Why Foreign Debt Forgiveness Would Cost Americans Very Little

It is easy to assume that sovereign debt forgiveness involves a collective transfer of wealth from the creditor country to the debt-owing country, but this is only true under specific—and unrealistic—conditions. In today’s environment, sovereign debt forgiveness mainly represents a transfer within the creditor country. It benefits farmers and manufacturers in the creditor country at the expense of the country’s nonproductive savers.

In light of the ongoing coronavirus pandemic and the resulting economic fallout, it is useful to consider what Washington’s policy stance should be toward debt forgiveness. Argentina and Ecuador each recently completed a long, drawn-out restructuring of their external debts, several more countries in Latin America and Africa urgently require debt relief, and government ministers of many poor and indebted emerging economies made a recent appeal for a much more ambitious debt relief effort as they grapple with the healthcare and economic consequences of the pandemic.

Should these countries’ creditors offer debt relief, and if so, what would it cost the creditor countries? The answer is probably counterintuitive. Most people would assume that debt forgiveness represents a transfer of wealth from the creditor nation (the United States, for example) to the obligor (or debt-owing) nation. But this is not necessarily the case. Under some conditions, the extent of such a transfer could be negligible or even nonexistent, even leading to an economic boost for creditor and obligor countries alike.

Whether or not there is a transfer of wealth from the United States to the obligor nation really depends on economic conditions in the United States and political conditions in the obligor country. In some cases, debt forgiveness does indeed represent such a transfer, in which case the move is more difficult for the government of the creditor country to justify on national economic grounds, even if it might be justified on humanitarian and political grounds.

But there are other economic conditions—which are much more likely to reflect real conditions today—in which debt forgiveness does not represent such a transfer, or if it does, the value of the transfer is a very small fraction of the amount of the debt forgiveness. In such cases, the direct impact of debt forgiveness by the United States or other creditor countries will cost their own overall economies little to nothing.

This doesn’t mean that there isn’t any wealth transfer at all. It only means that the wealth transfer is not between countries but rather between groups within a country. In this particular case, debt forgiveness would be a transfer mainly from international investors to U.S. workers, farmers, and producers. The obligor country would benefit, of course, but not at the expense of the creditor country. Any benefits it receives would effectively be paid for by an increase in total global production. Not only would debt forgiveness leave the obligor nation better off and wealthier, in other words, but it can also leave the United States better off and wealthier.

DEBT AND THE BALANCE OF PAYMENTS

To understand why, it is important first to understand how foreign debt affects a country’s balance of payments. The balance of payments must always balance, which means that every dollar that enters a country through its current or capital account must also leave the country through its current or capital account (and by “dollar” I just mean any foreign currency).

Countries essentially receive dollars in a variety of ways such as exporting goods; accepting foreign tourists; borrowing abroad; or taking in foreign investment in the form of stocks, bonds, real estate, or factories. They pay dollars, so to speak, when those transactions are reversed. To simplify the explanation without distorting the real experience of either the creditor country or the obligor country, let us just assume that countries can only export or import goods and can only issue or repay bonds. If that is the case, the following equation must always hold true:

Total dollars received = Total dollars paid out, or
Exports + bond issuance = Imports + bond repayments

If we add together bond issuance and bond repayments and call the sum “net bond inflows,” we can rearrange the equation like this:

Imports – exports = Net bond inflows

This tells us that when a country’s total proceeds from bond issuance in a given period exceed its bond repayments, the country imports more than it exports, so it runs a trade deficit. When the bond repayments in a given period exceed the total proceeds from bond issuance, the country exports more than it imports, so it runs a trade surplus.

Put differently, these equations tell us that when a country is a net recipient on the capital account, it must run a trade deficit (technically, it must run a current account deficit, not a trade deficit, but for the purpose of this argument the difference is irrelevant). Conversely, if that country is a net payer on the capital account, it must run a trade surplus.

WHAT FOREIGN DEBT RESTRUCTURING ACTUALLY ENTAILS

So what happens when a developing country is forced to restructure its debt? Let’s say there is a developing country called Fredonia that is perceived to have excessively high debt. At some point, bond investors become unwilling to continue lending to Fredonia, in which case the country may have terrible difficulty repaying its outstanding debt. When that happens, the country gets together with its creditors to renegotiate—or restructure—debt-servicing repayments of interest and principal to make these payments more manageable.

At first, these restructurings mainly tend to extend principal repayments and/or to capitalize interest payments, so as to give the country a few years of breathing space in which to implement the necessary economic reforms that would allow it to begin fully servicing its debt again. In some cases, as with South Korea in 1997–1998, this will be the right strategy. These are cases in which the borrower’s problem is not too much debt but rather badly structured debt, in which case restructuring it allows the borrower to fix the problem directly.

But in many if not most cases, the problem is too much debt, generally because lenders and borrowers were overly optimistic, or indeed foolish, about the ways in which borrowing would raise debt-servicing capacity. Eventually, in these cases, after multiple restructurings fail to restart economic growth, the country must give up simply extending payments and must negotiate partial debt forgiveness with its creditors. If that turns out to be the case, Fredonia’s creditors would agree to forgive some portion of the debt, and Fredonia would agree to a new debt-servicing schedule based on this new, lower amount of debt. If the restructuring is done well, and a sufficient amount of debt is forgiven, Fredonia will finally be able to regain enough growth that it can fully service this smaller amount of debt.

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