Resolving The Debt Crisis Of Low-Income Countries

Poverty Traps and the Debt Overhang

One key hypothesis of this paper is that poor countries are vulnerable

to a poverty trap, which can be caused or exacerbated by an excessive foreign

debt burden. The basic idea of a poverty trap is that nonlinearities in

saving, investment, and production can lead some low-income countries

to remain stuck at low or even falling levels of GNP per capita, despite the

forces of economic convergence that are also at play in the world economy,

such as the potential for capital inflows into capital-scarce countries

and the diffusion of technology from rich to poor countries. To illustrate

the key ideas, I introduce a very simple model in which the net saving rate

falls to zero when income drops below a minimum subsistence level.12

Suppose that individuals require a level of minimum real consumption

m to meet basic needs of personal health and hygiene, food intake, and

shelter. (Unless otherwise noted, all variables are in per capita terms.)

The overhang of unpayable debt, and still more, the buildup

of new debt if aid comes in the form of loans rather than grants, would

convince potential private sector investors that the country remains

trapped. Creditors themselves might promise their help now only to insist

on increased debt service payments in the future if the country starts to

recover. These are among the classic arguments for why a fresh start

rather than a simple postponement of debt is needed in the case of an

insolvent individual or municipality.

What kind of institutional changes are required to reorient the international

system in the recommended direction? I suggest the following:

Ð'--The creditors should understand that, in a sovereign insolvency,

whether under Chapter 9 in the United States or an international sovereign

insolvency, the systemic goal is not the simple maximization of debt

repayments to the creditors. Repayments to creditors must be placed in

the context of additional objectives: a fresh start for an insolvent sovereign,

preservation of its public functions, and achievement of broad

development objectives. For low-income countries, the basic standard for

debt collection should be to restructure debts in order to provide a macroeconomic

framework within which the countries can achieve the MDGs.

Ð'--Each HIPC should be encouragedÐ'--indeed, required, in order to

obtain comprehensive debt cancellationÐ'--to prepare medium-term plans

for scaling up its investments in health, education, and basic infrastructure

during the period from now until 2015. The targets should be set in

order to meet the MDGs. These plans should be designed in conjunction

with civil society, as part of the ongoing poverty reduction strategy

process.Ð'--The key U.N. agencies, including the UNDP, WHO, and UNICEF,

and the Bretton Woods institutions should support the countries in this

costing exercise, but they should also carry out independent estimates of

the countries' financing needs and incorporate those estimates into their

own key country strategy documents.

Ð'--An independent review panel, with representatives appointed by

both