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Forgive debt
and keep on lending
8-9/2005
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[ Development finance ]
Forgive debt
and keep on lending
The international debate has been distorted for years. While debt relief does make sense, discontinuing concessional loans does not. The Meltzer Report mistakenly linked these issues in 2000.
[ By Daniel Cohen and Helmut Reisen ]
Sir Bob Geldof, the charity rocker, relaunched the Live Aid concert, now entitled “Live 8”, as consciousness-raising exercise ahead of the Group of Eight summit in Scotland. The aim was to increase the pressure on the summit to ratchet up aid and debt relief for Africa. In fact, the international agreement on debt relief reached by the G-8 Finance Ministers in June cancelled $56.5 billion in loans owed to the World Bank, African Development Bank and International Monetary Fund. Fourteen countries in Africa and four in Latin America became eligible for immediate debt forgiveness. All of them are part of the World Bank's Heavily Indebted Poor Country Initiative (HIPC), in which countries commit to good governance, meet an IMF-endorsed financial plan and root out corruption.
As early as March 2000, an influential US Congress Report of the International Financial Institution Advisory Commission (better known as Meltzer Report) had concluded that total cancellation of poor country debt was essential. A corollary was the recommendation that multilateral development banks should henceforth provide support only in the form of performance-based grants rather than as loans at low interest rates (called “soft” or “concessional”). Now that the Meltzer report has been vindicated in terms of debt cancellation, will future aid to the poorest countries come only in the form of grants?
The figure clearly shows that bilateral donors have increasingly favoured grants over loans during the past three decades. In recent years, this preference has been emulated by the multilateral aid agencies as well, as even the regional development banks – with the exception of the Asian Development Bank – have started to provide more grants. However, the rising share of grants in ODA has not reduced poverty incidence in the developing world. In fact, where poverty has been reduced – namely in East Asia and Pacific – the share of grants in ODA has been lower than elsewhere, and falling. By contrast, in Africa both grants as a percentage of ODA disbursements and poverty incidence have both been on the rise. While these observations do not imply any causality, they should serve as a warning. Debt relief and grants will not eradicate poverty by themselves.
As for the impact of aid, three things really matter for developing countries. These are net transfers, allocative discipline and risk allocation. Whether a shift from grants to loans will increase transfers depends on the scale and terms of the loans relative to the scale of the grants. A shift from concessional loans to grants could even reduce the net transfers if the face value of the grants were small compared to the loans. This will quite likely be the case as repayments by successfully developing countries would cease to refinance soft loan schemes. A big advantage of loans over grants, at least in theory, is that a given amount of official development assistance (ODA) can be leveraged in time as the first borrower partially finances the second and so on. In this way, formerly poor Asian countries continue to replenish IDA, the World Bank branch dealing with the poorest countries.
Nonetheless, this argument is weakened by the prevalence of “defensive lending”. Multilateral banks tend to lend to the same indebted countries resources supposedly to be repaid. Indeed, such defensive lending to African countries was prominent in the 90s, but not in the 80s. Obviously, debt was too high in the 1990s to be repaid. However, as the 80s demonstrate, this is not an intrinsic feature of soft loans. Moreover, the G-8 Finance Ministers have pledged to make contributions to the World Bank and African Development Bank to ensure their financial strength is not undermined by the debt deal. One should, however, also consider the fact that a grants-only policy would risk barring poor countries from ever raising money on international markets.
A second crucial issue is to what extent the modality of aid influences budget and allocative discipline. As grants do not imply a burden of repayment, they may undermine efforts to mobilise public revenues and thus lead to greater aid dependency. On the other hand, frequent debt forgiveness and serial defensive lending may already have undermined the disciplining force of concessional loans. After all, borrower governments already seem to perceive them as equivalent to grants.
The evidence available so far favours soft loans over grants. Soft loans have been utilised more efficiently than grants during the past three decades, despite repeated debt crises. Particularly in the case of least developed countries, grants stimulate the financing and implementation of projects that miss usual efficiency criteria, as a United Nations study (Odedokun, 2004) has shown. And the International Monetary Fund found out that that grants simply result in tax gifts to influential groups in countries, stimulating consumption rather than growth (Gupta et al, 2003).
Third, aid allows poor countries to smooth consumption in spite of natural calamities as simple as poor harvests due to bad weather. The poorest countries are particularly shock-prone and, accordingly, depend on aid most as they lack access to private finance to help them cope. ODA helps smooth consumption of the poor, whereas private lending has been shown to add to rather than to reduce consumption variability (Reisen and Soto, 2001). Grants can be designed as counter-cyclical devices, rising when a country is hit by exogenous shocks and falling in tranquil periods. However, the delay between the start of a crisis and grant disbursement may be so long as to making the instrument pro-cyclical. Lines of credit, instead, are most likely a better way to protect a country against adverse shocks. They are drawn upon rapidly by a country in trouble, and potentially repaid when the bad shock wanes away.
Problems, however, are exacerbated when a country suffers a sequence of shocks making its debts unsustainable. One merit of public lending is precisely the fact that, being subsidised, public creditors are more willing to accept losses than private ones. With private markets, debt crises are usually solved much more painfully, after prolonged negotiations between creditors and debtors. As debt cancellation, however, is always prone to moral hazard, clear rules of the game are needed, making relief contingent on adverse external shocks rather than proceedings in ad hoc fashion.
All summed up, loans serve useful functions in concessional finance. The international debate has so far proceeded as if we had to chose between total debt relief and grants on the one hand and little debt relief and loans on the other. There is another way of looking at the problem. Rich countries should chose to be generous with debt relief in order to be able to keep making soft loans.
Prof. Dr. Helmut Reisen
works at the OECD Developoment Centre, teaches at Basel University and has a column on economics in the German policy journal Internationale Politik. A longer version of this article was published in the OECD Observer of July 2005.
helmut.reisen@oecd.org
Literature:
Gupta, Sanjeev, Benedict Clemens, Alexander Pivorarsky, and Erwin R. Tiongson. 2003: Foreign Aid and Revenue Response: Does the Composition of Aid Matter?, IMF Working Paper 03/176, September
Odedokun, Matthew O., 2004: Multilateral and Bilateral Loans Versus Grants: Issues and Evidence. World Economy, Vol. 27, pp. 239-263, February 2004.
Reisen, Helmut and Marcelo Soto, 2001: Which Types of Capital Inflows Foster Developing Country Growth? International Finance, Vol. 4, No. 1, pp. 1 - 14.
Prof. Dr. Daniel Cohen
works at the OECD Development Centre, teaches at Ecole Normale Superieur in Paris, and writes a column for the French daily Le Monde.
Daniel.cohen@oecd.org
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