To what Extent is Debt Relief an Essential Precondition to Effective Poverty Reduction?

Essay, 2015

11 Pages, Grade: 70 (Distinction) UK System


To what Extent is Debt Relief an Essential Precondition to Effective Poverty Reduction?

In this essay I will argue that the relationship between debt relief and poverty reduction is contingent on the relationship between conditionality and creditor-debtor responsibility. Doing so, I will focus on third generation conditionality of the Post Washington Consensus, which ties debt relief to the integration of poverty reducing policies. It is based on the idea that conditional debt cancellation will lead to policy improvements, which will boost investment and social expenditures, and consequently lead to economic growth and poverty reduction. (Dijkstra, 2008)

Doing so, I will concentrate on the political economy determinant of debt relief, asymmetric information, as it overshadows debt-overhung, crowding-out, and institution theory by far. (Johansson, 2010) I shall clarify in the first section of the paper why this is so and make reference to the broader debate. Asymmetric information - a situation, where one party in a transaction process has more or better information than the other (Bebzcuk, 2003, xi) - is also relevant with view to my claim being based on the premise that conditionality leads to adverse selection and moral hazard (Dijkstra, 2008), two classic examples of information asymmetry. The former correlates the demand for a loan (or debt relief) with the risk of potential default (on conditions) and renders the creditor, due to imperfect information, unable to reflect this calculation in the selection of candidates. The latter spreads all impacts born out of this correlation, resulting from information asymmetry and a lack of control over the debtor, across a pool of parties, so that one party's actions will affect that of all others. (Bebzcuk, 2003, 7)

In this sense, I will use the Enhanced Highly Indebted Poor Country Initiative (HIPCI II), which was launched by the IMF and World Bank (WB) embodying a major instrument of development policy linked to the realization of the Millennium Development Goals (MDGs) to illustrate how conditionality in debt relief triggers problems of adverse selection and moral hazard and, in turn, undermines poverty reduction (Dijkstra, 2008). However, I won't address the conditions' content as this would exceed the space provided for this assignment. It still needs to be born in mind though, that tensions between financing the MDGs and debt sustainability necessarily arise with program compliance. (Gunter, 2011, 52)

First, adverse selection is evidenced by the following observations: Being considered for HIPCI II assistance is tied to the fulfillment of eligibility criteria. Countries qualifying for HIPCI II assistance are then required to adopt reforms. (Berensmann, 2004, 321-322) The problems are two-fold: a) countries not meeting the criteria, regardless of their levels of poverty, won't be entitled for debt relief, and b) creditors feature defensive lending behavior by continuing to give loans to prevent default on past loans (= path-dependence) as well as to avoid admitting past mistakes regardless the degree of poverty reducing reform (Johannson, 2010, 1206).

Second, conditional debt relief spurs, on the one hand, debtor moral hazard. Not only will the cost of borrowing increase by enabling debtors to contract out from obligations affecting all debtors as a group (Tan, 2014, 255), but it also creates incentives for debtors to borrow in anticipation of debt relief (Easterly, 2002, 1679), which upon default and lack of punishment for non-compliance enlarges the burden of the group (Mwaba, 2005, 542-543) including the poor; through i.e. increased taxes for higher debt servicing (Easterly, 2002, 1681). On the other hand, debt relief also leads to creditor moral hazard since bilateral donors tend to underestimate the risks and over-lend after debt relief, usually in non-concessional ways. This not only aggravates debtor moral hazard (Arnone and Prespitero, 2013, 228), but also adds to the adverse selection problem, since creditors – now that capacity for new loans is freed - select those countries for further lending that don't have access to loans from others; which are presumably those with worse policies increasing the risk for renewed default. (Dijkstra, 2008, 120)

I will conclude that due to the absence of a legal framework to govern activities of debt relief and commercial lending (Pettifor, 2007, 138) as well as the lack of acknowledgment to make them a matter of shared responsibility by creditors and debtors alike, policy conditionality will inevitably lead to adverse selection and moral hazard rendering debt relief not more than “a necessary but insufficient condition” (Berensmann, 2004, 321) for poverty reduction.

From Conditionality towards Shared Responsibility

However multifold the literature on debt relief, only few (e.g. Easterly, 2001) would dispute that external debt is a major cause of poverty. (Berensman, 2004, 321) Efforts on debt relief have been endless but mostly with crushing results. It has been a complex issue under study on which four main theories developed inspiring the actions of creditors and donors alike.

Econometric studies have focused on how debt affects growth which in turn affects poverty. For example, Krugman and Sachs stated, when debt overhang occurs – a situation where a country's external debt exceeds its repayment ability – most of the country's output will be redirected from investment to debt servicing. Thus, through debt relief a country will regain its ability to pay, which encourages public and private investment. (Johansson, 2010, 1204) However, a reduced debt stock doesn't guarantee a government's ability to achieve growth. Arslanlap and Blaire Henry i.e. established in their comparative study of the Brady Plan and the HIPCI I, that debt overhung theory in the absence of functional economic institutions (i.e. imagine a tax base that achieves little revenue simply because the poor are too poor) falls short in providing the cure out of poverty. (2006)

Crowding-out theory, on the other hand, suggests that debt service payments not only impede growth, but crowd out spending in areas like health and education. But debt relief would in this respect only create additional fiscal space if a country had been servicing its debts before. (Johannson, 2010, 1205) Thus, debt relief and development aid need to complement each other in order for resources to be made available for social spending. However, additionality depends on the type of reallocations creditors/donors will make to their traditional aid upon debt relief, and since aid budgets are fixed aid-flows might stop or be redirected to other recipients. (Gunter, 2011, 54-58) But even if capacities were freed and additional aid provided, it remains questionable whether a government would channel its expenditures towards investments with high social returns. Clements (2005) et al found i.e. that debt relief has in most cases led to higher consumption instead of investment. And if investment would go up, it still leads to questions of adequate distribution (i.e. sectoral and population segmental) (Lumina, 2008, 5), the quality of reforms achieved, and actual correlation of such increase with debt relief and aid. (Moss, 289, 2006)

Thirdly, institutional quality and good governance are said to impact debt relief. (e.g. Asiedu, 2003) But, while Burnside and Dollar (2000) find that aid has a strong positive effect on growth in countries with sound management, and Agenor (2008) illustrates how increases in aid combined with reforms to improve the management of public resources can maximize the impact on growth and poverty reduction, Colderon et al. (2009, 79) find no effect of aid on poverty in countries with good institutions. They link their finding to the misallocation of resources to foreign firms and consultants and projects without productive value, and to policy makers prioritizing national security and domestic politics over poverty reduction.

These theories have influenced the approach the international financial institutions (IFIs) have taken in tackling the increasing debt burden of heavily indebted poor countries. However, their debt relief initiative HIPC I based on ex-post conditions containing a package of policy reforms (Structural Adjustment Programs) to be fulfilled in exchange for debt relief actually perpetuated the debt crisis. (Canel, 2009, 7-8) With view to poverty reduction, Dijkstra (2008, 69) found in a six-country study that even though social sector investment went up, aid and debt relief remained low compared to high debt payments, so that social expenditures didn't grow at the same rate or even declined.

This is not only due to the complexities discussed above, but is mainly the result of asymmetric information, or more specifically of a) adverse selection and b) moral hazard. In this respect, theory four states that a) debt relief will hardly be effective, if creditors allocate debt relief to countries with an unsustainable debt burden, rather than to countries better able and willing to increase investment, and b) debt relief encourages new loans in expectation of further debt relief, so that countries start borrowing excessively risking debt overhang anew. Hence, the investment effect sought by debt overhang, crowding-out and institution theory will be low because of information asymmetry (Johannson, 2010)

In response to a worsening debt crisis, the IMF and WB launched the HIPCI II as a follow-up on HIPCI I, which has offered greater debt relief than ever and tied the goal of sustainable development in form of quantified targets (MDGs) as a stringent condition to their assistance. This requires countries to account for how freed capacities from debt relief are channeled towards poverty reduction. (Tan, 2014, 259) To increase the effectiveness of the initiative the selectivity process was refined, whereby in a first step (decision point) countries must fulfill four conditions to be considered for assistance: 1. be eligible to borrow from the IFIs, 2. feature an unsustainable debt burden, 3. have a track-record of reform through the IMF's and WB's supported programs, 4. have developed a Poverty Reduction Strategy Paper (PRSP), and in a second step (completion point) to implement further reforms together with the PRSP for at least a year. (IMF, 2014)

However, the HIPCI II has so far only further exacerbated the debt crisis just as it has aggravated adverse selection and moral hazard, undermining the aim of poverty reduction. This is due to conditionality in general, and the HIPCI II's augmented “double conditionality” of ex-ante (decision point) and ex-post (completion point) conditions, in particular. (Dijkstra, 2008, 111).


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To what Extent is Debt Relief an Essential Precondition to Effective Poverty Reduction?
University College London  (School of Public Policy)
70 (Distinction) UK System
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ISBN (Book)
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extent, debt, relief, essential, precondition, effective, poverty, reduction
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Anna Scheithauer (Author), 2015, To what Extent is Debt Relief an Essential Precondition to Effective Poverty Reduction?, Munich, GRIN Verlag,


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