Debt Relief and Fiscal Sustainability
In the fall of 1996, and as part of a new approach towards poverty reduction, the World Bank and the International Monetary Fund developed a wide-ranging plan to provide debt relief to many of the poorest nations in the world. This program, which has come to be known as the Highly Indebted Poor Countries (HIPC) debt relief initiative, contemplates the forgiveness of a fraction of these countries bilateral and multilateral debt. An eligibility requirement for participating in the program is that the country in question develops a well-defined poverty alleviation program. The funds freed-up by debt-relief should be devoted to effective social programs that, in the eyes of the multilateral institutions, will contribute to the reduction of poverty. In addition, the country is expected to implement broad economic reforms aimed at strengthening the productive sector and increasing growth potential. By early 2002, 22 poor countries had made substantial progress in negotiating debt relief within the context of the HIPC initiative.
The amount of actual debt relief contemplated in the HIPC initiative varies from country to country. A basic principle guiding the program is that in the post-HIPC era the country in question will be able to achieve external sector sustainability, and thus will not require new rounds of debt forgiveness.
In a recent document, the World Bank and the IMF (2001) have stated this principle in the following way: [B]y bringing the net present value (NPV) of external debt down to about 150 percent of a countrys exports or 250 percent of a countrys revenues at the decision point, it aims to eliminate this critical barrier to longer term debt sustainability for these countries.
A particularly important question refers to the type of fiscal policy that will be consistent with maintaining debt sustainability in the post HIPC era. As the above quote suggests, the multilaterals have focused on policies required to stabilize the ratio of external debt to exports. A comprehensive answer to the fiscal sustainability question, however, requires going beyond the countrys external debt, and to consider the sustainability of aggregate public sector debt, including both foreign as well as domestic debt. While many HIPC nations have little domestic debt, others have accumulated a significant stock of debt that has been purchased by the local banking sector, pension funds and individuals. Indeed, by ignoring the role of domestic debt, sustainability analyses may underestimate the magnitude of the fiscal effort that poor countries will have to make in the post-HIPC era. Very large required fiscal adjustments could have, in turn, important political economy consequences. First, the adjustment may result in a reduction of funds available to implement the anti-poverty programs. And second, very large reductions in primary expenditures may result in political instability and reform backtracking. The purpose of this paper is to analyze the relationship between fiscal policy, aggregate public sector debt sustainability, and debt relief. In particular, the author develops a methodology to compute the fiscal policy path that is compatible with aggregate debt sustainability in the post-HIPC era. This model explicitly considers the role of domestic debt, and quantifies the extent to which future debt sustainability depends on the availability of concessional loans at subsidized interest rates. The working of the model is illustrated for the case of Nicaragua, a country that in 2002 had one of the highest net public external debt to GDP ratios: approximately 280%. Nicaragua is the second poorest country in the Western Hemisphere (after Haiti), and for the last decade has relied very heavily on foreign assistance and aid. The results from this analysis indicate that unless Nicaragua receives substantial concessional aid in the future, its public sector debt is likely to, once again, become unsustainable. The reason for this is that in the absence of large volumes of concessional assistance Nicaragua would be forced to undertake a fiscal adjustment in the order of 6% to 8% of GDP to achieve sustainability. Adjustments of this magnitude usually crowd out social expenditures, including poverty alleviation programs, and tend to create political economy difficulties. Although this result has been obtained for the specific case of Nicaragua, the methodology used is very general and underlies two general problems that affect most HIPC countries: First, ignoring the existing domestic debt burden is likely to result in highly misleading analyses. And second, the international community should be aware that sustainability would depend very heavily on the future availability of subsidized concessional loans.
The rest of the paper is organized as follows: In Section II a model of debt relief and fiscal sustainability is developed. In Section III the model is calibrated and simulated for the case of Nicaragua. Section IV deals with some extensions and results from a sensitivity analysis. In Section V author discusses the connection between grants, donations and fiscal effort. Finally, in Section VI some concluding remarks are represented.