I.  Overview

For decades, concessional lending has been an important element of international assistance to the developing world—often, for the poorest countries, at interest rates of 1 percent or less and maturities of over 30 years. Despite these favorable terms, many poor countries have had increasing difficulty making payments on their debts, mainly because they have not grown as rapidly as had been hoped.

Beginning in the late 1980s, creditor countries have worked together to provide progressively easier repayment terms for poor countries struggling with their debts and implementing policies to increase growth. Increasingly concessional relief was provided on countries' existing debt. Nevertheless, many countries continued to have problems. In time, it became clear that countries' repayment problems were not just temporary and that a more comprehensive solution was needed.

In 1996, a new debt relief initiative for the heavily-indebted poor countries—the HIPC Initiative—was launched by the IMF and the World Bank.¹ The HIPC Initiative was intended to resolve the debt problems of the most heavily-indebted poor countries (originally 41 countries, mostly in Africa) with total debt nearing $200 billion. These countries' 600 million people live an average of 7 years less than citizens of other developing countries, with half living on less than $1 per day. Debt service obligations that had risen to consume large shares—in many cases more than half—of countries' export earnings was a major obstacle to their economic and social development. The HIPC initiative, enhanced in 1999 to provide broader, deeper, and faster debt relief, seeks a permanent solution to these countries' debt problems by combining substantial debt reduction with policy reforms to raise long-term growth and reduce poverty. The key is to ensure that the money freed by debt relief will be used for sustainable development, so that the countries will not again face unmanageable debts and their people can exit from extreme poverty. The needed policies are not simple and take time to formulate and to attract a consensus, but an increasing number of countries are earning the help of the international community by adopting policies that help themselves. For its part, the international community—working through the IMF and the World Bank—is making every effort to ensure that countries able to make effective use of debt relief for poverty reduction receive it as quickly as possible.

II.  How the poor countries became heavily indebted

Worldwide events in the 1970s and 1980s—particularly the oil price shocks, high interest rates and recessions in industrial countries, and then weak commodity prices—were major contributors to the debt build-up in the HIPC countries. After rising by 12 per cent per year from 1970 to 1980, commodity prices dropped sharply in the early eighties. Countries partly compensated for declining terms of trade with increased foreign borrowing.

Domestic factors, however, also played a large role in the debt build-up. Many countries were already living beyond their means, with high trade and budget deficits and low savings rates, and had no way to cushion themselves from external shocks. Instead, they borrowed more heavily, often without any change in policies to reduce their dependence on loans. Poor public sector management, including at times poor project selection by donors, meant that much of the foreign borrowing was squandered, bringing no long-term benefit in terms of capacity to produce or to earn foreign exchange. Vagaries of weather, protracted civil wars, weak economic policies and poor governance all played a part in the build-up.

Some poor countries increasingly resorted to new borrowing simply to service debt. Funds for new investment became more scarce, economic growth slowed and debt dynamics were set off that became unsustainable in many cases. Developing (including middle-income) country debt rose from $500 billion in 1980 to $1 trillion in 1985 and around $2 trillion in 2000. The 41 HIPC countries—among the poorest of the poor—saw their total indebtedness increase from $60 billion in 1980 to $105 billion in 1985 and $190 billion in 1990, and would have been, in the absence of debt reduction, near $200 billion in 2000.

Initially, creditors believed the debt service problems of the poor countries to be temporary. Accordingly, debt relief took the form of payment rescheduling, sometimes on concessional terms, sometimes coupled with new packages of loans (Box 1 discusses such arrangements for middle-income debtors). Indeed, an elaborate mechanism developed to ensure that all of a country's bilateral creditors contributed equally. Creditor governments formed a committee to agree on the needed debt relief, in consultation with the IMF, and to try to make sure that all creditors offered terms at least as favorable as those agreed by the Committee. Hosted by the French Treasury, this committee became known as the "Paris Club". Repeated Paris Club reschedulings for many debtors led official lenders to recognize that a new approach was needed for these countries that went beyond rescheduling debt service. At summits of the G-7 industrialized countries in Toronto (1988), Trinidad (1990), London (1991), and Naples (1994), new and increasingly concessional mechanisms were devised to bring more lasting relief. Thus, increasing amounts of debt reduction were written into the terms of Paris Club reschedulings, so that by 1994 when the Paris Club began to offer "Naples terms" at the reschedulings, up to two-thirds of the stock of official debt was being cancelled. Around $60 billion in debt and debt service has been cancelled through the Paris Club process.

Still, the debt of the poor countries remained high. By the mid-1990s, it had become evident that the combination of existing debt relief mechanisms, new official assistance, and policy packages aimed at reducing borrowing needs were still not enough to reduce debt to sustainable levels. In October 1996, the IMF and the World Bank jointly announced the HIPC Initiative to provide a comprehensive solution to the problems of poor country indebtedness.

III.  The HIPC Initiative

The Initiative for Heavily-Indebted Poor Countries (HIPC) is an approach to debt reduction that requires the participation of all creditors—bilateral, multilateral, and commercial. The initiative aims for countries to make debt service burdens manageable, through a mixture of sound policies, generous debt relief, and new inflows of aid. For a country to be eligible, its per capita income must be low enough to qualify for concessional lending from the IMF and World Bank, and it must face an unsustainable debt burden even after traditional debt relief (such as the Paris Club's Naples Terms).

The total amount of debt relief expected to be provided under the HIPC Initiative—in addition to relief under traditional mechanisms such as the Paris Club, or additional action by bilateral creditors—is around $60 billion. Because some payments from which debt relief is given do not fall due for many years, it is possible for the creditors to make provisions (in their own budgets) for their write-off at a lower cost than the face value of the debt by investing today for those future payments. Consequently, the total cost of the HIPC initiative as of the beginning of 2000 was about $28 billion—the net present value (NPV) of debt reduction.

One of the ground-breaking features of the HIPC Initiative is that it is based on the full participation of multilateral creditors, including the IMF, the World Bank, and the regional development banks. These institutions have historically assumed the status of preferred creditors and not rescheduled their loans. Under the HIPC Initiative, all of these institutions are providing debt relief, substantially reducing their claims on qualifying countries. Indeed, half of the debt relief to be provided under the HIPC Initiative will be on multilateral debt.

Once countries have demonstrated their commitment to reduce macroeconomic imbalances and sustain growth-oriented policies, normally over a three-year period, they reach the "decision point". At this stage, an assessment of the needed assistance is made and appropriate relief is committed, including reductions in the stock of debt. The full stock-of-debt reduction is implemented following a further period of sound economic policies, at what is then called "the completion point".

Early progress with the Initiative did not meet public expectations, with seven countries qualifying for assistance in the first three years. In response, the HIPC Initiative was enhanced in October 1999, with new mechanisms to provide deeper, broader, and faster debt relief. Interim debt relief was introduced between the decision point and the completion point, so that debt service costs are reduced as soon as the decision is made, and assistance was front-loaded to free up resources for higher spending on poverty reduction. A "floating" completion point approach was adopted under which the completion point will be reached as soon as the country concerned implemented a set of predefined reforms central to faster growth and poverty reduction. To increase the amount of debt relief offered, the amount of debt a country could sustainably carry—what it would still have to service after the Initiative reductions are made—was redefined to be no more than 150 percent of annual exports, less in cases where there is a heavy fiscal burden of debt. These changes have led to a marked acceleration of HIPC debt relief. During the first year that these enhancements have been in place, $10 billion of debt relief was committed for 10 countries, much more than the debt relief approved under the "old" HIPC Initiative over the preceding three years (chart 1).

As creditors were committing to provide even more debt relief under the 1999 enhancements, the debtors' role was made more precise. Beneficiaries of the Initiative are expected to use the resources freed up by debt relief for poverty reduction. In order to qualify for assistance under the HIPC Initiative—or for concessional loans from the IMF or World Bank—countries are expected to prepare poverty reduction strategies (Box 2). To effectively target the sources of poverty in a country and make the most efficient use of available funds, these strategies should be prepared through a broad-based participatory process. The strategies, by transparently setting out priorities for poverty reduction in a country-owned process, are expected to contribute to ensuring that HIPC resources are indeed used for poverty reduction.

IV.  Meeting the objectives of debt reduction

Aggregate debt reduction through both traditional relief and the HIPC Initiative could amount to two-thirds of the total debt of eligible countries. For the ten countries that have already benefited from the enhancements, debt service-to-export ratios will on average fall to below 10 percent, one-half the developing country average. Over the next five years, these countries will save an average of 1 ½ percent of GDP in debt service. Compared with social spending averaging 5 percent of GDP, these reductions could finance substantial improvements in health and education. Perhaps more importantly, however, participating countries are laying the necessary foundation to prevent the emergence of new debt problems in the future, thereby improving their capacity to continue anti-poverty programs.

In order to take full advantage of these benefits, however, all of the parties to the HIPC Initiative must play their respective roles. Donors and lenders need to contribute to the cost of debt relief—including to the contribution of the multilateral agencies—without reducing other forms of assistance. The IMF and World Bank need to help countries adopt policies that set them on the path of sustainable growth and poverty reduction, while doing their utmost to see that countries that can make good use of the assistance get it promptly. And the countries themselves need to follow through on sometimes-difficult policy changes.

The role of bilateral creditors and donors

The HIPCs' bilateral partners are the major financiers for the Initiative, and so play a critical role. In particular, when preparing debt relief packages for individual HIPCs, donors and creditors need to ensure that debt reduction does not lead to a reduction in the ongoing flow of aid. These countries in aggregate receive twice as much in new money—some $16 billion—as they pay in debt service each year. All of this money comes from, or is guaranteed by, taxpayers in donor countries. Governments, even the most generous, take seriously their role as trustees of their citizens' money. They therefore need assurances that debt relief will be used effectively for poverty reduction.

The role of multilateral institutions

For the IMF, the World Bank, and regional development banks, reducing the debt of the poorest countries is today a high priority, as a critical component of the strategy to reduce poverty. However, their participation in the Initiative—representing half of the $28 billion total cost—is dependent on the support of their member countries: the debt relief they provide ultimately comes from taxpayers of member countries also. One of the important contributions of multilateral development banks has been their ability to provide loans to middle-income countries at relatively low interest rates. They can do this because they can, based on their financial soundness, borrow in the markets at extremely good rates and pass the saving on to borrowers. Debt reduction without special funding could undermine the creditworthiness of these institutions, and raise the cost or reduce the amount of new lending available. This would threaten the flow of new money, and not just to the HIPC-eligible countries. Other developing countries, including some two dozen low-income countries that—through good policies or kind circumstances—did not become heavily indebted, would pay higher costs because of the big debtors. Fairness dictates that this be avoided.

In order to help multilateral lenders meet the cost of the HIPC Initiative, a special HIPC Trust Fund was established with contributions from donor governments. The Trust Fund is intended to supplement the lender's own efforts. The IMF's $2 billion cost is to be funded in part from interest on the subscriptions (originally in gold) contributed by members when the IMF was founded; the rest depends on bilateral contributions. The World Bank will be able to finance its participation for the first few years out of earnings on its loans to middle-income countries; after that, it, too, will need donor contributions to cover its $6 billion share in the cost of the HIPC Initiative. The Inter-American Development Bank is expected to be able to cover much of its billion-dollar contribution from its own resources, but more than half a billion dollars in contributions will be needed for other multilateral agencies in this region. The African Development Bank, because it lacks the large pool of loans to middle-income countries that its cousins in other regions can tap, can provide less than 20 percent of the $2 billion it needs from its own resources; donors will need to contribute the rest. Thus, the HIPC Trust Fund will need additional donor contributions on a timely basis to allow the multilateral institutions to provide their share of debt relief and move the process forward more rapidly.

The IMF and the World Bank, of course, have special roles to play in the implementation of the HIPC Initiative. It is their duty to help governments formulate the economic policy programs that ensure that the resources of the HIPC Initiative will be properly used, and to form an assessment that countries' poverty-reduction strategies are up to the job. The task of balancing the need to safeguard donors' resources, and the credibility of the Initiative, against the needs of the HIPCs for debt relief is a delicate one. The Fund and Bank are committed to do everything possible to help those remaining countries not riven by conflict to proceed to their decision points in a matter of months—as soon as they are able to demonstrate that they can use the debt relief effectively for poverty reduction. To reach this goal, the IMF and the World Bank undertook further steps to accelerate the process of granting debt relief by:²

• Focusing pre-relief policy requirements on those that are essential—such as strengthened governance and accountability—to the success of countries' poverty reduction and growth strategies.

• Adopting a more flexible approach to "track record" requirements, to allow relief to countries whose economic performance is broadly on track.

• Limiting requirements for the interim PRSP, so that delays in preparation do not hold back debt relief.

• Using a high-level joint World Bank-Fund committee—the Joint Implementation Committee— to accelerate the process and to resolve problems as they develop.

These steps were complemented with the announcement of an "enhanced partnership" between the two institutions in September 2000. In their joint statement, Horst Köhler and James Wolfensohn said, "We are determined to bring the benefits of debt relief to as many countries as possible, as rapidly as possible. Our staffs are working together closely to make sure this happens. The ultimate test of the success of this initiative is how effectively debt relief contributes toward poverty reduction."³

The role of the HIPCs

The HIPC Initiative emphasizes not only the need to reduce debt to sustainable levels, but also the need for countries implement the policies needed to ensure that debt does not again become a problem in the future. With long repayment terms, poor countries have been given loans on the assumption they would grow out of their debt burden; the HIPC Initiative tries to make this a reality. By the time the completion point is reached, participating countries should have as much as 5 years of growth-friendly economic policies. Collectively, as the debt problems emerged between 1981 and 1994, the HIPC countries recorded average annual growth in real GDP of little more than 2 percent. Since 1995, growth has been about 5 percent. The challenge is to sustain and improve on this recent record and ensure that the poor benefit from growth.

Debt relief is provided when countries show they are truly on the road to sustainable growth, which is judged on several dimensions. One is the ability and willingness to implement sound macroeconomic and structural policies to provide a good environment for economic activity and poverty reduction. Good policies both aid growth and eliminate the need to use foreign borrowing to finance unsustainable policies. Another is the ability to use the debt relief and other donor resources wisely, and generally to create an environment in which corruption does not flourish and governance is good. There is little point in providing money to poor countries if it does not serve poor people in them. The provision of debt relief where it would be squandered would not only be a loss to the country concerned, but might jeopardize the provision of additional funds from donors concerned about whether this aid is used appropriately. Restrained debt management policies—ensuring that new borrowing is not excessive, not too expensive, and can be repaid—is also a key ingredient.

In the end, and also out of respect for those poor countries that do not have unsustainable debts that need to be lifted, the HIPC initiative can only move forward with those countries that can show they are ready and willing to work on their own behalf for that better future. For these countries, the IMF sees an ethical imperative to help, and the institution is moving with all speed to see that the HIPC Initiative provides both a clearing of the books and a long-term path out of poverty.