Debt Sustainability in Low-Income Countries World Bank Economic Policy and Debt Department May 2006

Debt and Debt Relief in the World Bank “Sector Units” Finance, Private Sector, Infrastructure Environment and Socially Sustainable Development Human Development Poverty Reduction and Economic Management Economic Policy and Debt 2

Outline 1. Why is debt relief a global issue? 3. How did the international community respond? 4. How can we avoid debt distress in future? 2. What led to debt distress in the 1990s?

Why is debt relief to low-income countries a global issue?  Despite access to highly concessional financing, many low-income countries have needed significant debt relief  The need to meet the MDGs has led many to question why the poorest countries should pay debt service to rich creditors 4

The Main Arguments for Debt Relief*  Moral argument  Financing argument  Debt overhang or growth argument  “Evergreening” or efficient lending argument 5 * Acknowledgement: the following 8 slides are adapted from work by Christina Daseking; all views expressed are those of the current presenter and should not be attributed to the IMF, its Executive Board, or its management.

The Moral Argument  Poor countries should not devote scarce resources to pay rich creditors  But...  No debt service means no borrowing  Smaller overall aid envelope  How pessimistic should we be? 6

Are poor countries doomed to stay poor? Per Capita Income in U.S. dollars Ghana Thailand 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,

The Financing Argument  Debt relief generates additional predictable resources in support of the MDGs  But...  Additionality cannot be taken for granted  There may be better ways to provide MDG financing, as debt relief is:  Backloaded  Allocated based on past lending decisions  Small relative to new development assistance 8

Debt Service and ODA for 28 Post-Decision- Point HIPCs,

The Debt Overhang or Growth Argument  As a high debt burden weakens incentives to invest, debt relief will foster growth  But...  Growth effect beyond financing controversial: Is high debt ratio cause or symptom of low growth?  HIPC Initiative has already removed large portion of debt  Other factors are likely to be much more important (trade deal, policies, institutions) 10

The “Evergreening” or Efficient Lending Argument  Debt relief removes roll-over concerns, allowing creditors to allocate new resources more efficiently  But...  Allocation of debt relief resources itself benefits heavy borrowers  Performance-based lending already possible  Debt relief may create incentive problems of its own by raising expectations for more 11

“Caveat Emptor”  All arguments for debt relief have some appeal and merit…  … but none is without caveats  Bottom line: don’t expect too much!  Debt relief generates predictable aid, but it cannot generate sustainable growth 12

What led to debt problems in the 1990s?

Debt burdens in some low-income countries rose dramatically from 1973 to % 50% 100% 150% 200% 250% HIPC Countries Low-Income Countries The Share of External Debt to GDP (in NPV terms)

Low Growth is the Main Cause of Debt Distress Note: Source: World Bank Global Development Finance Statistics. The graph shows the actual unweighted average of debt-to-GDP ratios across LICs versus the simulated ratio had all countries grown at 5% in dollar terms, a performance achieved by just over one in three LICs during the period. 15

Developing countries are dependent on commodities Commodities’ Share of Exports Commodities’ Share of GDP Major Commodity Zambia99.8%23.4%Copper Mauritania99.5%39.4%Iron Ore Guinea Bissau97.7%23.7%Cashew Nuts Benin93.7%16.1%Cotton Uganda90.5%11.1%Coffee Commodity Price Trends 16

Other factors played a part…  Waste of resources due to weak institutions, poorly designed projects, corruption  Poor debt management and unrestrained non- concessional borrowing; “loan pushing” by creditors  Wars, civil strife, conflict 17

How did the international community respond?

Bilateral creditors have forgiven increasing amounts of debts owed to them 50% 67% 80% 33% 90% Toronto (1988) London (1991) Naples (1994) Lyon (1996) Cologne (1999) Proportion of Grant Element in Paris Club Forgiveness Note: The forgiveness listed is the reduction in the NPV of the rescheduled debts owed to the Paris Club members. 19

Traditional debt relief reduced bilateral and commercial debt; not multilateral debt 0% 5% 10% 15% 20% 25% 30% 35% 40% Note: “Traditional Debt Relief” includes that of the Paris Club (bilateral debt owed to donor governments) and the London Club (commercial debt). Source: World Bank Global Development Finance Share of Multilateral Debt of Overall External Debt 20

HIPC Was the First Comprehensive Global Debt Reduction Initiative to Include Multilateral Debt Objectives  Reduce external debts owed by HIPC governments  Finance increase in government spending on poor people Design  Eligibility is based on external debts and income per capita  Requires government to formulate a poverty reduction strategy paper (PRSP) through local consultation  Requires satisfactory performance based on an IMF program  Then irrevocably provides debt relief – up to a pre-defined threshold 21

Multilateral Institutions Have Provided Half of All HIPC Debt Relief Committed Total Amount of Debt Forgiven (USD bn) Note: The figures of committed debt relief are current as of April 2005 measured in end-2004 NPV terms, and include 38 HIPCs as of Paris ClubOther BilateralsCommercialWorld BankIMFOther Multilaterals

Irrevocable debt relief The HIPC Process Decision Point Determination of: - NPV of debt - Debt Relief - Triggers Country fulfills HIPC Eligibility Criteria - Meeting triggers Completion Point Interim period - Satisfactory Performance under PRGF - Implementation of PRSP for one year Preliminary Discussion 23

March 2006: 29 Countries are receiving debt relief, nine countries had yet to benefit… Zambia Post-HIPC Uganda Tanzania Senegal Rwanda Niger Nicaragua Mauritania Madagascar Guyana Ethiopia Bolivia Mozambique Mali Honduras Ghana Burkina Faso Benin 18 Interim-HIPC Sierra Leone São Tomé & Principe Malawi Guinea-Bissau Guinea The Gambia Chad Congo, Dem. Rep. Cameroon 11 Pre-HIPC Togo Sudan Somalia Myanmar Liberia Lao PDR Congo, Rep. Comoros Côte d’Ivoire Central African Rep. 9 Causes  Conflict  Arrears  Weak governance 24 Burundi

May 2006: “Ring-Fencing” has identified four potentially eligible countries that may opt in… Zambia Post-HIPC Uganda Tanzania Senegal Rwanda Niger Nicaragua Mauritania Madagascar Guyana Ethiopia Bolivia Mozambique Mali Honduras Ghana Burkina Faso Benin 19 Interim-HIPC Sierra Leone São Tomé & Principe Malawi Guinea-Bissau Guinea The Gambia Chad Congo, Dem. Rep. Cameroon 10 Pre-HIPC Togo Sudan Somalia Liberia Congo, Rep. Comoros Côte d’Ivoire Central African Rep. 11? 25 Burundi Eritrea Haiti Kyrgyz Rep. Nepal

HIPC has substantially reduced debts and pro-poor spending has increased Notes: 1) Debt stocks of 28 decision point countries, USD billion 2004 NPV terms. 2) Projected debt service obligations of 28 decision point countries. 3) Debt service to government revenue for 28 decision point countries. 4) Ratio of poverty-reducing expenditures to government revenue. 26 Debts have been reduced 1 … Before Traditional Relief After Add. Bilateral Debt Relief and so have payments to creditors 2 … USD Billions Before HIPC Relief After HIPC Relief and increasing pro-poor spending % 47.6% reducing budget spent on debt payments 3 … 21.8% 13.4%

Pre-Conditions for Effective Debt Relief Priority Sectors MDGs HIPC Creditors Gov’t Budget Donors Debt Service Aid Inflows 1. Additional to aid inflows 2. Beyond arrears clearance Debt in Arrears 3. Economically significant HIPC Initiative MDRI

Preliminary Results: Debt Relief and Priority Sector Spending Debt Relief vs. Education (top) and Health (bottom) Expenditures y = 0.292x R 2 = % 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% 0.0%2.0%4.0%6.0%8.0%10.0%12.0%14.0% EDUC/GDP Debt Relief vs. Poverty-Reducing Expenditures (IMF definition) y = x R 2 = % 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0% 0.0%2.0%4.0%6.0%8.0%10.0%12.0%14.0% DR/GDP PRE/GDP DR/GDP y = x R 2 = % 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 0.0%2.0%4.0%6.0%8.0%10.0%12.0%14.0% HEALTH/GDP Other measures of poverty-reducing expenditures are also increasing with debt relief

Institutions and policies are better in countries that have gone through HIPC Note: Post, interim and pre-HIPC refer to the countries that are at the pre-decision point (10 countries), decision point (10 countries) and completion point (18 countries) as of end The first bars refer to 1998, the second bars to HIPCs: Evolution of CPIA ratings (1998 and 2003) Post-HIPCInterim-HIPCPre-HIPC CPIA ratings

Further Debt Cancellation for HIPCs HIPCs will receive 100 percent debt cancellation from IDA, AfDF and the IMF under Multilateral Debt Relief Initiative Debt relief is to be provided at HIPC completion point Average debt/export ratios in post-completion point HIPCs would fall from about 140 percent to 50 percent in present value terms Donors will compensate IDA and AfDF for reflows lost due to debt relief. This should result in approximately $50 billion in additional flows to low-income countries 4

MDRI significantly reduces debt stock ratios in HIPCs (18 CPs: NPV of Debt to Exports, Post MDRI) Uganda Burkina Faso Mauritania Benin Zambia Mozambique Niger Rwanda Ethiopia Tanzania Madagascar Mali Senegal Ghana Bolivia Nicaragua Honduras Guyana Prior to MDRI Post MDRI 31

Debt service reduction due to MDRI (18 completion point HIPCs) $ billions AfDF IMF IDA 32

How MDRI Affects IDA Allocations 33

How do we avoid future debt problems?

Low debt ratios in HIPCs could result in “free riding” by commercial creditors Debt Burden Indicators - Post MDRI Debt Relief: 18 CP HIPCs vs. Selected Lower Middle Income Countries Honduras Mauritania Guyana Bolivia Nicaragua Syria Guatemala China Jordan Ecuador Brazil Peru Thailand Philippines NPV of debt-to-GDP NPV of debt-to-Exports 18 CP HIPCsLower Middle Income Countries 35

Reaching the MDGs must not create a new debt problem  The Debt Sustainability Framework for Low-Income Countries (DSF) tries to ensure that countries receive financing on terms that are commensurate with their ability to service debt  The DSF determines up front the mix of World Bank (IDA) loans and grants  Countries with high risk of a debt crisis only receive grants  Over 40 low-income countries will now receive either 100% or 50% of their World Bank finance in the form of grants  Countries with low debts receive more resources  The DSF is an “ex-ante” tool for addressing issues related to debt sustainability. 36

Notes: Thresholds apply to public and publicly guaranteed (PPG) external debt, only. The Country Policy and Institutional Assessment (CPIA) assesses the quality of a country’s present policy and institutional framework. “Quality” means how conducive that framework is to fostering sustainable, poverty-reducing growth and the effective use of development assistance. Institutional strength and quality of policies Weak CPIA<3.25 Medium 3.25<CPIA<3.75 Strong CPIA>3.75 NPV of debt-to-GDP NPV of debt-to-exports NPV of debt-to-revenue Debt service-to-exports Debt service-to-revenue Sustainable levels of debt burden depend on a country’s institutions and policies 37

+10% -10% Threshold High Risk 100% Grants Medium Risk 50% Grants Low Risk 100% Soft Loans Debt burdens determine the mix of world bank loans and grants 38

From July 2006, grants will be based on debt sustainability analyses under the LIC DSF Accurate debt data Macroeconomic and financing assumptions Baseline scenario and standardized stress tests Staff judgment 39

Conclusions Debt reduction under the HIPC Initiative has reduced external debts (multilateral and other) by two-thirds. It has helped increase pro-poor spending and promoted economic reform Debt cancellation under the Multilateral Debt Relief Initiative will have a beneficial impact on HIPC debt ratios and provide additional resources for all IDA-only borrowers Low-income countries experienced debt repayment difficulties due to a variety of factors, both exogenous and endogenous Going forward, the World Bank has adopted an ex-ante framework to promote debt sustainability in low-income countries 5 40 Debt relief is only one part of the solution to financing needs and policy dialogue: expectations should be realistic about what it can deliver 2

A wealth of information is available on the World Bank website 41

Q & A