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Debt relief for post-conflict countries
The HIPC initiative needs new instruments
By Nassir Djafari
The conditionality of the HIPC-II Initiative is not well suited to post-conflict countries. Since in these countries both state and civil society need first to be reconstructed, they cannot be called upon as actors right from the start. Nassir Djafari (Senior Economist with the German development bank KfW) proposes that new rules should be introduced here, and that first of all a moratorium on debt servicing should be granted.
The conditionality of the HIPC-II Initiative is not well suited to post-conflict countries. Since in these countries both state and civil society need first to be reconstructed, they cannot be called upon as actors right from the start. Nassir Djafari (Senior Economist with the German development bank KfW) proposes that new rules should be introduced here, and that first of all a moratorium on debt servicing should be granted.
Violent conflicts in low-income countries have increased sharply since the beginning of the 1990s. They are mainly internal conflicts which, besides their enormous cost in human lives, have set back the countries' economic development by decades and dramatically worsened poverty. Most cross-border and civil wars have taken place in Africa, where during the last 10 years almost half of all countries were involved in armed conflicts. The African Development Fund estimates that armed conflicts in Africa have resulted in a 50 per cent decline in their economic growth and destruction of three-quarters of their infrastructure. In most cases, the countries affected by cross-border and civil wars no longer service their external debt.
For instance, the Democratic Republic of Congo, which from 1994 was involved in a civil war, had piled up a mountain of debt totalling US$ 12.9 billion by 2001. The country's arrears total US$ 9.4 billion, or almost twice its gross domestic product. Most of the poor conflict countries are indebted far above average and unable to sustain their debt servicing in the long term. For example, in Ethiopia external debt amounts to 343 per cent of its export earnings, in Burundi it comes to 985 per cent, and in Sudan 1,319 per cent. By comparison, the HIPC-II Initiative is based on a debt sustainability criterion of 150 per cent of export income.
Indebtedness of poor post-conflict countries
Apart from the unfavourable terms of trade for the developing countries on world markets and a misguided economic policy, the high proportion of military spending to their GDP is a major cause of the debt overload.. While the rich OECD countries' defence spending averages 1.9 per cent of their GDP, its share in many of the poor countries is much higher; in East Africa it averages 5.5 per cent, in Central Africa 3.3 per cent, and in West Africa 2.5 per cent.
For post-conflict countries the huge debts mean a heavy additional burden on their recon-struction efforts and thus consolidation of the peace process. Due to war-related destruction and the concomitant decline of the economy, the state has less revenue compared to the pre-war situation. Since debt servicing demands a major share of state revenues, even fewer re-sources remain available for reconstruction. For instance, in 2001 Sierra Leone spent 89 per cent of its state revenue on servicing debt. The country could manintain basic state functions only because they were financed from donor community funds. Following the country's in-terim relief under the HIPC II Initiative, its debt-servicing ratio dropped to 18 per cent.1
Studies by the World Bank show that 50 per cent of the post-conflict countries are affected anew by a violent conflict within 10 years of the ending of the last one. Therefore an impor-tant challenge to the international community is to prevent these countries lapsing back into civil and cross-border wars. Debt relief can play an important role here. It means post-conflict countries get the chance for reconstruction and thus consolidation of the peace process. How-ever, the general political and social framework needed to ensure that debt relief really does contribute to sustainable peace are possibly difficult.
Difficulties of reconstruction
The general conditions for debt relief in the case of conflict or post-conflict countries are more difficult than for other countries. On the one hand, the post-conflict countries face huge economic demands:
&Mac183; reconstruction of destroyed infrastructure;
&Mac183; repatriation of displaced persons;
&Mac183; resumption of basic social services;
&Mac183; start-up of food production; and
&Mac183; stimulation of the export trade.
On the other hand, their human and financial resources are largely exhausted. As the example of Mozambique shows, it takes many years before the pre-war level, which was already marked by poverty and underdevelopment, is reached again.
In this situation, debt servicing is a major burden for the post-conflict countries. In addition, it is often the case that the state itself is a (former) party to the conflict. Due to its security inter-ests the government often spends a relatively high proportion of its budget on arms even after the end of the war.
In addition, the state is weak, and frequently enjoys only a limited legitimacy among the peo-ple. Its administration is often not yet suited for effective governance. In many cases the state structures have gone to ruin and must be rebuilt. As a rule, the political leadership has been in power for only a short time, has hardly any experience of government and must first of all find its way into its role. Also, civil society or the political Opposition often have been badly weakened by cross-border or civil war and cannot articulate their interests vis-à-vis the state in an adequate way.
Debt relief under the HIPC-II Initiative
Of the 38 countries participating in the HIPC-II Initiative, 12 have a conflict or post-conflict background. Hence, the Initiative can play an import role in stabilising crisis-endangered poor countries or in consolidating the peace process in post-conflict states.
Based on its fundamental idea, the HIPC-II Initiative is much more suited to contribute to peacekeeping than previous debt relief initiatives, because for the first time not only macro-economic reforms but also the participation of the people in political processes, as well as measures to improve governance, have been made preconditions for relief. The governments of the debtor countries must commit themselves to develop and implement a national poverty reduction strategy (PRS) in a dialogue with civil society before their debt level will be reduced. The question arises of whether this is realistic in the case of the post-conflict countries, in which the state structures must first be rebuilt and civil society must first reorganise itself.
Preconditions for HIPC-II debt relief
To benefit from relief, debtor countries must qualify for it in two stages:
Stage 1: The HIPC must implement a three-year structural adjustment programme within whose framework substantial macroeconomic reforms are realised. In parallel, the government develops together with the civil society organisations a national poverty reduction strategy (PRS). The World Bank and International Monetary Fund (IMF) scrutinise the implementation of the reform programme and the draft PRS. If both preconditions are met, the country has reached the decision point. The donors then relieve part of the respective HIPC country’s debts.
Stage 2: The HIPC implements further reform measures agreed with the World Bank and IMF and develops together with the civil society organisations the final version of the PRS. After renewed examination by the IMF and World Bank, relief is implemented completely (floating completion point), meaning the country is granted relief to the extent that it can service its remaining debt on a sustainable basis. The government must commit itself to use the net present value of the relieved debt in national currency for poverty reduction measures, particularly measures in the education and public health sector.
To date, eight countries have achieved the preconditions of the completion point and 18 have reached the deci-sion point. The latter include the post-conflict countries Ethiopia, Guinea-Bissau, Rwanda and Sierra Leone.
The World Bank and IMF take account of the special situation of the post-conflict countries in that in their case they interpret flexibly the conditions of HIPC debt relief for reaching the decision point. For instance, in individual cases the usual structural adjustment programme period of three years was shortened, and less stringent demands were made in terms of the content of the interim PRSP to be developed with the participation of the people. In addition, in view of the difficult budget situation of some post-conflict countries (such as Guinea-Bissau), when they reach the decision point they are granted relief on a greater proportion of their debt than is usual.
Despite the demonstrated flexibility of the multilateral donors, high demands still remain. Thus, the governments of the post-conflict countries must prove that they are implementing macroeconomic reforms consistently, improving the transparency of public finances, as well as using their budgets in a poverty-oriented way, and cutting their military spending. As part of its budget analyses, the IMF checks among other things the partner countries' military ex-penditure. However, complete registration of military spending is difficult because in many cases it appears in public budgets either under other headings or is not recorded at all.2
On account of its guidelines on allocation of funds, the IMF usually does not approve loans to countries that are in arrears to it. But since this is the case with regard to almost all post-conflict countries, the IMF supports these states with complementary technical assistance and advisory services in the sectors of budgeting and monetary and exchange rate policy. As soon as a country's situation has stabilised sufficiently, financial support for it is also possible. Due to its internal regulations the IMF can provide funds to post-conflict countries only on non-concessionary terms. However, through grant cofinancing from bilateral donors it is possible to provide post-conflict countries with IMF funds at subsidised interest rates.
Like the IMF, the World Bank also supports post-conflict countries at first by advisory serv-ices and technical assistance before it supports through loan projects and programs. The World Bank loans are made at favourable rates compared to the usual market terms, but they nevertheless burden the already weak balance of payments of the post-conflict countries.
Solution: a moratorium on debt servicing
Debt relief for post-conflict countries results in the targeted impacts only if it is implemented quickly. This is because in view of the unstable political situation and social tensions after the ending of violent conflicts governments must act rapidly. This contradicts the conditions of the HIPC-II Initiative, whose fulfilment requires a long run-up (going through a structural adjustment programme, participatory drawing up of a PRSP, etc.). On the other hand, there are good reasons for the HIPC-II conditions, for democratic and market economy reforms are basic prerequisites for overcoming the structural causes of conflicts, as well as for sustainable poverty reduction. This conflict of goals has to date been paid too little attention in the debate on debt relief for post-conflict countries. The attempt by the World Bank and the IMF to come up with a solution by interpreting the HIPC-II conditionality 'flexibly', basically changes nothing about the dilemma.
The gap between the demand for debt relief and the unfavourable conditions of the post-conflict countries apparently makes it necessary to treat the heavily indebted poor post-conflict countries differently from the other HIPC states right from the start. For example, one could grant a moratorium on debt servicing to post-conflict countries which fulfil certain minimum criteria, yet to be laid down, on good governance and orientation on poverty. In the difficult postwar years, such strategy would give them the opportunity to restore the state to working order, build up the economy and bring about a national consensus without having to bear an external financial burden,. During this period they could also, without deadline pres-sure, draw up and implement a national poverty reduction and development strategy (PRSP) with the participation of the various societal actors and stakeholders.
Fresh money as grants only
This proposal appears to be worthy of discussion also under other aspects. To date, the donors have financed the poor post-conflict countries on account of their negligible own funds. As money is interchangeable the donors' reconstruction assistance has in the end indirectly financed debt servicing itself. Hence, loans are granted in fact at the cost of the countries' renewed medium-term debt overload. Would it not be more consistent to grant these countries a moratorium on debt servicing for, say, five years after the end of a war, so that additional money, both that of the country as well as of the donors, can flow into poverty reduction and thereby consolidate the peace process? Obviously, that also includes the proviso that the World Bank and other donors provide only grants and no longer loans for the reconstruction of poor post-conflict countries, as the KfW already does anyway with very poor countries, within the framework of German Financial Cooperation (FC). In many post-conflict countries, KfW promotes the reintegration of ex-combatants, the reconstruction of infrastructure and employment programmes by grants which do not have to be repaid. A special target group here are refugees and displaced persons, including women and the youth.
The moratorium on debt servicing could be combined with debt conversion models, such as those the KfW currently implements – for the German Ministry of Economic Cooperation and Development (BMZ) as part of its usual financial cooperation (FC) with developing countries. Such an approach is followed particularly in Latin America, where the relief on their FC debts is granted to partner countries, if they use the net present value in local currency (such as 50 per cent) for measures to reduce poverty or for environmental protection. In many cases, the present value funds are used to top up ongoing FC programmes. By this means the general impact of the FC programmes is enhanced. In the case of the post-conflict countries, with the aid of the FC debt conversion, the debt burden of the partner country was reduced in a very short time. The present value funds could be used together with fresh FC pledges for projects which promote the peace process directly, such as the reintegration of ex-combatants or resettlement of refugees.
1. IMF: Heavily Indebted Poor Countries Initiative – Status of Implementation August 16, 2002, p.98
2. DFID, Off-Budget Military Expenditure and Revenue: Issues and Policy Perspectives for Donors. Dylan Hendriksen and Nicole Ball, London January 2002
Nassir Djafari is Senior Economist in the Sector and Policy Division Development Eco-nomics of KfW’s Development Cooperation Strategy Department.
nassir.djafari@kfw.de
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