Foreign debt overhang represents a major barrier to the growth of many developing countries. A high debt discourages investors to provide capital and binds the developing countries in a poverty trap ("Debt Overhang" effect). The foreign debt issue has been present since the early seventies, when oil shocks, high interest rates, industrialized countries recession and high trade deficits, led, as a natural consequence, to an increase in the requests for international lending by developing countries. After an initial period of static approach to the problem of foreign debt (see Structural Adjustment Program and "Baker Plan"), many of the restructuring initiatives, developed by the international financial institutions, took place with the idea that debt reduction could bring benefits both to the debtor and creditor countries (see Laffer's Curve). The nineties welcomed different initiatives such as the Heavily Indebted Poor Countries Initiative (HIPC) with the main aim to significantly reduce the debt owed by developing countries in the world.
Foreign Debt and Sovereign Debt Restructuring
A trade deficit in the balance of payments indicates that a country needs, for consumption and investment, more resources than those available and it should therefore, attract foreign capital. Later on, the country in question, could attract foreign direct investment (FDI) or provide debt issuance (bonds) to international institutions like International Monetary Fund (IMF) and the World Bank or to commercial banks or finally, to private entities. This kind of debt is generally defined as "foreign debt" and it is the part of total debt held by creditors of foreign countries, i.e. non-residents of the debtor's country. This entry gives the total public and private debt owed to non-residents repayable in internationally accepted currencies, goods, or services. These figures are calculated on an exchange rate basis, i.e., not in purchasing power parity (PPP) terms. The foreign debt is the portion of a country's debt that had been previously borrowed from foreign lenders including commercial banks, Governments or international financial institutions (International Monetary Fund –IMF or World Bank).
While there is no universally accepted definition, a sovereign debt restructuring can be defined as an exchange of outstanding sovereign debt instruments, such as loans or bonds, for new debt instruments or cash through a legal process. Sovereign debt refers to debt issued or guaranteed by the Government of a sovereign State. The debt restructuring is based on agreements with the creditor countries on debt rescheduling, which can be defined as a lengthening of maturities of the old debt, possibly involving lower interest rates or the debt relief, which can be considered as a reduction in the nominal value of the old instruments.
Debt Crisis in Developing Countries
Since the end of World War I, the “rich” countries had been giving financial aids to the "poor" ones in order to increase their investments. Therefore, the debt of foreign countries cannot be considered as a recent issue. In the literature, the phenomenon generally dates back to the seventies, when the oil exporting countries had a large amount of currency resources used to grant loans for developing countries thanks to the international private banking system. The developing countries' economies dependent on exports, were directly affected by the energy crisis of 1973 and by the consequent lowering of commodity prices. Oil shocks, high interest rates, industrialized countries recession and high trade deficits, led, as a natural consequence, to an increase in the requests for international lending by developing countries. For developing countries, all these factors created a precarious macroeconomic situation. The situation aforementioned, represented the main concern of the international financial institutions in those years. These concerns became justified in 1982, when Mexico declared default (it was the first country ever) followed by Brazil. From the debt crisis of 1982-83, the international community developed important multilateral initiatives to reduce and cancel the foreign debt. Today, in addition to middle-income countries of Latin America, even the low-income countries, mostly located in Africa, are affected by the problem of the debt crisis.
Loans and Conditionalities. The Structural Adjustment Plans (SAPs)
In 1982, Mexico claimed not to be able to pay its debts and consequently, the IMF and World Bank entered in many commercial banks loans to allow new capital, preventing at the same time, a chain reaction. Mexico and other countries were “forced” to implement a series of reforms aimed at achieving the main objective which was the payment of debt through the Structural Adjustment Plans (SAPs). They were also known as the Washington Consensus, which was a set of "conditionalities" in order to receive new loans from the IMF or World Bank or to obtain lower interest rates on already existing loans. Through conditions, SAPs generally implemented "free market" programs and policy including internal changes (especially privatization and deregulation) as well as external ones, mainly the reduction of trade barriers. Countries that failed to enact these programs might be subject to severe fiscal discipline.
SAPs were designed to improve a country's foreign investment situation by eliminating trade and investment regulations and boosting foreign exchange earnings with the promotion of exports, reducing Government deficits through cuts in spending. The "tips" of the Bretton Woods institutions were followed by many countries, from Latin America to Africa and Southeast Asia, without getting the desired results. In the second half of the eighties, the IMF itself, began to study a new strategy. Initially, deadlines were postponed and this was the only tool used to improve the situation of debtor countries (debt rescheduling); arrears payments were also refinanced. At the end of the eighties, it became quite obvious that the debt restructuring only led to an increase in the total debt, mostly due to the capitalization of interest. Creditors realized that not all debts could be repaid.
Debt Reduction Initiatives
“Baker Plan”. Together with the beginning of the Structural Adjustment Plans (SAPs), the IMF and World Bank, it was launched a more direct debt relief initiative: a plan developed by U.S. Treasury Secretary, James Baker in 1985 to relieve debt in the developing world. The Plan was designed to help highly indebted middle-income countries, i.e., those countries that were not extremely poor yet, but nevertheless they owed a large amount of money. This Plan suggested that the World Bank and private banks should have provided funding while developing countries were undertaking liberalizing structural reform. At the very end, the plan was not implemented because no consensus could be reached while considering which countries to be included. It was succeeded by the Brady Plan.
“Brady Plan”. In 1989, the United States Treasury Department under the Treasury Secretary Nicholas F. Brady, formulated a new strategy for dealing with developing country debt. The Plan offered banks credit enhancements in exchange for their agreement to reduce claims. These credit enhancements were created at first by converting commercial bank loans into bonds (“Brady Bonds”), and then collateralizing principal and rolling interest payments on those bonds with US Treasury zeroes purchased with the proceeds of IMF and World Bank loans. The plan proposed that the IMF and the World Bank allocated resources to encourage the reduction of debt burdens and interest payments by debtor countries. Funds obtained from these organizations would have been used later on to enhance the credit worthiness of securities to be exchanged for commercial banks' existing loans.
Heavily Indebted Poor Countries Initiative (HIPC). The expression Heavily Indebted Poor Countries refers to a group of 41 developing countries with high levels of poverty and debt overhang which were eligible for special assistance from the International Monetary Fund (IMF) and the World Bank. The Initiative envisaged comprehensive action by the international financial community, including multilateral institutions, to reduce to sustainable levels the external debt burden on HIPCs, provided they built a track record of strong policy performance. The Initiative’s debt-burden thresholds were adjusted downward, which enabled a broader group of countries to qualify for larger volumes of debt relief. It represented a significant step forward, as it placed debt relief in the framework of poverty reduction with the aim to ensure that essential restructuring and the development of a country were not compromised by servicing unsustainable debt burdens. The HIPC are also required to embark on clearly defined poverty reduction strategies.
Why Reduce Debt. Debt Overhang Effect and the Laffer Curve
A high Foreign debt increases the uncertainty about the chance that the debt stock will be fully repaid. In a macro-economic system, characterized by a certain degree of uncertainty, the foreign and domestic investors prefer to postpone their choices ("Debt Overhang effect"). Debt reduction can decrease the uncertainty (due to the default risk, to the deadlines renegotiation and the accumulation of arrears) improving allocative efficiency and expectations in Governments and policies of debtor countries. In fact, beyond a certain level, the debt overhang exerts negative pressures on the willingness of investors to provide capital. For this reason, the presence of a high stock of debt, according to the theory of "Debt Overhang", changes the incentives, both of the creditor and of the debtor and its reduction can interest both. According to some economists (Paul Krugman, Jeffrey Sachs and Peter Kenen) the debt Laffer curve (Fig. 1) reproduces the possibility of repayment as a function of the debt stock and clarifies how its reduction can be beneficial both for debtor and creditor:
Fig.1 Laffer Curve
The axis of ordinate represents the value of the debt resulting from the expected future payments; while the axis of abscissas describes the current nominal value of the debt (total debt stock). In the initial phase when the debt is substantially lower, the curve follows the 45 degree line.
Point C shows the "Debt Overhang": the expected payments (per unit of additional debt) start becoming lower than the debt value as shown by the expected future payments which the developing countries are expected to be able to perform.
In the point R, the curve begins to decrease because the present debt value increases and imposes such disincentives that the expected payments, for the additional loans, increase rather than decrease.
Theoretically the best time to start a debt reduction is when the Country is beyond the point L and before the point R. This brings benefits both to the debtor and to the creditor because the debtor country will have less debt, but at the same time, the creditor will increase the value of their remaining debts.
When the debtor country is located to the right of point R(the so-called "wrong" side of the Laffer Curve), a debt reduction increases the chances of repayment and improves the condition of the creditor and debtor. By contrast, a high debt discourages investment in physical and human capital, as well as the implementation of new technologies and structural reforms, mostly because the debtor country believes that all future profits will aim at repaying the debt contract. This “Debt Overhang effects” analysis shows how excessive debt can constrain developing countries in a poverty trap.
Forum for Debt Restructuring. Paris Club and London Club
Paris Club. The Paris Club is an informal group of official creditors whose role is to find coordinated and sustainable solutions to the payment difficulties faced by debtor countries. It is the major forum where creditor countries renegotiate official sector debts. A Paris Club “treatment” either refers to a reduction and/or renegotiation of a developing country’s Paris Club debts. The origin of the Club dates back to 1956 when Argentina agreed to meet its public creditors. It includes 19 permanent members and the major international creditor Governments. In December 2013, the Paris Club reached 429 agreements with 90 debtor countries. Since 1983, the total amount of debt covered by Paris Club agreements, rescheduled or reduced, is approximately about 573 billion dollars.
London Club. The first meeting of the London Club took place in 1976 when commercial banks met to renegotiate Zaire's debt payment problems. There is no permanent London Club membership and it has no formal mandate. The Paris Club and the London Club are the two principal frameworks for restructuring (or, more practically, for rescheduling) sovereign debt. At a debtor nation’s request, a London Club meeting of its creditors may be held, the Club is subsequently dissolved after the restructuring. In the London Club, the interests of the creditor banks’ are represented by a steering committee composed of those banks with the greatest exposure to the debtor country in question.
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Editor: Giovanni AVERSA