Clubbing in Paris I s Debt Sustainability an Illusion ? Benu Schneider

1. Clubbing in Paris Is Debt Sustainability an Illusion ? Benu Schneider The views expressed are those of the author and do not necessarily represent those of the Financing for Development Office, Department of Economic and Social Affairs, UN

2. Debt Restructuring Debt to Multilaterals Debt to official creditors Debt to commercial Banks Bond debt Yes, London Club No, it cannot be restructured except for HIPC countries Yes, at the Paris Club The terms of treatment are determined on the basis of per capita and debt ratios (require bilateral agreements after Paris Club agreements) or Bilateral agreements Yes, with and without collective action clauses e.g. Pakistan Ukraine Ecuador Belize

3. Challenges in restructuring debt • The challenge to maintain contractual obligations • The challenge of servicing debt according to ability to pay and maintaining debt sustainability • The challenge of maintaining growth Basic principles required for restructuring • Neutral arbitrator and assessor • Transparency • Adequate representation of debtors and creditors • Efficiency • Symmetry between creditor groups

4. Existing Machinery • The Paris Club is an ad hoc machinery which emerged as a result of international cooperation and not an international agreement on financial architecture • No legal status of agreements • No voice for debtors. An OECD “creditor’s club” • No in house technical capacity – reliant on IMF • IMF “preferred creditor status” with significant role in the Club • Comparability of treatment from other creditors • Negotiations are influenced by the foreign policy objectives of the creditor countries • Conditionality

5. The Paris Club today is dealing with three sets of problems Liquidity problems Solvency problems Debt relief for development expenditure The treatment accorded may sometimes be the same for all three sets of problems The changing role of the Paris Club

6. Historical background of reform efforts • Late 1970s at the TDB – G77 called for a process sensitive to developing country needs • G77 proposed and International Debt Commission • Ended in failure for the G77 • UNCTAD granted “observer status” • Codified principles and procedures of 20 yrs in a UN resolution

7. Second international debate in 2002 SDRM (2002) IMF proposed to incorporate the Paris Club in a permanent machinery Ended in failure Strains in Paris Club New creditors Dominance of private capital flows Serial rescheduling

8. Issues in official debt restructuring ROLE OF IMF • Role of IMF as gatekeeper • IMF’s Technical support • Conditionality PARIS CLUB • International financial structure for official debt has flaws, leading to serial rescheduling and unsustainable debt • Transparency an issue • Signals to the private sector • No legal status for comparable treatment form other creditors

9. The role of the IMF in Paris Club negotiations • The IMF mediator in debt-restructuring agreements between debtor countries and official creditors • But a country negotiating does not necessarily reflect debt distress. The financing of Fund Programs became dependent on debt relief – protected its own balance sheet • This coincided with the build-up of arrears •  Bi-lateral flows have increasingly been used to pay International Financial Institutions • The amount of debt relief is contingent upon a Fund Program and its estimate of financing gap and in recent times debt sustainability analysis. There problems with both these sets of estimates by the IMF (Cont.)

10. The role of the IMF in Paris Club negotiations • No compatibility between role as gatekeeper for concessional resources and creditor and therefore a stakeholder in the inflow of the same resources • This conflict of interest entails that countries do not receive resources because of good policies and governance, but because they have a high debt burden. The problem of adverse selection. Bad policies receive more resources • Except for HIPC, multilaterals as a creditor class are excluded from debt negotiations because of their preferred creditor status

11. IMF Forecasts Overoptimistic • The dominant bottom-up (surveillance has a strong country orientation) approach yield consistently overoptimistic forecasts for certain regions • Does not sufficiently pick policy spillovers in a global context IEO, IMF, September 2006 • U.S. General Accounting office (2003) found that between 1990 and 2001, WEO forecasts for growth and inflation were optimistically biased for 57 countries under IMF supported programs

12. Conditionality • Too many conditions led to weak compliance • Did not lead to FS reform in many countries • Shifting emphasis – from austerity – cutback in social investments - to investments in the social sector

13. The IMF's Approach to Debt sustainability: Middle income countries • Debt Sustainability means that the borrower is expected to be able to continue servicing the debt without requiring a large future correction in income and expenditure • An unsustainable debt is generally associated with continually rising debt ratios over time • For countries with assess to international capital markets, the concept of debt servicing is used rather than the distinction between liquidity and solvency • Provided that market access is maintained liquidity is not a problem • But liquidity problems can turn into solvency problems as a rise in cost and/or availability of finance feed into debt dynamics • IMF also examines debt sustainability in the context of a given path of primary balance • Sustainability assessment reflects cost and availability of finance, thus continuing debt servicing

14. Critique of IMF Debt Sustainability Analysis • The focus is on debt dynamics and not debt sustainability suited to flow restr. • The new approach succeeds in giving a broader range of debt dynamics including additional variables • The optimal mix of the composition of debt and levels remain a problem • The threshold levels to be used for the Evian Approach shrouded in mystery • Even if a threshold level was defined, a ratio which is good for one country maybe a signal of distress for another or the same ratio may not be good for a country at a different point of the economic cycle • The approach is geared towards keeping current on debt servicing • Cannot provide early warning signals for insolvency • Contingent liabilities need consideration • It does not take into account the ability to pay and development objectives

15. Problems with IMF debt sustainability • For a middle income country the ability to pay depends on the degree of trade openness. Threshold levels for debt to export ratios cannot be uniformly apply to all countries. • GDP that is used as a dominator for threshold levels only reflects the size of the economy. Resources cannot be diverted from the non-tradable sector to the tradable sector to generate foreign exchange. • Taxes are collected in domestic currency and debt payments are in foreign currency. A currency mismatch in the government’s balance sheet. • The IMF computes public debt to GDP ratios. Private sector liabilities are important, which may become public liabilities. • The analysis is limited in capturing the spill-over effects in debt currency and banking problems. • Extrapolation exercises cannot factor in the variability caused by increase in interest rates and fiscal tightening. • Contingent liabilities are not considered in the exercise. • Stable ratios may not necessary mean that debt is sustainable. Sustainable at what level? • In the long run exchange rate misalignments in the region affect trade and capacity to repay.

16. Debt sustainability analysis for low-income countries: A new World Bank approach • The World Bank has set out a debt Sustainability Framework (DSF) in June 2004 and IMF and World Bank (2006) for identifying countries in actual or potential distress situations leading to a formula for determining grant eligibility within the amounts allocated during the fourteenth replenishment of IDA. • The key principle in the framework is to reduce the risk of debt service problems though grant funding while facilitating access to finance required by these countries to achieve the Millennium Development Goals • The IDA allocations will be based on a Performance based evaluation system and per capita income. The level of debt distress estimated by these methods will determine the eligibility for access to grants. • The DSF selects three debt ratios to judge debt sustainability. These are the ratio of present value of public and publicly guaranteed external debt to gross domestic product and to exports, and debt service on the same debt to exports. • The framework further uses Country Policy and Institutional Assessments (CPIA) for country polices and institutional capability, and vulnerability to shocks and to classify countries by performance and different thresholds for different indicators. Governance factor given a higher weight relative to other factors. • Policy dependent — conditional upon summary measure of policies (CPIA). • To serve as a guide to lending and policy advice.

17. Critique of Joint Fund-Bank DSF • What about returns on investments – too focused on the cost of funds • Domestic and private debt not part of framework • CPIA problematic – too much emphasis on governance • It is more to do with IDA allocations • Why a separate framework???

18. What is debt sustainability? • Ability to pay without compromising on long-term development objectives or ability to service debts? • A level of debt that is growth enhancing and not a hindrance to growth? • A threshold level that aims at crisis prevention and takes the cyclical nature of capital flows into account?

21. Serial Rescheduling: A Gap in International Financial Architecture ? Increase in debt and debt servicing Liquidity /Solvency Problems Agreement with the Fund - a new loan Agreement with the Paris Club Agreement allows new credits from Paris Club Creditors Houston Terms Repayment and Grace Periods: 2-8 years non-ODA, 10 years ODA Repayment Period: 5-10 years Increase in debt and debt servicing - Further increase in debt servicing because non-ODA is negotiated at market interest rates - Bunching of repayments Estimates of financing gap are based on forecasts of growth and other variables that are over optimistic This cycle continues leading to higher levels of debt-stock and debt-servicing In the near future repayment problems surface again A new arrangement with the Fund

22. Serial rescheduling • Short consolidation periods to keep debtors on a short leash • Mistakes in projections by the IMF • Problems diffrentiating between liquidity and solvency problems • «Snowballing» debt because of bunching of repayments due to lower grace periods; market interest on non-ODA on new reschedulings; and new credits issued after rescheduling

23. Salient features in the 1980s • In the 1980s the realization that serial rescheduling is futile in low income countries and debt reductions necessary • Beginning of the process of debt reductions in low income countries • A realistic approach to middle income countries was not considered

24. Salient changes in the 1990s • For the low income heavily indebted countries, generous debt reductions with a view to finance development expenditure • For middle income countries and upper middle income countries the PC did not engage indebt reduction but began to apply the principle of burden sharing more broadly and unilaterally to force bondholders to reduce their claims on individual countries. • In effect the G-7 used the PC for cutting back public resources required to resolve financial crisis in non-HIPCs by increasing the losses absorbed by bond holders.

27. What are the lessons learnt? • A neutral body is needed to make assessments of the amount and type of relief required. • The technical work to support official debt restructuring needs to go beyond models based on those applied by the private sector that give exclusive priority to assessments of liquidity situations in countries affecting their debt servicing. • More transparency is needed in official debt restructuring operations to include information on interest rates, the list of debts covered and penalty costs. • There is a need to harmonize debtor and creditor reporting systems on bi-lateral debt to reconcile differences in the list of debt and amounts due. .

28. A simplified process is needed so that the Paris Club negotiation and bi-lateral negotiation process can be merged into a single process. Keeping countries on a short leash with burdening conditionality is self-defeating. Debtor voice is needed both in the design of the machinery and in negotiations. Serial-rescheduling leads to rising debt service requirements and makes debt sustainability targets an illusion.

29. A fair debt restructuring mechanism needs to look at repayments made on the original loan contract and amounts due from the costs of rescheduling. The pros and cons of using Paris Club procedures for financing development expenditure in counties that do not have an existing debt problem need to be understood. A comparative cost-benefit analysis with other sources of finance is needed. The Paris Club rescheduling is seen as a signal of debt distress and impacts spreads and future costs of borrowing from the private sector.

30. A possible step Set up a committee at the UN examine options for reforming the financial architecture for debt negotiations and re-examine the proposal the G-77 made in the late 1970s for an International Debt Commission along with other proposals that have been tabled by experts in the intervening years.