Developing Countries: Challenges in Financing Poor Countries' Economic Growth and Debt Relief Targets
Released: 2004-04-20T00:00:00

Letter

Background

The World Bank and IMF have classified 42 countries as heavily indebted and poor; three quarters of these are in Africa. In 1996, creditors agreed to create the HIPC Initiative to address concerns that some poor countries would have debt burdens greater than their ability to pay, despite debt relief from bilateral creditors. In 1999, in response to concerns about the continuing vulnerability of these countries, the World Bank and the IMF agreed to enhance the HIPC Initiative by more than doubling the estimated amount of debt relief and increasing the number of potentially eligible countries. A major goal of the HIPC Initiative is to provide recipient countries with a permanent exit from unsustainable debt burdens. To date, 27 poor countries have reached their decision points, and 11 of these have reached their completion points. In 1996, to help multilateral creditors meet the cost of the HIPC Initiative, the World Bank established a HIPC Trust Fund with contributions from member governments and some multilateral creditors. The HIPC Trust Fund has received about $3.4 billion (nominal) in bilateral pledges and contributions, including $750 million in pledges from the U.S. government.

Key Multilateral Development Banks Face Significant Challenges to Financing the Existing Initiative

The World Bank, AfDB, and IaDB face a combined financing shortfall of $7.8 billion in present value terms under the existing HIPC Initiative (see table 1).

The World Bank Has An Estimated Financing Gap of $6 Billion

Financing the enhanced HIPC Initiative remains a major challenge for the World Bank. The total cost of the enhanced HIPC Initiative to the World Bank for 34 countries is estimated at $9.5 billion. As of June 30, 2003, the World Bank had identified $3.5 billion in financing, resulting in a gap of about $6 billion (see table 1). Donor countries will be reviewing the financing gap during the IDA-14 replenishment discussions beginning in spring 2004. If donor countries close the financing gap through future replenishments, we estimate that the U.S. government could be asked to contribute $1.2 billion, which is based on its historical replenishment rate of 20 percent to IDA.

Over 70 percent of the funds IDA has identified thus far come from transfers of IBRD’s net income to IDA. Although IBRD has not committed any of its net income for HIPC debt relief beyond 2005, we estimate that the financing gap of $6 billion could be reduced to about $3.5 billion, or by about 42 percent, if the net income transfers from the IBRD continue. Similarly, the U.S.’s potential share decreases by the same percentage, from $1.2 billion to about $700 million. However, transferring more of IBRD’s net income to HIPC debt relief could come at the expense of other IBRD priorities.

AfDB Has a Financing Gap of at Least $1 Billion

The total cost of the enhanced HIPC Initiative to the AfDB for its 32 member countries is estimated at about $3.5 billion (see table 1). As of September 2003, the AfDB has identified financing of approximately $2.3 billion, including $2 billion from the HIPC Trust Fund and about $300 million from its own resources. Thus, AfDB is faced with a financing shortfall of about $1.2 billion in present value terms. We estimate that AfDB will need about $400 million to cover its shortfall for its 23 eligible countries, as well as about $800 million for its 9 potentially eligible countries. In addition, we estimate that the U.S. share of the AfDB’s financing shortfall is between $132 and $348 million, depending on the method used to close the $1.2 billion shortfall.

IaDB Expects to Finance HIPC Commitments at the Expense of Future Lending

The IaDB expects to provide about $1.4 billion for HIPC debt relief to four countries—Bolivia, Guyana, Honduras, and Nicaragua. Most of the relief is for debt owed to the Fund for Special Operations (FSO), the concessional lending arm of the IaDB that provides financing to the bank’s poorer members. As of January 2004, the IaDB has identified financing for the full $1.4 billion, about $200 million from donor contributions through the HIPC Trust Fund and $1.2 billion through its own resources. Although the IaDB is able to cover its full participation in the HIPC Initiative, the institution faces about a $600 million reduction in the lending resources of its FSO lending program from 2009 through 2019 as a direct consequence of providing HIPC debt relief. According to IaDB officials, the FSO will not have enough money to lend from 2009 through 2013. To eliminate this shortfall, donor countries may be asked to provide the necessary funds through a future replenishment contribution. Assuming that donor countries agree to close the financing gap, we estimate that the U.S. government could be asked to contribute about $300 million so that the FSO can continue lending to poor countries after 2008. This estimate is based on the 50-percent rate at which the United States historically contributes to the FSO.

Financing Shortfall Is Understated

The $7.8 billion shortfall for the three MDBs is understated for two reasons. First, the estimated financing shortfall for two institutions—IDA and the AfDB—is understated because the data for four likely recipient countries—Laos, Liberia, Somalia, and Sudan—are unreliable. The World Bank considers existing estimates of the countries’ total debt and outstanding arrears to be incomplete, subject to significant change, and it is uncertain when the countries will reach their decision points. Similarly, the estimated costs of debt relief for three of AfDB’s countries—Liberia, Somalia, and Sudan—are likely understated due to data reliability concerns.

Second, the financing shortfall does not include any additional relief that may be provided to countries because their economies deteriorated since they originally qualified for debt relief. Under the enhanced HIPC Initiative, creditors and donors could provide countries with additional debt relief above the amounts agreed to at their decision points, referred to as “topping up.” This relief could be provided when external factors, such as movements in currency exchange rates or declines in commodity prices, cause countries’ economies to deteriorate, thereby affecting their ability to achieve debt sustainability. The World Bank and IMF project that seven to nine countries may be eligible for additional debt relief, and their preliminary estimates range from $877 million to about $2.3 billion, depending on whether additional bilateral relief is included or excluded from the calculation. The additional cost to the U.S. government could range from $106 million to $207 million for assistance to the World Bank and AfDB, based on the U.S. historical replenishment rates to these banks. Furthermore, the topping-up estimate considered only the 27 countries that have reached their decision or completion point; the estimate may rise as additional countries reach their decision points.

Achieving Economic Growth and Debt Relief Targets Requires Substantial Financial Assistance

Even if the $7.8 billion shortfall is fully financed, we estimate that, if exports grow slower than the World Bank and IMF project, the 27 countries that have qualified for debt relief may need more than $375 billion in additional assistance to help them achieve their economic growth and debt relief targets through 2020. This $375 billion consists of $153 billion in expected development assistance, $215 billion in assistance to fund shortfalls from lower export earnings, and at least $8 billion for debt relief (see fig. 1). If the United States decides to help fund the $375 billion, we estimate it would cost approximately $52 billion over 18 years.

Countries Projected to Receive Development Assistance through 2020

According to our analysis of World Bank and IMF projections, the expected level of development assistance for the 27 countries is $153 billion through 2020. This estimate assumes that the countries will follow their World Bank and IMF development programs, including undertaking recommended reforms. It also assumes that countries achieve economic growth rates consistent with reducing poverty and maintaining long-term debt sustainability. These conditions will help countries meet their development objectives, including the Millennium Development Goals that world leaders committed to in 2000. These goals include reducing poverty, hunger, illiteracy, gender inequality, child and maternal mortality, disease, and environmental degradation. Another goal calls on rich countries to build stronger partnerships for development and to relieve debt, increase aid, and give poor countries fair access to their markets and technology.

Countries Face a Substantial Financial Shortfall in Export Earnings

We estimate that 23 of the 27 HIPC countries will earn about $215 billion less from their exports than the World Bank and IMF project. The World Bank and IMF project that all 27 HIPC countries will become debt sustainable by 2020 because their exports are expected to grow at an average of 7.7 percent per year. However, as we have previously reported, the projected export growth rates are overly optimistic. We estimate that export earnings are more likely to grow at the historical annual average of 3.1 percent per year—less than half the rate the World Bank and IMF project. Under lower, historical export growth rates, countries are likely to have lower export earnings and unsustainable debt levels (see table 2). We estimate the total amount of the potential export earnings shortfall over the 2003 to 2020 projection period to be $215 billion.

High export growth rates are unlikely because HIPC countries rely heavily on primary commodities such as coffee, cotton, and copper for much of their export revenue. Historically, the prices of these commodities have fluctuated, often downward, resulting in lower export earnings and worsening debt indicators. A 2003 World Bank report found that the World Bank/IMF growth assumptions had been overly optimistic and recommended more realistic economic forecasts when assessing debt sustainability.

Since HIPC countries are assumed to follow their World Bank and IMF reform programs, any export shortfalls are considered to be caused by factors outside their control such as weather and natural disasters, lack of access to foreign markets, or declining commodity prices. Although failure to follow the reform program could result in the reduction or suspension of development assistance, export shortfalls due to outside factors would not be expected to have this result. Therefore, if countries are to achieve economic growth rates consistent with their development goals, donors would need to fund the $215 billion shortfall. Without this additional assistance, countries would grow more slowly, resulting in reduced imports, lower gross domestic product (GDP), and lower government revenue. These conditions could undermine progress toward poverty reduction and other goals.

Additional Assistance Will Lead to Debt Sustainability in Most Countries

Even if donors make up the export earnings shortfall, more than half of the 27 countries will experience unsustainable debt levels. We estimate that these countries will require $8.5 to $19.8 billion more to achieve debt sustainability and debt-service goals. After examining 40 strategies for providing debt relief, we narrowed our analysis to three specific strategies: (1) switching the minimum percentage of loans to grants for future multilateral development assistance for each country to achieve debt sustainability, (2) paying debt service in excess of 5 percent of government revenue, and (3) combining strategies (1) and (2). We chose these strategies because they maximize the number of countries achieving debt sustainability while minimizing costs to donors. We found that, with this debt relief, as many as 25 countries could become debt sustainable and all countries would achieve a debt service-to-revenue ratio below 5 percent over the entire 18-year projection period (see table 3).

In the first strategy, multilateral creditors switch the minimum percentage of loans to grants for each country to achieve debt sustainability in 2020. We estimate that the additional cost of this strategy would be $8.5 billion. The average percentage of loans switched to grants for all countries under this strategy would be 33.5 percent. Twelve countries are projected to be debt sustainable with no further assistance. In addition, 13 countries would achieve sustainability by switching between 2 percent (Benin) and 96 percent (São Tomé and Príncipe) of new loans to grants. A total of 25 countries could be debt sustainable by 2020, although only 2 countries would achieve the 5-percent debt service-to-revenue target over the entire period.

The second strategy is aimed at reducing each country’s debt-service burden. Under this strategy, donors would provide assistance to cover annual debt service above 5 percent of government revenue. We estimate that this strategy would cost an additional $12.6 billion to achieve the goal of 5-percent debt service to revenue for all countries throughout the projection period. Under this strategy, no additional countries become debt sustainable other than the 12 that are already projected to be debt sustainable with no further assistance. While this strategy would free significant resources for poverty reduction expenditures, it could provide an incentive for countries to pursue irresponsible borrowing policies. By guaranteeing that no country would have to pay more than 5 percent of its revenue in debt service, this strategy would separate the amount of a country’s borrowing from the amount of its debt repayment. Consequently, it could encourage countries to borrow more than they are normally able to repay, increasing the cost to donors and reducing the resources available for other countries.

The third strategy combines strategies 1 and 2 to achieve both debt sustainability and a lower debt-service burden. Under this strategy, multilateral creditors would first switch the minimum percentage of loans to grants to achieve debt sustainability, and then donors would pay debt service in excess of 5 percent of government revenue. We estimate that this strategy would cost an additional $19.8 billion, including $8.5 billion for switching loans to grants, and $11.3 billion for reducing debt service to 5 percent of revenue. Under this strategy, 25 countries would achieve debt sustainability in 2020—that is, 13 countries in addition to the 12 that are projected to be debt sustainable with no further assistance. All 27 countries would reach the 5-percent debt-service goal for the duration of the projection period. However, similar to the debt-service strategy above, this strategy dissociates borrowing from repayment and could encourage irresponsible borrowing policies.

If the United States decides to help fund the $375 billion, we estimate that it could cost approximately $52 billion over 18 years, both in bilateral grants and in contributions to multilateral development banks. This amount consists of $24 billion, which represents the U.S. share of the $153 billion in expected development assistance projected by the World Bank and IMF, as well as approximately $28 billion for the increased assistance to the 27 countries. Historically, the United States has been the largest contributor to the World Bank and IaDB, and the second largest contributor to the AfDB, providing between 11 and 50 percent of their funding. The U.S. share of bilateral assistance to the 27 countries we examined has historically been about 12 percent.

Volatility in Export Earnings Likely to Further Increase the Cost of Achieving Debt Sustainability

We also analyzed the impact of fluctuations in export growth on the likelihood of these countries achieving debt sustainability. The export earnings of HIPC countries experience large year-to-year fluctuations due to their heavy reliance on primary commodities, as well as weather extremes, natural disasters, and other factors. We found that the higher a country’s export volatility, the lower its likelihood of achieving debt sustainability. For example, Honduras has low export volatility, resulting in little impact on its debt sustainability. In contrast, Rwanda has very high export volatility, which greatly lowers its probability of achieving debt sustainability. Since volatility in export earnings reduces countries’ likelihood of achieving debt sustainability, it is also likely to further increase donors’ cost as countries may require an even greater than expected level of debt relief to achieve debt sustainability.

Mr. Chairman and Members of the Committee, this concludes my prepared statement. I will be happy to answer any questions you may have.

Contacts and Acknowledgments

For additional information about this testimony, please contact Thomas Melito, Acting Director, International Affairs and Trade, at (202) 512-9601 or Cheryl Goodman, Assistant Director, International Affairs and Trade, at (202) 512-6571. Other individuals who made key contributions to this testimony included Bruce Kutnick, Barbara Shields, R.G. Steinman, Ming Chen, Robert Ball, and Lynn Cothern.

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