The Debt Relief Conundrum

Whatever your musical, religious, or political tastes, it is hard not to find one of your idols in the vast coalition that supports debt relief. The coalition encompasses such diverse personalities as the Pope, the Dalai Lama, Bono and Manu Chao. How could one disagree with an initiative whose supporters range from Fidel Castro to Jesse Helms and Pat Robertson as well as most G8 leaders? However, if one moves beyond the simple rhetoric suggesting that it is immoral to collect debt from countries with millions of starving children, the evidence in favor of debt relief is far from clear-cut.

Supporters of debt relief argue that canceling the debt of the poorest countries has several potential advantages. First of all, it is an exercise in transparency as several institutions are de facto granting debt relief by continuously evergreening past loans rather than recognizing that their loans cannot be collected. Second, debt relief may create space for much needed expenditure in poverty reducing activities. Third, debt relief can kickstart growth in countries that suffer from what economists call debt overhang, i.e., a situation in which debt levels are so high that nobody will dare start new investment projects knowing that all the proceeds of these projects will be taxed away to pay for the old debt. 

Those who oppose debt relief, instead, argue that recipient governments will use the new resources for wasteful activities and that debt relief leads to moral hazard by promoting bad behavior or perpetuating poor economic policies. Why should highly indebted countries receive additional aid through debt relief but poor countries (such as Bangladesh or Guatemala) that managed to maintain low levels of debt be forgotten by the international community? A set of interesting questions on the impact of debt relief includes the following: (i) Has debt relief been successful in permanently reducing debt levels? (ii) Has debt relief been successful in increasing GDP growth and social expenditure? (iii) Is debt relief preferable to aid? (iv) Does debt relief bring additional resources?  

Has debt relief been successful in permanently reducing debt levels?

Past experience suggests that the answer to the first question is no. New York University Economist William Easterly studied the behavior of a set of countries that received debt relief over the 1979-1997 period and found that debt service for these countries increased throughout the period. How can increasing debt be reconciled with a large debt relief effort? A possible explanation is bad luck, but Easterly found no support for this hypothesis. His favorite explanation, instead, is that high levels of debt are due to the presence of policymakers with a high discount rate; that’s economic jargon to describe individuals who prefer to consume as much as they can today without worrying too much about what will happen tomorrow. If higher levels of debt are due to the government’s high discount rate and if debt relief does not affect the government’s discount rate, then debt relief will be ineffective in the long-run and just lead to a temporary consumption boom.

An alternative, and to some extent observationally equivalent interpretation of these facts is that borrowing by poor countries remains high not because of the behavior of spendthrift politicians but because these countries have many unsatisfied basic needs. According to this interpretation, as soon as a debt relief program relaxes their budget constraint, politicians spend as much as they can to satisfy these needs. Money is not wasted, but used in an effort to escape from a poverty trap.

The problem is that there is too little money and hence poor countries cannot escape poverty. A policy consistent with this interpretation is to cancel debt and also provide more aid. In fact, Columbia University economist Jeffrey Sachs and the United Nations’ (2005) report on how to achieve the Millennium Development Goals make this point explicitly: Poor countries need to increase their expenditure in poverty reduction activities and this can only be achieved by canceling debt and increasing aid flows. A simple debt cancellation without an increase in debt flows would just result in an immediate build up of debt.

Has debt relief been successful in increasing GDP growth and social expenditure?

Here, the answer is not so clear. Stanford University economists Serkan Arslananp and Peter Blair Henry provide convincing evidence that debt relief is beneficial for middle income countries but they argue that this is not the case for the Highly Indebted Poor Countries (HIPC) that are the object of the current debt relief initiatives. The reason for this difference is that the poor growth performance of extremely poor countries is not due to the presence of debt overhang but to the lack of basic market institutions.

Along similar lines, IMF Chief Economist Raghuram Rajan points out that if the main obstacle to growth is an impossible business climate, reducing the level of debt without providing additional resources or improving policies is unlikely to have any positive effect on growth.  Researchers who used data from past debt relief experiences did find a positive but extremely weak effect of debt relief on income growth and a positive but not very robust effect of debt relief on government spending in health and education. While there are different ways to interpret these findings, the bottom-line is that, so far, there is no strong evidence that debt relief is good for either growth or social expenditure.

In fact, lack of good data has been one of the main obstacles to detailed evaluations of past debt relief initiatives. One positive aspect of the HIPC initiative is that the coordinating role of the multilateral financial institutions and their need to conduct internal evaluations of the initiative greatly improved the information available to the research community.

Furthermore, the high visibility of the initiative is providing incentives to conduct in-depth evaluations of debt relief, not only among the multilateral financial institutions but in the academic and non-profit communities as well.  Hopefully, these evaluations will not tell us that better research was the only positive outcome of debt relief.

Is debt relief preferable to aid?

While there is wide agreement that the advanced economies need to direct more resources towards the developing world, there is less agreement on whether these resources should be delivered through debt relief, aid, or both. Some economists argue that the answer depends on the type of country. In particular, they claim that in middle-income countries that do suffer from debt overhang debt relief is preferable; however, aid is more efficient than debt relief in building market institutions and developing better policies and is, hence, preferable in low-income countries.

Nancy Birdsall, president of the Center for Global Development, presents a different view and argues that, even in the poorest countries, debt relief can be one of the most effective forms of aid because: (i) “Tied” aid (i.e., a situation in which donors force recipient countries to purchase goods or services from the donor country) reduces the value of aid by as much as 30 percent and debt relief cannot be tied. (ii) Debt relief stops defensive lending in which lending is not dictated by a country’s needs or the quality of its policies but by the level of its debt stock. (iii) Debt relief reduces the transaction costs of conventional aid programs because it liberates recipient countries’ government officials from satisfying the different needs and approaches to development of the various donor agencies. (iv) Debt relief provides flexible budget support and increases government accountability because it makes it possible for governments of recipient countries to set their own priorities instead of focusing on the pet projects of the various donors. 

Different views on debt relief versus aid partly depend on the opinion of the value added that can be provided by donor agencies. Those who think that such agencies can increase the positive impact of public expenditure by directing external resources towards the development of better institutions and infrastructure tend to favor aid. Those who think that these agencies only generate a useless bureaucratic apparatus and end up wasting resources tend to favor debt relief.

Does debt relief bring additional resources?

Systematic research on whether debt relief brings new money is limited. Birdsall and World Bank economists Stjin Claessens, and Ishac Diwan looked at debt relief to African countries over the 1990s and concluded that, because of poor data quality, it is hard to find solid evidence in either direction. However,  they find some evidence suggesting that the debt reduction of the 1990s crowded out other forms of aid and hence did not provide any additional resources. University of Massachusetts economist Léonce Ndikumana also looked at past experience with debt relief and found that beneficiaries received more aid than similar countries that did not benefit from debt relief.

However, he also found an overall decline in aid disbursements since the early 1990s, generating a situation in which beneficiaries of debt relief received more transfers than non-beneficiaries but not necessarily more than what they were receiving before becoming beneficiaries. This point is also made by Arslananp and Henry who show that over the 2000-2003 period net resource transfers to HIPC countries were lower than those prevailing over the 1980-1995 period both in terms of recipient and donor country’s GDP.

What is to be done?

So, what should we do about debt relief? The standard answer of the academic, i.e., gather more data and produce more research, is not useful for a policymaker who needs to make a decision, now. Considering the arguments above, I find myself a reluctant supporter of debt relief. It is unlikely that debt relief will do much harm (this would only be the case if debt relief substituted highly effective aid, and while it may replace aid, the evidence is that that aid, especially tied aid, is not very effective), but it may do some good, especially in those cases where there is a debt-overhang or where the policy environment is supportive. Debt relief should also enhance transparency, and focus the international community on gathering better information to improve future evaluations and, just maybe, aid-monitoring and (hence) aid effectiveness.

Ugo Panizza is a Senior Research Economist in the Research Department of the Inter-American Development Bank. The views expressed herein are those of the author and do not necessarily represent the views and policy of the IDB.