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Foreign, or external debt is created when a country has creditors – mainly bondholders - who reside in other countries. Debts may be owed to foreign individuals, organisations, commercial banks, national central banks, and to the World Bank, IMF and the ECB.
Debt repayments will typically include the repayment of the initial loan – the principal – and the interest on the loan.
Sustainable debt is debt which can be considered to be manageable without causing long term damage to an economy, and which is not paid out of future borrowing.
Borrowing is an essential economic activity, and facilitates trade and commerce and improves standards of living. Borrowing enables countries to fund investment projects which they might not otherwise be able to finance, and can help reduce any savings gap that exists. Throughout history countries have lent to each other for mutual gain. In a globalised world, the significance of lending and borrowing has increased, and the effectiveness of the global trading system relies on liquidity flows between countries. For example, were it not for the Marshall-Aid plan of 1948, the UK, France and Germany would not have been able to reconstruct their economies after the Second World War, and reach the level of development that they now enjoy.
Unsustainable debt refers to debt that cannot be repaid in the future without raising more debt and jeopardising the future development of the debtor country, or even sending its development into reverse.
Debt can be unsustainable if it represents a large % of current exports. The debt service ratio is the ratio of debt - interest and principal payments due during a year - expressed as a percentage of exports (typically of goods and services) for that year. The World Bank considers foreign debt to be unsustainable if the ratio of total external debt to exports exceeds 150%. There are several other key indicators of excessive debt levels. In absolute terms, the world’s richest economy, the USA, has more debt than any other country - it is with the world’s poorest countries that debt problems have become significant.
Unsustainable external debt can arise for several reasons:
Firstly, domestic policies can fail to develop robust and stable economies. This means that key industries in these economies fail to develop and generate sufficient export earnings by effective participation in the global trading system.
Ineffective control of public finances
Secondly, ineffective control of public finances can force national governments to borrow from abroad to enable them to fulfill their obligations as elected (or non-elected) governments. This could be due to either excessive spending on inefficient and uneconomic projects and activities, or because optimal tax revenues are not collected. A growing public sector can also ‘crowd-out’ the private sector, and prevent economic growth and job creation.
Artificially high exchange rates
A third cause could be that a country’s central bank sets its currency artificially high in an attempt to reduce imports and control inflation. This, of course, leads to export problems and the need to borrow.
Civil war can also divert scarce resources from production to defence, as in the case of several African economies – some 80% of the world’s most heavily indebted countries are African.
Destabilising macro-economic shocks can also generate the need to borrow. For example, a collapse in commodity prices, which affects those countries dependent on commodities and other primary products and can result in a significant collapse in export revenues and increase the need to borrow.
A rise in commodity prices, especially oil, can have a negative effect on countries dependent on oil imports. This can significantly hinder development as it can lead to recession, with falling public revenues. Many have argued that the debt which followed the first oil shock of 1973 pushed many countries into unsustainable debt levels. Significant Increases in oil prices in a short period of time forced many less developed countries to borrow to ensure sufficient oil supplies. At the same time, oil rich countries began to make loans as a way of investing their new found oil revenues.
Finally, natural disasters can have a considerable impact on public finances in the short run as well as destroying infrastructure, making the economy less efficient, less able to export, and increase the need for further finance for rebuilding works.
Many of the most heavily indebted countries will, over a period of time, have suffered from most, if not all, of the above adverse conditions.
There are four ways that high levels of debt have been dealt with historically: austerity, default and rescheduling, high inflation, and economic growth. It seems doubtful that debtor governments in recent years, and following the financial crisis, can just rely on austerity or growth to make their current debt levels sustainable – hence the need to restructure to avoid all out default.
Debt relief can be organised multilaterally, through organisations like the IMF and World Bank, or bilaterally – between the debtor countries and its specific creditors. Debt relief is almost invariably accompanied by conditions, such as structural reform.
There are two main elements in debt restructuring - debt rescheduling, where the maturity dates of old debt are lengthened, possibly involving lower interest rates, and debt reduction where the nominal value of existing debt is reduced. Both types of debt restructuring involve a loss in the present value of claims made by creditors – known as a ‘haircut’.
In 1996 the IMF and World Bank launched the Heavily Indebted Poor Countries Initiative (HIPCI). There are currently (2019) 39 countries classified as HIPCs - some 33 in Africa, 4 in Latin America, 3 in Asia and 1 in the Middle East. The main objective of the HIPCI is to reduce debts to sustainable levels, enabling resources to be reallocated towards poverty reduction. About 45% of the funding comes from the IMF and other multilateral institutions, and the remaining amount comes from bilateral creditors. The total cost of this assistance was estimated to be about $76.2 billion in 2018.
In an attempt to focus efforts towards the reduction of poverty, the UN launched its Millennium Development Goals (MDGs) in 2000, which included setting the following setting targets:
In order to hasten the achievement of these goals, in 2005 the G8 countries signed the Gleneagles Agreement which agreed a package of debt relief, mainly for Africa. It involved three multi-lateral organisations – the IMF, World Bank and the African Development Fund (ADF). The package, targeted at HIPCs, was dependent upon African governments continuing to introduce democratic reforms, and to improve standards of governance (especially increased transparency and accountability.)
The package is formally known as the Multilateral Debt Relief Initiative, and involves providing 100% debt relief for a number of heavily indebted countries where traditional debt relief would not make debts sustainable.
The Paris Club, which is exclusively for country-to-country debt restructuring, is a group of 20 creditor nations who first met in 1956 to agree debt restructuring for Argentina. Debtor countries may apply to restructure or reschedule their debts. Debtor countries dealing with the Paris Club are also required to agree to a structural adjustment program (SAP) with the IMF. Creditors not in the Paris Club are known as non-Paris Club creditors.
The London Club, which first met in 1976, involves debt renegotiations between national governments and commercial banks.
Unsustainable debt can be a considerable burden for a country, and can lock it into poverty, and prevent it from progressing towards greater development. Servicing debt creates a considerable opportunity cost for countries – the more that debt is repaid the less funds are available for reducing poverty and increasing development. Reducing or totally forgiving debt could therefore help reduce poverty and free-up resources for other uses, such as education and infrastructure.
Improving infrastructure is, of course, essential for the generation of long term efficiency gains and labour mobility and productivity, as well as enabling the economy to benefit from globalisation and become an active player in the global trading system.
Improvements in efficiency and productivity will, in turn, stimulate growth and development, and enable governments to implement more progressive tax policies which can both stabilise the macro-economy as well as provide a flow of funds into its central bank. Infrastructure is especially significant for land-locked countries. By reducing debt repayments, more national income is available for generating growth, and this will generate jobs.
As a by-product of structural adjustment requirements (SAPs) most indebted economies are forced into a period of austerity – as in the case of Greece. Rescheduling or reducing debt repayments will limit the length or severity of the austerity programme.
Of course, creditor countries do not necessarily lose in the long run by forgiving debt – they can gain in both a multi-lateral way - through the development of the global trading system which enables them to gain from general increases in export earnings – and in a bi-lateral way as the relief of debt may mean gains for specific exporting firms and those who may win contracts to improve infrastructure.
Critics of debt relief – usually the creditor countries - argue that it may send out the wrong signals to potential and existing borrowers. For example, by providing an insurance policy against poor financial management by national governments, debt relief creates the problem of moral hazard, so debtors do not take proper steps to prevent debt problems arising in the future. Furthermore, it may be argued that borrowers do not have a chance to learn from their mistakes, and continue to make the same mistakes that led to debt problems in the first place. This is certainly the view of Greek creditors, including Germany, who may take the view that debt relief will simply encourage debt defaulting in the future.
Cancelling debt, or the possibility of debt default, means that creditors will look to increase their expected return on new lending, meaning that interest rates on new loans are likely to increase - this in turn will have a negative effect on other borrowers. Furthermore, lenders in developed economies may be less likely to lend in the future.
Lost revenues from debt relief could have been used to help other developing economies who are also in debt, but have not reached unsustainable levels. To this extent, every unpaid dollar is one dollar less for, perhaps, more worthy lending.
It has been estimated that, without debt relief, total debt stock in Nigeria constitutes almost 52% of the country's gross domestic product. This means that a typical Nigerian worker would have to give up more than half of the value of his gross output each year simply to service external debt. However, with significant debt relief of around $18 billion this could be reduced to just 7%.
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