Who are the lenders, where do the debts come from, and how can the debt issue be resolved? In her usual ‘in-your-face’ style packed with poignant examples and revealing anecdotes, Hertz outlines the relatively brief history of the debts from the early days of the Cold War up to the present day. I.O.U. describes the different kinds of debts and explores why such debts not only threaten the societies of the indebted countries, but also pose an equal threat to other countries worldwide. This is followed by a definition of so-called ‘illegitimate debts’ and a proposal as to how the debt threat might be defused to the benefit of developing and developed countries alike.

2. The loans

a. Bilateral (State) loans

The roots of the current debt mountain can be traced back to the geopolitical situation during the Cold War. From the 1950’s onwards the three predominant camps, i.e. the US, the Soviet bloc and China, used loans as a means to create powerful allegiances and secure political stability across the globe. In a race to gain and maintain influence in regions ranging from Latin America to Africa, the three parties realized that bilateral loans were an effective mechanism of control as loans inevitably create dependency. The amounts lent more often than not far exceeded actual needs, and were provided under most favourable (financial) conditions.

Little attention was paid to the person behind the borrowing. For example, half the US loans to Africa at the end of the 1970s were issued to Mobutu’s Zaire. The people of Zaire currently spend 37% of their gross revenues on servicing these debts.

Most regimes simply took what they could get from the eagerly providing superpowers and in many cases used the loans to pay for arms manufactured by the lender. With little heed paid to the amounts actually needed or the soundness of the borrower, the lending system increasingly became divorced from simple economics.

Following the end of the Cold War, things changed dramatically. Loans were called in overnight and no new loans were forthcoming. By the mid-1990’s many developing countries faced huge bilateral Cold War-debts, often debts incurred by long-gone regimes.

b. ECA (corporate) loans

The bilateral loans of the Cold War period were followed by a flux of corporate loans from the 1980s onward. Most of these loans were underwritten by so-called Export Credit Agencies, i.e. government agencies that fund or insure domestic corporations seeking to extend their business to high-risk areas. For example, 95% of the current debts owed to the UK by developing countries are export credit debts. The Export Credit Agencies (ECAs) are the largest source of public finance for private sector investments in the world. They have enabled corporations to increase their exports to importers in the developing world without having to screen the importers’ ability to pay. When deals default the corporations know they will be compensated by the ECAs. The corporations (or the ECAs for that matter) are not obliged to screen the corruption level of the importer or project goals. This may explain the high failure rate of ECA projects. There is a close link between the ECA loans and the arms industry as arms sales typically account for a large percentage of ECA loans.

Unlike bilateral and multilateral (e.g. IMF) loans, higher commercial interest rates apply to ECA loans, and the burden of these insurmountable loans falls on the peoples of the developing world who must face the consequences of the increasing debt burden. As international aid continues to fall, the importance of ECA loans continues to increase.

Given the lack of screening of the borrowers and sound lending criteria, the ECA loans are a strikingly poignant example of the imbalance between corporate interests and the public interests (economic, social and environmental concerns) of the global loan system.

c. Commercial bank loans

Urged on by the sudden extreme wealth created among oil producers in the wake of the Yom Kippur War of 1973, the commercial banks joined the loan competition in the 1970’s. The billions of petrodollars were deposited in Western banks that in turn were keen to convert this windfall into more profits through financing loans with these newfound funds. Given that the borrower demand in the developed world failed to keep pace with the available credit, the banks actively sought out a new market for commercial debt. They found one in the developing world. Commercial banks from across the Western world were desperate to get a foothold in this new market and offered huge loans on terms that were almost impossible to turn down. In fact, in the middle of the 1970’s some loans had a negative interest rate. Third world countries had different reasons for accepting the loans: they wanted loans for the country’s future development and debt rescheduling, oil-importing countries needed funds to deal with the expense of rising oil prices, while for others the favourable terms of the loans were simply too difficult to resist. In addition, multilateral organizations such as the IMF and the World Bank and the governments of the developed world encouraged them to borrow from commercial banks.

However, like the Cold War governments and the Western corporations, the commercial banks failed to apply proper lending criteria and confined themselves to the short-term objective of lending for the sake of lending. , The military, dictatorial regimes of Latin America were for example swamped by loan offers, and between 1974 and 1982 the external debt of Argentina, Brazil, Chile, Mexico and Venezuela increased by $ 252 billion, a third of which was spent on real estate abroad and siphoned off to offshore personal bank accounts.

This lending frenzy lasted until 1979 when the Iran-Iraq war led to an oil price hike, which in turn led to a global recession with rising interest rates. The commercial bank loans had typically been issued with variable interest rates. As a result, the debt repayments skyrocketed, while investors, fearing a crash, pulled their capital out of the borrowing countries. The indebted countries were forced to take out even more loans for debt servicing and the debt mountain had become so huge that there was a danger that the banking system would be unable to cope. For example, between 1975 and 1982 Latin America’s debt quadrupled to $ 315 billion of which more than two thirds was owed to commercial banks. By 1988, more than half of Latin American countries were behind in their payments.

d. Multilateral (IMF loans)

The IMF and the World Bank stepped in with billions of dollars of ‘rescue packages’ from 1979 onwards to ensure that countries could at least keep up their interest payments. From the start, it was made clear that their actions were geared towards saving the banks rather than the indebted countries. The multilateral loans gained momentum in the 1980’s when developing countries desperately needed money to repay the Cold-War loans and the loans issued by commercial banks in the 1970’s.
In 1989, the IMF and the World Bank adopted the Brady Plan agreeing to offer guarantees for the repayment of 80% of outstanding loans, while the other 20% were cancelled. In exchange, the debtor countries had to comply with the IMF and World Bank’s structural adjustment package and accept an ever more intrusive control of their internal policies. The ‘one fits all’ solution imposed on the debtor countries by the IMF and the World Bank, i.e. opening up markets and removing capital controls and slashing expenditure on health care and education, has proved critically injurious to these countries and exacerbated poverty levels. Furthermore, like the commercial banks and the States before them, the IMF and the World Bank paid little heed to the corruption level of the borrowing governments. Recent World Bank audits show that as much as 60 to 70 per cent of the loans ended up in private foreign bank accounts, siphoned off by corrupt leaders.

e. Bonds

The Brady Plan also meant that the outstanding debt was converted into bonds, soon followed by more issuing of bonds by developing countries. The bonds in turn gave rise to the secondary market for emerging debt attracting many Western investors. Following the lending frenzy of commercial banks in the 1980s, many developing countries decided to raise money by issuing bonds. In the 1990s, bonds quickly overtook loans as the primary method for raising money (particularly for middle-income countries in Latin America, Asia and Africa, and later Eastern Europe and Russia).

Although the investors (i.e. the capital market) are unable to impose specific pre-conditions on countries, they are able to ‘intimidate’ through the use of interest rates. For example, countries failing to follow the (economic) policies set by the IMF and the World Bank are ‘penalized’ by higher interest rates.

Besides economic policies, the bond market also attaches great importance to the ‘propensity to default’ of the debtor countries. The governments of these countries must be regarded as trustworthy. For example, when ‘socialist’ Lula’s star rose in the Brazilian polls, interest rates shot up to 24 per cent at the height of the anti-Lula mood, posing a considerable burden on the Brazilian economy. Putin’s autocratic reign on the other hand has been beneficial to Russia’s status as a creditworthy country.

3. The threat

The world’s poorest countries currently have a combined debt of $ 458 billion, while 19 of the 27 countries receiving some kind of debt relief still pay more than 10% of government revenue on debt repayments at the expense of health care and education. Other countries receiving no debt relief at all spend much higher percentages on debt servicing. Nigeria for example spent $ 2.9 billion on debt repayments in 2002 and $ 350 million on health care in the same year. Ecuador spends $ 29 out of every $ 100 of its budget on debt servicing, compared to $ 13 on social welfare and education.

Rising debt means that countries, following the example of Russia and Argentina, are increasingly likely to default. This is even more probable in today’s globalized world where the citizens of highly indebted countries are far more aware of what they are missing.

All highly indebted countries are furthermore countries where the levels of social services, health and education are substandard, and half of these countries have majority Muslim populations. Militant Muslim groups are increasingly taking over government tasks by providing health care and education to the poor and providing employment in the form of military careers.

The debt situation and the stringent economic requirements of the IMF/World Bank have also meant that the natural resources of the indebted countries are being rapidly exhausted. Forests and woodlands are opened up to industrial logging companies, while fish stocks are dwindling at an alarming rate. Indebted countries cannot afford to act in an environmentally sound way. For example, funding for environmental preservation in the Amazon has dropped by 50 per cent since the 1980s when the IMF structural adjustment plans were first put into effect.

4. Resolving the debt crises

There is currently no system in place to resolve debt crises. Nor are there any international (regulations/criteria) to decide when debts must be considered illegitimate and/or insurmountable.  Hertz proposes the use of the national bankruptcy proceedings applied to businesses and natural persons as they provide a good blueprint as to how debtors and creditors should be treated, and ensure that debtor countries be accorded the right to start anew by way of debt cancellation.

The following definition of illegitimate debts is put forward:

1. "The regime that borrowed the monies lacked democratic consent;
2. The monies were used in ways that were inimical to the interests of the population;
3. The lender knew that the monies would be used in such a way.”

Where all three conditions apply simultaneously, the debt must be considered illegitimate.

The first condition is currently much debated in the discussion on Iraq’s debt and whether the people of Iraq can be expected to repay the debts incurred by the old Saddam-regime.

However, the illegitimacy of loans should not be the only ground for debt forgiveness. The principle of insurmountable loans must also be taken into account. In this respect, the principle that creditors’ rights should not be allowed to override fundamental rights must be applied. Debts should be regarded as insurmountable where debtor countries are unable to provide basic needs to their citizens.

5. National Regeneration Trusts

Given the developing countries’ negative track record when it comes to spending loans provided to them on basic needs, debt cancellation alone would not ensure the increase of the welfare levels in those countries. The freed monies must therefore ideally be used as a development tool.

Hertz puts forward the concept of ‘National Regeneration Trusts’. Such trusts would receive the monies that would otherwise be spent on debt repayments and use these funds to meet development goals. To ensure the proper operation of such trusts they must be subject to five conditions. First, the majority of the trust boards should be composed of nationals complemented by non-nationals appointed from United Nations bodies such as UNICEF or the World Health Organization. Secondly, the trust accounts should be transparent and accessible to the public so that the trust may be held accountable for its actions. Thirdly, putting money into the Trust must be the only stipulation for countries to qualify for participation. No other ‘structural adjustment’ conditions may be attached. Fourthly, the international donor community must pledge to continue similar financing flows to prevent a country from having to take money out of its budget to pay into the Trust. Finally, where a country is recognized as democratic and has reached sufficient levels of human development, the Trust is wound up and any remaining debt stock to be cancelled must be written off.

There are of course cases where the confidence in a government is so low that the Trust conditions are unlikely to be met. However, in the majority of cases the trust provides a strong financial incentive for compliance with the Trust terms, as the Trust would otherwise be dissolved and debt repayments would be continued.

In defence of the Trust proposal Hertz lists some international examples where the Trust concept has worked, e.g. the idea of an Oil Revenue Permanent Trust Fund to safeguard oil revenues for the Iraqi people. The Trust concept has furthermore long been recognized in most developing countries.

6. Conclusion

The history of the current debts of the developing world only spans some five decades, but it has had far-reaching effects on those countries. The debt repayments of many debtor countries exceed budgets for health care and education thereby crippling societies and destabilizing economic prospects. The history of these debts is above all characterized by three features: unsound lending, corruption and the close link with the arms industry, and all of this at the expense of the general welfare level of the borrowing country.

Preventive measures to put a stop to the current lending practises are therefore essential. However, as regards existing debts, I.O.U. provides a blueprint for sound debt cancellation and ensuring compliance with development goals through the establishment of the National Regeneration Trusts.

Debt cancellation has of course been on the international agenda since the Jubilee efforts that focused on debt cancellation in 2000, but which efforts continue to date. The debt relief issue gained new momentum recently (21 November 2004) with the Paris Club  resolution regarding the Iraq debt. The Paris Club secured a deal whereby most of the Iraq debt to Western countries was cancelled, albeit in exchange for contracts with predominantly US industries. No mention was made of the illegitimate nature of the debt and, poignantly, it was noted at the end of the final Paris Club statement that the debt relief does not constitute a precedent for any other country.