WORLD TRADE
ORGANIZATIONWT/WGTDF/W/10
20 September 2002
(02-5039)
Working Group on Trade, Debt and Finance Original:  English
COMMUNICATION FROM ECLAC
The following communication, dated 18 September 2002, has been received from ECLAC in
advance of their presentation to the Working Group on 30 September.
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MECHANISMS TO DEAL WITH DEBT OVERHANG1
I. INTRODUCTION
1. The external debt burden is one of the key impediments to economic and social progress. The
international community’s efforts to resolve the prob lems posed by the external debt burden need to
address some critical issues. Those that focus on the enhanced Heavily Indebted Poor Countries
(HIPC) Initiative are considered highly important for low-income countries. However, debt overhangsare also a problem for middle-income countries with access to international markets but with large
and unsustainable debts as well as high levels of poverty. In many cases, such debt burdens have
originated in the high interest rates prevailing in both international markets and in the domestic
markets of developing countries, as well as short debt liabilities issued as domestic debts but largely
subscribed by international investors.
2. This paper addresses these issues. It is divided in four sections, the first of which is this
introduction. The second measures the magnitude of Latin American debt overhangs.  The thirdfocuses on the HIPC Initiative, and the fourth on proposals to design broader debt workout
mechanisms.
II. LATIN AMERICAN DEBT OVERHANGS
3. Following a prolonged period of financial integration, public and private external debt has
ended up playing a central role in determining the financial system’s behaviour. When a country’sdebt service absorbs a large part of its gross cap ital inflows, its autonomy in deciding how and how
much it should open up its financial system is limited. As a result of this situation, the option of using
fixed exchange-rate regimes to reduce currency risk  has been restricted for some countries. FDI and
debt flows have caused the structure of the balance of payments to shift as the relative size of the trade
deficit has declined while the relative level of payments of profits and interest has risen. Vulnerabilityhas been heightened by increases in debt/GDP (or debt/exports) ratios and/or in current account
deficit/GDP (or current account deficit/exports) ratios. The increase in vulnerability is also associated
with the need for these countries’ to match maturities and currencies efficiently when intermediating
credit resources using these new modalities of external financing. When the market punishes
borrowers for this heightened vulnerability by ra ising risk premiums and/or reducing or reversing
                                                     
1 This paper has been prepared by José Antonio Ocampo, Executive Secretary, United Nations
Commission for Latin America and the Caribbean (ECLAC).WT/WGTDF/W/10
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financing flows, credit crunches tend to ensue. Thus, in the presence of certain sorts of international
financial shocks, countries’ efforts to achieve integration into the world economy may lead them into
a financing trap which, unless suitable international mechanisms for the provision of emergency funds
are designed, can leave them mired in long lasting recessions.
4. An examination of the region’s external debt position corroborates this analysis since,
although the region’s external debt is significantly smaller than it was during the critical years of the
1980s debt crisis, it nonetheless remains high. External debt coefficients declined considerably in the
late 1980s and early 1990s and then continued the trend downward during the greater part of that
decade, but the external debt/GDP ratio has never re turned to the levels seen in the early 1980s and
has been worsening in recent years. The trend in the external debt/exports ratio is more favourable,
but, except in the case of Mexico, it remains higher than it was in the early 1980s. In fact, as shown in
Table 1, external debt coefficients are clearly lower than they were in 1980 in just five countries of theregion, whereas, for all the rest of the countries, either the external deb t/GDP coefficient or the
external debt/exports coefficient is above 1980 levels, and in many cases, both of these indicators are
higher. Hence, the fact that the region is now at less risk of a 1980s-style crisis has less to do with the
countries' lower levels of indebtedness than it does with the stabilization of inflation in the
industrialized economies, since this makes an international interest rate hike such as the one seenduring that period quite unlikely (ECLAC, 2002a).
Table 1
Latin America and the Caribbean:  Exte rnal Debt Coefficients, 2000 and 1980 /a
Debt/GDP
Lower Higher
D Panama (51.4%) Argentina (52.4%)
e Trinidad and Tobago (22.6%) Bolivia (52.0%)
b Higher Brazil (40.1%)
t Colombia (43.4%)/ Ecuador (110.1%)
e Guatemala (20.2%)
x Guyana (153.6%)p Haiti (31.5%)
o Honduras (66.7%)
r Nicaragua (265.0%)
t Peru (50.5%)
s Uruguay (26.9%)
Costa Rica (19.8%) Chile (50.5%)
El Salvador (21.0%) Jamaica (43.9%)
Mexico (28.2%) Paraguay (28.6%)
Lower Dominican Republic (18.5%)
Venezuela (27.6%)
Source:  ECLAC, on the basis of official  figures from the relevant countries.
a/  The size of the debt, expressed as a percentage of GDP, in 2000 is shown in parentheses.WT/WGTDF/W/10
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III. THE HIGHLY INDEBTED POOR COUNTRIES INITIATIVE
5. The launching of the Highly Indebted Poor Countries (HIPC) Initiative in 1996 and the
approval of the enhanced HIPC Initiative in September 1999, following the Cologne G-7 Summit,
have been major steps in the solution of the debt overhang of poor countries. Advance in this area
serves also as a contrast to the significant lag in  the design of multilateral mechanisms to face debt
overhangs of middle income countries.
6. As of January 2002, 24 out of the 42 highly indebted poor countries had reached the “decision
point” of the Initiative, at which interim relief begins and eligible countries commit to adopt a Poverty
Reduction Strategy through a participatory process, the basic condition to advance to the “completion
point”. As of then, only four countries (Bolivia, Mozambique, Tanzania and Uganda) had reached that
stage, at which debt relief is irrevocably committed. For the 24 countries, debt relief in net present
value terms represents $22 billion, nearly half of their total debt. Together with more traditional debtrelief mechanisms, it is expected that these countries will experience a 62% reduction of external
indebtedness in net present value terms. With respec t to debt service effectively paid, debt relief is
less substantial: $2.0 billion a year in 2001-2003 vs. $2.9 billion in 1998-1999 (World Bank, 2002).
7. The Poverty Reduction Strategic Framework for HIPC and other low income countries, and
the papers (PRSPs) that materialize countries’ strate gies, represents also an important advance, as a
framework for co-ordinating donors, under the leader ship of recipient countries, and as a way to
promote national dialogues in recipient countries. In this regard, they follow principles that are now
widely accepted as a framework for the relations be tween donor and recipient countries. On the other
hand, PRSPs have been also viewed as an additional layer of conditionality associated to a complex
process (indeed, a case in which not only content but processes are subject to conditionality), and amechanism by which structural conditionality is simply “repackaged” (an argument made by some
NGOs and representatives of poor countries at  the Monterrey Confer ence on Financing for
Development) (United Nations, 2002). This mechanism also runs the additional risk of micro
management by multilateral institutions and bilateral donors. It is thus essential to closely review
progress in this area to guarantee ownership, diversity and effective recipient country control.
8. Aside from these potential risks, several criticisms have also been levied on the Initiative,
which relate to the characteristics of the debt relie f mechanisms, its inadequate financing, and its long
term effects on access to financial markets.
2  With respect to the first of these problems, it has been
claimed that the three year period between decision and completion points is too long. More
importantly, it has been argued that scenarios for debt sustainability (average GDP growth of 5.5%
and average export growth of 8.6% over the next decade) are too optimistic and do not take into
account external shocks and uncertainties that low-income countries face. Also, there are no bindingarrangements for non-Paris Club (particularly commercial) creditors to ensure adherence to the HIPC
Initiative terms, and the cutting point for liabilities eligible for reduction (the first Paris Club re-
negotiation) excludes a significant amount of debts in some countries. For all these reasons, even the
enhanced HIPC Initiative may not provide sufficient debt relief to enable countries to permanently
eliminate their debt overhang and to achieve the development goals agreed in the United NationsMillennium Declaration (particularly, halving extreme poverty by 2015). Additionally, it has been
argued that eligibility criteria are too stringent and have resulted in exclusion of countries whose
economic and social conditions are very similar to HIPC countries.
                                                     
2 See, for example, “Summary of Conclusions of the Interregional Meeting on Financing for
Development organized by the Regional Commissions of the United Nations”, January 2002 (www.eclac.cl);and Botchwey (2000).WT/WGTDF/W/10
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9. Inadequate financing has led to developing, including many poor and middle-income nations,
having borne a large share of the costs of the Initiative, either directly (when they are creditors to
HIPC countries) or indirectly (through higher spread s of World Bank loans, or reduction of technical
assistance from multilateral development banks). Also, many regional and sub-regional bank have
heavy costs which have been inadequately funded from the HIPC trust account, seriously affectingtheir financing and technical assistance activities.
10. Finally, the Initiative is paradoxical in terms of the history of debt rescheduling mechanisms.
Indeed, a traditional assumption of debt rescheduling is that it should facilitate renewed access to
financial markets, by bringing debt service to manageable levels. Although this assumption is not
always fulfilled, the HIPC Initiative explicitly forbids countries from accessing private markets for a
long time period (up to two decades). This reflects the fragile external and fiscal sustainability
position of most HIPC countries, and the concern of th e official creditors that they do not enter into an
unsustainable debt situation again, as well as the potential for moral hazard on the side of both private
lenders and HIPC countries. However, this condition may also be seen as the counterpart of what is
effectively an insufficient debt relief, which may thus reduce the positive impact of the Initiative on
growth and development in HIPC countries. An additio nal implication is also that these countries will
be subject to an equally long period of conditionality. This stresses the importance of how the PRSPprocess is managed, guaranteeing an effective respect for ownership and diversity of development
strategies. .
11. Also, eligibility criteria provided for under the enhanced HIPC Initiative are too stringent and
have resulted in the exclusion of countries whose economic and social conditions are very similar to
those of the HIPC countries.  Such countries should be considered under the HIPC Initiative.
12. Debt relief should be used for poverty reduction, and in this context the Poverty Reduction
Strategy-process should serve as a viable framework fo r delivering debt relief resources, provided that
its current limitations are addressed. The institutional and administrative costs of debt relief and
assistance delivery, monitoring and programme implementation should be minimized in order to
ensure effective utilization of scarce human and financial resources in HIPC countries. The allocationof assistance should be integrated within the national strategic expenditure framework and budget
execution cycle.  Donor reporting and accountability systems should be integrated into a national
system that has been developed on the basis of agreed standards, and a mutually agreed system of
financial monitoring should be put in place.
13. It is important to emphasize that debt relief should not be at the expense of additional ODA
and should be linked to sound economic management and good governance.
IV. INTERNATIONAL DEBT STANDSTILLS AND WORKOUT PROCEDURES
14. Although no actions have taken place, the extensive discussions on the need for international
rules on debt standstills and orderly workout procedures seems to be leading to an increasing
acceptance of the need to design a mechanism of this sort. As it is well known, such mechanism is
required to avoid the coordination problems implicit in chaotic capital flight, to guarantee an
appropriate sharing of adjustments between lenders and borrowers, and to avoid “moral hazard”issues associated with emergency financing. In international discussions, UNCTAD (1998, 2001) has
presented the most consistent and strongest defence of a mechanism of this sort. In turn, recent
proposals by the IMF (Krueger, 2001 and 2002) have speeded up the international debate on this
issue. In some proposals by developed countries, it has also figured prominently as an explicit
alternative to large rescue packages. There is, however, opposition by developing countries, whoconsider that this mechanism would increase the co sts or reduce access to private international capital
markets, as well as private sector opposition in industrialized countries to non-voluntary
arrangements.WT/WGTDF/W/10
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15. Furthermore, due to the practical difficulties in volved in designing a mechanism of this sort,
there are considerable disagreements on its desirable features.3 As summarised by the International
Monetary and Financial Committee (2000) and Köhler (2000), these difficulties are associated to the
need to strike a balance between broad principles, needed to guide market expectations, and the
operational flexibility, which requires elements of a “case by case” approach. The relative role ofvoluntary negotiations by the parties vs. the interventions required to solve the collective action
problems involved is also subject to heated debates. In any case, as a purely contractual approach is
insufficient, some statutory basis (universal treaty obligations) seem to be required to facilitate
uniformity of interpretation, and to create an international judicial entity that would verify creditors’
claims, the resolution of disputes, and the supervision of voting (Krueger, 2002).
16. Among the delicate issues involved, the first relates to the introduction of collective action
clauses in debt contracts facilitating eventual renego tiations. The most delicate issue in this regard is
the possible discrimination against countries or group of countries that adopt them. For this reason, it
can be argued that such clauses should be universal . Thus, the G-7 countries must actually lead the
process, as they suggested in October 1998, shortly following the Russian crisis (Group of Seven,
1998). Some (such as the UK and Canada) have taken such action, but important countries (especially
the US) unfortunately have not. Exit consent clauses can also play an important role.
17. There is broad agreement that declaration of a standstill by the debtor country should be
voluntary, but there should be some international mechanism that gives it legitimacy and avoids
disruptive legal processes. Although, due to the effect on their credit rating, debtor countries are
unlikely to abuse the mechanism, its use should be subject to control to avoid moral hazard on the side
of borrowers. The IMF seems to be best placed to play this role, particularly if provisions ofArticle VI of the Articles of Agreement are interp reted as providing the basis for such mechanism to
be put in place (Griffith-Jones, S. and Ocampo J.A. 2002).
18. It is also agreed that negotiations should be  voluntary, and should include in an integral
manner public and private sector debts. An international mediator or, eventually, arbitrator could
facilitate negotiations. However, in this regard, th e IMF is not the adequate international agent as, due
to its status as a lender, it fails to meet the “neutral mediator” requirement. So, a different institution
would have to play that role, probably within the United Nations system. An alternative would be for
the IMF to have the power to convene independent in ternational panels to play such roles, on the
principle that it would accept their recommendations. In any case, as an international judicial entity
would be required to play certain functions (see abov e), it might be easier to give the same institution
the role of mediator/arbitrator, including the possibility of convening such panels.
19. Seniority should be granted to lenders who facilitate funds during crises and indeed such
“bailing in” operations could be a requirement to benefit from restructuring, as it is typical in national
bankruptcy procedures. Agreements that include automatic rescheduling provisions for likely events
(e.g., a price collapse in a commodity-dependent country) could also be encouraged. A very
controversial issue relates to whether IMF and multilateral bank lending should be included in
renegotiations. In any case, lending by IFIs should be given automatic seniority, as these institutionsare clearly involved in “bailing in” counter-cyclical operations.
20. There is also broad agreement that capital controls must be in place in debtor countries
throughout the process and during the post-crisis period.
4 Also, capital controls on inflows in
                                                     
3 See a review of some of the controversies involved in IMF (1999, 2000a, 2000b), Boorman and Allen
(2000) and Fischer (1999).
4 This covers only one possible case for capital contro ls. For a broader discussion of this issue, see
Ocampo and Chiappe (2002).WT/WGTDF/W/10
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developing countries facing a rapid build up of debt should be encouraged early on by the IMF as a
result of its preventive surveillance activities.
21. The most controversial issue relates to th e relation between this mechanism and rescue
packages. Indeed, as already noted, some industrialized countries have supported this mechanism as
an alternative to rescue packages. There is a clear case for this view when countries face solvency
problems (i.e., unsustainable debt burdens), but it is more debatable when liquidity  issues are
involved.5 Indeed, due to the multiple equilibria considerations that characterise liquidity crises,
emergency financing is essential for supporting “good equilibria” results. The most clear case is that
in which liquidity constrains, by reducing investor confidence and forcing countries (or firms, in a
national context) to pay excessively high interest rates, effectively lead into a solvency crisis.
Alternatively, in order to avoid borrowing at high interest rates under a liquidity crisis, countries could
adopt very restrictive macroeconomic policies that may lead equally to a loss of confidence byinvestors, as they perceive that dwindling domestic resources would be insufficient to service debt
payments, or that political support would be lacking for full payment of the external debt. Although
some domestic policy issues were certainly involved, the recent Argentinean crisis had some elements
of these multiple equilibria issues.
22. It should be emphasised that there are alternatives to debt standstills for countries facing
liquidity constraints. In particular, during both the Korean and the Brazilian crises, regulatory
authorities in the industrialized countries strongly encouraged commercial banks to renew short term
credit lines these emerging economies.
23. These considerations imply that, although an international orderly debt workout procedure
would certainly help, adequate regulation of capital flows in the source countries and macroeconomicsurveillance will continue to play the most important role in avoiding moral hazard by both lenders
and borrowers. The basic complementary role that adequate regulation, lending of last resort and debt
workouts play in preventing and managing crises has been accepted for decades in domestic policies.
It is hard to understand why they still tend to be seen as substitutes in international financing.
6 
24. Indeed, an alternative system would significantly increase market instability and/or “solve”
moral hazard issues by increasing spreads or severely rationing financing to developing countries. The
recent experience shows, indeed, that the large rescue packages of the 1990s have been serviced
normally. This indicates that the problems faced by the emerging economies that led to large-scale
emergency financing had an important (and, in some country experiences, a dominant) element of
illiquidity rather than insolvency, a fact that argu es for more rather than less emergency financing.7
The case against emergency financing also underestimates the threat that developing country crises
can pose for global financial stability, and greatly overestimate the risks involved in providing funds,as indeed no single cent has been lost by taxpayers of industrialized countries in such operations.
25. Finally, it must be argued that multilateral credit support mechanisms, particularly by
multilateral development banks (MDBs), would be required during the period following debt
                                                     
5 This view is implicit in recent proposals by the IMF, which refer to “timely restructuring of
unsustainable… debts” (Krueger, 2002; emphasis added). However, these proposals avoid analysing what is the
adequate balance between debt workouts and emergency financing, including who judges what areunsustainable debt burdens.
6  There are obviously differences between domestic and possible international bankruptcy procedures.
Particularly, in domestic crises, there is collateral, a f act that implies that capital owners are facing actual risks.
This is unlikely to be as important in international bankruptcy procedures.
7 This does not mean that other structural issues were involved, but rather than liquidity issues were the
major ingredient in sudden  stop of external financing.WT/WGTDF/W/10
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renegotiation. As an essential role of such support should be to catalyse the reinsertion of countries
into private capital markets, a possible mechanism could be a guarantee fund managed by MDBs.
This mechanism would guarantee private sector lending to private or public sector borrowers in the
affected countries with adequate provisions (partial guarantees, higher in the initial years, at an
appropriate cost). This issue has not been included in recent debates and should thus be added as anintegral element of any international debt workout scheme.
26. The IMF should work more closely with the multilateral development banks in designing
more effective crisis-prevention instruments. They  should play a more active role in monitoring
developments in international financial markets, de signing vulnerability indicators or early warning
systems, monitoring domestic macroeconomic policies and developing programmes aimed at
strengthening domestic financial sectors.  The United Nations agencies should also play an active role
in many of these areas.
27. In crisis situations, the renegotiation of the debt with the private sector should be carried out
in the least traumatic way possible for the debtor country and the international community and should
seek to achieve a fair distribution of the associated costs, since for every country suffering from a debt
overhang, there is a corresponding voluntar y over-exposure on the part of its creditors.
28. Debt workouts should provide for an appropriate mix of finance, adjustment and
conditionality.  Preference must clearly be given to voluntary arrangements, but it is necessary to
create conditions that will pave the way for a rapid, appropriate solution for both creditors and
borrowers. Early renegotiations appear to be pref erable to automatic deferral clauses, which may
sometimes simply postpone or aggravate the problem. Steps must be taken to bring about an orderly
restructuring before reserves are depleted. Otherwise, countries will be pressured into acceptinghurried, disadvantageous negotiations that are unlik ely lead to a new, sustainable scenario, whereas
the aim is to ensure that the new obligations will actually resolve the original problem and thus
prevent its recurrence.
29. The standstill should cover all of the country’s obligations, with priority being given to its
sovereign debt; the sovereign debt and private-sector debt should be negotiated separately from oneanother.
30. Brady-type bonds could be used as appropriate restructuring instruments.  Official
development financing will be required during the period after renegotiations in which debtors will
lack access to private capital markets.  Alternatively, a debt guarantee fund managed by the World
Bank and regional development banks could facilitate renewed access to private markets.WT/WGTDF/W/10
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