Clubbing in ParisIs 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

Debt Restructuring

Debt to MultilateralsDebt to official

creditorsDebt to commercial

BanksBond debt

No, it cannot be restructured exceptfor HIPC countries

Yes, at the Paris Club The terms of treatment

are determined onthe basis of per capita

and debt ratios (require bilateral agreements after

Paris Club agreements)or

Bilateral agreements

Yes, London ClubYes, with and

without collectiveaction clausese.g. Pakistan

UkraineEcuadorBelize

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

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

The changing role of the Paris Club

The Paris Club today is dealing with three sets of problems

1. Liquidity problems

2. Solvency problems

3. Debt relief for development expenditure

The treatment accorded may sometimes be the same for all three sets of problems

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

• 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

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

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.)  

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

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

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

The IMF's Approach to Debt sustainability:

Middle income countriesDebt 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

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

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.

Debt sustainability analysis for low-income countries:

A new World Bank approachThe 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.

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???

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?

Chart 1: Debt Treatments Accorded at the Paris Club 1998 - Jan. 2008

0 2 4 6 8 10 12 14 16 18 20

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Jan-08

Ad-Hoc Classic Cologne Houston Lyon Naples 50% Naples 67%Source: Data from www.clubdeparis.org/

Note: Evian Approach was used in 9 countries since 2004

Serial Rescheduling: A Gap in International Financial Architecture ?

Increase in debt and debt servicing

Estimates of financing gap

are based on forecasts of

growth and other variables

that are over optimistic

Houston Terms 

Repayment and Grace Periods: 2-8 years non-ODA, 10 years ODA 

Repayment Period: 5-10 years

 

Agreement with the Paris Club

- Further increase in debt servicing because non-ODA is negotiated at market interest rates- Bunching of repayments

In the near future repayment

problems surface again

 

Liquidity /Solvency Problems

 

Agreement with the Fund - a new

loan

 Agreement allows new credits from

Paris Club Creditors

This cycle continues leading to higher

levels of debt-stock and debt-servicing

A new arrangementwith the Fund

Increase in debt and debt servicing

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

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

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.

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.

.

• 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.

• 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.

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.

ECUADORReschedulings

(1996-2005)

Date PC/LC Terms

June 13, 2003

September 15, 2000

August 2000

Paris Club (Houston)

Paris Club (Houston)

London Club

Spreads in 2003 fell slightly on longer-term debt, while rising more on shorter-term debt.

Bank lending increased after 2000, going against regional and aggregate trend (e.g. all developing countries). No data on bank lending for 2003 agreement.

Trade credits increased after 2000.

PAKISTANReschedulings

(1996-2005)

Date PC/LC Terms

December 14, 2001

January 23, 2001

January 30,1999

Paris Club (Ad-hoc)

Paris Club (Houston)

Paris Club (Houston)

Spreads fell by half after the December 2001 agreement. Data is still unavailable for previous agreements.

Bank lending rose after every Paris Club agreement. For the 1999 agreement, this went against the general fall in regional and aggregate banking flows. For the 2001/3 agreements, it followed the trends. There are no London Club agreements in the GDF files.

Multilateral Claims rose after the 1999 agreement, and fell after the 2001 agreements.

Trade credits fell, stayed level and rose for the 1999, jan 2001 and Dec 2001 agreements respectively.

PeruReschedulings

(1996-2005)

Date PC/LC Terms

November 1996 London Club

Bank lending increased after the 1996 PC agreement. For the LC agreement, it fell sharply the month after the agreement.

Multilateral claims increased slightly after the 1996 PC agreement, then rose substantially after the LC agreement.

Trade credits rose after the 1996 PC agreement, and fell after the LC agreement.

RussiaReschedulings

(1996-2005)

Date PC/LC Terms

February 2000

August 1, 1999

November 1998

April 29, 1996

London Club

Paris Club (Ad-hoc)

London Club

Paris Club (Ad-hoc)

Spreads rose for the 1999 PC agreement, while they fell for both LC agreements.

Bank lending rose for each LC agreement and fell for each PC agreement. For the PC agreements, this went against regional trends, and aggregate trends in the 1996 case. For the LC agreements, this was in line with both trends in 1998 and against in 2000.

Multilateral claims did not move significantly except for a fall after the 1998 LC agreement, although this was part of a previous negative trend.

Trade credits did not move significantly except for a large increase after the 1996 agreement.