Debt in Low Income Countries: Crisis Eases, Borrowers (Government, State-Owned En- Risks Remain Terprises)

KFW ECONOMIC RESEARCH

Focus on Economics

th No. 31, 19 September 2013 rose from USD 5 billion in 1971 to USD 115 billion in 1995 (see chart 1). This was mainly attributable to public-sector Debt in Low Income Countries: crisis eases, borrowers (government, state-owned en- risks remain terprises). Private-sector debt (compa- nies, banks) only accounted for around Author: Dr Martin Raschen, phone +49 69 7431-2434, [email protected] 10 % of the total, which also reflects the low credit rating of the private sector as a world countries also performed well. Developing countries' foreign debt is whole throughout the period. This could However, a number of other developing not a feature of the current discus- have been a warning sign. sions on the state of the global econ- countries were less successful. The omy. This is in stark contrast to the si- global wealth gap widened. In the poor- Many indicators pointed to the mas- 2 tuation from the 1970s to 1990s, when est countries (low-income countries sive debt crisis – LICs)1, extreme poverty was wide- these countries' debt rose sharply, The absolute increase in foreign debt al- spread. There was no shortage of advice many were barely able to service their ready paints a clear picture. The crisis- on how to accelerate development. Until debts, and development-related in- plagued nature of the development up to the mid-1980s, the dominant develop- vestment suffered, cementing poverty. the mid-1990s is particularly clear if the ment policy paradigm was: LICs should Two factors have contributed to the weak economic growth at the time is also invest heavily in their economic infra- change for the better since then: debt taken into account. On average, growth structure and industrialisation, both of relief initiatives by creditors and a in the LICs was only half that of middle- which were the responsibility of the gov- marked economic upturn in the coun- income countries. LICs even saw their ernment. To achieve this big push amid tries concerned. The subject of foreign average GDP decline in some years. As the low savings ratio and limited public debt is by no means completely off a result, the ratio of foreign debt to gross budgets, the path of high budget and the table, and Low Income Countries domestic product in the LICs surged balance of current account deficits was still need to weigh up the opportunities from under 20 to more than 90 % (see chosen. Warnings that would be given and risks of external financing. figure 1). from a current perspective, namely that Development paradigm and rising given the institutional weakness, it could A comparison between economic growth debt be risky to base a debt strategy on future and the average interest rate for new growth, were few and far between. After the Second World War, industrial- loans in the relevant years is also telling. When financing an investment, individual ised nations experienced an economic Against this backdrop, the LICs took on investors should ensure that their income boom and the economies of many third more and more foreign debt. Total debt will cover the interest of the loan. The same applies at the level of the econ- Figure 1: Foreign debt of LICs (public and private borrowers), in absolute terms omy. The weak economic growth in the and in relation to economic output LICs meant that GDP growth was higher 140 100 than the average interest rate for new loans in just six of the 25 years we are 120 looking at. This is already very problem- 80 atic on its own, but was further exacer- 100

[Percent of GNI] of [Percent bated by the fact that foreign loans were 60 80 taken out in foreign currencies, mainly the US dollar. Without exception, the cur- 60 40 rencies of the LICs depreciated against [Billion USD][Billion the US dollar during the period, in many 40 cases sharply. This made it much more 20 20 expensive to service the debt in local currency and was too much for many 0 0 borrowers. 3 9 5 1 7 9 7 77 79 83 85 91 9 97 0 03 0 971 9 9 9 9 9 98 9 9 0 00 1 1 1975 1 1 1981 1 1 1987 1 1 1993 19 1 1999 20 2 2005 20 2 2011 Lastly, the foreign trade situation also in- Public sector (left side) Private sector (right side) Total external debt (right side) dicated a mounting problem. The LICs' Source: World Bank, own calculations exports generally rose only moderately

Please note: This paper contains the opinion of the authors and does not necessarily represent the position of the KfW.

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during the period, even declining in the would be able to solve themselves. But it As a prerequisite for all of this support, early 1980s. As a result, the LICs fell fur- gradually became clear that a large the developing country must define and ther and further behind the international number of LICs had fallen into a debt implement a programme to improve competition. The debt to export ratio trap that they would be unable to escape general economic conditions and fight climbed from less than 200 % to more without their creditors' help. In the 1980s, poverty, as well as to achieve the Millen- than 600 % in the period from 1971 to bilateral donors first granted debt relief in nium Development Goals (MDGs). The 1995, and the debt service ratio (interest the form of debt rescheduling. Since World Bank and IMF monitor and assess and principal repayments in relation to 1988, they have cancelled up to 90 % of external debt continuously through a sys- exports) rose from around 10 initially to the debt through the Paris Club. tematic Debt Sustainability Analysis and 30 % by the end of the 1980s. Although provide considerable debt management the subsequent decline in the LIC debt The World Bank, IMF and other multilat- support to the countries, which has had a service ratio to 17 % in 1995 at first eral institutions did not become involved very positive effect. glance seems to indicate an improve- in this type of initiative until 1996, al- Impressive economic upturn since the ment, quite the opposite is true: the debt though their loans accounted for a large mid-1990s service payments declined because the proportion of the LICs' foreign debt. Un- outstanding arrears climbed steeply to der pressure from both bilateral donors As already mentioned, the weak eco- USD 26 billion. and non-governmental organisations nomic growth up to the mid-1990s was a (NGOs), the World Bank and IMF major contributing factor to the debt cri- Varied causes of the debt crisis launched the Heavily Indebted Poor sis. Encouragingly, this has since im- Countries Initiative (HIPC)3 to help poor The crisis was triggered by controllable proved considerably. The LICs have cor- developing countries4 unable to service internal factors and uncontrollable exter- rected economic policy errors, such as their foreign debt5. To date, bilateral and nal factors. Among the internal factors, manipulated exchange rates, inflationary multilateral creditors have waived an av- the dubious nature of development para- monetary policy and excessive budget erage of two-thirds of the debt of digm from a regulatory perspective has deficits. They have also significantly im- 32 HIPCs under this initiative. The HIPC already been discussed. However, this proved the regulatory environment for debt relief granted amounts to USD 7 was also encouraged from outside, as sustainable growth. In a number of 76 billion (present value), which is split donors were prepared to mobilise large cases, this has been achieved through between bilateral and multilateral donors amounts to finance these projects. Ad- donor-backed Structural Adjustment at a ratio of 55:45. In addition to the ded to the flawed basic concept were Programmes. However, good govern- HIPC Initiative, the Multilateral Debt Re- weak project management, a misguided ance is still a long way off and central lief Initiative (MDRI) was created in 2005. sector policy and generally bad govern- macroeconomic indicators show that the The World Bank, IMF, African Develop- ance, including corruption. As a result, brightness is marred by shadows. Never- ment Fund and the Inter-American De- many such projects failed to generate theless, numerous problematic trends velopment Bank have waived USD the income needed to service the debt. have reversed. A comparison between 37 billion (present value) of the debt of The internal causes of the crisis also in- the periods before and after 1995 re- HIPCs under the MDRI. Bilateral credi- 8 cluded the underdeveloped local capital veals the following. tors have also granted debt relief of USD markets, which left the potential for mobi- 11.9 billion (present value) through the  The growth trend is very positive. lising internal funding largely untapped. Paris Club.6 Economic growth has more than doubled Without this development deficit, de- (from an average of 2.1 % p. a. up to mand for foreign financing would likely have been reduced. Figure 2: Economic growth in country groups (actual, in percent)

The line between internal and external 6 factors is blurred. In any case, wars/civil wars, droughts, floods and similar events 5 also led to a lack of investment.

In the category of uncontrollable external 4 causes of the crisis, the two oil crises and the recession in industrialised na- 3 tions, protectionism in these countries and unfavourable price trends on the in- 2 ternational commodities markets hit the LICs hard. 1

Various initiatives eased the LICs' 0 debt situation Low income Middle income High income

Initially, many considered the problem to Ø 1971–1995 Ø 1996–2012 be a temporary one, which the LICs Source: World Bank, own calculations

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1995 to 4.7 % since). In fact, the growth some way off for LICs. level is sustainable. By way of compari- rate in LICs has been faster than that of son: the London Agreement on German HIPCs made good progress towards industrialised nations since 1996, al- External Debts between Germany and its poverty reduction and MDGs though still slower than in middle-income opponents in the Second World War countries (see figure 2). The picture is equally mixed from a de- provided for a debt service ratio of 5 % velopment policy perspective. As already for Germany.  Exports of goods and services have mentioned, debt relief under the HIPC more than tripled. Initiative requires the country concerned However, future developments will need to be carefully monitored so that LICs do  LICs have moved considerably closer to step up its efforts to reduce poverty and generally achieve the MDGs. Relief not again fall into debt crisis. Sensitivity to achieving monetary stability. Whereas to external shocks and the quality of the inflation before 1995 averaged more from debt service requirements provides the financial leeway to achieve this. In economic and development policy of the than 10 % p. a. almost across the board country in question need to be analysed. (with peak rates of more than 20 %), it their latest HIPC Initiative progress re- 9 The World Bank and IMF differentiate has since fallen back to 5–10 %. This is port for the years since 2001 , the World Bank and IMF reveal positive trends: between four risk categories in their debt still too high, though, and further efforts sustainability analysis. Currently, 23 LICs to reduce inflation are needed. while the debt service ratio has declined from 14.5 to 3.1 %, public spending to are classified in the two highest catego-  Saving ratios have risen, but are still reduce poverty10 has risen consistently ries High Risk of Debt Distress and In very low in LICs at an average of 10 %. from around 6.3 % of GDP to roughly Debt Distress. These countries are char- In industrialised nations, savings ratios 9 % (see figure 3). At the same time, acterised by their high concentration on have doubled and are around three ti- however, just seven HIPCs are on track a few export commodities and/or weak mes higher in emerging countries. to achieve the key MDG of halving pov- economic policy institutions, as well as a erty, and things do not look at all good sometimes problematic debt trend. Al-  The inflow of foreign direct investment for the other MDGs. though the World Bank and IMF do not into LICs has risen sharply. Up to the consider new debt-relief initiatives in the mid-1990s, these capital flows were Debt situation improved significantly, style of the HIPC Initiative to be neces- close to zero. They have since reached but a number of countries are still in sary, close monitoring of the situation, an an average of USD 4 billion p. a. (peak "debt distress" improvement in general economic policy of USD 19 billion in 2011). However, this Thanks to the debt relief granted and conditions (including through donor sup- also needs to be viewed in context: Chi- good economic growth, the LIC debt in- port) and careful review of the new bor- na alone receives foreign direct invest- dicators have improved significantly rowing conditions a country is able to ments of more than USD 200 billion per since the mid-1990s. The ratio of total sustain (keyword: concessionality) are year. debt to gross domestic product has de- the order of the day. clined from its peak of 93 % in 1994 to  Foreign exchange reserves, which Two other factors come into play. Firstly, less than 30 % today (see figure 1). The barely covered more than 2.5 months' the need for public spending (on infra- debt service ratio has also declined from imports on average up to 1995, have structure development, for example) is its highest level of more than 30 % at the subsequently risen to 3.5–4 months' im- rising due to the rapid economic growth end of the 1980s to less than 5 %. As al- ports. This is still low, however, given in the LICs mentioned earlier. The LICs ready mentioned, the debt service ratio that the LICs are highly vulnerable due to still have access to development aid. for HIPCs has even fallen to 3 %. This their heavy reliance on volatile commodi- However, since this source of financing ties prices. Figure 3: Debt service ratio (as a percentage of exports) and  The LICs external imbalance has poverty-reducing public spending (as a percentage of GDP) in HIPCs eased for the time being, but is still a se-

rious issue. The rising current account 16 10.0 deficit trend seen until 1995 had turned 14 9.5 around by 2002 (-1.5 % in relation to GDP). However, deficits have since 12 9.0

climbed back to 2–5 % p. a. A current 10 8.5 account deficit does not necessarily have 8 8.0 to be a problem if the import surplus con- tributes to growth and is solidly financed. 6 7.5

However, deficits of this scale need to be 4 7.0 closely monitored, particularly in LICs. 2 6.5 All in all, the recent trends are com- 0 6.0 mendable. However, it would be disin- 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

genuous to pretend that all-round satis- Debt service ratio (left side) Poverty-reducing expenditure (right side) factory economic development is not still Source: World Bank, IMF 3

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is limited and, at the same time, these that they were able to place bonds de- There is general awareness of this fact. countries are finding it difficult to gener- spite their poor speculative grade rat- As a result, four countries that were ate higher tax revenue, there could be a ings. It is notable that although six of qualified to receive HIPC debt relief ulti- strong temptation to fund increased pub- these seven countries have received mately decided to pull out of the initiative lic spending through debt. Secondly, the HIPC debt relief, they no longer rank due to concerns regarding their credit current economic problems in industrial- among the poorest developing countries rating (The Kyrgyz Republic, Nepal, Laos ised nations have led to poorer develop- thanks to their strong economic growth; and Bhutan). ing countries becoming attractive targets they have since been upgraded to the Conclusion for financial investors. The HIPCs Sene- group of middle-income countries (Bo- gal, Ghana and Zambia have recently livia, Ghana, Honduras, Nicaragua, The debt crisis in LICs has been eased placed bonds on the international capital Zambia and Senegal). Only Rwanda is significantly through the extensive debt market (see the following section). These still an LIC. It is therefore reasonable to relief granted by creditors and strong countries have barely any experience assume that debt relief coupled with con- economic growth in the debtor nations. with non-concessionary financial prod- tinued classification as an LIC made a This issue is by no means off the table, ucts traded on the market. significant contribution to the countries' however, and the development of risk poor (or total lack of) rating and severely factors still needs to be continuously Development vs. ability to access the hampered or completely blocked the monitored. The LICs must further im- capital market relevant countries' access to the interna- prove their macroeconomic and devel- Without doubt, the debt relief granted tional capital markets. opment policy conditions, which includes has eased the situation considerably, but developing local capital markets. Despite The history outlined above should by no it has not been without side effects. For all of the progress made, the LICs still means lead to advocating unbridled for- one thing, it has affected the sovereign have considerable scope to accelerate eign debt. However, carefully considered rating of the countries concerned. Of the their development. This could help them borrowing to invest in development fun- 32 HIPCs, which have to date received improve their access to the international damentally remains a sensible option extensive debt relief, 20 are not even capital markets and use the funds raised from a macroeconomic perspective. This rated by the ratings agencies Standard & there – responsibly – to make the most is particularly true at the moment, given Poors, Moodys and Fitch. The ratings of of future opportunities. ■ the remaining 12 HIPCs are all specula- the extremely favourable interest rates tive grade. Five of these 12 HIPCs have on the international capital markets. Be- ing largely unable to take advantage of not placed any US dollar government bonds on the international capital mar- this is the price the HIPCs have to pay kets.11 The other seven are interesting in for the debt relief received.

1 In this analysis, low-income countries (LICs) are the 36 developing countries with per capita income of no more than USD 1,035, in line with the World Bank classification. 27 of these countries are in Sub-Saharan Africa, eight are in Asia and one is in Latin America. It should be noted that the World Bank adjusts the income threshold each year, which means that the group of LICs changes over time. For example, China, India and Indonesia were still LICs in the 1980s, but are now medium-income countries. This poses a particular problem for the empirical analysis in this paper, as the data used comes from the World Bank, which only provides information on the current country groupings on its website. However, this should not undermine the basic line of reasoning presented in this paper. 2 The empirical statements in this section are based on the extensive data gathered by the World Bank (World Development Indicators and International Debt Statistics). 3 Among the multilateral institutions, the World Bank and IMF are the main players in the HIPC Initiative. However, regional development banks (the African Development Bank, Inter-American Development Bank and Asian Development Bank) also participate, as do bilateral donors. 4 The LIC and HIPC country groupings are not identical. For example, Bolivia, Zambia and Senegal received HIPC debt relief, but are no longer LICs and are now classified as lower middle income countries. See also footnote 1. 5 The establishment of limits, which if exceeded indicate that a country is unable to service its foreign debt, is carried out on a country-by-country basis in the World Bank and IMF Debt Sustainability Analysis. The findings of the Country Policy and Institutional Assessment are the decisive factor in the setting of these limits. If a country is classified as "poor quality" (the worst classification), a debt service ratio of 15 % and a debt (present value) that represents 100 % or more of exports and 200 % or more of public revenue is deemed unsustainable. 6 In addition, bilateral donors have waived debt through Debt for Development Swaps. In contrast to (foreign currency) debt relief, the developing country provides addi- tional funding to the national budget in the local currency for development purposes. The commercial banks in the London Club also promised debt relief of USD 4.6 billion (present value) to LICs as part of the HIPC Initiative, but have only partly implemented this so far. The World Bank has made funding to buy back commercial debt available to HIPCs through a Debt Reduction Facility. In some cases, financial investors take advantage of the low market value of commercial receivables to buy them up at a low price and then bring legal action for the nominal value, which is not in line with the HIPC Initiative objectives. 7 See the detailed special chapter in the IMF's World Economic Outlook, April 2013. http://www.imf.org/external/pubs/ft/weo/2013/01/pdf/text.pdf 8 Data source: World Bank 9 Heavily Indebted Poor countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI) – Statistical update 25th March 2013, http://siteresources.worldbank.org/INTDEBTDEPT/Resources/468980-1256580106544/HIPCStatisticalUpdate2013.pdf 10 Poverty-reducing public spending includes spending on education, health care, water supply, rural infrastructure, etc. There is no universally applicable definition for this type of spending; it is established on a country-by-country basis. 11 Source: Bloomberg.