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01/07
100 Percent Debt Cancellation? A Response from the IMF and the World Bank

By IMF and World Bank Staffs

July 2001

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Contents

I. The strategy for reducing poverty

II. The HIPC Initiative: What has been done?

III. Total debt relief by multilateral institutions—Would it help the attack on worldwide poverty?

IV. Maintaining the Capacity to Finance Development

V. The Way Forward


At the close of the last millennium, the international community succeeded in achieving an ambitious and important goal in our shared fight against poverty. In 1999, we committed ourselves to "deeper, broader and faster" debt relief to every eligible country which could translate the resources into better prospects for its poor. By the end of June 2001, agreements were in place—with relief flowing—to 23 countries, 19 of them in Africa, for debt service relief amounting to some $34 billion. And we are committed to helping the remaining HIPCs do what is necessary to access debt relief under the Initiative.

The progress to date is a crucial step in the fight against poverty, but much more needs to be done. The deep concerns of civil society in many countries helped to spur the international community to action in the HIPC Initiative. Now some debt relief campaigners are calling for a complete cancellation of all HIPC debts. Some are focusing their efforts on the international financial institutions. Is this really the best way to ensure that resources are available to attack poverty and promote development in the low-income countries?

This note considers the implications of proposals to cancel 100 percent of multilateral debt. First, it sets debt relief in the context of a broad strategy to fight poverty. Second it looks at the existing approach to poor country debt relief through the HIPC Initiative. Third, it turns to the fundamental question of what would be gained by such a proposal. Finally, the implications for development finance are looked at, including who would end up paying.

I. The strategy for reducing poverty

Many factors contribute to poverty in developing countries: economic and political history, poor economic management, weak governance, armed conflict and such external factors as deteriorating terms of trade and climatic problems. In about half of the 80 poorest countries, unsustainably high external debt has also become a key constraint on development.

Reducing world poverty is today's central development challenge. To do this we need to follow through on a comprehensive strategy to reduce poverty, based on the twin pillars of home-grown efforts by all the HIPCs to create the basis for sustained pro-poor growth, and on more decisive support from the international community.

Africa's leaders have reaffirmed their countries' responsibility to address the local obstacles to poverty alleviation. They recognize the importance of sustaining reform to avoid unsustainable debt burdens, and to restore investor confidence. Their efforts should focus on implementing national poverty reduction and growth strategies. This means creating delivery capacity for social policy, better expenditure management, and the many other elements of economic, social, political and institutional reform. For its part, the international community must respond by providing more official development assistance on appropriate terms, opening markets for poor countries, assisting with building capacity, and providing well-targeted debt relief.

The HIPC Initiative should be seen as part of this comprehensive approach. It is removing debt as a constraint in poor countries' struggle against poverty. It sets the stage for determined countries, supported by the international community, to overcome other constraints to exiting from poverty.

II. The HIPC Initiative: What has been done?

The agreements in place for the 23 countries mentioned above, with other sources of debt relief, reduce their total debt by two-thirds, bringing their indebtedness to levels below the average for all developing countries. Cash debt service savings in these countries are also substantial—about US$1.1 billion annually in the next three years. Debt service payments as a percentage of exports, GDP and government revenues will fall dramatically.

This is real progress. One important reason the Initiative is working is that, for the first time, debt relief is delivered within a framework that is transparent and comprehensive, and that, crucially, provides for equitable participation by all parties. Also unique, is that relief is delivered only to those countries which have demonstrated the commitment and capacity to use the resources effectively. These principles reflect the fact that debt relief comes at a cost. In a world of scarce development resources it is crucial to ensure that debt relief will actually make a difference in the lives of the poor.

These countries have been receiving an average of about $10 billion per year in grants and concessional loans. After HIPC debt relief is taken into account, their debt service obligations will fall to less than $2 billion per year (of which 10 percent is owed to the World Bank and 12 percent to IMF). In addition, a number of creditor governments have recently signaled their intention to provide additional debt reduction beyond the HIPC Initiative. These are welcome initiatives, although it is essential that the relief is not offset by reductions in aid flows. The figures above illustrate the importance of maintaining new flows of assistance if debt relief is to add to poverty reduction efforts: a decline of just 10 percent in new flows would wipe out the benefits of HIPC debt relief, and a total cancellation of debt would be offset by a cut of 20 percent in aid flows. Since total debt cancellation would require concerted action by all creditors, many of which continue to provide assistance, total cancellation would seriously jeopardize the overall flow of financial support for the poorest countries.

III. Total debt relief by multilateral institutions—Would it help the attack on worldwide poverty?

What is the argument for total debt cancellation? Some argue that the further reduction of debt service obligations would allow the HIPCs to make more poverty-related investments. But the HIPC Initiative is already changing the picture. So far, after debt relief, social expenditures in the 23 HIPCs mentioned above are projected to rise by an average of some US$1.7 billion per year during 2001-2002. Most of these resources will be directed toward health, education, HIV/AIDS programs, basic infrastructure and governance reform. And contrary to the statements of some debt campaigners, HIPCs will spend on average much more—not less—on priority social investments than on debt service. After HIPC relief, these countries will spend about 2 percent of GDP on debt service-well below the level in other developing countries-compared to about 7 percent on social expenditures.

To be sure, the HIPCs have a continuing need for targeted investment that benefits the poor. But the critical question is whether complete debt cancellation is the most effective and equitable way of supporting these efforts.

The debt reduction under the HIPC Initiative should be seen as a one-time action, the first step toward enabling the HIPCs to stand on their own feet. Their growth and poverty reduction strategies need financial support, which for many will mean a need for a much higher level of concessional official aid for many years to come. In time, they will become able to gain access to private international capital, including both direct investment and further borrowing.

Credit is an indispensable means of financing development, and for decades has helped developing countries become active participants in the global economy. It must, however, take place in a climate of mutual trust. It should be on appropriate terms, it should not be used to excess and must not be allowed to become unmanageable for the debtor. Equally, creditors should have confidence that loans can and will be repaid.

Some object to the very concept of poor countries borrowing for their development. But borrowing remains a crucial part of external assistance. In fact, HIPCs already receive significant net transfers of assistance in the form of highly concessional loans, especially from multilateral institutions. Most multilateral institutions, including the World Bank through IDA and the IMF through the PRGF, provide resources to poor countries through cooperative arrangements on highly concessional terms. This is a unique source of concessional finance for the world's neediest countries which operates on the principle that developing countries borrow from and pay back into the same sources of financing. The preferred creditor status of the IMF, World Bank and other international financial institutions ensures that they are able to continue to provide financial support to their members on a sustainable basis, even in very difficult circumstances.

Of course, good results from borrowing were not seen everywhere. Some countries, for many different reasons, have not experienced significant gains. In HIPCs, unsustainable debt is a result. The international community has a collective obligation to address this problem. The HIPC Initiative is doing this. But we must also be there to support the future development needs for all countries. That is why the goal of the Initiative is to help countries achieve debt sustainability, and is focussed specifically on the most highly indebted poor countries. Total debt cancellation for those countries alone would come at the expense of other borrowing countries, including those non-HIPCs which are home to 80 percent of the developing world's poor. Those who call for 100 percent cancellation for the HIPCs alone, must recognize that this would be inequitable for other poor countries.

IV. Maintaining the Capacity to Finance Development

Supporters of 100 percent debt cancellation must be honest about the costs. The total public external debt for low-income countries stands at some $460 billion. HIPCs and many other poor countries will rely on external financing for their development needs long into the future. A growing portion of this need is being met by bilateral and multilateral agencies on concessional terms. Total cancellation could imperil these funds. It would also undermine the confidence of existing and potential investors whose funds are vital for the long-term development of the low-income countries.

Beyond the flows from bilateral donors, the only other concessional financing comes from multilateral agencies, primarily the multilateral development banks and the IMF. These concessional flows are financed in two main ways: (i) budget allocations by developed countries; and (ii) repayment of the concessional loans made previously by these agencies. Of course, the community of shareholders could make a special budget allocation to pay for the cost of additional debt relief or new financing by the multilateral agencies, but at present there is little support in donor countries to do so. In these circumstances, what would be the effect on these agencies of a complete cancellation of the debt owed to these institutions?

IDA finances nearly half of its new commitments (about $6.5 billion annually) from repayments and investment income. As IDA has no provisions for losses arising on its credits to members, this means that write-offs would be a direct dollar-for-dollar reduction in IDA's ability to make future credits to poor countries. In effect, credits would be cut in half. Alternatively, to maintain future IDA lending at this level, contributions from the developed countries would have to double, a response which seems highly unlikely.

The regional development banks (IDB, AfDB, AsDB) also have soft lending windows, and face even greater constraints, since they are also dependent on the contributions from the developed countries. Indeed, the AfDB continues to face an uphill task in securing full financing of its share of HIPC costs under the existing arrangements. Total debt cancellation would likely cripple these institutions.

The IMF's Poverty Reduction and Growth Facility is also funded by contributions and borrowed resources. Although it is now close to being a permanent facility, its future operations will be financed purely by reflows. Debt cancellation would deplete the resources of the PRGF Trust and force closure of the facility. No resources would remain available for future concessional IMF lending, and the IMF would have to withdraw from providing concessional support to its poorest members.

But what of the nonconcessional resources of the multilaterals? The question is often asked whether the "hard" lending facilities of multilateral development banks and the IMF can pay for debt relief provided by the "soft" lending windows—beyond the substantial contributions to IDA & HIPC already being made from IBRD net income. The fact is that the hard lending windows already use their paid-in capital and reserves to underpin lending to developing country members. Provisions are taken against expected losses related to exposure on the balance sheets of multilateral development banks, and cannot be used to write off losses on other balance sheets without putting the institution at risk of going out of business.

The IBRD's equity capital is leveraged at a rate of about 5:1 through the issuance of AAA-rated debt. Therefore, its capacity to lend would be reduced by $5 for every $1 distributed to debt relief in respect of the concessional lenders' balance sheets. Furthermore, it is likely that the write-off would result in a weaker equity capital position for the Bank and therefore an increased cost of lending to its borrowers. Debt cancellation, with substantially reduced borrowing, at higher cost, would have a serious impact on IBRD-eligible borrowers, which are home to 80 percent of the world's poorest people.

The IMF: For the Fund, total debt cancellation in the absence of full funding by bilateral donors would do serious damage by fundamentally changing its role as an anchor for the international financial system based on the revolving character of its resources. Debt cancellation would not only eliminate PRGF lending, but also impair the Fund's financial integrity. The IMF's gold reserves are a fundamental strength in its financial position, giving it increased credibility and the capacity to assist its broader membership in crisis situations. The 1999 decision by the membership to use, as an exceptional one-time measure, income from the investments of the profits from limited off-market gold sales to help finance the IMF's contribution to the HIPC Initiative had a substantial cost to the institution and its members. Additional sales would put at risk the confidence of members in the Fund's solidity, and thus its ability to lend.

V. The Way Forward

We have made a great deal of progress in implementing the enhanced HIPC Initiative, but there is much more to do. The next challenge is to move forward with debt relief agreements for those countries which have yet to qualify for HIPC relief because of conflict or severe governance problems. With countries committed to peace and stability, we believe HIPC relief can contribute to the transition from conflict to sustainable development, and we hope to move forward with these countries as swiftly as possible. But more than just debt relief, we look forward to being there to support their development over the long term.

We believe the best way for the international community to support the poverty reduction strategies of the low-income countries is by opening their markets to the exports of poor countries and by increasing new concessional flows. Mr. Köhler and Mr. Wolfensohn have indicated that they would gladly join a campaign to convince industrial countries to move to the longstanding UN target for official development assistance of 0.7 percent of GNP within ten years. With current levels of foreign aid at some 0.24 percent of GNP, the difference between the figures is worth $100 billion per year, far more than the net flows generated by even the most ambitious of debt relief proposals. This financing needs to be complemented by greater access to industrial country markets so that developing countries can earn their way in the global economy. These are targets worth pursuing to achieve the International Development Goals.