics concerning 92 developing nations; it found that "no relationship exists between the levels of aid and rates of growth in recipient countries." In other words, aid is a crap-shoot, with some aid recipients growing while others stagnate. The argument that an aid cut-off would inevitably doom HIPCs to poverty is therefore a red herring.

In fact, official assistance (whether from the United States, multilateral institutions, or any other country) has undermined development in the instances where it crowded out private creditors, enabled governments to avoid instituting economic reforms, and increased a country's debt burden without improving economic growth. This is equally true of grants, which would largely prevent an accumulation of debt from international assistance, but would fail to create free-market incentives for economic reform. Countries would be assured of a costless and unending source of funds regardless of what economic policies they pursued. Under such a system, few economic reforms would be implemented and the poorest countries would be relegated to perpetual poverty.

It is likely that capital flows to HIPCs might be reduced in the short term if they were unable to receive official assistance -- after all, HIPC countries receive much more in loans and grants from official creditors than they do from private sources. Private credit would likely increase slightly to meet demand, but it would not offset reductions in official credit, since most HIPC countries cannot support that level of debt -- as the very need for debt forgiveness itself implies. Interest on private credit will be more expensive, but the higher costs should be offset by higher returns on investment.

In addition, the decline in resources would not be so precipitous as typically portrayed, because official credit would no longer be needed for debt service and foreign direct investment is unlikely to abandon the country. Access to private credit and investment will increase over time as countries adopt economic reforms, experience economic growth, and establish records of responsible debt management. There is ample evidence supporting this view. For instance, Hong Kong and Taiwan received little if any official assistance, yet they succeeded in outstripping large aid recipients in terms of economic growth by implementing economic and institutional reform. After decades of failure under the current official assistance-led development strategy, it is time to abandon it.

The Long-Term Approach
Debt forgiveness without instituting economic reforms in each country and altering the lending policies and tendencies of multilateral institutions is a short-sighted and ultimately futile gesture. Even the IMF acknowledges that the economic woes of HIPCs are at least partially self-induced through an unwillingness or inability to reform their economies, poor debt management, and denominating their debt in dollars or other currencies while their own currencies devalue.

The unfortunate reality is that debt forgiveness alone will not address the most critical of the obstacles to development poor countries face. It merely offers poor countries token relief while perpetuating their dependence on bilateral and multilateral assistance. The best solution therefore is a combination of debt forgiveness and termination of future economic assistance. This approach would prevent the accumulation of excessive debt and ensure that the market (a better judge of creditworthy projects and policies than are official creditors) is the determining factor in lending decisions.

Taxpayers whose money will be given away for debt forgiveness must hold policy-makers to a higher standard than rosy rhetoric. They should demand a lasting solution to the poor country debt problem. Heavily indebted poor countries need a remedy, not a short-sighted plan that foists the problem off on future leaders.

Brett D. Schaefer is Jay Kingham Fellow in International Regulatory Affairs for the Center for International Trade and Development at the Heritage Foundation.