1. Is Debt Sustainability an Illusion ?
Clubbing in Paris
Is Debt Sustainability an Illusion ?
Benu Schneider
The views expressed are those of the author and do not necessarily represent those of the Financing for Development Office, Department of Economic and Social Affairs, UN

2. Paris Club agreements)
Debt Restructuring
Debt to Multilaterals
Debt to official
creditors
Debt to commercial
Banks
Bond debt
Yes, London Club
No, it cannot be
restructured except
for HIPC countries
Yes, at the Paris Club
The terms of treatment
are determined on
the basis of per capita
and debt ratios
(require bilateral
agreements after
Paris Club agreements) or
Bilateral
agreements
Yes, with and
without collective
action clauses
e.g. Pakistan
Ukraine
Ecuador
Belize

3. Challenges in restructuring debt
The challenge to maintain contractual obligations
The challenge of servicing debt according to ability to pay and maintaining debt sustainability
The challenge of maintaining growth
Basic principles required for restructuring
Neutral arbitrator and assessor
Transparency
Adequate representation of debtors and creditors
Efficiency
Symmetry between creditor groups

4. Existing Machinery
The Paris Club is an ad hoc machinery which emerged as a result of international cooperation and not an international agreement on financial architecture
No legal status of agreements
No voice for debtors. An OECD “creditor’s club”
No in house technical capacity – reliant on IMF
IMF “preferred creditor status” with significant role in the Club
Comparability of treatment from other creditors
Negotiations are influenced by the foreign policy objectives of the creditor countries
Conditionality

5. The changing role of the Paris Club
The Paris Club today is dealing with three sets of problems
Liquidity problems
Solvency problems
Debt relief for development expenditure
The treatment accorded may sometimes be the same for all three sets of problems

6. Historical background of reform efforts
Late 1970s at the TDB – G77 called for a process sensitive to developing country needs
G77 proposed and International Debt Commission
Ended in failure for the G77
UNCTAD granted “observer status”
Codified principles and procedures of 20 yrs in a UN resolution

7. Second international debate in 2002
SDRM (2002) IMF proposed to incorporate the Paris Club in a permanent machinery
Ended in failure
Strains in Paris Club
New creditors
Dominance of private capital flows
Serial rescheduling

8. Issues in official debt restructuring
ROLE OF IMF
Role of IMF as gatekeeper
IMF’s Technical support
Conditionality
PARIS CLUB
International financial structure for official debt has flaws, leading to serial rescheduling and unsustainable debt
Transparency an issue
Signals to the private sector
No legal status for comparable treatment form other creditors

9. The role of the IMF in Paris Club negotiations
The IMF mediator in debt-restructuring agreements between debtor countries and official creditors
But a country negotiating does not necessarily reflect debt distress. The financing of Fund Programs became dependent on debt relief – protected its own balance sheet
This coincided with the build-up of arrears
 Bi-lateral flows have increasingly been used to pay International Financial Institutions
The amount of debt relief is contingent upon a Fund Program and its estimate of financing gap and in recent times debt sustainability analysis. There problems with both these sets of estimates by the IMF
(Cont.) 

10. The role of the IMF in Paris Club negotiations
No compatibility between role as gatekeeper for concessional resources and creditor and therefore a stakeholder in the inflow of the same resources
This conflict of interest entails that countries do not receive resources because of good policies and governance, but because they have a high debt burden. The problem of adverse selection. Bad policies receive more resources
Except for HIPC, multilaterals as a creditor class are excluded from debt negotiations because of their preferred creditor status

11. IMF Forecasts Overoptimistic
The dominant bottom-up (surveillance has a strong country orientation) approach yield consistently overoptimistic forecasts for certain regions
Does not sufficiently pick policy spillovers in a global context
IEO, IMF, September 2006
U.S. General Accounting office (2003) found that between 1990 and 2001, WEO forecasts for growth and inflation were optimistically biased for 57 countries under IMF supported programs

12. Conditionality Too many conditions led to weak compliance
Did not lead to FS reform in many countries
Shifting emphasis – from austerity – cutback in social investments - to investments in the social sector

13. The IMF's Approach to Debt sustainability: Middle income countries
Debt Sustainability means that the borrower is expected to be able to continue servicing the debt without requiring a large future correction in income and expenditure
An unsustainable debt is generally associated with continually rising debt ratios over time
For countries with assess to international capital markets, the concept of debt servicing is used rather than the distinction between liquidity and solvency
Provided that market access is maintained liquidity is not a problem
But liquidity problems can turn into solvency problems as a rise in cost and/or availability of finance feed into debt dynamics
IMF also examines debt sustainability in the context of a given path of primary balance
Sustainability assessment reflects cost and availability of finance, thus continuing debt servicing

14. Critique of IMF Debt Sustainability Analysis
The focus is on debt dynamics and not debt sustainability suited to flow restr.
The new approach succeeds in giving a broader range of debt dynamics including additional variables
The optimal mix of the composition of debt and levels remain a problem
The threshold levels to be used for the Evian Approach shrouded in mystery
Even if a threshold level was defined, a ratio which is good for one country maybe a signal of distress for another or the same ratio may not be good for a country at a different point of the economic cycle
The approach is geared towards keeping current on debt servicing
Cannot provide early warning signals for insolvency
Contingent liabilities need consideration
It does not take into account the ability to pay and development objectives

15. Problems with IMF debt sustainability
For a middle income country the ability to pay depends on the degree of trade openness. Threshold levels for debt to export ratios cannot be uniformly apply to all countries.
GDP that is used as a dominator for threshold levels only reflects the size of the economy. Resources cannot be diverted from the non-tradable sector to the tradable sector to generate foreign exchange.
Taxes are collected in domestic currency and debt payments are in foreign currency. A currency mismatch in the government’s balance sheet.
The IMF computes public debt to GDP ratios. Private sector liabilities are important, which may become public liabilities.
The analysis is limited in capturing the spill-over effects in debt currency and banking problems.
Extrapolation exercises cannot factor in the variability caused by increase in interest rates and fiscal tightening.
Contingent liabilities are not considered in the exercise.
Stable ratios may not necessary mean that debt is sustainable. Sustainable at what level?
In the long run exchange rate misalignments in the region affect trade and capacity to repay.

16. Debt sustainability analysis for low-income countries: A new World Bank approach
The World Bank has set out a debt Sustainability Framework (DSF) in June 2004 and IMF and World Bank (2006) for identifying countries in actual or potential distress situations leading to a formula for determining grant eligibility within the amounts allocated during the fourteenth replenishment of IDA.
The key principle in the framework is to reduce the risk of debt service problems though grant funding while facilitating access to finance required by these countries to achieve the Millennium Development Goals
The IDA allocations will be based on a Performance based evaluation system and per capita income. The level of debt distress estimated by these methods will determine the eligibility for access to grants.
The DSF selects three debt ratios to judge debt sustainability. These are the ratio of present value of public and publicly guaranteed external debt to gross domestic product and to exports, and debt service on the same debt to exports.
The framework further uses Country Policy and Institutional Assessments (CPIA) for country polices and institutional capability, and vulnerability to shocks and to classify countries by performance and different thresholds for different indicators. Governance factor given a higher weight relative to other factors.
Policy dependent — conditional upon summary measure of policies (CPIA).
To serve as a guide to lending and policy advice.

17. Critique of Joint Fund-Bank DSF
What about returns on investments – too focused on the cost of funds
Domestic and private debt not part of framework
CPIA problematic – too much emphasis on governance
It is more to do with IDA allocations
Why a separate framework???

18. What is debt sustainability?
Ability to pay without compromising on long-term development objectives or ability to service debts?
A level of debt that is growth enhancing and not a hindrance to growth?
A threshold level that aims at crisis prevention and takes the cyclical nature of capital flows into account?

21. Serial Rescheduling: A Gap in International Financial Architecture ?
Increase in debt
and debt servicing
Liquidity /Solvency Problems
Agreement with the Fund - a new loan
Agreement with the Paris Club
 Agreement allows new credits from Paris Club Creditors
Houston Terms
Repayment and Grace Periods:
2-8 years non-ODA, 10 years ODA
Repayment Period: 5-10 years
Increase in debt
and debt servicing
- Further increase in debt servicing
because non-ODA is negotiated at
market interest rates
- Bunching of repayments
Estimates of financing gap
are based on forecasts of
growth and other variables
that are over optimistic
This cycle continues leading to higher levels of debt-stock and debt-servicing
In the near future repayment problems surface again
A new arrangement
with the Fund

22. Serial rescheduling
Short consolidation periods to keep debtors on a short leash
Mistakes in projections by the IMF
Problems diffrentiating between liquidity and solvency problems
«Snowballing» debt because of bunching of repayments due to lower grace periods; market interest on non-ODA on new reschedulings; and new credits issued after rescheduling

23. Salient features in the 1980s
In the 1980s the realization that serial rescheduling is futile in low income countries and debt reductions necessary
Beginning of the process of debt reductions in low income countries
A realistic approach to middle income countries was not considered

24. Salient changes in the 1990s
For the low income heavily indebted countries, generous debt reductions with a view to finance development expenditure
For middle income countries and upper middle income countries the PC did not engage indebt reduction but began to apply the principle of burden sharing more broadly and unilaterally to force bondholders to reduce their claims on individual countries.
In effect the G-7 used the PC for cutting back public resources required to resolve financial crisis in non-HIPCs by increasing the losses absorbed by bond holders.

27. What are the lessons learnt?
A neutral body is needed to make assessments of the amount and type of relief required.
The technical work to support official debt restructuring needs to go beyond models based on those applied by the private sector that give exclusive priority to assessments of liquidity situations in countries affecting their debt servicing.
More transparency is needed in official debt restructuring operations to include information on interest rates, the list of debts covered and penalty costs.
There is a need to harmonize debtor and creditor reporting systems on bi-lateral debt to reconcile differences in the list of debt and amounts due. .

28. A simplified process is needed so that the Paris Club negotiation and bi-lateral negotiation process can be merged into a single process.
Keeping countries on a short leash with burdening conditionality is self-defeating.
Debtor voice is needed both in the design of the machinery and in negotiations.
Serial-rescheduling leads to rising debt service requirements and makes debt sustainability targets an illusion.

29. A fair debt restructuring mechanism needs to look at repayments made on the original loan contract and amounts due from the costs of rescheduling.
The pros and cons of using Paris Club procedures for financing development expenditure in counties that do not have an existing debt problem need to be understood. A comparative cost-benefit analysis with other sources of finance is needed. The Paris Club rescheduling is seen as a signal of debt distress and impacts spreads and future costs of borrowing from the private sector.

30. A possible step
Set up a committee at the UN
examine options for reforming the financial architecture for debt negotiations and
re-examine the proposal the G-77 made in the late 1970s for an International Debt Commission along with other proposals that have been tabled by experts in the intervening years.

31. ECUADOR PAKISTAN Reschedulings (1996-2005) Date PC/LC Terms
June 13, 2003
September 15, 2000
August 2000
Paris Club (Houston)
London Club
Spreads in 2003 fell slightly on longer-term debt, while rising more on shorter-term debt.
Bank lending increased after 2000, going against regional and aggregate trend (e.g. all developing countries). No data on bank lending for 2003 agreement.
Trade credits increased after 2000.
PAKISTAN
Reschedulings
( )
Date
PC/LC Terms
December 14, 2001
January 23, 2001
January 30,1999
Paris Club (Ad-hoc)
Paris Club (Houston)
Spreads fell by half after the December 2001 agreement. Data is still unavailable for previous agreements.
Bank lending rose after every Paris Club agreement. For the 1999 agreement, this went against the general fall in regional and aggregate banking flows. For the 2001/3 agreements, it followed the trends. There are no London Club agreements in the GDF files.
Multilateral Claims rose after the 1999 agreement, and fell after the 2001 agreements.
Trade credits fell, stayed level and rose for the 1999, jan 2001 and Dec 2001 agreements respectively.

32. Peru Russia Reschedulings (1996-2005) Date PC/LC Terms Reschedulings
November 1996
London Club
Bank lending increased after the 1996 PC agreement. For the LC agreement, it fell sharply the month after the agreement.
Multilateral claims increased slightly after the 1996 PC agreement, then rose substantially after the LC agreement.
Trade credits rose after the 1996 PC agreement, and fell after the LC agreement.
Russia
Reschedulings
( )
Date
PC/LC Terms
February 2000
August 1, 1999
November 1998
April 29, 1996
London Club
Paris Club (Ad-hoc)
Spreads rose for the 1999 PC agreement, while they fell for both LC agreements.
Bank lending rose for each LC agreement and fell for each PC agreement. For the PC agreements, this went against regional trends, and aggregate trends in the 1996 case. For the LC agreements, this was in line with both trends in 1998 and against in 2000.
Multilateral claims did not move significantly except for a fall after the 1998 LC agreement, although this was part of a previous negative trend.
Trade credits did not move significantly except for a large increase after the 1996 agreement.