Solving Sovereign Debt Overhang
by Internationalising Chapter 9
By Kunibert Raffer
B. Debts and Structural Disequilibria
C. Debt Management after 1982 â€“ A Never-ending Hapless
1. Delaying the Necessary Solution
2. From HIPC I to HIPC II - Delaying Further
3. Creditor Caused Damage
A Free and Transparent Arbitration Process aka International Chapter 9 Insolvency
1. Early Calls for International Insolvency
2. The Essence of Insolvency
3. Chapter 9 Insolvency within the US
4 The Framework of an International Chapter 9 or FTAP
E. The Need for an International Chapter 9 -
Lessons from History
F. Renewed Interest in International Insolvency Procedures
"Present debt management has been characterised by
unhampered creditor power with dire consequences for debtor countries, in particular for so-called vulnerable groups. Granting too small reductions too slowly has prolonged rather
than solved the problem. It is clear that debtors will be unable to repay more than a fraction of their nominal debts. Quick initiative was shown occasionally to bail out money
centre banks or in the cases of Mexico 1994-5 and Asia 1997 speculators at large".
This statement might have sounded radical when it was published in
1998. Meanwhile, however, it is shared by the International Financial Institution Advisory Commission established by the US Congress as
part of the legislation authorising approximately $18 billion of additional funding by the US for the IMF, colloquially referred to as the Meltzer
Commission. Stating that neither "the IMF, nor others, has [sic!] produced much evidence that its policies and actions have this
beneficial effect" of cushioning declines in income and living standards, the Commission concludes: "One reason may be that IMF loans permit
some private lenders to be repaid on more favorable terms, so the benefits have gone mainly to those lenders." The Meltzer Commission also found:
It soon became apparent that the growing debt burdens of
Latin American debtor countries were not sustainable, regardless of whether countries followed or ignored IMF advice. IMF assistance postponed debt reduction. The
postponement of the inevitable debt write-down and restructuring was costly. It delayed renegotiation of the debt and the resumption of capital inflows, investment and
economic growth. As a result the decline in living standards was deeper and more prolonged. During the 1980s, as the unpaid principal and accumulated interest rose, Latin America
remained stagnant. Many critics of the IMF policy of lending to countries that could not service their debts viewed this policy as contributing to the delay of the necessary
restructuring process and subsequent recovery.
The Meltzer Commission stated expressly that "default
should not always be prevented in these countries or elsewhere", but stopped short of demanding a proper, fair, and economically sound procedural framework for such
defaults. It stated: "Proposals for bankruptcy courts, collective action clauses and other contractual changes, or other attempts to share losses between private and public
lenders and institutions, raise many unresolved problems. None of them is problem free." Nevertheless it "believes
that the development of new ways of resolving sovereign borrower and lender conflicts in default situations should be encouraged but left to the participants until there is a better
understanding by debtors, creditors, and outside observers of how, if at all, public sector intervention can improve negotiations."
This invitation to advocate a viable model of international
insolvency is gladly taken up by this publication, although the idea of government insolvency a such is not really that new. One of the Commissionâ€™s members, Jeffrey D. Sachs, was an
outspoken advocate of an internationalisation of US insolvency procedures of private firms during the 1980s. The first to make this proposal, though, was a Glaswegian
professor of moral theology, held in esteem by most economists as well as by quite a few politicians. Unfortunately, though, his lucid advice is still not accepted:
When it becomes necessary for a state to declare itself
bankrupt, in the same manner as when it becomes necessary for an individual to do so, a fair, open, and avowed bankruptcy is always the measure which is both least
dishonourable to the debtor, and least hurtful to the creditor.
Unfortunately, official creditors are still determined to deny
an economically indicated and sensible solution to Southern Countries (SCs), upholding the equivalent of debt prisons for Southern debtors, to whom they keenly preach on human
rights and decent legal frameworks, accepting high social costs â€“ to which inter alia the Meltzer Commission drew attention â€“ to the worldâ€™s poorest.
After too many years of economically inefficient "debt
management" that put creditor interests in the narrowest possible sense above the Rule of Law and basic principles of human rights but could not even avoid continuous and
substantial growth of debts in the South there have been encouraging signs recently. Many NGOs have taken up the proposal of an international insolvency modelled after the
basic ideas of the US Chapter 9, a special procedure for debtors with governmental powers. Quite often the formulation Fair and Transparent Process of Arbitration
(FTAP) has been used recently to avoid the word insolvency, particularly by NGOs from the South. The Declaration of Tegucigalpa, though, the platform of Latin American Jubilee
movements, explicitly calls for an international Chapter 9 insolvency on 27 January 1999. So do ErlaĂźjahr 2000 in Germany and the Austrian Jubilee campaign, ErlaĂźjahr 2000 Ă–sterreich.
Another more recent and very positive evolution is the
emphasis put on this proposal within the UN, during the UN processFinancing for Development, and most notably the call for a "debt arbitration process to balance the interests of
creditors and sovereign debtors and introduce greater discipline into their relations" in his Millenium Report by the Secretary General himself.
Very recently, the ministers of finance of the US, the UK,
and Canada have supported the idea of international insolvency. Finally, even the IMF's new First Deputy Managing Director, Anne Krueger demanded a framework "mimicking the
features of the formal process that happens frequently in domestic bankruptcy regimes".
Encouraged by what has to be seen a greater openness
towards the solution advocated already by Adam Smith this publication is going to present the idea of an international insolvency once again in greater detail. It will start by
pointing out that the problem of Southern overindebtedness has to be seen in a broader context. Also, it is important to show that the debt problem existed long before August 1982,
when Mexico declared itself unable to honour debt obligations as contractually due, and the date conventionally called the beginning of the debt crisis, although Poland's default in 1981
was already a major shock. Dating the beginning of the debt crisis in the 1980s veils the fact that the underlying structural causes of the debt problem had existed long
before. The date also disguises the long and dismal record of debt management and the ineffectiveness of the policies enforced by the Bretton Woods Institutions (BWIs) in
restoring the sustainable economic viability of debtor countries. 1982 is an important date with respect to BWI-influence on debtor economies, though, which increased
dramatically since then. Any financial support to debtors has been made contingent on the "seal of approval" by the BWIs, even though they have not delivered any sustainable
successes. Apparently, fundamental structural disequilibria in economic North-South relations seem to be the root of the problem. The debt crisis was foreseeable and was foreseen
well before that year. This is important for the evaluation of the effectiveness of present debt management by the BWIs.
The publication will then produce a rather brief sketch of
the history of "debt management" since 1982, to be followed by a description of domestic Chapter 9 procedures in the US. Then, the basic features of an international Chapter 9 â€“ or
FTAP â€“ are described. Doing so this publication will also discuss counterarguments that have come up since internationalising Chapter 9 for sovereign debtors was first proposed in 1987. Referring to historical de facto precedents it will argue that this solution can be
implemented. Finally, it will list authors and institutions that have supported this idea or at the very least mentioned it favourably. The final conclusion is, of course, that Adam
Smithâ€™s advice should finally be heeded to avoid further unnecessary damages to debtor economies and further unnecessary suffering by vulnerable groups.
B. Debts and Structural Disequilibria in the Global Economy
Prepared on request of the president of the IBRD the
Pearson Report already identified structural origins of the debt problem in 1969, strongly recommending debt relief. It
warned of "many serious difficulties" that could result from "very large scale lending", emphasising that "The accumulation of excessive debts is usually the combined
result of errors of borrower governments and their foreign creditors. Failures on the part of the debtors will be obvious. The responsibility of foreign creditors is rarely mentioned." This sounds as modern as its finding that debt management had emphasised spending cuts and credit restrictions while
neglecting the need to sustain sound development outlays.
The Pearson Report considered the debt problem already so
urgent that it suggested the application of a unique feature of the $3.75 billion US-UK loan in 1945 (at 2 per cent interest), the so-called Bisque clause, to provide "a timely
policy alternative to moratoria or debt rescheduling when a country is in temporary balance of payments difficulty". This clause allowed the debtor (the UK) to waive or cancel interest payments unilaterally contingent on certain
conditions. It was agreed to change it in 1957: the UK was then entitled to postpone up to seven instalments of principal and interest. Four of these seven deferrals had been used
when the Pearson Report was written. Deferred payments were to be paid after 2001, carrying an interest of 2 per cent.
Recently the OECD started a thirty-year retrospective on aid with the "pathbreaking" Pearson Report, recalling some
of its findings as "still relevant today". However, the Report's recommendations regarding overindebtedness are not mentioned, even though they are highly topical at present
The Pearson Report proves that the problem was there
before the lending spree of the 1970s and thus well before 1982. The debt problem results from structural inequalities and disequilibria in the global economy, putting SCs at a
disadvantage - the structural resource gaps to which the Prebisch-Singer-Thesis (PST) had drawn attention when showing evidence for secularly falling terms of trade. The PST
rocked the boat of professional complacency exposing an apparent contradiction between theoretical expectations and practical outcome. Economists had initially expected Southern
Net Barter Terms of Trade to improve because of industrial economies of scale, faster technical progress in the North, and the law of diminishing returns applying to the raw
material exporting South. Regarding price relations, economies of scale and technical progress have the same effect: both reduce costs, which must lead to lower prices in a functioning
market. The dominant view on Net Barter Terms of Trade necessarily results from the neoclassical model, which had ruled unchallenged before. One conveniently assumed that
actual trade was in fact as beneficial as its academic model. Prof. Jevons was indeed so worried about price hikes for raw materials so steep that a modest full professor's pension
would be insufficient to heat his home that he stored as much coal in his house to provide for his bleak future as he possibly could. If Professor Jevons had been right the market
would have worked and might actually have solved the problem of development as assumed.
Really existing markets however do not live up to theoretical
models. The PST rocked the boat of professional complacency exposing an apparent contradiction between theoretical expectations and practical outcome. Secularly
deteriorating Southern Net Barter Terms of Trade destroy the whole established logic based on a beneficial world market. While this point is elaborated in greater detail elsewhere, only the one point essential for the topic discussed here is summarised: export earnings are lower than they should be
according to neoclassical theory, and resources needed to finance development are lost. Or, world markets push SCs into structural disequilibria. The existence of structural
disequilibria was to some extent also recognised by orthodoxy and its dual gap approach. Naturally, this theorem was less controversial, stating that there was a domestic gap due to
insufficient savings to finance necessary investments, and a scarcity of foreign exchange. The external gap generated from the necessity to import most investment goods. One
could explain the foreign exchange gap by domestic shortcomings as well as by failures of international markets. The foreign exchange gap has to be overcome by external finance.
The problem recognised by the Pearson Report was covered
up by the "easy money" of the 1970s - more precisely the increasing exposure of commercial banks in the South, starting as early as the end of the 1960s. One should note
that this was well before the so-called first oil crisis of 1973-4, which is usually but wrongly blamed as the one and practically only reason of the present crisis. Commercial
banks lent eagerly. The importance of official and multilateral sources for the South declined. Commercial loans covered the structural problems identified in the 1960s. Political
intervention to help commercial banks through comparatively small crises during the 1970s contributed to the growth of debts. The end of high international liquidity in the 1980s
brought the problems identified by the Pearson report again to everyone's attention.
Abbott saw the roots of the debt crisis in Sub-Saharan Africa in the 1960s, when foreign debts first began to
accumulate faster than economies or foreign exchange earnings were growing. Seeing insolvency rather than illiquidity as the problem, he already proposed debt cancellation.
Accepting the need for debt alleviation the major creditors
adopted the so-called Retroactive Terms Adjustment (RTA) in 1978, measures to provide debt relief and improve the net flow of bilateral official aid to Low Income Countries. Debts of
these countries were mostly caused by official flows, including aid. One should mention the co-responsibility of official creditors deciding and monitoring where and how their
money is spent. The programme's long-winded, clumsy name documents the creditors' desire to avoid the words debt relief or debt cancellation, not to mention insolvency. This
steadfast refusal to recognise realities officially has remained the most important hindrance to proper debt management and to a viable solution of the crisis until the most recent
declarations at the end of 2001. The word insolvency remained ostracised until the first shock after the Mexican disaster in 1995, and creditor governments were still not
willing to accept insolvency procedures as the proper and necessary solution to the debt problem until very recently.
Warnings against overindebtedness were heard in Latin
America as early as the late 1960s. Citing dramatic proportions of foreign public debts Wionczek thought a debt crisis comparable to the 1930s possible. Many crises in the South after 1982 have dwarfed the experience of the
1930s. A conference in Mexico City in October 1977 discussed solutions to the debt problem. G.K. Helleiner
demanded rules for debt relief, including the reduction of present values of repayments. The IBRD's C.S. Hardy
warned of debt problems, classifying refinancing as "not really a credible alternative". The co-ordinator of this conference, M.S. Wionczek, explained the post-1977 wave of optimism in the face of a deteriorating situation: "in terms of
institutional interests and social psychology rather than economic and financial analysis".
The BWIs themselves started Structural Adjustment well
before 1982. According to Finance & Development, their official quarterly, the IMF started in Sub-Saharan Africa already after 1973. During this early phase, when the
Fund was apparently glad to find clients, conditionality was considered lenient "in relation to the required adjustment effort". Adjustment programmes were initially planned for one year. This time horizon was preferred, apparently because of convenient accounting. In 1979 conditionality became stricter. 88 arrangements were approved by the IMF between January 1979 and December 1981, to support
adjustment policies, particularly measures to reach a sustainable balance of payments position. All countries
asking for rescheduling in 1981 "had adopted an adjustment program" with the Fund when negotiating with their creditors.
Officially the IBRD started its involvement in programme
lending in 1980, but it exerted influence in connection with projects before. The Bank always used its leverage to support the IMF and its policy against resistance by SCs.
After some turf fighting Structural Adjustment has been administered jointly by both institutions â€“ a duplication of bureaucratic procedures that hardly recalls efficient management.
The BWIs, particularly the IMF, did not arrive on the scene
after August 1982 to solve a problem created by others, but they had been part of the process leading to it . Their
type of adjustment did not prevent the debt crisis. A critic might say that the first unsuccessful adjustment programmes existed before the official start of the debt crisis. The IMF
might counter by pointing out that it did not have sufficient leverage before 1982 to force countries into necessary reforms. Naturally, this would be at odds with the claim that
debtors themselves "own" programmes only "supported" by BWIs. The issue of "ownership" is another peculiar feature of the BWIs. Depending on occasions and audiences these
institutions either claim to be only supporting a country's own programme or to make a country adopt "sensible" policies - one but not the only clear logical inconsistency. The claim of
country-"ownership" is heard more often recently than in the past, when more pride was expressed on how tightly SCs were controlled. Both official sources and publications by
leading BWI-staff show that countries do not "own" programmes. Finally, one would have to ask why programmes were financed if and when the IMF was aware
that necessary reforms were not undertaken and the money could thus not be put to good use.
C. Debt Management after 1982 â€“ A Never-ending Hapless
After 1982, when commercial banks withdrew from the
South, multilateral funds poured in, allowing commercial banks to receive higher (re)payments than otherwise possible. A remarkable shift in the structure of debts occurred. It
deserves mentioning that the BWIs did not even criticise the practice of some private banks to force debtor governments to guarantee retroactively already insolvent private debts.
They chose to ignore it. Although this ex post socialisation made debt management more difficult the BWIs insisted on punctual service of these debts as well.
Debt management by Bank and Fund has received
unconditional support by their major shareholders, in spite of apparent and protracted lack of success. Gravest officially documented failures, e.g. by the internal Operations
Evaluation Department or the Wapenhans Report, have not even made creditor countries dominating the BWIs by their voting majority question the effectiveness of the BWIs
seriously, let alone demand appropriate reforms.
The substantial bail-out of private banks by multilaterals
was aptly called an "implicit taxpayers' subsidy" by Jeffrey Sachs. In a major process of risk-shifting risk was reallocated to public multilaterals, increasing their share of
debts substantially. This hardened conditions for debtors since multilaterals - in marked contrast to private banks - have always refused to reschedule or reduce their claims until
HIPC I. A financial merry-go-round started to keep up the pretence that multilaterals do not reschedule. Funds from, say, the Bank were used to repay the IMF, allowing it in turn
to lend again to the SC, so that the IBRD's loan could be serviced "in time". Not seldom OECD governments participated as intermediary financiers. The whole bill had to be picked up
by debtors. It must also be pointed out that official debts are not necessarily cheaper than private loans.
In the 1990s another shift took place. New flows from new
sources, namely bonds (as in the 1930s) and foreign direct investment poured into some SCs, allowing voluntary repayments to commercial banks and easy servicing of
multilateral debts. Commercial banks themselves knew better than putting substantial sums of their own money into these countries again, a fact that should have cautioned those
positing that the debt crisis had been overcome. Regulatory changes, relaxed quality guidelines and lowered minimum credit ratings, induced institutional investors to place money
in the South. Official optimism as well as interest rate differences helped to attract money until the Mexican crash. Risk was shifted again, this time away from mulitlaterals onto
institutional investors and the public at large. Induced by regulatory changes and official optimism they had replaced banks and international financial institutions to an extent that
these "tens of millions of little-guy investors" were one, if not the, main argument for the new $50 billion bail-out in Mexico.
Many SCs, particularly the poorest, remain burdened by a
high amount of multilateral debts they have to service with priority. Other creditors must wait and multilaterals receive the lion's share of debt service payments poor SCs actually
make. After an embarrassingly long time of multilateral involvement in Africa - and before the euphoria about Latin America - it was attempted to declare that Structural
Adjustment had worked. However, the famous statement "Recovery has begun" by a leading IBRD official had to be
withdrawn quickly, quite rightly so, as present experience shows.
The specific characteristic of multilateral debts is that
creditors do not only lend, but have always influenced the way their resources are used on a massive scale and down to details, to an extent that clients do not see these operations
as in their interest any longer - they do not "own" them. As SCs have to pay for BWI-errors this is hardly surprising. This victim-pays-principle is a unique arrangement, which cannot
be justified by economic or legal reasoning. Under market conditions international firms can and do sue their consultants successfully in cases of wrong or negligent
advice if they fail to observe certain standards of professionalism. Orange County sued Merill Lynch for $2 billion. Bank Austria sued Price Waterhouse for ÂŁ147 million,
arguing they had not checked Sovereign Leasing, a firm Bank Austria invested in, with sufficient care. Damage compensation is also awarded to private individuals in the
Anglo-Saxon legal system if a bank goes beyond mere lending. A British couple borrowing money from Lloyds sued the bank successfully, because its manager had advised and
encouraged them to renovate and sell a house at a profit. The High Court ruled that the manager should have pointed out the risks clearly and should have advised them to
abandon the project. Because of its advice Lloyds had to pay damages when prices in the property market fell and the couple suffered a loss. If comparable standards were applied to the South there would be no problem of multilateral
debts. Failures caused by the staff of multilateral institutions have to be paid for by borrowers, who might get burdened with a further loan enabling them to repair the damage
financed by the first. At a time when letting the market work by connecting decisions and risks is gaining popularity in the former Soviet Union there is no reason why it should not
become popular with multilateral creditors. Bringing the market to multilaterals would increase the quality of their programmes and projects considerably. The total and
unjustified protection of the BWIs from legal and market consequences is one important factor explaining the present disaster. It defies both the very basic principle of the Rule of
Law that anyone has to compensate damage done by him/her and the most basic principle of economics that those deciding must carry financial risks connected with this decision. It is
therefore mandatory that multilaterals too are finally subjected to these principles, having to pay for damages done by them and their staffs.
1. Delaying the Necessary Solution
Assessing the evolution of debts and the severity of the
crisis after 1982 one must remember that the BWIs strongly encouraged SCs to borrow in international markets. Giving this advice the BWIs are part of the problem. In spite of RTA,
the Pearson Report and other explicit warnings quoted above, the fact that new loans were mostly used to service old ones on time during the last years before 1982, or their own
macroeconomic interventions and adjustment programmes the BWIs did not realise how serious the situation was. It took them an embarrassingly long time to acknowledge the nature
and the dimension of the debt problem, as can be proved by a host of evidence from their own publications. As late as 1982 a paper in their official quarterly allayed fears that
private banks might not cover SC-deficits. These wide spread concerns of "two years ago" had become unfounded "nowadays", although it could not be excluded that some groups of non-oil-exporting SCs might not be able to borrow
all the funds they might need in the future. Nowzad echoes the findings of an IMF working group on international capital markets published in Finance & Development of March 1981 in
an unsigned article and as an Occasional Paper.
Even after August 1982 the BWIs thought the money
market functioned well, seeing no signs of liquidity bottlenecks, nor of restrictions regarding the capital base of private banks limiting lending to SCs, which was supposed to continue on a large scale. The Task Force on Non-Concessional Flows established by the BWIs in 1979 presented their findings in May 1982. Pointing out that the conclusions had been presented before the crisis and there was presently even less reason for optimism the author
insisted that they did still hold.
In spite of this embarrassing (now largely forgotten) record
the BWIs are now allowed to lecture on prudent borrowing. TheWorld Debt Tables 1992/93, e.g., explain that "the principal policy lesson of the debt crisis is that domestic
resources and policy, not external finance per se are the key to economic development". The IBRD goes on drawing
conclusions such as
heavy reliance on external finance is a risky strategy
because it increases vulnerability to adÂverse external development and their attendant long-term development impact ...
Prudent lending and borrowing policies should take into
account the vulnerability to adverse external shocks. Current interest rates are a poor guide for external finance decisions. Seemingly cheap vaÂriable-rate loans may turn out to be
expensive if interest rates increase. Negative terms of trade shocks may be permanent rather than transitory and merit adjustment rather than external finance.
In a solvency crisis, early recognition of solvency as the
root cause and the need for a final settleÂment are important for minimizing the damage. ...protracted renegotiations and uncertainty damaÂged economic activity in
debtor countries for seveÂral years ... It took too long to recognize that liquidity was the visible tip of the problem, but not its root.
Ahmed and Summers quantify the costs of delaying the recognition of the "now" generally acknowledged solvency
crisis as "one decade" lost in development. This delay was caused by defenders of the so-called illiquidity theory in the 1980s, notably the IMF and the IBRD, positing that the debt
crisis was a liquidity, not a solvency crisis. As most explicit advocates they supported this theory by overly optimistic forecasts "showing" that debtors would "grow out of" debts.
In line with US policy they defended the view that debt reductions were unnecessary until the "Brady Plan" discarded it in 1989. The needed solution was delayed.
After defending the illiquidity theory for quite some time the
BWIs simply chose to forget their own arguments and analyses. They also fail to remember that the policies advised to (or forced on) debtor countries by them were based on
this error. In other words: their "advice" or - paraphrasing a sterner source - their "firmer understanding" of monitoring
has created economic and social damages in SCs for which the countries, not the BWIs had to pay, thus increasing debt burdens, not least by new multilateral loans necessary to
finance rehabilitation measures. Bank and Fund gained financially from their own errors. Naturally, official creditors do not see their delaying tactics as a reason for
compensating at least part of the damage caused by them.
Until September 1995 the BWIs denied officially that
multilateral debts were a problem. Then a leaked discussion document of the IBRD's acknowledged for the first time that something had to be done about multilateral debt, since it
was a heavy burden on many poor countries. A Multilateral Debt Facility was suggested and backed by the new president of the IBRD, James Wolfensohn, against strong
internal opposition. The idea is simple: a fund financed by contributions from individual countries and from multilaterals themselves would pay off multilateral debts of eligible
countries, thus maintaining the fiction that multilaterals do neither reschedule nor reduce debts. As creditor countries had to bail out multilaterals repeatedly in the past to keep
this fiction "intact", the first part is not entirely new. The suggestion that multilaterals themselves should finance reductions of their own debts may be called new, although
the IDA Debt Reduction Facility was already funded from the Bank's net income to reduce commercial debts. Making debt service of the IBRD's own loans easier, this implies an element
of fungibility. The precise contribution by multilaterals to the new Facility remained unclear for some time, although the IBRD expected a $850 million windfall surplus in that year,
which was seen as one source to finance the fund. According to The Economist of 6 September 1995 many people within the BWIs still clung to the old idea that new money and
growing out of debts were the best solutions. Considering that this had been practised unsuccessfully for quite some time this view is hard to understand. It has delayed the early
recognition of solvency and final settleÂment important for minimising damages, to which the IBRD itself rightly drew attention.
2. From HIPC I to HIPC II - Delaying Further
The first HIPC-Initiative was a step into the right direction and James
Wolfensohn's efforts are highly commendable. By recognizing the need of multilateral debt reductions another important step forward was made. Some features of HIPC I already - though remotely - recall
customary features of insolvency procedures. The officially declared objective of the first HIPC Initiative was to reach overall debt
sustainability by co-ordinated action, allowing the country to exit from continuous reschedulings.
So-called vulnerability factors introduced by HIPC I as well
as the ranges of indicator ratios allow a more specific and tailor-made approach, as usual in insolvency cases. Finally, accepting actual data of the recent past as the basis, rather
than notoriously "optimistic" BWI-projections introduced more realism. Nevertheless, optimism underlies HIPC II as well. In an assessment of the enhanced HIPC initiative pursuant to a
congressional request the US General Accounting Office (GAO) points out that maintaining debt sustainability will depend on assumptions of annual growth rates above 6 per
cent (in US dollar terms) - in four cases including Nicaragua and Uganda even above 9.1 per cent - over 20 years. The GAO doubts whether such growth rates can actually be
maintained for that long, warning also about the volatility of commodity prices. It points out that additional money ("increased donor assistance") will be necessary. HIPC II is
apparently again built on fragile, optimistic assumptions.
To qualify the country has to have a good track record with
the BWIs. The indicators used for HIPC I were a ratio of debt stock (in Present Value terms) to exports of 200-250 per cent and a Debt Service Ratio (DSR: defined as debt service
divided by export earnings) of 20-25, which were considered sustainable for extremely poor countries. As will be shown below this is a multiple of what creditors had considered
sustainable in the case of Germany's debt reduction in 1953. Nevertheless creditors felt they were "generous". In practice HIPC I fell short of the needs of debtor economies, as even
creditors had to recognise, mainly because creditors remained all powerful, judge, jury, bailiff, interested party, and witness all in one. Only NGO advocacy has provided some
countervailing pressure. The results of the first HIPC-Initiative and the rules established by creditors prove what has been known: creditors must not be allowed to
decide on debt reductions. This is not allowed by insolvency procedures in any decent legal system.
If the IBRD is correct that the root is insolvency and that
delays cause grave damages, there is no economic justification for delaying relief further, most evidently so for countries classified to be in an "unsustainable" situation.
Delay only means allowing debts to grow further, as the history of debt management in general as well as of both HIPCs proves. Nevertheless HIPC I did not foresee immediate
reductions but foresaw two three year periods first.
Analysing the performance of HIPC I Raffer predicted two years before Cologne that "another round - HIPC II - might already be in the making". At the Cologne G8 summit of
1999 the major creditor governments themselves recognised HIPC's failure, demanding a new approach, now often called Enhanced HIPC or HIPC II. With HIPC II creditors have
officially admitted that HIPC I failed.
Meanhwile HIPC II drags on and delays further. When the
Okinawa summit took place in the summer of 2000 only one country, Uganda, had reached its completion point, after discussions and delays. The BWI Conference in Prague did not
produce a new impetus. During the concluding press conference on 28 September 2000 the IBRD's president answered a question whether there were moves to simplifying
procedures and whether there was progress justifying high expectations for deeper debt relief for the poorest very clearly
There were high expectations, indeed, by some, but our
expectations were to advance the implementation of the second program of the enhanced HIPC facilities. There was no indication that I'm aware of, given by Horst [KĂ¶hler, the
Managing Director of the IMF] or myself, that we were going to get deeper or broader. That was certainly something that Jubilee 2000 and many others had been hoping for.
But we have maintained a position that what we want to do
between now and the end of the year is to implement, for as many countries as possible, the enhanced HIPC Initiative. We are hopeful that we will reach the target of 20 countries by
the end of this year, at which point debt relief can be operative.
As this only means reaching decision point, this does not
mean adequate relief yet. Maybe a Reuters report on the G7 finance ministers' meeting at Palermo in February 2001 formulated this point best, quoting that 22 of the world's
poorest countries had been brought into the so-called HIPC debt relief initiative in 2000 according to the communiquĂ©. The agency added that G7 representatives also said they
would work to ensure those countries benefitted fully from HIPC over the coming years (!), which would eventually (!) see two-thirds of their debts written off. In plain English no
meaningful relief yet, nor in 2002.
The new focus on poverty goes into the direction of one
element of insolvency, debtor protection. Within an international insolvency procedure modelled after the US Chapter 9 it is proposed to exempt those resources needed
to finance a humane minimum of basic education, health etc. for the poorest from the reach of creditors by establishing a Fund financing such measures. Focussing more on poverty -
which the BWIs have claimed to have done anyway during the recent past - is thus a laudable idea. One may hope that it becomes more visible in the future than it was in the past.
What happens at present largely repeats past errors. Too
little is given too late, even though it might be more than in the past. By delaying a proper solution creditors continue to make debts grow further. They increase ultimately
unrecoverable amounts, which exist only on paper, thus making debt relief look more expensive than it actually is. Rather than accepting the economic fact of insolvency, let
alone financial accountability for their own errors, creditors saw both HIPC I and Cologne's HIPC II again as acts of mercy, not as steps towards the economic solution to
overindebtedness universally applied to all debtors unless they are SCs. The problems of implementing HIPC I under creditor leadership and the continued delays since Cologne
show very clearly that a legal framework is needed to deal with overindebted SCs, which - in contrast to Structural Adjustment - protects a minimum of human dignity of
vulnerable groups. Without it the goal posts for eligibility may be moved any time, and one may resort to statistical tricks to minimise actual reductions, thus prolonging the problem.
Also, one may go on treating some countries that meet all objective economic criteria for a HIPC differently from others, denying them the same treatment simply because creditors
are afraid that this might be too costly.
Nigeria, also a Severely Indebted Low Income Country, is an
interesting illustration. It was classified a HIPC initially, but removed from the list in 1998 as no longer meeting the criteria. Its indicators were 250.14 and 11.22 in 1998.
However, the low DSR results exclusively from the fact that Nigeria - unable to pay as due - had been accumulating huge arrears. Since 1993 debt service was a fraction of interest
arrears on long term debt. Arrears of principal were always much higher than these interest arrears during that period. Simply by adding interest arrears Nigeria's DSR would have
been slightly above 35 per cent in 1997. Adding all principal arrears shown by the Bank for 1997 would result in a DSR of 90.93 per cent. In 1998 the situation is even more drastic. DSR obtained by dividing actual debt service plus
interest arrears - as shown by the World Bank - by exports amounted to 60.4 per cent. Adding principal arrears in the numerator results in well over 160 per cent, not surprisingly
so, as arrears on long term debt alone were slightly higher than export income. Recent increases in crude prices will certainly affect Nigeria positively, but it remains to be seen
whether they will push ratios back sufficiently to bring the ratio of debt service due to exports below the Cologne limits. Conveniently for creditors the country's very debt overhang -
producing a low DSR - measured by the IBRD as actual payments but disregarding substantial arrears - provides a "reason" to argue that it is not highly indebted, therefore not
in need of HIPC treatment. The higher arrears a bankrupt country amasses, the less necessary HIPC treatment becomes. This is a good illustration of the "sensible"
economics on which both HIPC Initiatives are based.
Unsurprisingly, one unsuccessful HIPC-Initiative has created
the next unsuccessful HIPC-Initiative. With good reason the Zedillo Report already stated that HIPC II has "in most cases" not gone far enough to reach sustainable debt
levels, suggesting a "re-enhanced" HIPC III. Past record
and new rhetoric about the debtor country now being in charge leads one to assume that all the blame will again be put on debtors, claiming that they had not pursued proper
policies. This blame could be corroborated by figures showing how "generous" actually given insufficient debt relief was compared with irrelevant market conditions. According to the IMF "PRSPs [Poverty Reduction Strategy Papers] have been produced by the country authorities, and not by Bank
and Fund staff". Thus blame must logically rest with the country even though the Fund states: "Greater ownership is the single most often cited, but also the least tangible,
change in moving to PRGF-supported programs. There is no single element of program design or documentation that will signal this change." An economically sensible solution with a
human face is needed, an international Chapter 9 provides it.
3. Creditor Caused Damage
Wrong decisions by creditors unwilling to accept economic
facts and powerful enough to have their way have exacerbated the problem. Avoiding smaller write-offs first, official creditors increased debts and the write-offs
unavoidable later. One can protect the illusion that everything will by repaid by bankrupt borrowers by going on lending or capitalising interest arrears for quite a while,
theoretically forever. This increases the costs of debt relief on paper, due to higher shares of uncollectable debts. One must not forget, though, that the poorest, not creditors,
have been affected by the crisis most severely.
The economic inadvisability of present debt management
and the growth of unpayable debts it causes can be shown with some extremely basic mathematics. For the sake of simplicity and clarity an interest rate of 5% is assumed, no
amortisation, and total debts of $1000 at the beginning of year 1.
Table 1: Evolution of Unpayable Debts
Debt Stock Debt Service Debt Service New Debt
Year 1 1000 50 25 25
Year 2 1025 51.25 26.25 25
Year 3 1050 52.5 26.5 26
Year 4 1076 53.8 27.8 26
Year 5 1102 55.1 28.1 27
Year 6 1129 56.45 28.45 28
Year 7 1157 57.85 28.85 29
Year 8 1186 59.3 29.3 30
Year 9 1216 60.8 29.8 31
Year 10 1247 62.35 30.35 32
At the end of year 1 debts have grown by $25 due to the
debtor's inability to pay and the need to capitalise interest arrears. As the debtor is insolvent rather than (temporarily) illiquid this liquidity problem does not disappear. Debts start
accumulating. At the end of year 10 the stock of debts is $1279 ($1247 + $32). The gaps between debt service due and actually paid widens although the debtor pays steadily
more debt service, possibly so because of the lemon squeezer effect of BWI-type "Structural Adjustment". Nevertheless, debts accumulate in the books of creditors with increasing
shares of debts that cannot be repaid, which we may call "phantom debts".
The example in Table 1 could be complicated, e.g., by
introducing amortisations, variable interest rates or inflation, but the basic mechanism remains unchanged. Capitalised arrears increase debt stocks, as anyone familiar with basic
mathematical operations can verify. Phantom debts eventually grow too. Caused by creditors unwilling to acknowledge insolvency, debts are boosted to ever more
unrealistic levels, making debt reductions to economically sustainable amounts appear costlier and costlier on paper. Forgiving $520 at the end of year 2 would have allowed the
debtor to pay the rest without problems - if the level of foreign exchange income assumed for this year by the example can at least be maintained. This is by no means sure
if and when protracted debt service at the cost of necessary replacements has reduced production capacities, as feared by the IBRD or the GATT already in the 1980s. Finally, $672
must be forgiven (new debt stock: $607) to allow honouring all obligations with $30.35. The difference of $152 results from the unwillingness of creditors to grant timely reduction.
It never existed economically as it could never be actually cashed.
Logically, debts have grown further by capitalised arrears,
adding unpayable debts on top of those obligations an insolvent debtor is already unable to honour. If a debtor has to pay n% interest, but is only able to pay m% (m<n) the
stock of debts grows by (n-m)% every year. Debts keep growing by capitalisation of arrears, multiplying by [1 + (m-n)](k-1) over k yearsif arrears occur at the end of year 1
for the first time and the relation m/n remains constant. With n and m assumed constant (5 and 2.5 respectively) debts would, e.g., increase by 28 percent over a decade. If the
debtor is insolvent rather than illiquid, debts start accumulating on paper, further beyond an insolvent debtor's economic capacity to repay. Debts that can never be repaid
because of increasing gaps between economic capacity and payments contractually due - "phantom debts" - must
increase eventually. Creditors unwilling to grant sufficient relief when necessary, increase irrecouperable debts. Total debts are pushed to ever more unrealistic levels, making
reductions to economically sustainable amounts appear costlier and costlier on paper as the share of phantom debts increases. Existing only on paper they nevertheless
compromise the debtor's economic future. They also allow creditors to exert pressure. The important point is that phantom debts can never be recouped by creditors. There is
some justice in that because they owe their existence to creditor mismanagement anyway. "Forgiving" them does not really mean losing money as official creditors often claim.
Money one cannot get, cannot be lost. Reducing phantom debts is simply an acknowledgement of facts. Minds more critical than I might even call it redress. Deleting phantom
debts simply means stopping to play the Emperor's New Clothes, acknowledging the naked economic truth.
As phantom debts make sensible debt reductions look costly
creditors are reluctant to grant them, although the money is already lost, and real costs are zero. This applies in particular to official creditors, either because they unjustifiedly insist on
preferential treatment, or because they have no loan loss reserves. Trying to keep write-offs small to go easy on their budgets, official creditors allowed debts to grow further, thus
increasing the problem, forcing themselves to accept much bigger write-offs later when the illusion of repayment finally crumbles. Insolvency laws in all decent legal frameworks
avoid precisely this kind of creditor dominated debt management increasing phantom debts at the expense of the debtorâ€™s economic recovery. They insist on neutral bodies
deciding necessary debt reductions. The fatal flaw of both HIPC-Initiatives - unhampered creditor power causing insufficient debt reductions - is ruled out by all insolvency
procedures. Debtors are not left completely at the mercy of creditors. Phantom debts show that a neutral institution makes economic sense.
The assumption that actual payments are never less than
half the payments due is quite optimistic, in particular for HIPCs. According to the IBRD Sub-Saharan Africa has, e.g., paid less than one fifth of the amounts due in quite a few
years during the recent past. The realism of the simple illustration in Table 1 is corroborated by official sources. Despite high net transfers HIPC-debts have kept growing. The IBRD acknowledges the effects of delaying relief:
The surge in borrowing, coupled with increasing reliance on
rescheduling and refinancing, increased the nominal stock of debts of HIPCs from $55 billion in 1980 to $183 billion in 1990 ... by the end of 1995 it had reached $215 billion.
The slowdown from an annual growth rate of 12.77 per cent
to 3.28 per cent in the 1990s was achieved by a shift towards more grants, higher concessionality and forgiving ODA debts. The IBRD acknowledged: "In many HIPCs the negative impact of external debts seems to come more from
the growing debt stock rather than from the excessive burden of debt service actually paid." In plain English: countries pay little, capitalising a lot of arrears.
This accumulation of arrears is hidden by conventional debt
indicators of the BWIs that are based on actual payments. This debt service ratio divides actual payments by export earnings. The less a country pays - the higher its debt
overhang - the lower its DSR becomes, while arrears accumulate. Therefore I recommended dividing actual debt service by contractually due debt service as a suitable indicator for the real debt problem. This new indicator is simply
0â‰¤ DSR/DSRd*â‰¤1 (1)
DSR is the Debt Service Ratio as defined by the World Bank
(cash base). The subscript d denotes payments contractually due. DSRd* in the denominator contains debt service plus arrears. Theoretically the real debt service ratio must include
all payments due but not effected including interest arrears and amortisation of short term debt and capitalised interest. Furthermore, it should include rescheduled principal arrears
for every year. Due to constraints of data availability I had to define DSRd* as the contractual debt service ratio (DSRd)
plus interest capitalised. While an improvement on traditional debt indicators, it still understates the burden of debt service. The index is 1 if payments are made on time, 0 if the
debtor does not pay at all. The less the debtor pays, the lower my index gets, revealing the real debt burden, which conventional indicators hide. It does not suffer from the
ambiguity of the IBRD's Interest Service Ratio or Debt Service Ratio, which may be equally low if a debtor has few debts or simply does not pay as stipulated.
Assuming exports earnings of $600 in our example above,
conventional debt indicators based on actual payments are 5.06% - Debt Service Ratios (DSRs) are also Interest Service Ratios. This hides accumulating arrears. The less countries
pay - the higher a debt overhang grows - the lower DSRs become. If debt service actually due were divided by export revenues (DSRd*) 10.4% would result, more than double the
conventional ratio. Calculating DSRd* with readily available IBRD-data for Sub-Saharan Africa and Low-Income Countries during the 1990s produces values around 0.2 and 0.4
respectively. In 1992 Sub-Sahara Africaâ€™s DSRd*was 0.126.
Interestingly, SSA's conventional debt indicators were
dramatically lower than Latin America's at the beginning of the 1990s. However, International Financial Institutions (IFIs) did not interpret them as optimistically as in the case of Latin
America, a fact which must be taken into account when evaluating their optimism on Latin America's recovery.
From this simple illustration interesting conclusions emerge:
1) Deleting phantom debts is "generosity for free". Debtors
get no real relief. Costs of debt relief are exaggerated by including phantom costs at face value. An example are costs of $34 billion over time â€“ two thirds of HIPCâ€™s total costs -
estimated officially for 22 Decision Point HIPCs.
2) Meaningful reduction must go beyond removing phantom
debts. A certain share of remaining claims can be paid if the debtorâ€™s future - in US legal parlance: "fresh start" - is put at risk. In any insolvency case more than $672 would be
cancelled to protect debtors and to ensure economic sustainability. Investment needed to ensure viability and "tools of trade" are exempt. Debtor are also guaranteed a
minimum standard of living. Too small reductions â€“ Highly Insufficient Payments Cuts (HIPCs) - expose debtors to relatively small external shocks and are likely to impair their
capacity to honour remaining obligations. Rational private investors will be reluctant to invest, fearing the next "Adjustment" programme. Nationals have an incentive to
transfer assets out of their country. Highly speculative, short term capital may by attracted, hoping for quick profits, particularly so if official bail-outs socialising losses can be exacted.
3) Too small or just sufficient reductions conditioned on
additional expenditures by debtors logically produce new crises as lending is needed to finance debt relief. The interest rate of additional borrowing is immaterial. Even 0.5% is
unfeasible. If $160 are cancelled conditional upon the debtorâ€™s financing measures (e.g. poverty reduction) amounting to, say, $16, new arrears accumulate, even
without external shocks. 8 cents are moderate. A 10% swap for poverty reduction is low. But circular causation of arrears starts again, evolving relatively slowly due to the high
concessionality of additional borrowing. Poverty reduction and investments necessary for sustainability must be financed from debt reductions beyond $672 â€“ from money creditors
could technically collect without debtor protection.
4) Delaying relief creditors caused damages to debtors, and
made things more difficult for themselves. Substantial shares of present debts were caused by creditors delaying the necessary solution.
The problem boils down to determining which percentage of
debts is uncollectable. This should be done in an economically sensible way while protecting a minimum of human dignity of the poor in indebted countries. An economic solution with a
human face is needed - an international Chapter 9 provides it. Since 1987 this proposal has repeatedly been presented. Designed and used for decades in the US as a
solution to the problems of debtors vested with governmental powers - so-called municipalities - it can be easily applied to sovereign lenders. Like all good insolvency laws it combines
the need for a general framework with the flexibility necessary to deal fairly with individual debtors.
The fatal flaw of the HIPC-Initiative as well as of Paris Club
relief - unhampered creditor power causing insufficient debt reductions - is ruled out by all insolvency procedures. Debtors are not left completely at the mercy of creditors. Civilised
insolvency laws applicable to practically all debtors except developing countries demand a neutral institution assuring fair solutions. As phantom debts show, this makes economic sense.
A.o. Professor am Institut fĂĽr Wirtschaftswissenschaften der UniversitĂ¤t Wien
Associate Professor at the Department of Economics, University of Vienna
* An earlier version was published as by the Arbeitspapier 35, OeIIP (Oesterreichisches
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which argued that Latin Americaâ€™s debt situation was unsustainable, was already available as a mimeo at the Annual Conference of the Development Studies Association, Lancaster, 7-9 September 1994, viz. before the Mexican crash of 1994-5
and the Tequila Crisis.
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no. 2, pp.301ff is the first paper that presented it in elaborated detail. A brief survey can e.g. be found in Raffer, Kunibert & H.W. Singer.(1996), The Foreign Aid Business,
Economic Assistance and Development Co-operation, Cheltenham (UK) & Brookfield US: E. Elgar 1996 [paperback edition: 1997], pp.203ff. The latter passage as well as
other papers discussing this topic - among them Raffer, Kunibert. What's Good for the United States Must Be Good for the World: Advocating an International Chapter 9 InsolÂvency. In:
Bruno Kreisky Forum for International Dialogue (ed) From CancĂşn to Vienna. International DevelopÂment in a New World. Vienna: Kreisky Forum 1993, pp.64ff - can also be found on my homepage http://mailbox.univie.ac.at/rafferk5