Debt Cancellation

Debt cancellation has enabled governments in poor countries to increase key public spending in areas such as health and education.

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 barrier 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 world’s poorest countries – primarily through the ‘Heavily Indebted Poor Country’ (HIPC) scheme and the ‘Multilateral Debt Relief Initiative’ (MDRI) (see below) – but debt burdens are still a problem.

Firstly, not all poor countries have been able to benefit debt cancellation. Some 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 their debt. In 2013, for example, Lesotho spent $40 million paying its external creditors. Kenya spent $620 million servicing its external debt, which is equal to 20% of the aid it received the same year. The HIPC scheme is now coming to an end. Except for the few countries still eligible to enter it, there is now no international process in place for dealing with government debt crisis.

A second problem is vulture funds – financial speculators looking to profit from countries experiencing a debt crisis – which buy up debt from other investors at a much reduced price and then demanding full payment from the state. Argentina is the most notorious example of this. Following its debt default in 2001, Argentina reached agreement with the majority of its creditors to pay back the debt at a reduced rate, but two vulture funds took the nation to court for full payment and won the case.

Thirdly, a significant number of countries that benefited from the first rounds of debt cancellation are now re-accumulating debts because of a boom in new lending. Foreign loans to low-income countries trebled between 2008 and 2013. The World Bank and International Monetary Fund (IMF) estimate that over half of the countries that were included in HIPC and MDRI are now at risk of returning to unsustainable debt levels. Some countries, such as Ethiopia, Mozambique and Niger, could be spending as much of their government revenue on foreign debt payments in a few years as they were before debt relief.

One reason for this is that many countries are facing shortfalls of promised development assistance, and more of this is being given as loans instead of grants. Loans can be counted as official development assistance (ODA) if they fulfil certain ‘concessionality’ criteria. Such concessional lending to developing countries has more than doubled over the last two decades. In December 2014, the OECD Development Assistance Committee (OECD-DAC) – the body responsible for collecting ODA statistics – modernised its definition of concessionality as the criteria that had been set in the 1970s had become out-of-date and allowed some DAC countries to report loans as part of their ODA efforts even though they had not been subsidised by the country’s budget. Furthermore, the DAC’s rules did not include a debt sustainability requirement to ensure that ODA providers do not lend to countries with high risks of debt distress. The new DAC’s rules about loan concessionality, which will take effect next year, will better reflect current market realities and include a debt sustainability criterion. However, the new rules were worryingly designed in such a way as to incentivise lending to the poorest countries where grants remain the most appropriate form of support.

A rapidly growing number of African countries are also issuing international sovereign bonds. For example, in 2014 alone, Zambia, Kenya, Côte d’Ivoire, South Africa, Senegal and Ghana issued bonds raising almost $7 billion in total. While this development is positive in many ways and shows the strengthening of many of Africa’s economies, it also brings new risks – especially because these bonds are denominated in foreign currencies such as the US dollar, which can dramatically increase the repayment costs for governments if their national currency weakens against the dollar. This risk becomes even more acute if the price of natural resources upon which these borrowing countries are dependent starts to drop (as has happened with oil and copper, among others, in recent months). For example, the Jubilee Debt Campaign has estimated that Ghana’s repayments could increase from 16% to 23% of government revenue due to the devaluation of its currency, the cedi, against the dollar (which many of its foreign loans are denominated in).

Compounding this problem is the fact that many developing countries are increasingly borrowing from creditors offering quicker deals and fewer conditions but less favourable interest rates, such as China. In addition, the private sector has an increasingly large role, particularly during the economic recession affecting many developed countries, leading speculators to look for better returns further afield. Not only has this resulted in higher average interest rates for borrowing countries, it is also leading to fragmentation of creditors, which makes it very difficult to coordinate action to prevent debt crises.

On the other side of the equation, private borrowing by households and businesses is increasing dramatically faster than public debt, but only half of low-income countries report on privately-owed debt (among these, average debt is over 15% of GDP and has doubled to $10 billion at end-2011). This lack of data makes it very difficult for regulators and policymakers to make informed decisions. It was the rapid build-up of private debt that triggered the global financial crisis beginning in 2007.

The Opportunity

From 1996, rich countries sought to cancel many poor countries’ debt through two vehicles: the Highly Indebted Poor Country (HIPC) initiative and the Multilateral Debt Relief Initiative (MDRI). Thirty-six countries, mostly in sub-Saharan Africa, have completed these schemes. A further three countries (Eritrea, Somalia and Sudan) are eligible to receive debt relief through these mechanisms but as yet have not chosen to start the process. Combined, HIPC and MDRI have cancelled $97 billion worth of debt, most of which was in sub-Saharan African countries. The total debt relief possible under both schemes combined for all 39 eligible countries is estimated at $116 billion.

Qualifying countries agreed to channel their debt savings to poverty reduction activities. Many governments used debt savings to help abolish primary school fees. In Tanzania, fees were abolished in 2002, following debt relief the previous year, and primary enrolment increased dramatically from 49% (1999) to 98% (2008). 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, countries need to take five steps:

  1. Debt relief: Success with HIPC and MDRI can be replicated in other countries. Development assistance providers 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 in Kenya and Lesotho). Debt relief should not be double-counted in official aid statistics and should be additional to ODA budgets.
  2. Grant-based financing: Progress can be preserved by delivering a large share of development assistance in the form of grants rather than loans so that accessing finance in order to reach the Global Goals does not lead to unsustainable debt. Loans for development should be given at low interest rates and on highly favourable terms for recipients.
  3. Responsible borrowing and lending: Both debtors and creditors should act carefully when creating new loans. The United Nations Conference on Trade and Development (UNCTAD) has established a set of Principles on Responsible Sovereign Lending and Borrowing, which countries and private-sector actors should endorse and implement. The Addis Ababa Action Agenda agreed by governments at the 2015 Financing for Development Conference unfortunately fell short of endorsing these Principles, but did note them. Such standards on responsible financing should be universally agreed, then strengthened and enforced. This requires all actors to publish detailed information about the contraction and management of debts and public-private partnerships. Furthermore, debt sustainability analyses must be improved to account for different kinds of debt and liabilities, and to ensure that borrowing does not endanger countries’ progress towards sustainable development.
  4. Debt workout mechanism: For many developing countries, accurate data on public debt (and contingent liabilities – debts which the public sector is not yet formally obliged to pay back, but may need to honour in the future) and external private sector debt is simply not available, making it extremely difficult to assess risks to a country’s debt sustainability. In the Addis Ababa Action Agenda adopted by governments at the 2015 Financing for Development Conference, they invited the creation of a central debt data registry and encouraged all governments to improve transparency in debt management, which would be a helpful step forward.
  5. Better debt data: For many developing countries, accurate data on public debt (and contingent liabilities – debts which the public sector is not yet formally obliged to pay back, but may need to honour in the future) and external private sector debt is simply not available, making it extremely difficult to assess risks to a country’s debt sustainability. In the Addis Ababa Action Agenda adopted by governments at the 2015 Financing for Development Conference, they invited the creation of a central debt data registry and encouraged all governments to improve transparency in debt management, which would be a helpful step forward.