openEconomy

Sovereign debt work-out: reform needed

Excessive national debt in low-income countries, sometimes incurred by dubious means and parties, is a major hindrance to development and a burden to creditor country citizens. An international mechanism is needed to offer countries a way to negotiate balanced resolutions with their creditors.
Nic Benton
13 August 2010

The accumulation of debt by low and lower-middle income countries often leads to significant hardship, as funds which could be used to promote human development are diverted to service onerous repayment agreements. According to the World Bank, low and lower-middle income country long-term external debt stands at in excess of $1,000 billion.

When a debt becomes unsustainable there are presently only limited responses available to a debtor; either they can default and risk excommunication from the international community or they can submit themselves to creditor-led forums. Creditor initiatives, such as ad hoc bilateral negotiations through the Paris and London Clubs or the formal multilateral Heavily Indebted Poor Countries (HIPC) initiative provide some relief to the world’s poorest countries but they remain limited. This is because creditor domination results in a dictation of terms and eligibility, an outcome that endorses the belief that creditors can act irresponsibly and without sufficient regard for due diligence as borrowers will always be made to pay. As argued by The European Network on Debt & Development ‘this has meant countries have been forced back to creditors again and again due to protracted debt repayment problems.’ (EURODAD, A fair and transparent debt work-out procedure)

The abstraction of benefits provided by the current debt work-out model, with indebted countries needing better cancellation of unpayable and unjust debt, requires a new system. One that gives debtors: parity in the decision making process; the right to contest the legitimacy of certain debts being repaid; the power to hold creditors accountable for approving irresponsible loans; and the potential to declare themselves insolvent.

This new mechanism would be best served through a neutral decision-making body, one that is independent of any creditor-led institution. It can explicitly, therefore, not be based in the creditor International Monetary Fund or World Bank; institutions that have proved themselves incapable of neutral decision-making. Instead, arbitration, based on principles of transparency and inclusion,should be concluded either in a permanent body situated in, for example, the UN or the Permanent Court of Arbitration in The Hague or by means of an ad-hoc arrangement. While any arrangement may still be open to bias towards a particular party, the independence and legitimacy of independent arbitrators will improve on the skewed mechanisms already in place.

Legitimacy and co-responsibility

It is essential that reforms to the debt work-out mechanism be supported internationally as a significant proportion of global debts can be considered illegitimate (or as sometimes referred to as odious). While there is no universal agreement on the general term ‘illegitimate debt’, various forms are often identified. These include, but are not limited to, debts incurred by undemocratic means or by undemocratic regimes, debts that cannot be serviced without threatening basic human rights, debts linked to the morally reprehensible misuse of funds, debts resulting from irresponsible projects that failed to serve development objectives or devalued human and/or environmental security.

The case for a more formal mechanism empowered to cancel odious and illegitimate debts is being increasingly recognised. In Norway, for example, the Soria Moria Declaration on International Policy commits the government to pursuing a fair and transparent debt work-out procedure at the international level.

The Government [of Norway] will support the work to set up an international debt settlement court that will hear matters concerning illegitimate debt.

Norway has led the way in tackling the issue of illegitimacy. In 2006 the Government of Norway undertook an audit of its conduct, regarding the export of 156 vessels and ships equipment totalling NOK 3.7 billion to 21 countries between 1976 and 1980. At the end of the process it was found that the Norwegian Guarantee Institute for Export Credits (GIEK) had supported a policy that had produced a disastrous developmental legacy. As a consequence, Norway took the unilateral decision to cancel the claims still outstanding for Ecuador, Egypt, Jamaica, Peru and Sierra Leone.

It is essential that creditors take responsibility for odious debts and repudiate loans that have failed because of inadequate due diligence, failure meet intended objectives or produced harmful environmental, social, governmental and/or human impacts. A further example is the sale of military hardware by countries of the North to the brutal dictatorship of General Suharto in Indonesia. Evidence shows that this equipment was used against the civilian population, and in the subjugation of East Timor. Today, the people of Indonesia are repaying hundreds of millions of pounds in debts – in effect they are paying for their former repression. Creditors must take co-responsibility for their actions in supporting oppression, particularly as human rights abuses were in evidence throughout his reign.

The utility of an audit is not limited to creditor countries. The empowering potential of an audit for debtors can be seen through the experience of Ecuador. In 2008 the Internal Auditing Commission for Public Credit of Ecuador (CAIC) found that Ecuador was servicing $3.9 billion in illegitimate and/or illegal debt. An outcome that has caused ‘incalculable damage’ to Ecuador's economy and forced different governments to marginalise development, in order to service the demands of its international creditors.

While this debtor-led initiative is valuable, there is presently no international mechanism that allows for a debtor to legally contest the validity of debts being serviced.

Learning the lessons from these audits, debtors and creditors alike should evaluate the history, purpose and impact of loans and/or debts and be empowered to bring concerns to arbitrators. Arbitrators must then be mandated to rule on the legitimacy of creditor claims, based on clear and identifiable criteria of illegitimate debt, and cancel all those that are found to illegitimate. During any process there should be a stay on all applicable debt repayments until dispute is resolved.

International solvency

Alongside limitations in debt work-out procedures regarding disputes over legitimacy, measures to ensure debt sustainability remain problematic. A neutral body affording parity to both debtor and creditor would be in a stronger position to adjudicate on questions of solvency. In Germany, through the Coalition Agreement signed between the Christian Democratic Union, Christian Social Union andFree Democratic Party, the government has pledged to support efforts to establish an international insolvency framework.

[The parties to the agreement] advocate the implementation of an international insolvency code.

The urgent need for a workable international solvency mechanism is illustrated by the crisis currently facing Europe. Greece is presently foundering under a debt burden that threatens its ability to secure the basic human needs of its citizens. Greece is reported to have run up sovereign debts totalling some 300 billion euros (£260 billion); a result of uncontrolled borrowing over the last decade.

In response to this, Greece has detailed plans to cut its budget deficit, which stood at 13.6% in 2009, to less than 3% by 2014 and to support a range of austerity measures and tax increases totalling 30 billion euros over three years. The EU and IMF have also agreed to finance a controversial loan of 110 billion euros (£95 billion) to protect Greece from defaulting on payment to its creditors. In spite of this, Greece is still vulnerable as its debts continue to be unsustainable.

A successful arbitration process can help resolve unsustainable debt situationsA State should be considered to be insolvent when the servicing of external debt is producing sustained negative effects on human development; sustainability cannot be seen in purely economic terms. An effective guide for ruling on insolvency is chapter 9 of the US Insolvency Code. Chapter 9 provides that governmental institutions (municipalities) can receive protection from creditors during periods of financial and development unsustainability. This would entail the stopping of repayments during debt adjustment negotiations and limit subsequent repayments to levels that are sustainable. Internationalisation of this chapter will allow a municipality to protect human dignity, and protect basic human needs.

Responsible financing

A fair and transparent debt work-out mechanism is not a means of enabling debtors to avoid paying legitimate and sustainable debts; it is supposed to create an environment where creditors and debtors have to take a greater responsibility for their actions as they will be subject to rigorous oversight and accountability by independent arbitrators.

Critics may argue that independent arbitration places too great a power in the hands of debtors. On the contrary, the presence of binding international arbitration mechanisms will provide a major incentive for loan negotiations to be conducted in a legitimate and sustainable manner, and so make it less likely that odious debts will arise in the first place.

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