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Chapter 16Adjustment and External Debt in

Low-Income Countries

© Pierre-Richard Agénor

The World Bank

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Growth, External Debt, and Adjustment The Debt Overhang and the Debt Laffer Curve Measuring the Debt Burden Debt Rescheduling The HIPC Debt Initiative

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Debt crisis of early 1980s had severe impact in developing countries.

Closure of world capital markets led to inflationary financing of fiscal deficits, a slowdown in investment, and low rates of economic growth.

Servicing external debt continues to be a key concern for policymakers in low-income countries.

Has led to a variety of proposals aimed at ensuring that debt burden does not hamper capital formation and growth.

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Growth, External Debt, and Adjustment

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Illustrating the dynamics: An extension of Villanueva (1994).

National income, Q, given by,

Q = Y - r*D*,

r*: cost of borrowing,

D*: stock of external debt.

High foreign debt levels’ adverse impact on savings, investment, and growth.

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National income per unit of effective labor, q, is then,

q = k - r*d*,

y = k: intensive form Cobb-Douglas production function;

d* = D*/AL. Foreign saving, S*, equals changes in net external

debt,

D* = S* (4).

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Domestic saving, S, equals Sp + Sg with,

Sp = s(1 - )Q

Sg = Y - G.

K = I - K (7).

Changes in the capital stock,

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Domestic investment, financed by foreign and domestic savings,

I = S = (Sp + Sg) + S* (8)

Using (4), (7) and (8),

K + K - D* = S (9). .

Labor, grows exogenously,

L/L = (10).

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Following Villanueva’s learning-by-doing, labor efficiency,

A = (K/L) + A, > 0..

(10) implies growth rate in efficiency units is given by,

A/A + L/L = k + + (11).. .

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Change in foreign debt; dependent on difference between, r (k-1 - ) and r*;

D*/D* = (k-1 - - r*), > 0.

rf* : risk free rate

: risk premium; function of a country’s stock of debt in effective units of labor, d* and , exogenous market perceptions.

r* = rf* + (d*,), (13)

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Using (9), the change in the capital-effective labor ratio is given by,

k = (Sp + Sg) - K + D*

AL- [k + ( + )]k

..

Model composes a system of two differential equations in d* and k. See Figure 16.1 for graphical solution.

Figure 16.2.

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Figure 16.1Foreign Debt and the Capital-Effective Labor Ratio:

Long-Run Equilibrium

D

d*

E

A

D

K

KB

k~

d*~

k

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Figure 16.2Growth, Foreign Debt, and Fiscal Adjustment

kD

d*

E

E'

D

K

K

k~

d*~

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Implications: Fiscal adjustment reduces foreign debt burden and

has a permanent and positive effect on growth. Despite high marginal returns to capital, risk premium

may still be high enough to lead to credit rationing. In such cases, foreign aid can help both directly by

increasing aggregate investment and indirectly through conditional aid that may induce policy changes to reduce distortions.

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The Debt Overhang and the Debt Laffer Curve

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Medium-term uncertainty associated with heavy external debt burden can have adverse effects on domestic investment--a phenomenon that the model did not capture.

Helpman (1989), Krugman (1988), and Sachs (1989): beyond a certain point, external debt levels act as a marginal tax on investment; fraction of return on capital goes towards paying back creditors.

Debt overhang: when expected repayment on foreign debt falls short of its contractual value.

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Illustrating debt overhang: Consider an economy with current debt, D*, that must

be paid in the next period. Repayment given by,

R = min(D*, Y - Cmin).

Production function given by,

Ys = UsI, 0 < < 1,

s: state of nature,

I: investment output

Us: productivity shock; high (UH) and low (UL).

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Debt overhang exists if,

D* > YL - Cmin

If UH and UL differ such that,

YL = uLImax < uHI

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Debt Laffer curve Relates a country’s nominal debt obligations to the

market’s expectation of repayments on those obligations.

Figure 16.3: Y-axis (D*), X-axis (V-market expectations).

Laffer curve drawn as a straight line up until a point A, and concave down thereafter.

: probability of repayment falls below unity at debt levels above point A.

Results in a point E > A, that represents a maximum for V.

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Figure 16.3 The Debt Laffer Curve

Source: Adapted from Krugman (1989b).

E

V

0

A

45º

D

Zero probability of default

D*

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Thus, levels of D* higher than E result in lower V; country is said to be on the wrong side of the debt Laffer cure: reducing total debt would increase its market value; reduction in the debt tax rate would increase debt

servicing.

Froot and Krugman (1989): Tried to estimate debt Laffer curve for 35 countries. Used secondary market price of debt as proxy for V. Debt overhang exists when additional debt increases

the discount rate to such an extent that the marginal debt reduces the total market value of the debt stock.

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Found that in 5 of the 12 low-income countries, high debt-to-export ratios placed them on the wrong side of Laffer curves.

Two problems with results: Cannot be used when there is no secondary market

for debt. Classens (1990), observed debt Laffer curves, while

concave, rarely actually slope downwards.

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Deshpande (1997): Examined investment experience of 13 highly

indebted countries from 1971-92. Found significantly negative relationship between

external debt levels and investment. Argued that debt overhang impacts investment

through two channels: direct disincentive effect, fear of appropriation of

funds invested for debt servicing; indirect effect; via adjustment measures

undertaken to face debt-servicing difficulties, e.g. imports cuts and decreased public sector investment.

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Depshande implications: Complementarity between public and private capital

outlays implies that fiscal adjustment programs would tend to reduce private investment.

However, fiscal consolidation that reduces government spending, by reducing the crowding out effect of public sector demand for credit, may lead to an expansion in private investment.

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Eliminating debt overhang and capital formation renewal Debt relief beneficial to creditors, if increase in market

value of debt, V , is sufficient to make up for the decline the face value of debt outstanding.

Formal model (Krugman, 1989), see Figure 16.3

dV/dx = - + (1 - )(dI/dx)I-1 > 0,

: loss in good states of nature;

dI/dx: increase in marginal investment due to debt relief;

I -1: marginal product of investment.

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If dI/dx = 0, dV/dx = - < 0; barring investment effects,

debt relief never optimal from creditor viewpoint.

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Measuring the Debt Burden

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Debt Ratios Conventional measures:

Stock of debt to output; debt stock can be a misleading proxy, as it neglects both the duration and interest rates on debt.

Actual debt service to exports; a measure of a countries foreign exchange constraints, low value may reflect, in part, an unwillingness to pay.

Scheduled interest payments to exports. Second and third measure differ by concessions

made in rescheduling agreements and new lending.

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Debt ratios that capture fiscal impact Two conventional measures that capture fiscal

impact of external debt burden: ratio of scheduled interest payments to

government revenue; capacity measure, ratio considered low if less than .2, moderate at .2-.5, high if above .5;

ratio of scheduled interest payments to government expenditure.

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Alternative measures: Comparing present value of debt obligations against

the present value of estimated future export revenues. World Bank looks at present value of debt obligations

against current revenues. Practitioners consider ratios below 200% as

sustainable.

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Three weaknesses of indicators: Data requirements complex; considerable uncertainty

over future exports; volume and prices. Results sensitive to assumed discount rate. Ratios provide no information about a country’s credit

risk profile.

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Observed ratios

In many countries, conditions have worsened: In HIPC countries, external debt reaches $207 billion

in 1996, or 1.5 times GNP. Average ratio of foreign debt to exports was 450% in

1995. Ratio of actual debt service payments to exports was

17% in 1995. Ratio of actual debt service to government revenues

reached 70% in Uganda from 1992-94. Figures 16.4 to 16.8.

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Figure 16.4aTotal External Debt Service

(In percent of GDP)

Source: World Bank.

Benin

Burundi

Cameroon

Côte d'Ivoire

Ethiopia

Gabon

Ghana

Kenya

Malawi

Nigeria

Tanzania

Zimbabwe

0 5 10 15

Africa

Bangladesh

India

Indonesia

Korea

Malaysia

Nepal

Pakistan

Philippines

Sri Lanka

Thailand

0 1 2 3 4 5 6 7 8 9

Asia

1980 1995

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Figure 16.4bTotal External Debt Service

(In percent of GDP)

Source: World Bank.

Algeria

Egypt

Jordan

Mauritania

Morocco

Oman

Syria

Tunisia

Turkey

Yemen

0 2 4 6 8 10 12

Middle East and North Africa

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Ecuador

Jamaica

Mexico

Peru

Uruguay

Venezuela

0 5 10 15 20

Latin America

1980 1995

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Figure 16.5aTotal External Debt Service

(% of exports of goods and services)

Source: World Bank.

1980 1995

Benin

Burundi

Cameroon

Côte d'Ivoire

Ethiopia

Gabon

Ghana

Kenya

Malawi

Nigeria

Tanzania

Zimbabwe

0 10 20 30 40 50

Africa

Bangladesh

India

Indonesia

Korea

Malaysia

Nepal

Pakistan

Philippines

Sri Lanka

Thailand

0 10 20 30 40 50

Asia

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Figure 16.5bTotal External Debt Service

(% of exports of goods and services)

Source: World Bank.

1980 1995

Argentina

Bolivia

Brazil

Chile

Colombia

Costa Rica

Ecuador

Jamaica

Mexico

Peru

Uruguay

Venezuela

0 20 40 60 80 100 120

Latin America

Algeria

Egypt

Jordan

Mauritania

Morocco

Oman

Syria

Tunisia

Turkey

Yemen

0 10 20 30 40 50

Middle East and North Africa

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Figure 16.6Heavily Indebted Poor Countries: Debt Indicators, 1992-94

(In percent)

Source: United Nations.

Angola

Benin

Bolivia

Burkina Faso

Burundi

Cameroon

Central African R

Chad

Congo

Côte d'lvoire

Equatorial Guinea

Ethiopia

Ghana

Guinea

Guinea-Bissau

Guyana

Honduras

Kenya

Lao

Liberia

Madagascar

Mali

Mauritania

Mozambique

Myanmar

Nicaragua

Niger

Nigeria

Rwanda

SaoTomé & Prínc

Senegal

Sierra Leone

Somalia

Sudan

Togo

Uganda

Tanzania

Viet Nam

Yemen

Zambia0 20 40 60 80

Paid debt service/

government revenue(excluding grants)

Angola

Benin

Bolivia

Burkina Faso

Burundi

Cameroon

Central African R

Chad

Congo

Côte d'lvoire

Equatorial Guinea

Ethiopia

Ghana

Guinea

Guinea-Bissau

Guyana

Honduras

Kenya

Lao

Liberia

Madagascar

Mali

Mauritania

Mozambique

Myanmar

Nicaragua

Niger

Nigeria

Rwanda

SaoTomé & Prínc

Senegal

Sierra Leone

Somalia

Sudan

Togo

Uganda

Tanzania

Viet Nam

Yemen

Zambia0 2,000 4,000

Debt to exports ratio

( present value of external debt)

Angola

Benin

Bolivia

Burkina Faso

Burundi

Cameroon

Central African R

Chad

Congo

Côte d'lvoire

Equatorial Guinea

Ethiopia

Ghana

Guinea

Guinea-Bissau

Guyana

Honduras

Kenya

Lao

Liberia

Madagascar

Mali

Mauritania

Mozambique

Myanmar

Nicaragua

Niger

Nigeria

Rwanda

SaoTomé & Prínc

Senegal

Sierra Leone

Somalia

Sudan

Togo

Uganda

Tanzania

Viet Nam

Yemen

Zambia0 20 40 60 80

Paid debt service/

scheduled debt service

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Figure 16.7aHeavily Indebted Poor Countries:

Debt to Exports Ratio and Per Capita GDP Growth Rate 1/(In percent)

Source: United Nations.1/ Excluding Ethiopia, Cameroon, Congo, Nicaragua, Somalia, and Sudan.

-5 -4 -3 -2 -1 0 1 2 3 4 5

0

500

1,000

1,500

2,000

2,500 External debt measured at face value (1992-94)

Per capita real GDP growth rate (1985-94)

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Figure 16.7bHeavily Indebted Poor Countries:

Debt to Exports Ratio and Per Capita GDP Growth Rate 1/(In percent)

Source: United Nations.1/ Excluding Ethiopia, Cameroon, Congo, Nicaragua, Somalia, and Sudan.

-5 -4 -3 -2 -1 0 1 2 3 4 5

0

200

400

600

800

1,000

1,200

1,400 External debt measured in present value terms (1992-94)

Per capita real GDP growth rate (1985-94)

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Figure 16.8Heavily Indebted Poor Countries:

Paid Debt Service/Exports and Per Capita GDP Growth Rate, 1985-94 1/(In percent)

Source: United Nations.1/ Excluding Ethiopia, Cameroon, Congo, and Uganda.

-5 -4 -3 -2 -1 0 1 2 3 4 5

0

10

20

30

40

Per capita real GDP growth rate

Pai

d de

bt s

ervi

ce/e

xpor

ts o

f goo

ds a

nd s

ervi

ces

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External Solvency Measures: Current account deficit in an open economy defined

by,

CA = D* - D-1* = -(Y - A) - NT + i*D-1

*

A: domestic absorption;

NT: net transfer respeipts from abroad;

i*: interest rate on foreign liabilities. This yields,

D* = (1 + i*)D-1* - Z

Z: net external surplus, the trade balance plus net transfers.

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Setting d* = D*/ Y, z = Z/Y and g: constant growth rate of output, and applying the no ponzi game condition,

)h = 1

1 + g1 + i*

d0*

( hzh (23)

By (23) external solvency requires that current ratio of net foreign liabilities to output be less than or equal to the maximum level of debt that can be sustained by prospective net external surpluses.

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Debt Rescheduling

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Two approaches to debt repayment (see Kletzer, 1988) Ability-to-pay approach:

required debt service exceeds debt servicing capacity; in general a solvency rather than liquidity problem.

Willingness-to-pay approach.

Two types of debt relief approaches: flow reschedulings; stock-of-debt reschedulings.

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Toronto terms: From October 1988-June 1991, terms of concessions

as outlined by the Paris Club: Option A, or partial cancellation. 1/3 of debt

canceled, remaining two thirds rescheduled over 14 years with 8 year grace period.

Option B, or extended maturities. Debt rescheduled over 25 years with 8 year grace period.

Option C, or concessional interest rates. Debt rescheduled over 14 years, 8 year grace, with interest rate set at market rate - 350 basis points.

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London terms: December 1991-December 1994; 50% reduction in

NPV terms.

Naples terms: Since January 1995, terms of concessions as outlined

by the Paris Club: Eligibility; decided by creditors on individual basis. Concessionality; most receive 67% NPV

reduction on non-ODA (official development assistance) debt. Countries with per capita income greater than $500 and debt/exports < 350% receive 50% NPV reduction.

Coverage; non ODA pre-cut-off date debt decided on individual basis.

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Choice of options; DR (Debt reduction; 23 year maturities with 6 year grace) or DSR (Debt service reduction; 33 year maturities with concessional interest rates).

Capitalization of moratorium interest option. ODA credits; pre-cutoff date credits rescheduled

on the original concessional interest rates over 40 years with 165 years’ grace.

Uganda first low-income rescheduling country to receive stock of debt rescheduling under Naples term.

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The HIPC Debt Initiative

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For HIPCs, multilateral debt a large fraction of total external debt, about 31% at the end of 1996, 42% for bilateral official creditors and 12% for private creditors.

HIPC Debt Initiative: joint World Bank-IMF proposal, September, 1996:

addresses debt owed to multilateral official creditors;

requires countries to show a track record of good policy performance as monitored by the IMF and the Bank;

6-year performance period, two stages of implementation.

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First Stage: Initial 3-year period; debtor country must establish

track record with Paris Club providing flow rescheduling on Naples terms.

Subsequent decision point reached after a three-year track record of good performance.

Debt sustainability analysis undertaken to determine eligibility for further debt relief.

Three possible scenarios: If debt sustainability possible in three years, country

is deemed capable of exiting debt rescheduling process.

If sustainability deemed not possible, then country becomes eligible for further debt relief.

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In cases of doubt, flow rescheduling under Naples terms.

Second Stage: Normally three years. Debt relief through flow rescheduling, up to 80% of

present value of Paris Club debt. At completion point of second stage, Paris Club

provides 80% reduction in NPV of debt stock.

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Eligibility:

Debt sustainability analysis determines eligibility and amount of debt relief based on following criteria:

ratio of NPV of debt-to-export ratio between 200-250% by completion point;

debt-service-to-exports ratio between 20-25% at completion point;

various measures of vulnerability; ratio of NPV of debt to fiscal revenue below 280%

with 2 other criteria: export-to-GDP ratio of at least 40% and fiscal revenue to GDP of 20%.