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The US and development financing


03/2005
  

[ Development financing ]

Indecent proposal

John Snow, the US Treasury Secretary, is a proponent of comprehensive debt relief. He also wants to stop multilateral lending to the least developed countries. The proposal sounds generous. However it would, in the long run, undermine the capacities of the World Bank and reduce the funds available to the weakest members of the international community. Therefore, donor countries did not cave in to Snow’s ideas when they recently decided on replenishing the funds of IDA, the World Bank affiliate serving least developed countries.


[ By Helmut Gauges and Alexandra Albin ]

Many economists in the USA, as a matter of principle, dislike the idea of waiving the debts of highly indebted states. They fear “moral hazard”. This term stands for the ethical confusion, which results when over-indebtedness is not penalised and which consequently, might encourage governments to behave even more irresponsibly. On the other hand, it is clear that over-indebted countries need relief. This is why the Clinton administration agreed to the highly indebted poor countries initiative in 1999 (“HIPC II”).

Last year, John Snow, the US Treasury Secretary, made a radical proposal to resolve the matter of over-indebtedness once and for all. He suggested that,
– debts due to the World Bank, IMF and African Development Bank from those HIPC countries that meet the debt relief criteria should be waived in full, and that
– these countries should, in future, only be given grants by the World Bank affiliate IDA (International Development Association), which are not to be repaid.

So far, IDA has been granting loans on particularly favourable terms to the least developed countries. Over 40 years, they do not pay interest but only an annual service charge of 0,75 %. IDA works with a revolving fund, and approximately 40% of its budget stems from return flows. If these funds were to drop in the future, either the allocations from the donor countries would have to increase or the new loan commitments to poor countries would have to decrease. In late February, donors agreed to increase IDA funds by at least 25 % to $ 34 billion over the next three years.They agreed to raise the share of grants from 20 to 30 %, which makes sense in order to prevent unsustainable indebtedness of particularly poor countries. However, the USA’s aspiration of reaching a 50% ratio of grants and shares was rejected.

And rightly so. The USA argues that the net transfer of resources from IDA to the HIPC countries would remain the same if debt relief and grants were set off against lower loan commitments. This notion is based on the idea that debt service payments to IDA would drop by the same extent, as new loan commitments would be reduced. But this reasoning is short sighted. The United Nation’s Millennium Development Goals (MDG) require more resources until 2015. This was also confirmed by the Monterrey Summit on Financing for Development in 2002. In this context, the American proposal is not helpful at all.

Instead, Washington’s supposedly generous recommendation amounts to a clear reduction of IDA funds in the long run. The end result of this could even be to jeopardise the institutional viability of IDA and to force the World Bank Group to drastically reduce its capacities. The American idea thus goes even further than the controversial Meltzer report did five years ago. This document suggested that the World Bank withdraw from emerging markets and focus exclusively on the least developed countries.


Sound criteria must be developed

There are other arguments against America’s over-simplified position on the HIPC countries:
– These countries are not a homogeneous group. The debt sustainability criterion used in the HIPC-II initiative is the ratio of their debt to export earnings. This figure amounts to 127% in the case of Tanzania but to 1765% in the case of Liberia. While Tanzania has made considerable steps forward over recent years both in the diversification of its exports and in regard to its debt management, Liberia is a post-conflict country where the economy has completely broken down and state structures have disintegrated. There are considerable differences even among those HIPC countries, which have fulfilled the previous conditions for debt relief. For example, three export products make up 91% of the export revenue in Mauritania, while the respective share for Senegal is only 13%. According to the International Monetary Fund, Ethiopia has succeeded in doubling the proportion of public revenue in its gross domestic product since 1992, while that ratio has remained constant in Mozambique.

– Internationally, it is not in dispute that countries, which are unable to bear their debts, should only receive grants. However, what is controversial is how debt sustainability is to be measured and what negative impacts classifying a country as a “grant only country” would have on potential investors. An agreement on sound criteria is necessary and the World Bank has already come up with a suggestion (2004).

However, Secretary Snow does not restrict his comments to demanding more grants for the most highly indebted developing countries. He generally argues against development lending. In concrete terms, the US administration is challenging bilateral practices that it considers trade-distorting to the detriment of American companies. The USA’s bilateral aid only makes grants, and thus the blame is entirely on other governments. Last autumn, at a meeting of the seven leading industrial nations, the USA pushed through a “transparency exercise”, initially restricted to two years.

From 2005 on, this is meant to provide information on the procurement practices that go along with development lending. At the insistence of the USA and other donor countries, grant-based projects are not included, even though these may distort trade considerably. To date, Washington has not published any official figures on the proportion of grant-financed projects tied to American supplies. Estimates put the proportion at more than 90%.


Counter-productive initiative

The USA also wants further regulation and limitation of concessionary lending, which is not tied to supply contracts. Among other things, the idea is to permit the granting of loans to middle income countries only up to a total volume of seven million special drawing rights (approximately ¤ 8.1 million). This rule would prove counter-productive. In the early 1990s, the OECD’s Development Assistance Committee introduced an initiative against tied loans. Many countries have joined it. On top of everything else, Snow’s ideas also run counter to the MDG agenda and the Monterrey consensus. A large number of poor people live in middle-income countries and it is these countries, in which favourable loans can mobilise considerable funds for poverty reduction.

Even if the US government doesn’t want to admit it, loans can definitely serve development policy well. Intelligent development financing is not limited to grants. Rather, it is possible to transfer much more money by mixing state funds with commercial loans in order to create a high volume of low -interest loans. KfW development bank has successfully done so by raising capital on the financial markets for the benefit of developing countries and adding this money to funds from Germany’s Federal Budget.

One example of this approach is the “Mise à Niveau” programme in Tunisia with ¤ 6 million from the Development Ministry and ¤ 32 million from the KfW. The programme is geared towards preparing companies for the abolition of trade restrictions with the EU and securing jobs. The fact that Germany has a development bank of its own helps to design such policies and gives the country a comparative edge over other donors which do not have such an institution.

In any event, loans, rather than donations, improve responsible ownership by partner countries. They promote debt management skills, reduce dependency and help to introduce countries to financial markets. On the other hand, being branded as a “grant only country” would send danger signals and scare off direct foreign investors.

What is needed now is not a generalised demand to increase grants. Rather, we should discuss how to use grants correctly and intelligently so as to stem the indebtedness of the HIPC countries on the one hand and to achieve the maximum level of funding possible on the other hand. In international discussions, KfW is in favour of country-specific solutions, with the aim of reducing the impacts of external shocks and decreasing the volatility of development funding. The goal in the medium term must be to create and further develop innovative instruments. They must be aligned to the economic credit-standing of each country and provide a broad range of funding conditions, so as to satisfy the various needs of our various partners.



Further Information:
World Bank 2004: Discussion Paper: “Debt Sustainability and Financing Terms in IDA, 14 June 2004”.



Helmut Gauges
is director of the Strategy Division of the KfW development bank.
helmut.gauges@kfw.de

Alexandra Albin
works at the KfW as senior economist.
alexandra.albin@kfw.de