Debt Cancellation

The Challenge

Developing countries spent years repaying billions of dollars in loans, many of which had been accumulated during the Cold War under corrupt regimes. Years later, these debts became a serious impediment to poverty reduction and economic development in many poor countries. Governments began taking on new loans to repay old ones and many countries ended up spending more each year to service debt payments than they did on health and education combined. Wealthy countries and international financial institutions have taken action to relieve debt burdens in many of the most impoverished countries, but debt burdens remain an issue for two main reasons:

First, not all poor countries were able to benefit from the first two rounds of debt cancellation. Some countries, for example, were excluded from the original HIPC deal because they had done a relatively good job in managing their debts. Today, these countries still spend a significant portion of their resources servicing debt. In 2006, for example, Lesotho paid $47 million to its creditors, an amount equivalent to two-thirds of its annual development assistance inflows.

A second, emerging challenge is that a significant number of countries which benefited from the first rounds of debt cancellation are now accumulating new debts. The World Bank and IMF estimate that more than half of the countries that were included in HIPC and MDRI are now under high or moderate risk to reincur unsustainable debt levels. One reason for this is that many countries are facing shortfalls of promised development assistance. Additionally, an increasing percentage of the aid is being given as loans now instead of grants. Compounding these shortfalls of aid has been the economic stress on developing countries as a result of the financial crisis and growing costs for essential imports like fuel and fertilizers. More countries have been forced to take out new loans and often reach out to new donors like China, who tend to offer loans with less favorable interest rates. Combined, these trends are increasing the likelihood that the number of countries reincurring unsustainable debt levels will increase.

The Opportunity

Beginning in 1996, industrialized countries sought to cancel many poor countries' debt through two vehicles: the Heavily Indebted Poor Country (HIPC) Initiative and the Multilateral Debt Relief Initiative (MDRI). Combined, these two initiatives have cancelled nearly $110 billion worth of debt, $93 billion of which was in African countries. In exchange for this debt relief, qualifying countries agreed to channel their debt savings to poverty reduction activities. As a result, poverty reducing spending by HIPC-countries has increased by the same amount by which their debt service decreased. For example, many African governments used debt savings to help abolish primary school fees, Mozambique used its debt service savings to vaccinate children against tetanus, whooping cough and diphtheria, as well as to install electricity in schools and to build new ones, while Cameroon used its debt savings to launch a national HIV/AIDS plan for education, testing and prevention, including of mother-to-child transmission.

To build on these successes, donors need to take three steps. Firstly, the success can be replicated in other countries. Donors should explore extending debt cancellation to certain other poor countries that spend a significant portion of domestic resources servicing debt, but were excluded from debt relief because their debt levels did not meet the HIPC threshold (as was the case in Kenya and Lesotho).

Secondly, the successes can be preserved by delivering development financing increasingly in the form of grants rather than loans so that accessing finance in order to reach the Millennium Development goals is not tantamount to reaccumulating unsustainable debt. Loans for development should be given on highly concessional terms.

Thirdly, the international community should establish a sovereign debt workout mechanism. If despite all efforts some countries fall back into unbearable debt burdens, it is essential to avoid debt rescheduling dragging on for decades. A sovereign debt workout mechanism would provide an arbitration panel structure similar to the WTO, where cases of state insolvency could be worked out in a fair, transparent and orderly manner.