Nafziger Economic Development (4th ed)

566 Part Four. The Macroeconomics and International Economics of Development

Yet, ironically for some countries, a high rank among LDC debtors indicated a high credit rating among commercial banks. South Korea, which received substantial overseas development assistance until it graduated to high-income status in 1994 and borrowed at submarket interest rates showed that heavy borrowing can be serviced as long as exports, GNP, and debt-servicing capacity grow rapidly (Demirguc-Kunt and Detragiache 1994:261–285). Even after Korea suffered from the contagion of the 1997 Asian crisis, the U.S. Treasury and the IMF agreed to a Christmas Day rescue, persuading creditors (commercial banks) to roll over the debt of Korea, who international financial magnates decided was too big to fail (Bluestein 2001:175–205). Indeed, Korea’s debt-service ratio was only 7 percent, compared to the following for slow growers: 38 percent for Bolivia, 22 percent for Ecuador,19 percent for Ethiopia, 14 percent for Honduras, 35 percent for Kazakhstan, 23 percent for Mauritania, 37 percent for Nicaragua, 23 percent for Peru, and 25 percent for Vietnam (World Bank 1993g:Vol. 1, 234–237; World Bank 2003e:232–234). A large debt need not be a problem so long as foreign creditors believe an economy can roll over the debt or borrow enough to cover debt service and imports.

Although no leading debtors were from sub-Saharan Africa, its external debt ($209 billion, comparable to Brazil’s 2001 figure) was probably as burdensome as any other world region, at least for those countries not receiving HIPC debt reductions. From 1980 through 2002, more than three-fourths of the 45 countries in the IMF African Department negotiated debt relief agreements with creditors (World Bank 2003e:145–153). From the 1970s to late 1990s, rulers of Nigeria and Congo – Kinshasa squandered their loan funds, sometimes expanding patronage for intermediaries and contractors so rapidly that they lost track of millions of dollars borrowed from abroad. During Nigeria’s second republic (civilian government), 1979 to 1983, the ports sometimes lacked the capacity for imports such as cement going to government agencies controlled by politicians distributing benefits to clients. Compared to Asian–Latin debtors, the two African countries have poorer credit ratings among commercial banks because of poor national economic management, as reflected in previous balance of payments crises, and a slow growth in output and exports.

Financial and Currency Crises

As pointed out in this chapter’s introduction, the extraordinary cross-border capital movements benefited the long-term growth of recipients of inflows but, because of the potential reverse outflows, increased their vulnerability to financial and currency crises. The Asian, Latino, and Russian crises in the 1990s and early years of the 21st century were major example of financial and currency crises; Chapter 17 discusses the Latino and Russian crises, which introduce issues related to currency regimes and exchange rates.

In Chapter 14, we indicated that financial markets channel funds to those with productive investment opportunities poorly when banks have a high percentage of bad (nonperforming) loans, bad credit risks are disproportionately eager to take out loans, loan officers lack information in assessing expanded lending, banks bear most

16. The External Debt and Financial Crises

567

of the loss when the project of the borrowers fail, uncertainty about bank failure and government policy increases, borrowers’ collateral falls from currency devaluation, and interest rates increase sharply. These problems bring about asymmetries or disparities in information in which lenders have poorer information than borrowers about the potential returns and risk associated with investment projects. These asymmetries or disparities were present in the crises of the 1990s, when partially informed lenders steered away from making loans at higher interest rates, because they had inadequate information about borrower quality and may have feared that those willing to borrow at high interest were more likely not to pay back the loan. Screening was imperfect, especially during liberalization with new banks or with old banks formerly dependent on known state enterprises or members of the same keiretsu-like conglomerate expanding to new borrowers. Banks lack the expertise to evaluate risk, whereas weak bank supervision contributes to a failure to screen and monitor new loans enough (Mishkin 1999:11–19).

Jong-Il You (2002:216) charges the IMF with contradictory signals, supporting

capital account liberalization [that] expos[es] a country to the ebbs and flows of capital that are regulated by the judgement and opinions of international bankers and fund managers. . . . Having helped generate the financial crises by urging capital account liberalization in developing and transition economies, the Fund took on the role of firefighters, enlisting the Bank for a supporting role. . . . [T]he patent failure of the Fund’s initial rescue operations in the wake of the Asian financial crisis underscored the fact that it was ill-equipped to deal with this new form of crisis.

Initial conditions in the year before the crises in Mexico in 1994 and East Asia in Thailand, Indonesia, Malaysia, the Philippines, and Korea in 1997 indicate that capital inflows/GDP, bank nonperforming loan ratios, and current account deficits were high; credit growth was fast; and (except for Korea) the domestic currency, set at a constant nominal rate for several years, had experienced a real appreciation4 (that is, adjusted for inflation, the value of the domestic currency had increased relative to foreign currencies; Chapter 17 discusses real appreciation in more detail). Several other potential culprits – large fiscal deficits, inflation, and the money supply (here currency, transactions deposits, and near money) – were not factors in the crises (Mishkin 1999:10–12).

Manuel Montes and Vladimir Popov (1999:91–100) argue that successful globalizers take risks in internationalizing their capital markets. They suggest flexible exchange rates (see Chapter 17), hedging on the forward market5 to fix rates for converting to foreign currency, and capital controls, if necessary, to prevent external pressures from increasing interest rates that contribute to domestic macroeconomic contraction.

4Rodrik and Velasco (1999) find that countries with short-term liabilities to foreign banks in excess of foreign reserves were three times as likely to have a sudden capital outflow, and thus a financial crisis.

5 Canales-Kriljenko (2004:5) contends that LDC foreign exchange markets “are predominantly spot markets, [with] forward markets undeveloped,” thus limiting forward hedging opportunities.

568 Part Four. The Macroeconomics and International Economics of Development

Indeed, in 1998, two prominent trade economists endorsed Malaysian capital controls, on the heels of recommendations that liberalizing capital accounts be a part of IMF articles and amid Malaysian Prime Minister Mahathir Mohammad’s jailing of Finance Minister Anwar Ibrahim on what Westerners considered trumped-up charges. The economists Paul Krugman and Jagdish Bhagwati (1998:7–12) came out in support of capital controls, followed by Mahathir’s announcement of these controls days later (Krugman 1999:142–146). These controls on exchange convertibility by domestic residents enabled Malaysia to attain monetary independence to expand monetary policies to increase aggregate demand, income, and employment without increasing vulnerability to capital outflows. Mahathir’s decision was vindicated by Malaysia’s recovery during the next year that was faster, whereas real wages and employment had smaller declines, than others hurt by the Asian crisis. Within a year, after Asia’s capital accounts were stabilizing, Mahathir restored capital convertibility (Eichengreen and Leblang 2003; Kaplan and Rodrik 2001; Komo 2001). Not surprisingly, however, capital controls and the firing of Anwar also “provided a screen behind which [political cronies and] favored firms could be supported” (Johnson and Mitton 2001).

If controls on capital outflows are too blunt an instrument, what about disincentives for capital inflows? After massive inflows, Chile required foreign portfolio capital inflows in 1978–82 and 1991–98 (except trade credits) to deposit funds without interest at the central bank. The first time Chile prohibited inflows with maturities below two years and set reserve requirements from 10 to 25 percent for up to five and one-half years. These controls reduced short-term inflows, changing the composition of capital inflows toward longer-term capital, and allowed the central bank to raise interest rates as an anti-inflationary policy. To be sure, the private sector found ways to avoid controls, for example, by mislabeling portfolio inflows as trade credits or support for foreign direct investment (Edwards 1999:71–78). Still, taxing inflows may be effective for a short time and are less objectionable than restricting capital outflows. Moreover, as Chapter 17 argues, exchange-rate flexibility combined with inflation targeting may be a preferable alternative.

World Bank and IMF Lending and Adjustment Programs

Throughout most of the post–World War II period, the World Bank emphasized development lending to LDCs, whereas the IMF lent resources to help DCs and LDCs cope with balance of payments crises. In the late 1970s, 1980s, and 1990s, LDCs with chronic external deficits and debt overhang whose creditors failed to reschedule debt required economic adjustment (structural or sectoral adjustment, macroeconomic stabilization, or economic reform), imposed domestically or (usually) by the World Bank or IMF. In 1979, World Bank introduced structural adjustment loans (SALs) and soon thereafter sectoral adjustment loans (SECALs). SECALs emphasized reforms in trade, agriculture, industry, public enterprise, finance, energy, education, or other sectors. SALs were no longer tied to specific projects, but to support the balance of payments through 15–20 year loans, with 3–5 years’ grace, and interest

16. The External Debt and Financial Crises

569

rates only 0.5 percent above the Bank’s borrowing costs except for a front-end fee on new commitments. Structural adjustment policies emphasized growth and improved allocative efficiency as well as controlling domestic demand and improving the current account (Khan 1987:26–27; Nafziger 1993:xxi–xxii).

In the 1980s and 1990s, the Bank led donor coordination, increasing the power of external leverage. Although IMF direct credits to LDCs fell in the mid-1980s, the IMF retained substantial influence because of IMF–World Bank cooperation and a required IMF “seal of approval” for virtually all commercial bank, bilateral, and multilateral aid and loans. In 1986–87, the IMF used trust funds and funds from surplus DC countries for SALs to LDCs (especially in Africa) experiencing unanticipated external shocks (Feinberg 1986:14–18).

Chapter 19 analyzes World Bank and IMF adjustment policies further.

Fundamentalists versus the Columbia School (Stiglitz–Sachs)6

What are the origins of the Asian crisis, 1997–99? Fundamentalists, such as the Institute for International Economics’ (IIE’s) Morris Goldstein (1998) see the crisis resulting from the following: (1) financial sector weakness, including inadequate supervision (2) high bad-debt ratios, (3) large current-account deficits, (4) fixed exchange rates, (5) overvalued currencies, (6) contagion of financial disturbances causing portfolio investors to reassess Asian investments, (7) increased risky behavior, including failure to hedge future transactions, by bankers and international investors, and

(7) moral hazard from previous international bailouts, as in Mexico in 1994. The overextension of domestic credit by Asian banks based on excessive foreign borrowing at short maturities contributed to the panic of both domestic bankers and international investors. Other fundamentalists include the IIE’s Marcus Noland et al. (1998), U.S. Secretary of Treasury Lawrence Summers, 1999–2001 (Harvard’s president, 2001–), and the IMF, including Harvard’s Kenneth Rogoff, the IMF’s Director of Research, 2001–03.

Joseph Stiglitz and Jeffrey Sachs agree with much of the fundamentalists’ analysis of the causes of the crisis but differ on the prescription. Fundamentalists want the IMF to lend to crisis-stricken countries on condition that they undertake fundamental structural reforms in banking. Stiglitz, however, thinks it is unrealistic for the IMF to loan short-term, expecting reforms that can only be attained in the middleto longrun. For an LDC to establish the legal and institutional preconditions for effective banking supervision, licensing, and regulation and operational independence takes time and resources.

Fundamentalists believe that the herd7 behavior of Western portfolio investors, such as pension and mutual funds, transmitted the crisis from one Asian country

6In 1997, Stiglitz was at the World Bank and Sachs at Harvard. Both men were at Columbia University in 2002–04.

7 The “irrational exuberance” from herding ensues from investors choosing assets others think are valuable. This is analogous, Keynes explains (1936:156), to choosing a beauty contest winner in which the prize is “awarded to the competitor whose choice most nearly corresponds to the average preferences

570Part Four. The Macroeconomics and International Economics of Development

to another, and then to Russia and Latin America. Stiglitz (2002a:199), by contrast, accepts a Keynesian explanation for contagion of the crisis, viz., that the “belt tightening” imposed by the IMF reduced incomes and imports that successively weakened neighboring countries, and through the reduced demand for oil, spread to Russia.

For Jong-Il You (2002:216), contagion was not a result of fundamentals but of the IMF’s failure.

Having helped generate the financial crises by urging capital account liberalization in developing and transition economies, the Fund took on the role of firefighters, enlisting the [World] Bank for a supporting role. The quick recoveries of Mexico and Asia . . . are [not] vindication [but] may simply have been a consequence of the fact that the crises were mainly panic-driven. In fact, the patent failure of the Fund’s initial rescue operations in the wake of the Asian financial crisis underscored the fact that it was ill-equipped to deal with this new form of crisis (ibid.).

Stiglitz (2002a:12–15) believes that the IMF, as initially conceived, was to undertake global collective action to ameliorate market failure. Its major task should be to support global economic stability by spurring growth and reducing unemployment. The IMF, according to Stiglitz, is a public institution provided with funds from taxpayers around the world. As such, the IMF should report to the citizens who finance it and not just finance ministries and central banks. To serve these citizens, Stiglitz opposes the conditions that the IMF sets for low-income loan recipients, the draconian monetary and fiscal policies (see Chapter 14) and adherence to free markets that were a part of the Reagan–Thatcher ideology.

Stiglitz regrets changes in the Bretton Woods’ institutions, the IMF and World Bank in the early 1980s. According to him, as part of the liberal counterrevolution, the IMF shifted from a Keynesian emphasis on expanding employment and combating market failure to adopting “a new ‘Washington Consensus’” (see Chapter 5). He also regrets a purge at the World Bank at the same time that shifted its emphasis to structural adjustment loans to LDCs dependent on IMF approval and IMF-imposed conditions. Stiglitz (2002a:15) also supports the Krugman–Bhagwati view on capital controls, denouncing IMF policies of “premature capital market liberalization [which has] contributed to global instability.”

Stiglitz (2002a:198) criticizes the IMF for its lack of exchange rate flexibility, undertaking “massive interventions [of] billions of dollars . . . trying to sustain the exchange rate of Brazil and Russia.” He understands why IMF strategies are “greeted with such hostility. The billions of dollars which it provides are used to maintain exchange rates at unsustainable levels for a short period, during which the foreigners and the rich are able to get their money out of the country at more favorable terms. . . . The billions too are often used to pay back foreign creditors even when the debt was private. What had been private liabilities were in effect in many instances nationalized” (ibid., p. 209). Essentially, Stiglitz (2000a:209–211) feels that

of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of other competitors.”

16. The External Debt and Financial Crises

571

the IMF was more concerned about the views of the IMF, the U.S. Treasury, and the world financial community than East Asian workers and taxpayers. We return to trade policy in Chapter 17.

Changing the IMF and the International Financial Architecture

How can the world financial community contain and resolve these widespread financial, capital, and macroeconomic crises in LDCs? We have discussed proposals to control damaging capital movements. This section examines ways to change the IMF and world economic governance, that is, the international financial architecture. After that, we discuss piecemeal efforts or plans to resolve the debt crisis. Then in Chapter 17 we analyze how trade and exchange rate policies can diminish the frequency and intensity of these crises.

Sometime World Bank economist Percy Mistry (1999:93–116) contends that the IMF exacerbated what should have been a mild currency shock into a deeper cataclysm by maintaining a monopoly over crisis management. Developing countries have few institutions besides the IMF to rely on during crisis; ironically, only DCs have separate international arrangements, such as the Group of Seven, European Monetary System and European Monetary Union, and Bank for International Settlement, for support. Asia (and perhaps other developing countries) need regional financial institutions, such as a bank for international settlements, a regional monetary facility for mutual assistance and regional intervention support, a monetary fund under Asian-Pacific Economic Cooperation (APEC) (a forum for spurring economic growth, cooperation, trade and investment), standby funding arrangements to support IMF programs (under APEC), regional agreements to borrow, and enhanced regional surveillance arrangements (among the central banks of ASEAN, perhaps also with Japan and China). DCs have these types of arrangements; why shouldn’t Asia? Mistry asks.

For Deepak Nayyar (2002:367–368), the major missing institution is one for global macroeconomic management. In 1944, at the meeting that established the IMF, John Maynard Keynes proposed an International Clearing Union (ICU) in which all members would accept the debt obligation of the ICU’s banker. In contrast to the competing U.S. proposal, Keynes, the U.K.’s negotiator, wanted IMF member countries to manage demand to achieve full employment and rapid growth. To achieve this, the ICU or IMF should put the burden for correcting external imbalances on surplus, not deficit, countries. Because of trade interactions between countries, Stiglitz (2002c:240–242), a contributor to Nayyar’s volume, sees global collective action to expand demand and employment as the preeminent global public good. “Today,” Stiglitz maintains, “Keynes must be turning over in his grave” with the major IMF thrust to cut back fiscal spending, increase taxes, and reduce trade deficits of poor countries (ibid., p. 242). Moreover, he argues, “it is much harder for poor countries to bear the risks of exchange rate and interest rate fluctuations than it is for rich ones. . . . Debt burdens that look moderate become unbearable after big devaluations.” After pointing out that “This year Moldova, already desperately poor, will

572Part Four. The Macroeconomics and International Economics of Development

spend about 75 per cent of its government’s income on debt repayments,” he asks for international economic institutions to undertake the role of providing a mechanism for distributing risk (Stiglitz 2000a). Nayyar (2002:368) thinks that the explosive growth in international finance necessitates global macroeconomics, although he and others pressing for change despair of finding an “institutional framework for this task, which is left almost entirely to the market.”

The International Financial Institution Advisory Commission (2000), appointed by the U.S. Congress and chaired by Allan H. Meltzer, recommended that (1) the IMF, World Bank, and regional development banks write off all debts of the highly indebted poor countries (HIPCs) that implement effective development policies; (2) access to IMF credit be automatic and immediate to countries meeting a priori requirements without additional conditions or negotiations; (3) the World Bank and regional development banks should concentrate on poverty reduction; and (4) because the world was on a flexible exchange system, the IMF should only loan for short-term liquidity, until an equilibrium exchange rate is restored, and not for poverty reduction, long-term development assistance, or long-term structural reform, for which the IMF is ill-suited. In addition, the Meltzer report indicated that LDCs should not adopt pegged exchange rates.

Most critics would welcome (1). However, writing off all HIPC debts requires additional appropriation from the U.S. Congress for IMF, World Bank (that is, International Development Association), and regional bank concessional aid. Other donors’ aid for debt relief waits for a U.S. initiative. On (2), as indicated in Chapter 15, no country undertook IMF prior surveillance for Contingent Credit Lines (CCL), 1999– 2003, fearing the label of being vulnerable to crisis. Many may have feared that IMF prescreening before the crisis would be more rigorous than the assessment at the time of crisis. On (3), the World Bank’s and regional banks’ moneys are revolving funds, based on recipients paying back loans. Antipoverty projects rarely pay off for multilateral banks, which need to lend at bankers’ standards to maintain funds. To enhance funds for poverty reduction requires additional concessional funds by the United States and other DCs. The George Bush administration learned this when it followed through on Meltzer Commission recommendations by calling on the World Bank in 2001 to increase its share of grants to 50 percent of social sector aid to LDCs. Other OECD countries, fearing an erosion of World Bank’s resources, opposed Bush’s effort without major concessional aid that the United States was not prepared to give. Finally, on (4): for many LDCs, attaining an exchange rate that eliminates chronic deficits is much more difficult than international trade theory indicates, especially with potential capital flight (see earlier and Chapter 17).

Given the resistance of central bankers and treasury officials to radical change and the vested interest of the IMF in the status quo, Barry Eichengreen’s and most other economists’ proposals have been for marginal changes in the system. Eichengreen, from the University of California-Berkeley, favors Chilean-type taxes and controls on short-term capital inflows and encourages exchange-rate flexibility (see Chapter 17). He also would require banks borrowing short-term from abroad and lending longterm domestically to hedge on the forward market, and would shift IMF conditions

16. The External Debt and Financial Crises

573

for the loan from changes in monetary and fiscal policies to improvement in banking regulation, supervision, monitoring, and disclosure; more emphasis on securities (to be better regulated) rather than bank intermediation; protection against a small minority preventing restructuring of international bonds; “bailing in” (expanding losses to) private foreign investors and banks; corporate bankruptcy standards; and information transparency. Eichengreen’s proposal would reduce bad loans and marginally improve the position of LDC debtors. The next few sections discuss marginal changes recommended by the IMF economists Stanley Fischer and Anne Krueger.

IMF Failed Proposals to Reduce Financial Crises

Stanley Fischer, as IMF Deputy Managing Director, in discussing “On the Need for an International Lender of Last Resort” (1999:85–104), asks whether the IMF should play that lending role in financial crises similar to those in Asia and Mexico. His standard is that of the 19th-century English economist Walter Bagehot: “In a crisis, the lender of last resort should lend freely, at a penalty rate, on the basis of collateral that is marketable in the ordinary course of business when there is no panic.” This lender’s role is to offer an assurance of credit, given under certain limited conditions, which will stop a financial panic from spreading – or better still, stop it from even getting started” (ibid., p. 86). But this lender, to avoid market participants from taking excessive risks, should maintain constructive ambiguity (italics in the original) about when it will seek to stabilize a crisis (ibid., p. 91).

Fischer thinks that the IMF should be able to reduce financial crises, even though international capital markets cannot operate as well as U.S. domestic capital markets. According to Fischer, the IMF does at times play the role of a lender of last resort but needs to be improved to reduce the frequency and intensity of LDC financial crises. He proposes precautionary lines of credit from private creditors to LDCs with sound policies (Fischer 1999:86–99). This proposal became the IMF’s Contingent Credit Lines (CCL), which, however, was discontinued in 2003 from LDCs’ fear of being labeled as precrisis (Chapter 15).

Another suggestion by Fischer (1999:99) was to allow a stay of payments during crisis, a scaled-down version of Jeffrey Sachs’s bankruptcy proposal and a precursor of Anne Krueger’s proposal for sovereign debt restructuring in 2002, which was rejected by IMF members for the next two years. We discuss Sachs’s approach to canceling debt and the advantages of concerted action before examining Krueger’s approach.

Debt Cancellation8

For Sachs, sometime advisor to Latin American, Eastern European, and African economies, LDCs facing a substantial debt overhang might be better off defaulting

8The first three paragraphs of this section are based on Sachs (1989:279); Devlin (1989:233); Devlin (1987:91–93); Diaz-Alejandro (1984:382); Cline (1989:45); Greene (1991).

574Part Four. The Macroeconomics and International Economics of Development

on a portion of its debt than undertaking austere domestic adjustment or timely debt-servicing. About 20 countries undertook such unilateral action in the 1980s. Many LDC leaders felt there was no IMF adjustment program for full debt-servicing that makes the country better off than forgoing the program by partially suspending debt payments.9 Any IMF program may be too tight relative to other options for the debtor government.

The precedent for defaulting on debt is the 1930s. Countries that stopped paying their debt service recovered from the Great Depression more quickly than countries that resisted default and had virtually identical access to post–World War II capital markets.

However, country default in the 1990s is more costly than it was in the 1930s, when debt was held among scattered bondholders ranging from retired individuals to large corporations, so that creditor collusion was virtually impossible. Currently, debt is, in contrast, largely held by an oligopoly of international commercial banks, which hold the lion’s share of LDC international reserves, dispense LDC credit, maintain close communication with each other, and coordinate action with the IMF and DC central banks. Moreover, contemporary LDCs face a relatively prosperous, not a depressed and divided, North. Furthermore, today’s bank cartel insists on a case-by- case approach, thus increasing their bargaining power vis-a`-vis debtors.

Yet, the debtor may be able to avoid sanctions when the lender agrees to debt reduction or cancellation or the conversion of loans to grants. Sachs (1989a:279) maintains that the best strategy for the IMF (or other international agencies) would be a program based on partial and explicit debt relief, which can serve as a carrot for political turnaround. William R. Cline (1989:45) doubts, however, that these agencies can use debt relief as a “policy bribe” in exchange for economic reform. Indeed, creditor sanctions on debtor behavior are very ineffective. The IMF’s Joshua Greene (1991) admitted that assessing African debt for rescheduling is so hopeless that it would be simpler to forgive the entire debt.

Should DCs or multilateral agencies use concessional aid for debt relief or cancellation? Most large debtors are middle-income countries, and not among the poorest states. Many of the poorest countries adversely affected by external shock or growth deceleration, including Bangladesh, and most low-income sub-Saharan Africa, borrowed less by choice than necessity (low creditworthiness) (Buiter and Srinivasan 1987:414). Thus, the U.N. Conference on Trade and Development (1978) emphasized widespread debt renegotiation to cancel or reschedule debts of leastdeveloped (largely overlapping with IDA-eligible) countries.

From 1978 through 1990, 14 Organization for Economic Cooperation and Development (OECD) countries canceled more than $2 billion of concessional debt (mostly under Paris Club auspices), about one-fifth of concessional loans to IDA-eligible

9Ndikumana and Boyce (1998:2–47) argue that successor governments, such as in Congo–Kinshasa, should be able to repudiate their liabilities for prior predatory regimes’ debts (for example, the spiriting by Mobutu of official borrowed capital for his personal accounts overseas) on the basis of creditor complicity in odious debt.

16. The External Debt and Financial Crises

575

countries in sub-Saharan Africa. Sweden, Canada, the Netherlands, Belgium, the United Kingdom, Germany, Denmark, Norway, and Finland were major contributors to debt forgiveness to the sub-Sahara. OECD nations also gave recipients concessional aid to buy commercial bank debt instruments at heavily discounted prices (Humphreys and Underwood 1989:45; World Bank 1989g:Vol. 1, 24, 44). In addition, the highly indebted poor countries’ (HIPCs) millennium initiative by the IMF, World Bank, and DC donors wrote off more than $50 billion from 2000 through February 2004 (IMF and IDA 2004:5).

Concerted Action

To understand IMF Deputy Managing Director Anne Krueger’s proposal for sovereign debt restructuring, we need to discuss the advantages of concerted action or collective action clauses.

Debt reduction is the restructuring of debt to reduce expected present discounted value of the debtor’s contractual obligations. The general commercial debt writeoffs, write-downs, and reductions (encompassing other than the largest debtors) envisioned under the 1989 Brady Plan, still in effect in 2004, failed because of the lack of multilateral coordination. Bilateral arrangements are subject to free-rider problems, where nonparticipating banks benefit from increased creditworthiness and value of debt holdings. Banks are willing to reduce LDC debt, but only if their competitors do likewise (Sachs 1989b:87–104).

The solution lies in concerted debt reduction, in which all banks owed a debt participate jointly on a prorated basis. For debt relief, just as in U.S. bankruptcy, settlements (under Chapter 11 of the Bankruptcy Reform Act of 1978), concerted efforts are more effective than individual deals by creditors with debtors, and rebuilding of debtor productive capacity more effective than legalistic solutions (Sachs 1989b:239– 240; Dell 1991:139).

Debt reduction can improve creditor welfare, as a large debt overhang can worsen debtor economic performance, and diminish the creditor’s expected returns. Just as in bankruptcy, decentralized market processes rarely result in efficient debt reduction, because each individual creditor is motivated to press for full payment on its claims, even if collective creditor interests are served by reducing the debt burden. The bankruptcy settlement cuts through the problem of inherent collective inaction and enforces a concerted settlement on creditors. Bankruptcy proceedings (under U.S. law) force individual creditors to give up some legal claims, reducing the contractual obligations of debtors, and thus preserving debtor capacity to function effectively and thereby service as much of the debt as possible. The debt overhang prevents countries from returning to the loan market; the most effective way to revive lending is to reduce the debtor’s debt-servicing burden. We should apply the lesson of bankruptcy to sovereign debt overhang, even though debtor LDCs face a liquidity rather than a solvency problem. A major objective in debt reorganization is to reverse investment and productivity declines resulting from poor creditworthiness. Debt reduction may be the only feasible alternative, as banks, lacking incentives, are