Debt Crises in the Least Developed Countries (LDC) and the Impact of the Debt Reforms in LDC - Essay Example

Learning Lessons from Least Developed Countries Debt is a tool that, when used prudently, helps governments plan and pay for large public works projects. Borrowing is essential when the cost of a necessary, worthwhile capital investment is prohibitive. Where the state undertakes these types of financial obligations to fulfil needed improvements or expansions to the state’s infrastructure, just as with one’s personal finances, it is vital that great care be exercised to determine what the state borrows for, how much it borrows, for how long and when it borrows—all have critical importance to the states overall economic health. Much like personal finances, debt should not be passed along to the next generation without an accompanying asset (Hevesi 2005, p.3). International debt is a major issue for many of the world’s poorest nations. Loans taken by developing countries to pay for previous development projects still weigh heavily on current national budgets. These nations often desperately need to increase budgets for education, health care, and environmental protection, but must instead pay back loans (International Debt 2005). In 1998, the total debt stock of least developed countries (LDCs) amounted to US$154 billion. This is almost four times as high as the LDCs debt stock of 1980 (Eurodad 2001, p.11). The Harvard University Centre for the Environment’s Forum on Religion and Ecology (2005) cites that a major reason governments incur debt is that they are attempting to stabilize the value of their currencies. A government borrows an amount of another, more stable currency ["hard currency"], and then sells that currency to its own domestic companies in order to keep the price of foreign currency from rising, which would make the value of the nations own currency fall. In its latest triennial review of the list of Least Developed Countries in 2003, the Economic and Social Council of the United Nations used the following three criteria for the identification of the least developed countries (LDCs): (1) a low-income criterion, based on a three-year average estimate of the gross national income (GNI) per capita [under $750 for inclusion, above $900 for graduation], (2) a human resource weakness criterion, involving a composite Human Assets Index (HAI) based on indicators of: (a) nutrition; (b) health; (c) education; and (d) adult literacy; and (3) an economic vulnerability criterion, involving a composite Economic Vulnerability Index (EVI)1. Eurodad and the United Nations University World Institute for Development Economics Research (2001, p.1) cites that debt presents one of the main stumbling blocks to LDCs’s social and economic development. Many LDCs have unsustainable debt burdens, in addition to the 31 LDCs that are classified as heavily indebted poor countries (HIPCs). At least six other LDCs have, even according to rather conservative and narrowly defined World Bank and IMF criteria, debt levels that exceed their repayment capacity. When the concept of debt sustainability is approached from a human and social development perspective—and there is no other way to approach debt sustainability in a country such as Bangladesh where 78% of the people live on US$ 2 a day—many more LDCs have an unsustainable debt level. Many of the world’s least developed countries face a huge debt burden. The low productivity of investment, slow export growth and large terms-of trade shocks, together with weak state capacities (including corruption), are all key causes of the build-up of an unsustainable external debt burden (United Nations 2002, p. 150). The amount of credit issued to these countries by bilateral creditor countries, multilateral agencies, and to a lesser extent commercial banks, has led to a piling up of the debt burden and to debt service requirements that surpass by far these countries’ repayment capacities (Eurodad & the UNU/WIDER 2001, p.4). . According to Dell (1991), although small and poor countries are not likely to start a world-scale economic crisis, many of them have been faced with a series of destructive debt crisis. Dell (1991) also provides a sobering lesson for other countries: in many low-income countries of all regions, debt ratios to exports are as large as, or larger than corresponding ratios in major debtor countries. In 1984, the World Bank reports Sudan’s case that even if arrears currently outstanding were consolidated and rescheduled on 1983 Paris Club terms with a 10% interest rate, Sudan would face debt service ratios averaging 80%-90% for the rest of the 1980s. The World Bank attributes this phenomenon to debt rescheduling, mostly done in conventional terms, which gave short-term relief at the expense of increasing the debt service for a longer time in the future. The case of African countries such as the Central African Republic, Madagascar, Somalia and Zaire are no different from Sudan’s (Dell 1991, p.148). In her study on the impact of external debt on the Ethiopian economic growth, Desta (2005) writes that the accumulated large stock of external debt and its repayments by LDCs act as an impediment to their economic growth and development. The study sought to find out if a large stock of accumulated external debt has a negative impact on economic growth in Ethiopia, through the debt overhang2 effect and if external debt servicing has a negative impact on economic growth in Ethiopia, through the crowding out effect. Researchers like Sachs (1989) and Krugman (1989) have analyzed the "crowding out" effect of debt service payments, arising from the fact that many highly indebted poor countries frequently divert resources, including foreign aid and other foreign exchange resources, to take care of pressing debt service obligations, particularly debt owed to the multilateral institutions, which is deemed "nonreschedulable". She states that debt crisis experienced by Sub-Saharan African countries which, it has been argued, resulted from a complex combination of elements, some of which are external to the individual debtor countries, while others are direct results of wrong policies. She writes: Ethiopias external debt has changed significantly in magnitude, structure and composition over the last quarter of the 20`h century. In 1975, it stood at about US$ 343.7 million, equivalent to 14% of the GDP, and US$ 9.1 billion (214% of GDP) in 1991. As at June 30, 1999 this figure had increased to an equivalent of US$ 10.2 billion and very recently, as at 29 April 2004, following the debt relief granted in accordance with development initiatives designed to benefit the HIPCs, it had declined to US$ 3 billion. Therefore, the problem is how economic growth will be affected by the accumulated external debt stock and the repayment of debt in the long run (Desta, 2005). What impact does an unsustainable debt have? Unsustainable debt levels keep countries caught in a cycle of poverty, aid dependency, and unsustainable debt levels. The most obvious stumbling block that unsustainable debt represents towards economic and social development and poverty reduction is the cash flow implication of debt service obligations, the so-called crowding out effect. As governments have to pay large sums of money to foreign creditors, less can be spent on recurrent social expenditure or essential investments, such as infrastructure, health or education. LDCs, with extremely low levels of social and human development often have to pay more to foreign creditors than they can afford to invest in basic health care or education. For example, in Burkina Faso, where one out of five children dies before the age of five, in 1998 the government spent as much on debt as on health (US$5 per capita in 1998 and US$5 per capita in 190-1998). And in Niger, where 78 percent of adult males and 93 percent of adult women are illiterate, debt service amounted to 3.1% of GNP in 1998, while spending on education was only 2.3% of GNP. This may seem a considerable amount compared to some other severely indebted countries, but it is almost nothing compared to what middle and high income countries spend on health in the same period: respectively US$199 and US$2585 per capita annually (Eurodad 2001, p.8). The 2002 Least Developed Countries Report by the United Nations also found out that there is a very high probability that any LDC that exports primary commodities has an unsustainable external debt and that there is a close association between falling and volatile commodity prices and unsustainable external debt. It also said that the debt problem of commodity-exporting LDCs is rooted in the low level of domestic resource mobilization, low rates of return on investment, the vulnerability to external shocks and slow export growth. For debt sustainability to be achieved, one major condition is that the rate of growth of exports must be greater than the rate of interest on outstanding debt. What distinguishes the commodity-exporting LDCs from others is that they have had much slower export growth rates. As a result, they have a strong propensity to develop debt problems and also to fall back into debt after debt relief. The commodity price recession of the early 1980s is a root cause of indebtedness in many LDCs, and terms-of-trade shocks associated with movements in primary commodity prices can at all times push poor countries back into unsustainable indebtedness (United Nations 2002, p.152). While debt is a useful tool, it should not be the sole mechanism to address the state’s infrastructure needs. In moderation debt is acceptable. The key word is moderation (Hevesi 2005, p.5). Eurodad (2001) also states that one of the reasons why LDCs’ debt has been piling up in the past is irresponsible borrowing and lending practises. In order for a debt management policy to be successful, it must balance need with capacity and intergenerational equity. Debt level targets should be manageable to avoid consuming other state spending priorities (Hevesi 2005, p.93). Loans should be productive: resources should be generated to ensure that the loan can be repaid. Often this is not the case. Examples are loans for white elephant projects, loans for military expenditures, defensive lending [i.e. loans to refinance debts], but also corruption. In the case of corruption, many civil society organisations, particularly organisations from the South, point out that the debts that piled up under the rule of corruptive dictatorial and undemocratic governments should be considered ‘illegitimate debts’. The people living in these countries now bear the burden of these debts. For example, Nigeria’s former military regime, which is to a large extent responsible for the country’s enormous debt burden, has transferred substantial sums of money to foreign bank accounts. To prevent LDCs from falling into the same debt trap as they are now, much deeper debt relief is needed, as to make sure that countries do not need new loans to service their debts. Furthermore, current borrowing and lending practices should also be changed (Eurodad 2001, p.34). Study done by Clements et al. (2005) found that although high levels of debt can depress economic growth in low-income countries, external debt slows growth only after its face value reaches a threshold level estimated to be about 50 percent of GDP (or, in net present value terms, 20–25 percent of GDP). These findings imply that the substantial reduction in external debt projected for the countries participating in the HIPC Initiative would directly add 0.8–1.1 percent to their per capita GDP growth rates. Indeed, the positive effects of debt relief may already be reflected in some of the healthier growth rates achieved by these countries in the past few years relative to their poor performance in the 1990s [Annual GDP growth averaged 1.2 percent in 2000–02, compared with 0.2 percent during the 1990s.]. A major challenge LDCs face is ensuring that a reasonable resource level is allocated for debt servicing to avoid the risk of default and to maintain conducive relations for debt relief negotiations with its debtors. These countries also face the challenge of ensuring that budget resources are released in time to produce debt service payments. Much of Nigeria’s debt stock build-up was significantly accounted for by the capitalization of interest arrears and penalties for default. It is pertinent at this juncture to elaborate on the applicable penalties in case of default in debt service payments (DEBT: Challenge to Nigeria’s Sustainable Development 2006). Citing the effects of debt reform in LCDs, the Economic Commission for Africa (1999, p.1) reported that in 1998, African Least Developed Countries achieved improved Gross Domestic Product (GDP) with the groups overall output rising by 4.1% as against 2.4% in 1997. The improvement was attributed to a twin formation: the favourable weather conditions in most of these countries; and reform programmes that have been put in place, since mid 1980s. The reforms had allowed for deepening of market-based private sector driven policies. Defaulting on loans remains to be a very bitter pill for LDCs. Apart from increased speculation from its creditors, defaulting on debts carries stiff consequences. In the case of Nigeria, the present debt contracts carry enormous legal obligations. For example, under existing terms, if par bonds on promissory notes payment is not received as and when due, creditors could attain the assets of the central bank and NNPC3 anywhere in the world, as Nigeria has expressly waived her sovereign immunity under the terms of the agreement (DEBT: Challenge to Nigeria’s Sustainable Development 2006). . Conclusion Debt helps governments in LDCs plan and pay for large projects for education, health, and public works among others. However, when LDCs’ debt pile up due to irresponsible borrowing and lending practises, unproductive loans such as white elephant projects, and when the rate of export growth is allowed to hover below the interest rate to be paid on outstanding debt, this debt of LDCs becomes a stumbling block towards economic and social development and poverty reduction. Governments must make efforts to stabilize commodity prices, perk up their levels of domestic resource mobilization, increase rates of return on investments and raise export growth, and finally protect themselves from external shocks. Debt reform not only includes maintaining a manageable level of debt but also decreasing corruption incidence in LDCs, allocating a reasonable resource level for debt servicing to avoid the risk of default, without sacrificing than they can afford to invest in basic health care or education. This is supported by study done by Clements et al. (2005) concluding that substantial reduction in external debts translates to an increase in per capita GDP growth rates in LDCs. Chart 1. The International Poverty Trap of Commodity-Dependent LCDs Source: United Nations, Escaping the Poverty Trap, The Least Developed Countries Report 2002, p.149. Table 1. External Debt Sustainability in LDCs grouped according to Export Composition, 1998-20000 Source: United Nations, Escaping the Poverty Trap, The Least Developed Countries Report 2002, p.151. Reference List Clements, B, Bhattacharya, R & Nguyen, T 2005, Can Debt Relief Boost Growth in Poor Countries?, Economic Issue No. 34. Retrieved March 3, 2006 from http://www.imf.org/External/Pubs/FT/issues/issues34/index.htm Dell, S 1991, International Development Policies, Duke University Press, United States of America. Retrived 4 March 2006, from Duke University Press: http://books.google.com.ph/books?ie=UTF-8&hl=en&id=O24-NwZplt8C&dq Desta, MG 2005, External Debt and Economic Growth in Ethiopia (Abstract). Retrived April 4, 2006 from http://unpan1 .un.org/intradoc /groups/public /documents /IDEP /UNPAN020636.pdf DEBT: Challenge to Nigeria’s Sustainable Development 2006. Retrieved March 3, 2006, from http://www.nigeriafirst.org/article_55.shtml Economic Commission for Africa 1999, Economic Performance in African Least Developed Countries 1999: The Challenges of Poverty Reduction in Africa. Retrieved March 2, 2006 from http://unpan1.un.org/intradoc/groups/public/documents/idep/unpan005206.pdf# search = debt%20reform%20in%20least%20developed%20countries EURODAD and the World Institute for Development Economics Research (United Nations University) 2001, Debt Reduction for Poverty Eradication in the Least Developed Countries. Retrieved March 3, 2006 from http://www.wider.unu.edu/conference/conference-2001 2/poste r%20 papers / EURODAD%20Mills.pdf Forum on Religion and Ecology 2005, International Debt. Retrieved March 3, 2006 from http://environment.harvard.edu/religion/disciplines/policy/trends/intldebt.html Hevesi, A 2005, ‘A Need for Reform’, New York State’s Debt Policy. Retrieved March 4, 2006, from http://www.osc.state.ny.us/press/debtreport205.pdf Rajan, R 2005, ‘Institutional Reform and Sovereign Debt Crises’, Cato Journal, vol. 25, no. 1. Retrieved March 4, 2006 from http://www.cato.org/pubs/journal/cj25n1/cj25n1-3.pdf UNITED NATIONS 2002, ‘Escaping the Poverty Trap’, The Least Developed Countries Report 2002. Retrieved March 4, 2006 from http://www.unctad.org/en/docs/ldc2002_en.pdf UNITED NATIONS Economic and Social Council 2003, The Criteria for the Identification of the LDCs. Retrieved March 4, 2006 from http://www.un.org/special-rep/ohrlls/ldc/ldc%20criteria.htm Read More