The political economy of debt relief

Andreas Freytag, Gernot Pehnelt

11 December 2008

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The global financial market crisis has fed fears that individual countries face such serious problems that they might go broke, with this causing a cascade of national crises.
In particular, developing and emerging economies, which so far have been regarded as being decoupled from the crisis in the industrialised world, are endangered. Countries that may be regarded as problematic in this context are Hungary, Pakistan and Iceland.

The IMF has loaned $15.7 billion to Hungary to help the country combat negative fallout from the global financial crisis. Most recently, Pakistan got into deep trouble when the country's foreign exchange reserves shrunk dramatically and the rupee plunged in October as the balance of payments deficit in the three months from July 1 widened to $3.95 billion from $2.27 billion a year earlier. The decision of the IMF to approve a US$7.6 billion credit to Pakistan to stave off a balance of payments crisis reduces for the time being the prospect of Islamabad defaulting on its foreign debts. Iceland received a bailout of almost $5 billion from the IMF and the neighbouring Nordic countries.

The IMF also promised to help Latvia deal with its economic crisis after it assisted Iceland, Hungary, Ukraine, Serbia and Pakistan.

Table 1 shows the cost of some of the bailout programmes since the mid 1990s. Not a few analysts believe that the worst is yet to come with respect to some transition and developing economies.

Table 1: Crises and bailout-cost

Crisis GDP (in billions) Cost* (in billions) %GDP
USA 2008 $14,312 $1.500? >10%?
Pakistan 2008 $130 $8? 6%?
Hungary 2008 $170 $16? 9%?
Argentina 2000 $299 $22 7%
Brazil 1998 $844 $42 5%
Russia 1998 $271 $24 9%
Korea 1997 $527 $57 11%
Thailand 1997 $151 $17 12%
Indonesia 1997 $238 $21 9%
Mexico 1995 $421 $48 11%

*Progressive Policy Institute, September 24, 2008, and own estimations.

If the bailout programmes do not help quickly, one might think of an old instrument, namely debt relief, to overcome the problem. The question is if bailing out broke countries is a remedy for the tilt or rather part or even a cause of the problem.

The rationale of debt relief

There are three efficiency arguments for the provision of debt relief. The first is the so called ‘debt overhang’. It has been stated that highly indebted countries benefit very little, if ever, from the returns on any additional investment because of the debt service obligation. Large debt obligations can be seen as a high tax on investment, policy reforms and development, because a significant part of the gains from economic adjustment would go to foreign creditors and not to the country itself. Creditors should therefore offer debt relief to countries with large stocks of external debt in order to reduce future debt obligations. This would increase the share of any marginal gains from economic adjustments that goes to the debtor country and create incentives to make these adjustments. This strategy could end up in a win-win-situation by not only easing the debt burden of debtors but also increasing future repayments to the creditors.

Secondly, debt relief may have a stimulating effect on investment and economic development. The clincher with respect to the resource position of low-income countries and therefore to the capacity to pay their obligations and to invest, is still the net resource transfer from donors, including aid. Since the reduction of multilateral debt is partly financed by bilateral donors (e.g. through their contributions to multilateral funds), and these contributions usually come from the same political reservoir, namely the donors’ aid budget, there might be a trade-off between debt relief and official development assistance.

The third rationale for debt relief could follow different lines. If an individual country’s bankruptcy causes investors to withdraw their capital from other countries with similar but not identical problems, the crisis cascades and even countries without the structural problems of the country in question are endangered.

The determinants of debt relief

Despite these arguments, past debt relief programs have been rather ineffective. The determinants of debt relief obviously deviate from economic reasoning. It can be argued that neither absolute poverty nor lack of access to foreign exchange (through exports) have been criteria in allocating ODA debt relief and pure grants. If politicians and international bureaucrats realise that default risks become very high, they prefer to grant debt relief in order to conceal their imprudent past lending and to “sell” the renunciation of funds as an innovative poverty reduction measure, especially if lobbying by non-governmental organisations (NGOs) in favour of debt relief increases their chances of obtaining positive public credit for the delivered debt relief. According to this reasoning, politicians in donor countries do not like to admit policy errors. Politically rational governments in creditor countries would find arguments for further debt relief measures. Thus, debt relief is driven by path dependence. Debt relief then is a politically cheap, but economically expensive form of publicly visible development policy.

In our study, we analysed the determinants of debt relief in more than 100 developing countries between the mid-1990s and 2004. On the one hand, our findings confirm the political rationale outlined above but are – on the other hand – somehow encouraging, as creditor governments indeed seem to learn. The most striking result for the 1990s is the strong path dependence of debt relief. At the beginning of the 21st century, this pattern has changed. Path dependence, though still visible to some extent, is much weaker in the period 2000-2004. In this period, the institutional quality became more relevant, in particular the change in institutional quality. The provision of debt relief in recent years seems to follow some prudential rules and to be conditioned on relatively decent policies rather than only the level of indebtedness and the amount of previous debt forgiveness.

The results also suggest that recent debt relief has been provided in favour of poor countries that have shown improvements in their governance quality, of course not neglecting the level of indebtedness and the amount of debt relief granted in the 1990s (see table 2).

Table 2: Determinants of debt relief 1995 - 2004

Determinant Period 1995 - 1999 Period 2000 - 2004
Past debt relief Positive and highly significant Positive and weakly significant
Poverty Positive and significant Positive and highly significant
Institutions No correlation Positive and significant
Change in institutions n.a. Positive and significant
Controls No significant correlation No significant correlation

These results suggest that the discussion of institutions in development, which has its roots in academic circles and has been transferred into the international development organisations, has not only produced political statements but also some policy measures. Along these lines, a debt relief for emerging economies in the current situation may also be based on economic rather than on political rationality.

Conclusions

The history of debt relief is characterised by political failure and short-term thinking. Consequently, so far debt relief did not deliver promising results. Neither the economic performance nor the governance quality has increased. Analysing the determinants of debt relief programs in the 1990s, we derive a standard result of international political economy. Governments of creditor countries have granted debt relief rather because of political than of economic reasoning. In particular, we can confirm a path dependence with respect to debt relief granted.

However, the determinants of debt relief for highly indebted poor countries have changed slightly, which indicates learning processes in creditor countries. Thus, recent debt relief programs since 2000 seem to be positively influenced by economic and institutional development as well as the results of the latest research on the role of institutions for growth and development. This may indeed be the result of a successful learning process of donor countries’ governments and a slight change in the allocation pattern of debt relief along with the introduction of some sensible criteria during the last decade. Analysing debt forgiveness within the framework of the Enhanced HIPC initiative, one can find a relation between debt relief and enhanced institutional quality. This is a very promising sign for the future.

As a consequence of the dramatic financial crisis the world has changed. The global financial system will never be the same. Traditional instruments, certain financial products and regulations will disappear. A new order is requested, though yet to be developed. The determined reaction of the IMF and national governments has undoubtedly helped securing the savings of many people and has been necessary to prevent a collapse of the banking sector and whole economies. However, the question remains if bailing out broke countries and banks will stabilise the financial markets and fiscal policies in the future or rather set further incentives for irresponsible lending, unsound policies and business practices. Much depends on the application of the rule to tie debt relief to good governance for helping the emerging countries.


1 Andreas Freytag and Gernot Pehnelt (2009): Debt Relief and Governance Quality in Developing Countries, World Development, Vol. 37, pp. 62-80.

 

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Topics:  International finance

Tags:  IMF, financial crisis, debt relief

Professor of Economics, Friedrich-Schiller-University Jena; Honorary Professor; University of Stellenbosch

Founder and Director of GlobEcon and Research Associate, European Centre for International Political Economy (ECIPE)

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