How debt relief can turn into punctured life boat

Last week's discussion focused on the need to premise borrowing on solid laws and policies. This week, I sought insights from Zara Tayebjee, a brilliant first year undergraduate with whom I co-write this article. Zara, a double major in political science and statistics at Barnard College of Columbia University, was particularly interested in demonstrating how debt relief programmes are at times necessary but cannot be a panacea to debt management problems.

She began with a look into the African mad debt rush of the 1970s which was triggered by the countries’ insatiable thirst for infrastructure development. Moreover, poor foresight and political mismanagement prevented African countries from adopting countercyclical fiscal policies. By the 1980s, we were trapped under mountainous debt.

Unpaid debts had to be renegotiated, restructured, or even better, forgiven. The two chief initiatives we mentioned in our previous articles (Heavily Indebted Poor Countries – HIPC and Multilateral Debt Relief Initiative - MDRI), aimed to free chosen countries of their debt burdens allowing them to funnel more money into developing infrastructure.

Was this a clever move? HIPC effectively reduced African debt burden in the short run but it failed in the long run. Let us see how it happened.

Debt Markers: How do we measure debt sustainability?

There are two key elements that are taken into consideration while assessing whether a country’s debt is sustainable. The first is the level of debt based on the ratio of debt to gross domestic product (GDP). The other is the cost of servicing the debt – interest payments.

American economist Paul Krugman suggests that if the debt-to-GDP ratio exceeds 70 per cent, a country is likely to be unable to pay back. The IMF also prescribes 77 per cent, given certain conditions. Debt levels on the continent, for example, are on average way below the 100 per cent debt-to-GDP ratio mark.

According to Mischek Mutize, an academic, the problem with African states is not in their quantum of debt, but rather, in the cost of servicing that debt. In order to offset the risk of future default among developing nations, the debt market imposes upon them a higher interest rate.

The quantum of debt and repayment amount— linked to the interest rate— are the corporate equivalent of a balance sheet and a profit and loss statement. States considered to have more sustainable debt also have lower interest rates on their debt.

In light of this, states may have similar debt-to-GDP ratios but varying interest rates on the debt. For example, one country may borrow at close to a zero per cent interest rate and the other at eight per cent. While both have the same debt-to-GDP ratio, the latter’s actual debt burden is much greater. The impact of interest rates on a state’s debt sustainability can therefore, not be understated.

The effect of excess, unsustainable debt can be damaging to a country. At the point of debt unsustainability, debt overhang arises. Figure 1 below illustrates this.  After point X; the point at which debt becomes unsustainable, the more debt the state takes on, the less its ability to pay back creditors. Its payments also decrease. The excess debt after X is referred to as the debt overhang.

Figure 1: The Debt Laffer curve

In the case of African countries, debt overhang in the 1980s led to decreased confidence from creditors. Their costs of borrowing hence increased to reflect increased risk of future default leading them to take on debt with unfavourable terms. The result was: debt spirals –where the countries only recorded ever increasing levels of debt; and debt trap diplomacy—which we will explore in the next article.

It was in this context that the HIPC and MDRI debt forgiveness schemes were conceptualised.

The African Debt Problem: Why HIPC Was Necessary

In the case of HIPC nations, average Debt to GDP ratios in the early 2000s were above the 100 per cent mark and were set to rise. The light blue line on graph (figure 2) below shows the computed trend line of Debt to GDP ratios of HIPC countries before receiving HIPC aid.

Figure 2: Graph showing HIPC countries debt to GDP ratio trendline without HIPC assistance

If (all other factors held constant) HIPC countries continued to acquire debt at the rate in which they did at the time, following this trendline, they would have an average debt-to-GDP ratio of over 400 per cent by the year 2005— well over sustainable levels. This was largely due to the increase in debt available to African countries at the time.

Due to the debt overhang effect, without debt relief initiatives the HIPC countries would have entered into a debt spiral, not only tanking development but also threatening political and social stability in these states. HIPC acted as a life raft for the affected African countries, saving them from this debt. It is thus clear that debt relief was necessary. But how effective was the HIPC programme itself?

HIPC in the short-term

The short-term objective of the HIPC programme was to reduce the African debt burden by lowering debt-to-GDP ratios to sustainable levels. Comparing the debt-to-GDP ratios of countries who participated in HIPC to those who didn’t, within Africa, can help us evaluate the effectiveness of the programme.

An effective way to do so is to subtract the average debt-to-GDP ratios of HIPC countries from the average debt-to-GDP ratios of non-HIPC countries. A positive value would indicate that HIPC countries had a lower debt-to-GDP ratio for the year in question compared to non-HPIC countries.

Conversely, a negative value would indicate that HIPC countries had a higher debt-to-GDP ratio than non-HIPC countries. For example, in the year 1995 on the graph below, HIPC countries on average had a higher debt-to-GDP ratio than non-HIPC countries and the opposite in 2000. Figure 3 below shows this comparison.

Figure 3: Average of non-HIPC debt to GDP - average of HIPC debt to GDP

As can be seen from figure 3 above, there is a significant positive difference from the year 2000 to 2007 in the average debt-to-GDP ratio of non-HIPC countries as compared to HIPC countries. This coincides with the completion dates of the HIPC program for most countries.

Figure 3 also shows that throughout the period of the HIPC programme, and for a short time after the completion of the programme the average debt-to-GDP ratio of non-HIPC countries was significantly larger than the average debt-to-GDP ratio of HIPC countries. This indicates that in the short run, HIPC was effective in reducing debt-to-GDP ratios.

However, after 2010, the difference in debt-to-GDP ratios between non-HIPC and HIPC countries became negative once again. This means that HIPC countries' debt-to-GDP ratios were becoming larger than non HIPC countries very shortly after the completion of the programme. In this event, it is important to assess what could have caused this reversal so soon after a significant debt write-off?

HIPC in the Long-run

The long term objective of HIPC was to help affected African countries install regulatory institutions and necessary fiscal policy to help them manage their debt in the future without the baggage of debt overhang. One would therefore expect that upon successful completion of the programme, HIPC countries’ debt-to-GDP ratios would remain lower than those of non-HIPC countries. Unfortunately, this was not the case.

Figure 4 below shows the computed trendline of HIPC countries debt-to-GDP ratios after completion of the programme. 

Figure 4: Average HIPC debt to GDP trendline after debt forgiveness

As seen above, HIPC countries after their completion points rapidly reaccumulated debt at an almost pre-HIPC programme rate. In fact, Dino Moretto et al. in a World Bank report suggests that some HIPC nations could return to pre-HIPC debt-to-GDP ratios by the year 2025.

There are several reasons for increases in African debt. Gamel and Van, economists from Baylor University, suggest that following the immediate success of the programme, HIPC countries with lowered debt-to-GDP ratios had increased access to investments, including bilateral loans from China.

Furthermore, Rozenberg et al. in a World Bank report on African infrastructure, suggests that African countries, invigorated to meet their infrastructure deficits then, borrowed heavily to complete infrastructure projects; at times legitimately and at times illegitimately.

In theory, had the HIPC programme been successful in the long run, the participating countries would have implemented successful governance structures preventing the re-accumulation of unsustainable debt. Unfortunately, as seen above, this was not the case. In the long term, HIPC did not meet its aims.

The moral hazards of debt forgiveness

Upon reaching the conclusion that the HIPC debt forgiveness scheme was not effective in reducing debt accumulation in the long run, it is important to assess the implications of such debt forgiveness. Specifically: the moral hazard created by simply writing off debt.

The most obvious implication of simply writing off debt is that it sets a precedent for debt forgiveness for countries that have accumulated excess debt. This means that countries do not have to do the hard work of creating fiscal policy aimed at reducing their debt burden. As seen in the case of the HIPC countries, they simply reaccumulated debt after their completion of the programme. Debt forgiveness signalled that excess debt will be written off.

Another problem that debt forgiveness creates is that of postponing the need to address critical problems such as government corruption that leads to debt accumulation. As part of the HIPC initiative countries participating in the programme were required to create or increase transparency in their debt tracking systems, in order to prevent corrupt individuals from misappropriating funds.

Looking at the World Bank’s Governance Index on Corruption it is clear that corruption indices of countries that participated in the HIPC programme did not decrease at a statistically significant rate throughout the duration of the programme. HIPC was therefore unsuccessful in stimulating anti-corruption policies.

African HIPC countries, during the post-independence era, borrowed beyond their ability to pay. This meant that debt forgiveness schemes of the early 2000s notably the HIPC and MDRI initiatives were necessary to save Africa from a debt trap.

However, it is also clear that the HIPC initiative was only effective in the short run. It significantly decreased the debt-to-GDP ratios of African countries, at least initially, but did not result in a long-standing impact on fiscal policy that was effective in the long run. As a result, the African debt scene in the near future is set to look eerily similar to that of the early 2000s.

The moral hazard of debt forgiveness perhaps contributed to the failure of HIPC. Writing off debt sets a precedent that excess debt will simply be forgiven in the future. This, compounded by the programmes’ failure to address critical underlying issues such as weak fiscal regimes, the HIPC and the subsequent MDRI programmes were a punctured life raft, saving Africa from the sea of debt only to let it slowly drown once again.

This article is part of a long series of articles on the rule of law in the context of politics and ethics. The series is researched and co-authored by:

Karim Anjarwalla, Managing Partner of ALN Anjarwalla & Khanna, Advocates;
Kasyoka Salim, Research Associate at ALN Anjarwalla & Khanna, Advocates;
Wandia Musyimi, Research Associate at ALN Anjarwalla & Khanna, Advocates;
Zara Tayebjee, Barnard College of Columbia University;
Rayaan Anjarwalla, St Andrews University; and
Prof Luis Franceschi, Senior Director, Governance & Peace, The Commonwealth, London