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CGD experts have played an important role in debt relief deals for several developing countries. We provided technical analysis that led to a $30 billion reduction in Nigeria’s debt, and analysis that helped shape debt reductions agreements for Liberia and South Sudan.
When the world’s finance ministers and central bank governors assemble in Washington later this month for their semi-annual IMF meeting, they will no doubt set aside time for yet another discussion of the lingering debt problems in the Eurozone or how impaired bank debt could impact financial stability in China. They would do well to also focus on another looming debt crisis that could hit some of the poorest countries in the world, many of whom are also struggling with problems of conflict and fragility and none of which has the institutional capacity to cope with a major debt crisis without lasting damage to their already-challenged development prospects.
Nearly two decades ago, an unprecedented international effort—the Heavily Indebted Poor Countries (HIPC) Debt initiative—resulted in writing off the unsustainable debt of poor countries to levels that they could manage without compromising their economic and social development. The hope was that a combination of responsible borrowing and lending practices and a more productive use of any new liabilities, all under the watchful eyes of the IMF and World Bank, would prevent a recurrence of excessive debt buildup.
Alas, as a just-released IMF paper points out, the situation has turned out to be much less favorable. Since the financial crisis and the more recent collapse in commodity prices, there has been a sharp buildup of debt by low-income countries, to the point that 40 percent of them (24 out of 60) are now either already in a debt crisis or highly vulnerable to one—twice as many as only five years ago. Moreover, the majority, mostly in Sub-Saharan Africa, have fallen into difficulties through relatively recent actions by themselves or their creditors. They include, predictably, commodity exporters like Chad, Congo, and Zambia who have run up debt as they adjusted (or not) to revenue loss from the collapse in oil and metals prices. But they also include a large number of diversified exporters (Ethiopia, Ghana, and the Gambia among others) where the run-up in debt is a reflection of larger-than-planned fiscal deficits, often financing overruns in current spending or, in a few cases, substantial fraud and corruption (the Gambia, Moldova, and Mozambique).
The increased appetite of sovereign borrowers has been facilitated by the willingness of commercial lenders looking for yield in a market awash with liquidity, and by credit from China and other bilateral lenders who are not part of the Paris Club. It is striking that between 2013-16, China’s share of the debt of poor countries increased by more than that held by the Paris Club, the World Bank and all the regional development banks put together.
Nor do traditional donors come out entirely blameless. Concessional funding for low-income countries from the (largely OECD) members of the DAC fell by 20 percent between 2013–16, precisely the period in which their other liabilities increased dramatically. As for the IMF and World Bank, while it may have been wishful thinking to hope they could prevent a recurrence of excessive debt, it was not unreasonable to expect that they would have been more aware as this buildup was taking place and sounded the alarm earlier for the international community. There is also a plausible argument that excessively rigid rules limiting the access of low-income countries to the non-concessional funding windows of the IMF and World Bank left no recourse but to go for more expensive commercial borrowing, with the consequences now visible.
How likely is it that these countries are heading for a debt crisis, and how difficult will it be to resolve one if it happens? The fact that there has been a near doubling in the past five years of the number of countries in debt distress or at high risk is itself not encouraging. And while debt ratios are still below the levels that led to HIPC, the risks are higher because much more of the debt is on commercial terms with higher interest rates, shorter maturities and more unpredictable lender behavior than the traditional multilaterals. More importantly, while the projections for all countries are based on improved policies for the future, the IMF itself acknowledges that this may turn out to be unrealistic. And finally, the debt numbers, worrying as they are, miss out some contingent liabilities that haven’t been recorded or disclosed as transparently as they should have been but which will need to be dealt with in any restructuring or write-off.
The changing composition of creditors also means that we can no longer rely on the traditional arrangements for dealing with low-income country debt problems. The Paris Club is now dwarfed by the six-times-larger holdings of debt by countries outside the Paris Club. Commodity traders have lent money that is collateralized by assets, making the overall resolution process more complicated. And a whole slew of new plurilateral lenders have claims that they believe need to be serviced before others, a position that has yet to be tested.
It is too late to prevent some low-income countries from falling into debt difficulties, but action now can prevent a crisis in many others. The principal responsibility lies with borrowing country governments, but their development partners and donors need to raise the profile of this issue in the conversations they will have in Washington. There is also an urgent need to work with China and other new lenders to create a fit-for-purpose framework for resolving low-income country debt problems when they occur. This is not about persuading these lenders to join the Paris Club but rather about evolution towards a new mechanism that recognizes the much larger role of the new lenders, and demonstrates why it is in their own interest to have such a mechanism for collective action.
Traditional donors also need to look at their allocation of ODA resources, which face the risk of further fragmentation under competing pressures, including for financing the costs in donor countries of hosting refugees. Finally, the assembled policymakers should urge the IMF to prioritize building a complete picture of debt and contingent liabilities as part of its country surveillance and lending programs, and to base its projections for future economic and debt outcomes on more realistic expectations. They should also commission a review to examine the scope for increased access to non-concessional IFI funding for (at least) the more creditworthy low-income borrowers.
It is the poor and vulnerable that pay the heaviest price in a national debt crisis. They have the right to demand action by global financial leaders to make such a crisis less likely.
International actors have criticized decisions by the Trump administration to reject the Paris Climate Accord, abandon the Trans Pacific Partnership, and withdraw from a United Nations declaration intended to protect the rights of migrants. However, there is one international body, the Paris Club, whose members may be rooting for the United States to leave. That’s because, in the absence of congressional action, continued US membership in the Paris Club could impair the economic prospects of some of the poorest countries in the world.
Some context on the Paris Club
The Paris Club, which first convened some 60 years ago, is a group of government representatives whose most important function is to negotiate agreements to reduce or relieve outstanding debt between debtor countries and Paris Club members. Over the years, the Club has concluded 433 agreements with 90 different debtor countries, with the number of agreements peaking at 24 in 1989. In recent years, as shown in the chart below, there has been little to no activity:
Paris Club Agreements by Calendar Year
In its negotiations with debtor countries, the Club operates in accordance with six principles:
Case by case: The Paris Club makes decisions on a case-by-case basis in order to tailor its action to each debtor country's individual situation.
Comparability of treatment: A debtor country that signs an agreement with the Paris Club agrees to seek comparable terms from all bilateral creditors, including non-Paris Club commercial and official creditors.
Conditionality: Agreements with debtor countries will be based on IMF reform programs that help ensure the sustainability of future debt servicing.
Consensus: Paris Club decisions cannot be taken without a consensus among the participating creditor countries.
Information sharing: Members will share views and data on their claims on a reciprocal basis.
Solidarity: All members of the Paris Club agree to act as a group in their dealings with a given debtor country.
The United States has historically played a major role in the Paris Club, due, in part, to the large number of loans and guarantees it has extended to other countries over the years. But as the result of a shift from loans to grants, US credit exposure to sovereign governments has fallen dramatically—from over $90 billion USD in 1999 to roughly $35 billion today—and much of what remains is in the form of guarantees. The number of countries that owe the United States money or have a guarantee has dropped from 135 to 85 over the same period.
US Government Credit Exposure to Official Obligors
Here’s the problem:
In cases where the US government is still a creditor, the consensus principle (cf. principle 4 above) stops any Paris Club debt negotiation from proceeding without US participation, but the United States is unlikely to participate in any agreement that requires debt reduction due to current budget constraints.
At the beginning of each negotiation process, the IMF seeks assurances (“financing assurances”) from individual Paris Club creditors that they are willing to provide the debt relief needed to fill the financing gap built into the debtor country’s IMF program (cf. principle 3 above). Historically, the US Paris Club representative has not provided such assurances without having the necessary authorization and appropriation of funds for debt reduction from Congress.
Under the Federal Credit Reform Act of 1990, an appropriation by Congress of the estimated cost of debt relief—on a net present value basis—is required for debt reduction. And there is a value for all debt owed to the United States, even if it hasn’t been serviced in decades (which is the case for several countries that currently owe money to the United States).
Unfortunately, the United States currently lacks any authorization or appropriation for debt relief so it is not in a position to provide the IMF with any financing assurances. Moreover, the outlook for future US funding isn’t great. The administration’s FY 20198 budget request seeks reduce the foreign assistance budget by almost 30 percent and there is no request to authorize debt relief. Congress, too, has shown little interest in providing funding for debt relief. Appropriators consistently rejected requests to fund the US commitment to the Multilateral Debt Relief Initiative—to the point where the Obama administration stopped asking.
What’s more, the US budget process itself creates an enormous obstacle to future US participation in Paris Club agreements. The process for formulating a budget begins almost a year before the fiscal year begins, which means that Treasury Department planners are asked to anticipate the need for funding almost two years in advance of an actual request for financing. This is at odds with events in the real world, where liquidity and solvency issues in debtor countries can evolve quickly.
To date, neither the executive nor the legislative branch have demonstrated a willingness to establish “rainy day” funds for unforeseen emergencies. In the past, this problem has been avoided by packaging a request for debt relief money as part of a large, multilateral initiative such as the Heavily Indebted Poor Country Initiative, or by including it in a supplemental budget request for an emergency, such as defense spending for Iraq or the emergency spending for Tsunami relief. But amid growing budget pressures, future debt relief cases are unlikely to be able to take advantage of these vehicles.
The United States and the Paris Club are likely to confront this US funding problem head on when a country from sub-Saharan Africa comes to the Paris Club for debt relief, whether that’s one of the three remaining HIPC Initiative countries—Sudan, Somalia, and Eritrea—or a country currently in debt distress such as Zimbabwe.
A potential nightmare scenario
In the summer of 2018, the IMF and the Government of Somalia agree on a staff-monitored program (SMP) that meets the standards needed for HIPC debt relief. Somalia fulfills the SMP requirements and requests an IMF funded program in 2019. So, in July of 2019, the IMF requests financing assurances from Paris Club members, at which point the United States refuses to provide assurances—due to the absence of authority and lack of funding—and stops Somalia from receiving debt relief despite support from every other creditor. Condemnation of the US position begins.
What can be done to prevent this nightmare scenario? I offer three potential options:
In the FY 2019 budget, Congress should re-institute language authorizing a transfer of resources from State Department to Treasury to cover the cost of bilateral debt relief. While the Treasury Department has been the US agency that has traditionally had to include the appropriation for debt relief in its budget, it makes more sense for State Department to take on this role, particularly given that Treasury has almost $2 billion USD in unmet commitments to the multilateral development banks.
Like many states have done to protect themselves from unforeseen emergencies, the executive branch should work with Congress to establish a “rainy day” fund that can be tapped when needed to cover the cost of bilateral debt relief. Congressional oversight could proceed by subjecting its use to a rigorous congressional notification process.
The executive branch and Congress should work to secure an understanding that the loans extended to countries before the Federal Credit Reform Act went into effect and which have not been serviced in decades are “uncollectible” and that no authorization and/or appropriation is required for the United States to participate in a Paris Club debt treatment agreement (the legal basis for doing this is subject to interpretation).
In the absence of one of these three options or some other creative means to address the lack of funding for bilateral debt relief, the United States will find itself in the position of preventing some of the poorest countries in the world from normalizing their relations with the international financial community—stifling their access to support for critical development needs. The administration and Congress can work in concert to avoid this truly untenable position, but if they fail, the United States may no longer be welcome in Paris.
Last October, the US government permanently removed US sanctions on Sudan, presumably in return for various actions by the Khartoum government, such as backing Saudi-led efforts in Yemen, cutting off relations with North Korea, and progress on human rights. While removal of the sanctions was obviously welcomed by President Omar al-Bashir, the US said nothing about supporting debt relief. As I pointed out in a previous blog post, debt relief is high on the Sudanese government’s agenda since it would remove one of the final hurdles to normalization with the international financial community. This week’s budget proposals coming out of the White House indicate that Sudan may finally get its wish—but there’s something weird about where the money comes from. Here I offer an alternative.
Sudan is one of three remaining countries that are eligible for comprehensive debt relief under the Heavily Indebted Poor Country (HIPC) Initiative, launched in 1996. This debt relief would allow Sudan to normalize relations with its creditors, including international financial institutions (IFIs) such as the World Bank and the African Development Bank, paving the way for new financing. HIPC debt relief would eliminate Sudan’s arrears to the IFIs as well as bilateral creditors.
According to a recent IMF assessment, 39 percent of Sudan’s public and publicly guaranteed external debt is owed to non-Paris Club creditors, 36 percent to Paris Club creditors, 11 percent to IFIs, and 14 percent to commercial creditors. Virtually all of this debt is in arrears, including debt to the United States. The USG is reportedly the third largest Paris Club creditor.
The HIPC debt relief process is complex, requiring a number of actions by creditors and the intended beneficiary. A key early step in the process is an IMF request for assurances from the Paris Club creditors that they will be in a position to provide debt relief. To date, the Paris Club has been unable to provide such assurances because of US opposition and the fact that the Paris Club works by consensus. The US opposition has been driven by noneconomic factors, particularly the Sudan government’s attacks on civilians in Darfur and Sudan’s support for terrorist activities abroad. While the November removal of US sanctions dealt with one obstacle to US support, there remain two other significant hurdles: lack of money to cover the cost of debt relief and Sudan’s designation as a state sponsor of terrorism (SST) by the State Department.
The Trump administration is now proposing to rectify the money problem. Though not mentioned in any of the agencies’ congressional budget justifications, the FY19 budget request restores language that would allow the State Department to transfer funds to the Treasury Department’s Debt Restructuring Account to cover the cost of debt relief if certain conditions are met, such as severing all relations and ties with North Korea and improving freedom of religion. More significantly, following last week’s budget deal the administration reportedly sent Congress a list of “discretionary adds” for the FY18 budget, one of which is US$300 million for Sudan debt relief from the Economic Support and Development Fund (ESDF) account.
There is also growing belief that the administration could drop Sudan from the SST list this year. In accordance with various statutory requirements and recent precedents, the president would first instruct the secretary of state to launch a formal review of Sudan and provide a report within six months. If the decision is made to remove Sudan, Congress would have 45 days to try to block the removal, after which the decision would be formalized.
While the USG is taking steps to remove Sudan from the SST list and secure funding to finance bilateral debt relief, the IMF and the Khartoum government will need to reach agreement on a Staff Monitored Program that will underpin the debt relief process. The IMF, World Bank, and African Development Bank will also need to identify and secure the resources necessary to clear Sudan’s arrears. In the absence of any significant stumbles, Sudan could reach the HIPC Decision Point within the next 18 months.
The US$300 million request for FY18 funding could face significant resistance from Congress, particularly in the face of proposed cuts to other foreign assistance programs and lingering doubts about Sudan’s human rights record. It will be made all the more difficult by the proposal to use money that would otherwise go to Economic Support and Development Fund programs. The $300 million represents over 40 percent of the funds requested for Economic Support and Development Assistance programs in Africa in the FY18 budget.
Rather than require the State Department to cover the cost of debt relief, Congress should consider requiring the agencies that originated the bad loans to cover it. In the case of Sudan, the Defense Department is responsible for almost 60 percent of the amount outstanding and the US Department of Agriculture another 40 percent. Why make State pay for the poor credit decisions made by other agencies?
As I said last year, doing nothing is not a viable option. The United States would be rightfully accused of reneging on its past debt relief commitments. This could exacerbate tensions in the East Africa region and weaken Sudan’s interest in working with the United States on regional conflicts and the threat of terrorism, among other issues.
With last week’s decision by the Trump Administration to extend the review period for permanent removal of long-standing sanctions on Sudan, the debate over the nature of future US engagement with Sudan will continue. As this month’s report of the Atlantic Council’s Sudan Task Force points out, US support for debt relief will be high on the Sudanese government’s agenda; such relief would unlock international financing that supports economic development and poverty reduction. What the report does not mention is that such relief would likely require significant new funds being appropriated by Congress. In light of proposed cuts to US foreign aid and doubts about Sudan’s human rights record it is hard to imagine the US Congress agreeing to any money for Sudan debt relief now. But in the event the necessary political support is established down the road, I offer three options for addressing the financing challenge.
Sudan’s Debt is 60 Percent of its Entire GDP
As shown in the most recent World Bank/IMF debt sustainability assessment, Sudan is in debt distress. At end-2015, it had $48.2 billion in external public and publicly guaranteed debt, equivalent to roughly 60 percent of the country’s gross domestic product. 86 percent of the debt was in arrears. The Paris Club group of creditors accounted for almost $18 billion of the total, and the United States is reportedly the third largest Paris Club creditor. Virtually all the debt owed to the United States is in arrears.
Sudan is one of three remaining countries that are eligible for comprehensive debt relief under the HIPC Initiative , launched in 1996 (the other two are Somalia and Eritrea). Sudan’s access to debt relief is also a key element of the cooperation agreement with South Sudan. Under the 2012 agreement, Sudan agreed to retain all the external liabilities of the two states contingent upon a commitment from the international community to provide Sudan with debt relief within two years (the deadline has since been extended). This debt relief would allow Sudan to normalize relations with its creditors, including the international financial institutions (IFIs). The IFIs would then be in a position to finance development projects.
No HIPC debt relief without US participation
The HIPC debt relief process is extraordinarily complex, requiring a number of actions by creditors and the intended beneficiary. A key early step in the process is an IMF request for assurances from the Paris Club creditors that they will be in a position to provide preliminary debt relief (using so-called “Naples terms of treatment”). Without these “financing assurances” the HIPC process stops. Unfortunately for Sudan, the US is not currently able to provide such financing assurances as discussed below, and the likelihood for being able to do so down the road is bleak.
Roadblocks to US participation
While the US Congress has passed various laws that constrain any US support for the Sudanese government, there does not seem to be any provision that would bar bilateral debt relief, providing certain conditions are met and the necessary funds are appropriated. For example, the annual appropriations bill generally includes language prohibiting the use of funds for debt relief for Sudan, but it provides exclusions such as “assistance to support implementation of outstanding issues of the Comprehensive Peace Agreement [with South Sudan].” Presumably debt relief funds could be covered by this exclusion. A more significant obstacle is Sudan’s designation as a state-sponsor of terrorism, but there are reports it may be removed from the list and, in any case, the President has the authority to waive any legislative restrictions associated with such a designation.
The primary roadblock to US participation is lack of funds to cover the cost of debt relief. Under arcane US government accounting rules, the US government agencies that lent money to Sudan decades ago must be compensated for writing those debts off. According to the US Foreign Credit Reporting System, roughly 60 percent of what Sudan owes is held by the Department of Defense and 40 percent by the Department of Agriculture. And the amounts owed are increasing every year due to penalties and interest. Even though there is virtually no chance that Sudan will ever make payments, there is a residual value—the expected net present value—that will be calculated at the time the debt is written off. In the case of Sudan, this could amount to as much as $350-400 million by the end of FY2019.
Where to Find $400 Million for Debt Relief
The customary process for securing the necessary funds for HIPC debt relief is for the US Treasury Department to request the money in its portion of the overall foreign assistance request (once the budget is signed into law, Treasury dispenses the money to individual agencies to cover the debt relief costs). $400 million would represent a 25 percent increase over the FY2018 request, and the largest single amount ever requested for bilateral debt relief. In light of current budget constraints and the prospect for cuts to foreign assistance, it is implausible to think that there would be widespread support for any such request. (In fact, it should be noted that the Trump Administration FY2018 budget proposal did not include language from the Obama Administration budgets that contemplated transfer of funds from the State Department for this purpose).
I offer three possible options for the Administration and Congress to consider:
Follow the usual procedure, with Treasury requesting funds in its budget submission—presumably for FY2019—while explaining that the request is an anomaly that does not reflect an ongoing program.
Make the agencies that extended the loans cover the costs of debt relief in their own budgets. In the case of Sudan, the Department of Defense and USDA would take the hit. In view of the shrinking foreign assistance pie, it doesn’t seem right that Treasury Department would have to cover the costs of bad loans extended by these other agencies.
Ask Congress to waive the statutory requirements for funding debt relief for Sudan and strike it from the US books without an appropriation. There are sound arguments for providing such a waiver given the unique circumstances involved and it may be the only politically feasible option.
Doing nothing is not a viable option. If sanctions are permanently removed, pressure will immediately build to provide Sudan with debt relief so it can resume borrowing from the World Bank and other international financial institutions. Not only would the image of the United States, which has the largest economy in the world, be further tarnished by reneging on its past debt relief commitments, but the US would be accused of walking back from debt relief commitments made in the context of the Sudan-South Sudan cooperation agreement. This could exacerbate tensions in the east Africa region and weaken Sudan’s interest in working with the United States on regional conflicts and the threat of counterterrorism, among other issues.
Among the outcomes of the Asian Infrastructure Investment Bank’s (AIIB) annual meeting was approval of three new financial commitments by the Board of Directors. While approval of the first AIIB equity investment garnered the headline, for me the most interesting item was the loan to Tajikistan, co-financed by the World Bank (and the Eurasian Development Bank), for badly needed rehabilitation of the Nurek Hydropower Plant. This is the AIIB’s second loan to Tajikistan in the space of a year, and raises questions about lending on “hard terms” to poor countries. In its eagerness to meet the investment needs of Asian countries, is the AIIB going to get burned by lending at non-concessional rates to poor countries? Or, if a country becomes unable to pay all its bills, will it treat the AIIB as a preferred creditor and prioritize debt service payments over the needs of the poor?
The Risk of Lending to Countries Like Tajikistan
Tajikistan is a low-income country, with an average per capita income of roughly US$1,200 per year. And, according to the IMF, the most recent debt sustainability analysis (DSA) concluded that Tajikistan is at “high” risk of debt distress, so borrowing for investment needs is difficult. While the staff report for the most recent IMF Article IV consultation has yet to be released, the press release issued at the end of the 2017 review mission appears to corroborate the DSA assessment. Most notably, it says, “Concrete steps in key reform areas will need to be taken. . . [including] preparing a medium-term fiscal strategy to assure debt sustainability, an assessment of the macroeconomic implications (on growth, exports, and debt sustainability) of large infrastructure projects, and banking reforms.”
The situation is all the more troubling given increased domestic borrowing by the government, persistent budget deficits, and reported large liabilities on the balance sheets of state-owned enterprises. The IMF press release does commend the authorities for a 2017 budget that targets a decline in the deficit, but the credibility of such an effort is undermined by the failure to balance the budget in 2016. An anemic Russian economy due to low oil prices is hampering the Tajikistan budget picture as well.
World Bank and AIIB Lending Terms
Because of Tajikistan’s high risk rating, the World Bank’s portion of the financing package for Nurek is required to be on extremely concessional terms. The package includes two separate IDA loans for a little over $169 million and an IDA grant of roughly $56.6 million, with a total grant element of roughly 52 percent. By comparison, the AIIB will provide a $60 million loan and charge a lending spread of 1.4 percent over LIBOR, which is slightly less than what the World Bank’s hard loan window (IBRD) charges for similar loans. While the World Bank’s non-concessional borrowing policy attempts to constrain high-risk countries like Tajikistan from borrowing on hard terms, exceptions are granted on a case-by-case basis, and presumably Tajikistan was granted such an exemption for the AIIB loan.
From a strictly financial perspective, a non-concessional loan may make perfect sense because of the increased cash flow generated by electricity sales from Nurek. In fact, while the Tajikistan state-owned energy company currently charges a tariff for electricity below the recovery cost, a critical element of the Nurek project is a commitment by the government to introduce a new cost-recovery tariff that will allow the servicing of debts and provide the necessary funds for operation and maintenance. So what is the problem?
One problem is that the higher lending rate charged by AIIB will make it even more difficult for Tajikistan to generate the revenues needed to cover the cost of the repaying the loan. Given that the current weighted average tariff is estimated to be 55 percent below the cost-recovery level, rate hikes needed to meet the government’s commitment will be difficult to implement. A number of studies have revealed the difficulty of keeping such commitments, including a recent World Bank evaluation of a broad range of World Bank interventions in the power sector, which noted that “political commitment to serious financial stabilization and recovery objectives is often fragile.” If AIIB charged the same rate as IDA, it would make it easier on Tajikistan to repay everyone, but the AIIB is not in a financial position to provide such concessional loans.
Another problem is that there is little, if any, financial incentive for AIIB to pressure Tajikistan to meet its rate hike commitment. It will be the Tajikistan finance ministry, not the electric company, that will need to come up with the funds to repay the AIIB (and other creditors). And even if the finance ministry finds itself in a bind and is unable to repay all its creditors, the AIIB (like other multilateral lenders) will presumably argue that it is a preferred creditor and should be paid in full, even if it requires reducing expenditures for other needs. This could create bad publicity for the AIIB; given the needs of a country like Tajikistan, any cuts to essential services to pay off the debt are likely to exacerbate poverty levels. AIIB should therefore be very concerned if Tajikistan cuts expenditures while making Tajikistan’s creditors whole.
More broadly, a third problem is a potential perception that the AIIB is “free riding” within the international financial architecture since it does not provide concessional loans. At low levels of lending to low-income countries, this is unlikely to be a concern. But if the AIIB ramps up its lending programs in poor countries, the concessional lenders may begin to raise a fuss, particularly if there is a “credit event” and the AIIB falls back on its preferred creditor status to be repaid in full. Perhaps the concessional lenders should have AIIB compensate them for reducing the financial risks of individual transactions and begin to consider whether the AIIB should be held harmless in the event of a credit event.
As indicated in the Trump administration’s skinny budget released in March, the FY18 budget request incorporates the idea of transitioning the Foreign Military Financing (FMF) program from grants to loans. The stated intention is to “reduce costs for the US taxpayer, while potentially allowing recipients to purchase more American-made weaponry with US assistance, but on a repayable basis.” As with a consumer purchasing a new automobile, a loan is sometimes advantageous for the parties involved—but not always. And a transaction involving the US government incorporates additional elements. From a financial perspective, the end result could be good, bad, or very, very ugly.
Some historical context
This is not an entirely new practice. As noted by the State Department in a March release, the Obama administration concluded a $2.7 billion loan to Iraq for the purchase of US weapons. However, providing loans to sovereign governments, rather than grants, has been the exception rather than the norm. According to US Treasury Department data, the amount of outstanding Department of Defense loans has dropped from roughly $7.5 billion 20 years ago to around $350 million currently (not counting the $2.7 billion Iraq loan). The drop is due to a combination of old loans being repaid, a pause in new loans, and the write-off of a number of uncollectible loans (more on that below).
While critics worry that loans will have a negative impact on sales, the basic concept of requiring countries to finance purchases, rather than receive grants that subsidize purchases, has some merit from a purely financial perspective. It would align the approach for supporting exports of military hardware with the practice applied by the US Export-Import Bank for nonmilitary goods. It is arguably a much more efficient use of US taxpayer resources: following US budget rules established under the 1990 Federal Credit Reform Act, appropriated funds would only need to cover the estimated long-term cost to the government of the loan, calculated on a risk adjusted net present value basis over the life of the loan (the methodology and process for calculating the subsidy cost was assessed in considerable detail by the Government Accountability Office in 2004). In the case of Iraq, only $250 million in appropriated funds was needed to finance $2.7 billion in purchases. For countries where the risk of default is low, the cost to the taxpayer from a budget standpoint could be lower for every dollar of hardware purchased, compared to grants. And if the loan is repaid in full and on time, there would be no net expenditure. In fact, as is the case with Ex-Im and the Overseas Private Investment Corporation, the program could return more to the US Treasury than was expended at the time of the purchase.
There is a frightening lack of transparency to the FMF sales program that leaves it vulnerable to corruption—a not-insignificant risk, as demonstrated by past activities in the Department of Defense procurement process. There does not seem to be a transparent, accountable process for determining the terms of the loans, much less how the grants are applied. Moreover, based on statements by OMB Director Mulvaney at the May 22 budget briefing, there does not seem to be an agreed methodology for determining which countries would continue to receive grants and which would receive loans. And finally, the fact that the US Treasury Department database on foreign credit exposure does not reflect the 2016 Iraq loan raises doubts that the lending program will be subject to the oversight and public financial management best practices that the United States encourages other governments to adopt.
The very ugly
As mentioned above, the United States has had to write off a considerable amount of debt over the years following debt treatments negotiated at the Paris Club. These debt reduction agreements cover a number of countries that have recently benefited from the FMF program, such as Liberia, Egypt, Pakistan, and Iraq. There is a considerable risk that US lending activity, if not well managed in accordance with recently endorsed G20 operational guidelines for sustainable financing, will push these countries toward the brink of another series of debt crises.
Members of the US Congress would be well advised to take a closer look at the FMF program as it transitions from grants to loans. Questions they may want to pose include:
Why should some countries that can afford loans be given grants, and others that struggle with debt sustainability be required to take loans?
Is there a transparent and accountable methodology for determining the terms of the loans?
Is the US government consulting with the IMF and World Bank on the terms of loans to developing countries?
Taking a transparent, disciplined approach to FMF loans can help mitigate the risk of needing to provide debt relief in future years, which would cost considerably more money for American taxpayers than would be saved in the early years of a lending program.
Somalia, among the poorest countries in the world, is one of three remaining countries that are eligible for comprehensive debt relief under the HIPC Initiative (the other two are Sudan and Eritrea). Somalia is estimated to have over $5 billion in external debt, with Paris Club creditors representing the largest single bloc (roughly $2.5 billion), followed by non-Paris Club bilateral creditors (roughly $1.5 billion) and multilateral creditors (roughly $1.5 billion). Much of Somalia’s debt is in arrears. Under the HIPC Initiative and the complementary Multilateral Debt Relief Initiative, virtually all of Somalia’s multilateral debt and the vast majority of its bilateral debt would be eliminated. It is important to note that none of this debt is currently being serviced, and no creditor actually expects to be paid.
While Somalia’s government should be applauded for its ambition and recognition of the importance of normalizing relations with international financial institutions and the broader financial community through the debt relief process, meeting the humanitarian and security needs of the Somali people should remain its primary focus. Diversion of time, talent, or resources from these near-term urgent priorities to the longer-term debt relief cause would be counterproductive. But there are measures that can be taken to support the debt relief process that would also support humanitarian and security objectives.
Liberia’s experience in the 2000s, as it began the process of extricating itself from over a decade of violent conflict, provides some useful lessons. While Somalia’s challenges are arguably much more difficult, the debt relief process in Liberia successfully established the building blocks for sound economic policy and basic institution building. The government of Somalia and its international partners will need to move forward in a disciplined manner, recognizing that there will be bumps, if not boulders, in the road ahead.
Five recommendations for Somalia’s debt relief process
I offer the following five recommendations for the government of Somalia that should help pave the way toward a successful HIPC process:
Work closely with the International Monetary Fundon a macroeconomic policy framework that would lead to a Staff Monitored Program (SMP) with upper credit tranche standards. While the current Somalia SMP serves as a useful starting point, it will need to be significantly strengthened, and sustained performance observed, before Somalia fulfills the HIPC condition of demonstrating a track record of reform and sound policies. In the case of Liberia, the period from agreement on the SMP to HIPC decision point was two years, but in Somalia’s case it is likely to be much longer given the protracted insecurity, weak institutions, and current drought-related challenges.
Secure agreement with the international donor community on a medium-term strategy for economic management that reflects a coherent approach to basic public financial management, including measures to fight corruption. Many of the pieces already exist under the World Bank’s Multi-Partner Fund, but there does not appear to be any agreed overarching strategy, and there is no reference to fighting corruption, despite reports on the severity of the problem. In the case of Liberia, the government and its international partners established the Governance and Economic Management Assistance Program, which provided donors and creditors with the confidence that their resources would be effectively used and measures would be applied to mitigate the risk of corruption.
Maximize use of pre-arrears clearance grants, including through donor-supported trust funds. Trust funds, such as the Multi-Partner Fund and the UN Multi-Partner Trust Fund, are playing a critical role in supporting Somalia’s development and reconstruction needs. Moreover, despite Somalia being in arrears to the World Bank and African Development Bank, both institutions provide for pre-arrears clearance grants for capacity building and other urgent needs. Demonstrated success in meeting the objectives of these smaller operations will provide evidence of Somalia’s ability to effectively utilize much larger amounts when arrears are cleared.
Work with donors to establish a National Development Plan (NDP) that can serve as the Poverty Reduction Strategy Paper required for HIPC debt relief. The current NDP is an excellent start but it needs improvement, including addressing issues related to fiscal federalism and plans for increased domestic resource mobilization. Measures to monitor and assess progress on the NDP also need to be established.
Begin to develop a debt relief roadmap that identifies the potential sources and uses of funds for arrears clearance and debt relief. Arrears clearance at the international financial institutions should be fairly straightforward. Unlike at the time of Liberia’s arrears clearance, the World Bank and the African Development Bank have set aside resources under the IDA and African Development Fund replenishment agreements that should cover the cost. IMF arrears clearance, which is likely to follow the Liberia model, is more complicated but feasible. The Paris Club element could be a problem since the United States, which is a large creditor to Somalia, may find it difficult to come up with the money needed to cover the cost of debt relief given proposed cuts to US foreign assistance by the Trump administration. But this is a problem that does not need an immediate solution, since it is highly unlikely that Somalia will be ready for the HIPC decision point within the next two years, despite its government’s wishes.
Cambodia’s Prime Minister and former Khmer Rouge commander Hun Sen has called on the Trump administration to cancel Cambodia’s debt to the US Government incurred by the Lon Nol regime in the 1970s. Because the loans, which were used to pay for food purchased from the United States, have not been serviced, the total amount owed is estimated to now be more than US$500 million. While the Trump administration may not immediately embrace Cambodia’s request, it is worth both sides considering the possibility of a deal.
This is not a new issue. In fact, in 1995 then Prime Minister Norodom Ranariddh reached agreement with the Paris Club of creditors, including the United States, on a debt treatment that included partial cancellation. Unfortunately, unlike with other creditors (France, Germany, Italy, and Japan), the Cambodians refused to sign a bilateral agreement with the United States that would have enacted the Paris Club accord. In 2008, there was a congressional hearing on the topic and in 2010 former Secretary of State Hillary Clinton committed to send a team of experts to Cambodia to explore options. The subsequent talks went nowhere.
While the executive branch is clearly in the driver’s seat when it comes to debt relief, Hun Sen would be well advised to also direct his appeals to the US Congress. Under the “appropriations clause” of the US Constitution, the executive branch is generally prohibited from spending any funds absent “appropriations made from law.” And cancelling funds owed to the US Government would equate to spending the funds. In today’s budget environment, finding $500 million would be an extraordinarily difficult task, but under government accounting rules the amount needed would be less than the face value. The exact amount is calculated using a complex formula that takes into account, among other things, a country’s credit rating, the nature of the debt, and the US cost of borrowing. Cancellation generally costs a lot less than the face value of the debt, but even at 50 cents on the dollar, this would still be more than $250 million.
Rather than press for full debt cancellation, with its attendant political and financial challenges, Hun Sen may want to look to its next door neighbor, Vietnam, for a win-win solution. Like Cambodia, communist Vietnam was faced with paying debts that were incurred by the previous regime. And like Cambodia, Vietnam negotiated an agreement with the Paris Club of creditors, including the United States. But unlike Cambodia, Vietnam signed a subsequent bilateral agreement with the United States in 1997, an act of considerable courage by the Vietnamese leadership. As US Treasury Secretary Robert Rubin said at the time, “the signal sent by this agreement will be important to the rest of the world in building confidence in Vietnam in a way that will benefit its economy.”
Moreover, Vietnam benefited from a debt swap arrangement under which a portion of the funds that would have been paid to the US Treasury, in accordance with the Paris Club agreement, were funneled to an organization established by the US Congress under the Vietnam Education Foundation Act. During the life of the program, it financed the studies of over 600 Vietnamese students in the United States as well as teaching opportunities for US faculty members at Vietnamese universities. The United States also has experience managing debt swap programs in other areas, such as environmental conversation.
While a debt swap solution carries certain risks that need to be carefully addressed before any agreement is concluded, it would seem to be the only option that provides the elements needed by both parties to move forward in an amicable manner. For the United States, any agreement on Cambodia’s debt must be based on the 1995 Paris Club treatment. To do otherwise would risk breaking with the US commitment to the Paris Club and its principled approach to debt restructuring. For Cambodia, repaying the United States for debts incurred by the Lon Nol regime would only seem politically palatable if Cambodia received a direct benefit, as did Vietnam with its debt swap arrangement.
Given the myriad strategic challenges it faces in Southeast Asia and elsewhere, it is difficult to envision a debt deal with Cambodia rising to the top of the Trump administration’s “to do” list, particularly when Hun Sen’s interest in resolving the issue is subject to doubt. That said, if the Cambodian authorities exhibit a tangible commitment to resolving this bilateral irritant, President Trump and Congress should be prepared to offer a debt swap that could bolster a relationship in a region dominated by China.