Debt - Is it the disease or the symptom of a larger problem?

First of all, let me welcome all of you to this speakout session. I want to thank all of you for the number of questions that you have provided, and I must say there is a wide range, but this is a very good question to begin with.

The question really asks whether there is a relationship between the debt of a country and its growth rate, and this is the question that we have been grappling with for some time.

There is very clearly a negative relationship between the debt burden of countries, and I use the term debt burden advisedly, and its rate of growth. That is to say, the higher the debt burden of a country the lower would tend to be its rate of growth or vice versa, the lower the growth rate of a country the higher would tend to be its debt burden.

And there are several ways of interpreting this stylized fact. The first way which most people tend to interpret it is that high debt tends to lead to low growth, and that's the sense of the question that's being posed by Michael Korczynski, but there is another alternative of looking at this issue. It's not that countries get into debt traps or high debt burdens because they borrow a lot, but they develop high debt burdens because they tend to grow too slowly. In other words, it is slow growth that leads to high debt burdens. That is certainly an alternative explanation worth looking at and looking at very carefully.

Then let me offer a third explanation for this stylized fact, and that there could be a third variable, a third possibility that affects both growth as well as debt burdens, and that is perhaps the quality of policies and institutions in a country which have obviously impacts on the amount that countries borrow, and also have an impact on the growth rate of those countries.

So, countries with weak policies and weak institutions could possibly have higher levels of debt as well as low rates of growth, and that could also explain this association between high debt and low growth.

Well, let me first start by saying that I agree with Adam's first statement, that debt is a symptom of a bigger problem. As I just mentioned in the previous answer, it is usually that countries that grows slowly are the ones that tend to have a higher debt burden. And the question that really is being asked is, why do countries grow more slowly? That's a very difficult question to answer, and really lies at the heart of development economics, and I don't want to spend this hour talking about this, but let me just say the following.

The reason for slow growth in many countries really is due to very specific country circumstances, and I don't think one should make any generalizations. In some cases it could be because of the specific geographical location of countries, or in other countries it may be a country has a certain history which has led to, say, a lack of infrastructure. In other instances it could be because of weak policies or weak institutions. In other words, there are many reasons why countries may grow slowly, and it's important not to provide any generalizations on the causes of slow growth.

But let me move to the next point that Adam makes, and that is what difference will HIPC make to the prospects of these highly indebted poor countries? And really the answer to this is that the HIPC Initiative is only a debt reduction initiative. The HIPC Initiative is not a magic bullet. It is not something that can guarantee growth in poor countries, nor is it a program that can guarantee debt sustainability in these countries. The HIPC Initiative is simply a debt reduction initiative. What it does is lower the debt burden of these countries. Therefore, it should be considered only as only one part of a broader architecture of development. Debt reduction is a critical requirement in many of these very highly indebted poor countries in order for them to jump start growth, but it is not a sufficient condition for growth or debt sustainability. What is also required are adequate levels of resources from abroad, good policies and institutions within the country, and, of course, a benign external environment that will allow these countries to export products under foreign exchange which they could repay their external debt.

So, there are a whole set of circumstances that need to come together for a debt reduction initiative such as HIPC to assist in bringing about higher growth and development in these countries.

Well, I think Matthew has really hit the nail on the head with this particular question. If one goes back in history, it becomes quite clear that the debt burden is the symptom of a much deeper development challenge. From the 1960s onwards, there has been a series of efforts by the international community to first reschedule the debts of poor countries, and then later to actually reduce the debt burdens of these countries. Initially, it was through the Paris Club that the rich countries of the world began to reduce the debt stock of the poor countries starting in 1988 when the Toronto terms were introduced, which allowed the poor countries to have a 33 percent reduction in their debt stock.

But as time went on, that 33 percent was increased to 50 percent, and then 67 percent, and then 90 percent. And, indeed, now many Paris Club members offer a hundred percent debt reduction for the highly indebted poor countries. This Paris Club effort to reduce the debt stock of the poorest countries was then followed by the Heavily Indebted Poor Countries Initiative which allows not just the bilaterals but also the multilaterals to reduce their debt stocks that were owed by these poor countries. And we had in 1996 the initial HIPC Initiative. In 1999 it became the enhanced HIPC Initiative, and then in 2001 it became the enhanced HIPC Initiative with topping up.

So, there has been a steady progress, a steady additional amount of debt relief that has been provided over the years, and yet the debt problem of these countries has not really been ameliorated. And that, in part, is what Matthew Higgins in his question describes, that despite these efforts, the debt burdens of these countries continue to be very serious, and the issue arises for what can be done to change the situation to break the cycle, as he puts it, and begin to generate real economic progress. The international community has been thinking a great deal about this, and I think there have been two important developments which are worth pointing out.

The first is that now all donors have agreed to support poverty reduction strategies in these poor countries, and these poverty reduction strategies should be the outcome of internal dialogue within these countries on what are the highest priorities that are needed in order to accelerate growth and reduce poverty. And the second important development which the international community has introduced is the new debt sustainability framework, a framework which has just been discussed at the boards of the World Bank and the IMF, and which is now also being discussed amongst other creditor and donor agencies.

What this framework says is that we must recognize that for certain countries which either already have high debt burden or have weak policies and institutions or are susceptible to exogenous shocks, it would not be appropriate for the international community to pile on yet more debt on these already overburdened economies. So, it is important therefore, in advance, to recognize that where debt sustainability concerns exist, the international community should provide more concessional resources, including additional grants, especially in countries which are trying their best with good policies, good institutions, and strenuous efforts to improve their growth rates and reduce their own poverty levels.

So, I think with these two new efforts, these two new initiatives, the poverty reduction strategy papers being produced by the countries themselves, the agreement within the international community to support these poverty reduction strategies, and the new debt sustainability framework, I think there is sort of a redoubling of effort and energy on the international community's part to a try to assist these countries to improve both their prospects as well as their debt sustainability situation.

It's a much deeper question than appears at first blush. Under the HIPC Initiative, the rules required that the debt of the heavily indebted poor countries should be reduced such that the net present value of their debt to export ratio should be 150 percent. In other words, there was a judgment that somehow, where countries had their debt ratios reduced to 150 percent, there would be a higher probability of debt sustainability in these countries. And that certainly has been borne out by recent analysis.

Our empirical analysis, which was done over the last year, seems to suggest, as I mentioned earlier, that there are three factors that influence a country's risk of debt distress.

Let me first define what I mean by debt distress. By debt distress I mean where poor countries either accumulate arrears or they seek debt reduction through the Paris Club of the HIPC Initiative or they have to resort to nonconcessional borrowing from the International Monetary Fund. And clearly any of these three are a symptom of a deep underlying debt problem in a country. The risk of debt distress tends to rise very sharply when either countries already have a high debt burden, which is unsurprising, or when countries have weak policies and institutions, or third, when countries are hit by exogenous shocks.

So, rather than saying that the country's debt burden is sustainable or unsustainable, we now much prefer to say that a country's risk of debt distress is higher or lower, has climbed or declined, because it is so much more appropriate to look at the debt issue as a risk management question rather than a simple black and white, up or down issue.

So, how do we actually calculate debt sustainability? What we have done is that we initially take certain thresholds of debt burdens which come out of our empirical analysis which we have done over the past year. And as I said, these indicative debt thresholds are the result of both the quality of a country's policies and institutions as well as whether they have hit an exogenous shock or not.

Secondly, once we know what these debt burden thresholds are, we ask where is the country specific debt burden in relation to these thresholds, either today or projected into the future? If the debt burden of the country that we are looking at is above these thresholds, then clearly there is a concern that the risk of debt distress is unacceptable. And, therefore, we have to take special precautions both in providing new loans to the country, and secondly where the country's resources are great in order to meet the Millennium Development Goals. For example, it is important that those resources are provided either in the form of grants or in the form of yet more highly concessional loans.

And lastly, when a country is hit by an exogenous shock, then, I think, we have to bring to bear certain additional instruments which will help countries tide over these exogenous shocks, for example by providing additional resources after the exogenous shock has hit, but providing those resources, again, either in the form of grants or in the form of highly concessional loans so that these additional resources don't further add to the debt problems of these countries.

As I just indicated in the previous question, the new debt sustainability framework that has been put forward by the Bank and the Fund tries to address ex ante the issue of debt sustainability so that the risk of debt distress of countries is kept within certain reasonable bounds. The whole reason for the debt sustainability framework is that we don't want to have yet another HIPC Initiative where countries get into debt distress and their debts have to be reduced at very high cost.

The underlying rationale for this is that debt distress imposes very high cost on countries. This is because once debt burdens become excessive, then two things happen: First, there is a disincentive in the countries themselves to actually implement reforms because any benefit from those reforms tend to go towards the payment of debt service; and second, it corrodes the credibility of lending institutions who find that they have to continue lending just in order for the countries to be able to pay back their debt service.

So, clearly, when countries get into debt distress, it has a negative effect on development and on growth, and it has a negative effect on policy reforms and on the credibility of the international institutions that provide these resources. Therefore, now that we've gone through, or are going through the debt initiative and reducing the debt of these countries, it is important to introduce a new system that will at least try to ensure these countries don't get into debt crises in the future.

I say the words try to ensure advisedly because I don't think any framework is necessarily going to eliminate debt crisis in the future, but hopefully it will reduce the incidents, the frequency of such debt crises in the years to come.

And the way the debt sustainability framework tries to do this is, that it tries to recognize in advance which countries have a high risk of debt distress, and then tries to tailor the terms of the new resources in a way that will ensure that that risk of debt distress is kept within reasonable bounds.

And I guess the main new feature of the debt sustainability framework is the recognition that if countries are to meet the Millennium Development Goals and they have a high risk of debt distress, then it is very important that the international community provide resources in the form of grants so that the debt problems of these counties don't become unsustainable because that in itself will harm the achievement of the MDGs.

Thank you for raising this particular question about the HIPC Initiative because this is an issue that we are currently dealing with right now and preparing a paper for our boards on exactly this question.

Margaret's question relates to 11 countries that have not yet reached the decision point of the HIPC Initiative, and the decision point is the point in the HIPC Initiative at which HIPCs receive a commitment for reduction of debt by the international community, and it is unfortunate that out of the 38 countries that are deemed eligible for relief under the HIPC Initiative, 11 have yet to reach the decision point.

The reason these 11 have found it difficult to get to the decision point is that many of these countries have either been in conflict or are emerging from conflict or are countries where governing standards are so weak that they have found it difficult to maintain the minimum standards of macroeconomic performance and policy performance to qualify for debt relief under the HIPC Initiative.

Unfortunately, the sunset clause for the HIPC Initiative comes into effect by end 2004. The sunset clause, the specific clause that was introduced at the start of the HIPC Initiative which said that countries which have not developed a macroeconomic performance track record leading to decision point would no longer be considered eligible for debt relief under the initiative by the particular date stated. Initially, the sunset clause was to take effect after two years. It was then extended for another two years, and currently is set to expire in end 2004.

The boards of the Bank and the Fund have asked the staff of the two institutions to examine what options are available to help these 11 countries that have not yet reached the decision point. It's possible that some of these country will reach the decision point at the end 2004, in which case they will receive debt relief under the HIPC Initiative.

But for those who cannot, there are three possible options as far as we can see. The first is that the sunset clause does become effective. The HIPC Initiative does come to an end, and for those countries that have not reached the decision point, we will have to think of other ways to tackle their debt overhang.

The second option is that we seek an extension of the sunset clause by another few years in which case any and all countries that meet the HIPC criteria could become eligible for debt relief if they meet the minimum standards required at a decision point.

Then there is the third option. The third option could grandfather these 11 countries, or any other list of countries for that matter, and say that these grandfathered countries could remain eligible for debt relief under the HIPC Initiative for a specific period in the future. That specific period could be two years, four years, five years. None of it has been decided yet.

Now, the staffs of the two institutions are working on these three options and, indeed, any other options as they become evident as time goes on, and we will be presenting these options to the boards of the two institutions hopefully in early July, and we expect that a decision on how to proceed will be made by the two boards sometime before the Annual Meetings in October later this year.

First of all, there are 27 countries that have received debt reduction under the HIPC Initiative in the sense that they have reached decision point, of which 13 have gone beyond completion point, which is to say that their debt reduction has become irrevocable.

Now, of the countries that have gone beyond completion point, as far as we know, Bolivia and Uganda have found that their debt indicators have climbed to levels above the thresholds of the HIPC Initiative. That does not necessarily mean that their debt is unsustainable. As I mentioned in my previous answers, the risk of debt distress depends on what the quality of a country's policies and institutions are, on the level of its debt, as well as on whether it is affected by exogenous shocks. And just because a country's debt burden rises does not necessarily mean that its debt becomes unsustainable.

However, having said that, it is important to recognize that the rising debt burdens in these countries should be a matter of concern and should influence the way in which the international community assists both these countries.

But Lucy asks another question. She asks: Can more relief be made available?

One of the important factors to take into account when looking at debt relief is that debt relief is not costless. In fact, debt relief is very costly. The cost of the HIPC Initiative so far is of the order of $53 billion in nominal debt service reduction over time for the twenty seven countries.

Much of this debt service reduction comes from multilateral institutions, like the World Bank. When the World Bank provides debt relief, that means that it does not receive debt service payments from these countries, and that means that it has fewer resources available to lend to other countries who may be just as poor, but who have managed their debts well, who have been using their resources wisely.

For example, it would be a real shame if, as a result of debt service reduction to a bunch of countries in one part of the world, we find that we can't provide highly concessional assistance to other parts of the developing world where the needs of the poor are just as great.

Under the current HIPC Initiative, it is ironic that we are struggling to find adequate resources to meet the existing costs of the current HIPC Initiative. Of the total cost to the World Bank of roughly fourteen billion dollars of debt service reduction over time, only some 2.36 billion dollars in nominal terms have been made available through net income transfers from the IBRD. The rest of the resources still have to be raised in order to ensure that IDA, which is the soft loan arm of the World Bank, has adequate resources to make sure that its lending levels to the poor countries of the world do not decline.

Therefore, even under the existing HIPC Initiative, we are finding it difficult to finance the costs involved. It would be inappropriate for us to provide more debt relief when we are unable to finance our existing commitments.

But let me add that even if more finance were made available, should this additional finance be made available to countries with high levels of debt, or should it be made available to countries that could use these resources particularly well? And they are not necessarily the same set of countries, and this is certainly an issue which we need to think very carefully about.

The last question, the last point that Lucy raises is whether the World Bank can afford to write off more debt, and why does it not? Well, as I mentioned, the World Bank, if it writes off more debt, would find it difficult to lend to the other poor countries of the world. There is the additional question of whether there can be more additional net income transfers from IBRD to finance debt reduction for IDA. But here, too, there are several limitations because any net income that IBRD makes has to be allocated initially to very high priority uses, and it is not necessarily clear that debt relief should be considered the highest priority use of these resources.

First of all, this is a very important question because it recognizes that low-income countries are particularly vulnerable to exogenous shocks. In fact, our analysis shows that low-income countries have a higher frequency of exogenous shocks and a higher magnitude on average of exogenous shocks when compared to middle income countries or high income countries.

And there are really two kinds of shocks that these countries face. The first kind is by natural disasters: Floods, hurricanes, droughts, earthquakes, volcanic eruptions, disasters of that sort. And there is a second set of shocks these countries face, which is largely through factors which are outside their control, but which affect their export performance. These would include things like commodity price declines, sudden changes in the situation in their major export markets, wars in neighboring countries which might affect the ability to get their exports out to international markets, problems which afflict many countries that are land locked or lie in troubled parts of the world. And, therefore, the question of what the international community can do to assist these countries becomes terribly important.

What we have found is vulnerability to exogenous shocks does have an important impact on the debt sustainability in countries as well as their prospects for economic growth.

So, the question which Khaled asks is a very important question and one which we spend a lot of our time thinking about.

First of all, I think it is important to recognize that the responsibility for trying to deal with exogenous shocks does lie with the developing countries, with the low-income countries themselves. And one means of doing this, of course, is to try to develop as much of a diversified export base as possible. For example, countries that have diversified export bases or export production find that problems in any one market could be compensated by export earnings in other markets. Droughts in agriculture can be compensated by increases in industrial production, for example.

But let's remember that many of the poor countries that we are talking about are countries which are very dependent on commodity production and do not have diversified production bases, and it will take a long period of relatively rapid growth and good policies for them to develop diversified economies. In the meantime, what can be done?

Well, there are two sorts of ways that the international community can help. The first is by providing resources once exogenous shocks actually hit low-income countries. When there are natural disasters in low-income countries, we have noticed that the world community comes together rather quickly and provides resources rather rapidly in a well coordinated fashion. But shocks that take time to develop, such as commodity price shocks are much more difficult to deal with because they don't lead to headline news, they are much more difficult to diagnose, and as a result it is much more difficult to coordinate international assistance in such circumstances.

What we are thinking of is to develop instruments within the international community, not just in the World Bank and the International Monetary Fund, but hopefully assisted by other donor and creditor agencies, of introducing instruments that provide resources on the right terms to countries once exogenous shocks actually affect those countries.

In order for the system to work, it is important to diagnose when shocks take place, what the magnitude of these shocks are, and what is the magnitude of resources, therefore, that are needed to assist these countries.

The alternative way is to design financial instruments or lending instruments that act as insurance instruments so that when shocks hit countries are automatically compensated for their sudden decline in earning capacity.

For example, we are asking the question, would it be possible to design a lending instrument where a country provides a smaller debt service when it hits an economic shock, and that debt service payments can be accelerated when the country hits a boom period, for example.

These sorts of issues are actually much more complex than they seem at first sight, and it is no accident that in the developing world it has been extremely difficult to develop insurance instruments of this kind when it comes to sovereign debt. However, having said that, both the Fund and the Bank are working on such instruments, and we hope that sometime in the future if, indeed, such possibilities do exist, we will be able to develop them and operationalize them.

India's total debt burden is high, although its external debt burden is relatively low. In addition, India has grown fast, generating sufficient resources to avoid falling into debt traps as it has met its debt servicing obligations on time.

As other analysts have pointed out, the crucial issue in India is fiscal adjustment, which is necessary not only to reduce the level of debt, domestic debt, but also to create room in the government's budget for poverty oriented expenditures given that roughly a third of the budget currently goes to service the debt obligations.

So, while India has avoided falling into a debt trap in the traditional sense, if it fails to achieve fiscal adjustment and if growth falters, we see problems with dealing with India's debt, which is, in its totality, relatively high.

Strictly speaking, this question is not on the issue of debt, but nevertheless I thought it was an interesting question, and it is well worth responding to.

The World Bank and other such multilateral institutions derive their legitimacy from the fact that they have the participation of virtually every country in the world, and that these countries are represented on the boards of these institutions.

Secondly, the operations of these institutions are highly transparent. Virtually all board decisions, all major documents are made available to the public for scrutiny. Moreover, the World Bank and the IMF are subject to the oversight of the governors of the two institutions represented by the finance ministers of most of the world's major economies.

It therefore follows that the legitimacy of these institutions derive from the fact that their operations are open for the world to see, and that they base their judgments and their decisions on what is considered to be in the best interests of serving their mandate, which is the development process in the developing world.

Were there to be any hint that these multilateral organizations become captive to any one or other nation state, that legitimacy would be severely weakened and jeopardized. It is therefore in the interest of the world and in the interest of these organizations that they continue to serve the mandate for which they were created, and that the ways by which they pursued this mandate is subject to the scrutiny of the entire world, including the public, and I would invite you to access the World Bank's Web site where you can take a look at all aspects of the World Bank's operations.

Incidentally, while you are there, take a look at the HIPC Web site as well, which has many of the documents related to HIPC dealing with several of the issues that we have discussed during the course of this conversation.

I'm very glad this question has been raised because this is one aspect of the HIPC Initiative that I have not been able to touch on, but this gives me an opportunity to do so.

A critical aspect of the HIPC Initiative is that any savings that arise from debt service payments following debt relief should be used for pro-poor growth expenditures by the government or for poverty reducing programs by the government.

We have done some analysis on this, and, indeed, not just the World Bank but several nongovernmental organizations have also done some analysis on this, and both sets of analyses have found that, indeed, there is a pretty good track record in terms of the use of these savings for poverty reducing expenditures.

In the case of the World Bank's analysis, what we have found is that even after we have taken into account all other factors that might influence the growth of poverty reducing expenditures and HIPCs, debt relief is an important explanatory variable that accounts for a substantial increase in pro-poor growth expenditures in these countries. Of course, there is no one for one relationship between debt reduction and pro-poor growth expenditures, but there is a clear relationship that seems to exist and which is, indeed, designed in the program.

Now, the question also relates to the process by which budgets are formulated and allocations of resources are done, and clearly this differs from country to country. In some countries, there is strong oversight by parliaments. In other countries that may not be the case. In some countries there is strong oversight by nongovernmental organizations. Indeed in the case of Zambia, several inappropriate expenditures from national HIPC savings have been brought to light thanks to the vigilant activities of civil society organizations.

The World Bank has been monitoring the public expenditure processes of HIPCs through something called the public expenditure tracking survey and has found that the public expenditure management systems of most of these countries has been improving with time. Clearly, they are not perfect, and they will not be perfect for a long time, but I think the encouraging thing to recognize is that these management systems had been improving and correspondingly the resources that have been allocated to poverty reducing expenditures are being used more efficiently than they had before.

There will always be instances where mismanaged expenditures will come to light, and it is important that immediate corrective action be taken by governments when such information is brought to their attention. Indeed, if there are any such inappropriate expenditures that occur and such action may not be taken, it will be very useful to bring them to the attention of the World Bank so we can inquire and find out what exactly is happening because clearly we have an interest in trying to ensure that the savings from debt relief are used appropriately.

So, any assistance that you can provide in giving us such information would always be appreciated.