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Chance to Break Free from Cycle of Debt (Financial Times)

June 30, 2005

Chance to Break Free from Cycle of Debt
By Steven Radelet

This op-ed originally appeared in the The Financial Times on June 30, 2005.

The Group of Eight’s debt forgiveness deal is an historic agreement that could end two decades of debt problems for 18 poor countries, with another nine waiting in the wings. Although the financial benefits are small, the deal forgives 100 per cent of the debts owed to the World Bank, International Monetary Fund and African Development Bank (AfDB). It is a good deal, as far as it goes. The key challenge now is to ensure make sure the recipients do not end up with unpayable debts again but instead achieve sustained growth and poverty reduction.

The agreement wipes out overmore than $40bn in debt but, since the loans were heavily subsidised, it generates only about $1bn per year in new money. This is equivalent to just over 1 per cent of global aid flows – nice but hardly enough to dent world poverty. Awkwardly, the deal , the deal leaves out many equally poor countries that had not borrowed enough to be considered “heavily” indebted, such as Kenya, Sri Lanka and Nigeria, which now rather perversely) end up with more debt than the heavy debtors. A similar deal should be offered to these countries. , so they too can start with a clean slate.

Still, Neverthelessfor the qualifying countries, the agreement will end decades of time-consuming and nettlesome debt negotiations, freeing up their finance officials for to focus on more important development issues. For years, debtors have had to negotiate new loans to repay the old. But debts continued to mount, in some cases even after partial debt forgiveness. This cycle of lend and forgive and re-lend undermined the credibility of both debtors and creditors. and absorbed the scarce time of the debtors’ small cadre of financial experts.

Now that the deal is done, it is critical that these countries do not soon end up in another debt mess. Four key steps can help avoid that problem. First, donors should be smarter with their aid, giving less to middle income countries and political friends and more to well-governed countries with a strong commitment to good development policies. UnfortunatelyThe debt problem forced the donors instead to devote more funds to the most indebted just to keep them solvent. The original British debt relief proposal did the same: donors would make repayments on behalf of the debtors, ensuring that those that owed the most got most of the new money. The US successfully pushed for the better outcome that new money would go to the World Bank and AfDB to be allocated to countries with the greatest needs and strongest policies, not necessarily the 18 that received debt relief.

Second, the World Bank and AfDB should provide more money as grants, rather than loans, especially to the very poorest countries. The Bank recently agreed to give 30 per cent of its funds for poor countries as grants but decided to allocate them based on debt: highly indebted countries get more grants, while less indebted ones get loans. This flawed system is clearly flawed, since it rewards those that borrowed the most with grants, while providing more prudent countries only with more loans. IndeedU, under the current system, The 18 countries whose debts were forgiven are now prime candidates for more loans. FortunatelyWith the debt cancellation deal, The Bank now has the chance opportunity to introduce a fairer, and simpler way to allocate grants.

Simply put, The Bank should give grants to the poorest, not the most indebted. All countries with average annual incomes below a certain level – say $500 – should get grants. These countries face the deepest development challenges, are most vulnerable to shocks and have the greatest difficulty achieving growth. Some investments take a generation to pay off, and gains in one place are often offset by setbacks elsewhere. When their investments do pay off, the Returns should be reinvested at home, not repaid to the Bank to be re-lent elsewhere. This approach would free the poorest from debt and be consistent with the way the Bank determines which countries get subsidised loans (countries with average incomes of less than about $900) and which get near-market rate loans (countries with incomes greater than $900).

Third, grants should not just be giveaways. Donors must make funding more performance-based, providing more to countries that achieve results and less to those that do not. Fourth, more must be done to accelerate growth and poverty reduction. African governments must continue to improve their governance, strengthen economic policies and invest in health and education. Rich countries must reduce trade barriers and agricultural subsidies so that poor countries can compete on a level playing field and significaintly increase aid levels where they can be used well. And Tony Blair, the British prime minister, is right that more aid is needed for Africa, while and that the aid can be used well. President George Bush deserves credit for tripling American aid to Africa, although the amounts are still small.

The combination of less debt, stronger governance, greater market access and more well-directed aid holds the promise finally to make a significant dent in fighting poverty in Africa.

The writer is a senior fellow at the Centre for Global Development in Washington and was formerly deputy assistant secretary of the US Treasury