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Debt swaps for development

Creative solution or smokescreen?EURODAD report

Marta RuizOctober 2007


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Debt swaps for development. Creative solution or smoke screen? 2

About EURODAD

EURODAD (the European Network on Debt and Development) is a network of 54 non-governmentalorganisations from 17 European countries who work together on issues related to debt, developmentfinance and poverty reduction. The Eurodad network offers a platform for exploring issues, collectingintelligence and ideas, and undertaking collective advocacy.

Eurodads aims are to:

Push for development policies that support pro-poor and democratically defined sustainabledevelopment strategies

Support the empowerment of Southern people to chart their own path towards development andending poverty.

Seek a lasting and sustainable solution to the debt crisis, promote appropriate development financing,and a stable international financial system conducive to development.

More information and recent briefings are at: www.eurodad.org

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Disclaimer

This report has been written by Marta Ruiz, of EURODAD, broadly based on the work of the SESFoundation and in close collaboration with the Latindadd network. We are grateful for thecollaboration and valuable comments provided by Esteban Serrani and Alberto Croce from SESFoundation; Humberto Ortiz from Jubileo Per; Hugo Arias from Jubileo Ecuador; Jrgen Kaiser fromErlassjahr.de; Susanne Luithlen, Global Fund consultant; Eddie Boelens, from the Belgian Ministry ofFinance, Marta Filipowic, University of Warsaw and Gail Hurley, Lucy Hayes and Alex Wilks ofEURODAD among others. This is a EURODAD document but the analyses presented do not necessarily

reflect the views of all member organizations of EURODAD.


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CONTENTS

THE ORIGINS OF DEBT SWAPS ...............................................................................................................5

THE STRUCTURE OF DEBT SWAPS FOR DEVELOPMENT................................................................6Stages in debt swaps for development............................. ............................... ............................... ............. 10

Conversion rates and discount rates ............................. ............................... ............................... .................. 11Use of swapped funds............................. ............................... ............................... ............................... ............. 12

WHY DEBT SWAPS FOR DEVELOPMENT?............................... ............................... .......................... 13Why do creditors swap? ............................. ............................... ............................... ................................ ....... 13Why do debtors swap? ............................... ............................... ............................... ................................ ....... 13

PROBLEMS FOUND IN DEBT SWAPS FOR DEVELOPMENT.............................. .......................... 16

SWAPS: NOT A SOLUTION TO THE DEBT PROBLEM............................... ............................... ..... 20

DEBT SWAPS AS A MEANS OF INCREASING SOCIAL INVESTMENT........................... .......... 22

MULTI-CREDITOR SWAPS, AN EXAMPLE TO FOLLOW? ............................. ............................... 24The Eco-Fund.............................. ............................... ................................ ............................... ............................ 24Debt 2 Health ............................ ............................... ................................ ............................... ............................ 24Debt 4 Education ........................... ............................... ................................ ............................... ....................... 25

CONCLUSION: TO SWAP OR NOT TO SWAP?............................. ............................... ................ 26


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EXECUTIVE SUMMARY

Debt swaps are not a new idea. Via a debt swap, the creditor country cancels a debt at its nominalvalue. In return, the debtor invests part of the cancelled amount in development projects according toconditions previously agreed by both parties. In the 1980s debt swaps were widely used, particularly inemerging economies. The main aim of these swaps was to encourage private investment through the issue

of equity in publicly owned enterprises. Debt swaps have been less frequently used in recently years buthave re-surfaced on the agendas of some donors as one way of financing the Millennium DevelopmentGoals set down in the United Nations Millennium Declaration.

Given the urgent need for resources in sectors such as health and education, debt swaps may present avaluable opportunity for civil society organizations and governments both on the debtor and creditorside. Debt swaps can also encourage participation of local civil society groups in the management andmonitoring of local development projects. Yet critics warn that debt swaps are a way of legitimizingdubious debt that should instead be audited and cancelled. Either way, it is generally accepted thatdebt swaps alone cannot be used to solve the problem of debt in poor countries. Debt swaps are aflawed solution: they fall short of international commitments on debt cancellation; they are expensive toadminister and they reinforce conditionality, in some cases benefiting only the creditor.

Debt is one of the main burdens of poor countries. Current debt cancellation initiatives such as the

Heavily Indebted Poor Countries (HIPC) initiative and its spin-offs all fall short of solving this problem.Debt forgiveness is a question of justice that should be applied to many more countries than is currentlythe case. In many cases it is an urgent and fundamental precondition for meeting the UNs MillenniumDevelopment Goals.

Aside from such theoretical considerations, debt swaps have a real and growing presence on the politicalagendas of donor countries such as Spain, Italy and Germany. It is for this reason that it is important tostudy how such swaps are being administered. In an ideal scenario, a debt for development swapbenefits all participants: the creditor raises his levels of Official Development Aid; the debtor increasesinvestment in the social sectors while reducing the countrys foreign currency external debt load; needycommunities benefit from new investment and from the monitoring and participation in projects by civilsociety.

In order for swaps to have a real impact on the improvement of social conditions, they must be conceived

and administered independently by the debtor country and integrated into national developmentstrategies. However, this report illustrates that in many cases, the reality of debt swaps for developmentis far from the win-win ideal. Instead, the benefits for debtor countries are shown to be very limited whilethe cost to them of the swap in terms of management and budget as well as sovereignty andconditionality is very high.

Multi-creditor initiatives are another model that deserves attention. One of these is the debt for natureswap agreed by several members of the Paris Club and Poland in 1992 (the so-called Eco-Fund).Another is the Global Funds Debt 2 Health swap for health services. It is important to understand howthese swaps work and how they are implemented. These initiatives address many of the problems arisingfrom bilateral development swaps.

This report analyses debt swaps for development, studies how they work and on the basis of concreteexamples highlights the achievements and problems of debt repayment and development. It proposes a

set of criteria that should be applied to every swap with a view to these criteria being agreed within aresponsible financing model complying with the principles of Aid Effectiveness set down in the ParisDeclaration by donors of the international community.


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THE ORIGINS OF DEBT SWAPS

Market swaps: from debt for equity swaps to debt for nature swaps

Developing countries have been undertaking debt swaps for more than 20 years. Ever since Chileconducted the first debt for equity swap in 1985, some fifty countries have undertaken debt swaps with

different aims.

Debt for equity swaps emerged in the 1980s particularly in Latin America as a way of encouragingprivatisation and reducing external private debt as structural adjustment programmes peaked followingthe 1982 debt crisis. The main objective in these cases was to improve the fiscal solvency so as to grantdebtor countries access to new international finance. In this way, countries swapped their external privatedebt and in return creditors or private investors acquired shares in public companies. This mechanism waswidely used in countries such as Chile and Argentina and peaked in the late eighties, reaching a total ofUS$ 27 billion in 1990. Debt for equity swaps subsequently declined, largely due to the revaluation ofthese countries debt within the secondary market, which came as a result of the improved solvency of theeconomies of the main countries involved: Argentina, Brazil, Chile and Mexico

i.

The mid-eighties saw the introduction of debt for nature swaps in which the investor was usually anenvironmental non-profit agency and the swapped funds were directed towards projects for the

protection of biodiversity and natural resources. Debt for nature swaps were much smaller than debt forequity swaps. Between 1987 and 1994, these represented a total of US$177.96 million aninsignificant figure compared to the value of debt for equity swapsii. The first nature swap occurred in1987 between Bolivia and Conservation International, which together with a Swiss bank acquiredUS$650,000 of Bolivias private debt at a cost of US$100,000. The Bolivian government swapped thesum at US$260,000, investing the money in an investment fund for the protection of biodiversity

iii. Since

then, it is estimated that some 30 debt for nature swaps have been carried out. Most notable amongthese is Eco-Fund, which was founded in 1992 by Poland and a group of Paris Club creditors

ivat a value

of US$571 millionv. This is without doubt the largest swap conducted within the environmental domain

and is, in this sense, an exception to the rule.

UNICEF emerged towards the end of the eighties as a key player in private debt swaps for child aidprogrammes. Between 1989 and the end of the 1990s, UNICEF carried out 21 swaps worth US$52million out of a total of US$199 million

viin cancelled debt.

Swaps beyond the market: the emergence of swaps for development and social investment

Initially swap operations were conducted exclusively on the secondary market with the privatecommercial debt of banks or export credit agencies. Since the nineties bilateral debt has also begun tobe swapped.

Prompted by the United Nations Secretary-General, in 1991 the Paris Club introduced a clause for debtswaps for social investment, thereby establishing a framework for concessional and non-concessionalbilateral debt swaps for social investment. This marked the beginning of so-called social investmentswaps or development swaps between bilateral creditors and debtors. Most members of the Paris Clubhave made or are currently making development swap operations. Among the pioneers in the use ofswaps the following stand out: the USA, which carried out debt for nature swaps in the nineties, Canadaand Switzerland, with the latter launching a broad debt swap programme on the occasion of the 700thanniversary of the confederation. Currently Germany, France, Spain, Italy and Norway are among thecreditor nations that actively use this instrument as a mechanism to improve their levels of OfficialDevelopment Assistance (ODA).

vii

Other official initiatives exist for reducing debts: they will not be considered as swaps in this documentviii

.


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UNICEFDutch Committee

ArgentineanGovernment

(creditor)

SenegaleseGovernment

(debtor)

Three Phases:1. UNICEFs Dutch committee bought debt worth US$24 million in nominal terms from the Argentine

government (a creditor to Senegal) for US$6 million (25% of the purchase price).2. UNICEF transferred US$24 million of debt to the Senegalese government for cancellation.3. The Senegalese government paid the equivalent of US$11 million (46% of the amortization

price) in CFA francs into UNICEF-Senegal projects for women and children over the course ofthree years.

PHASE1

PHASE2

PHASE3

UNICEF SenegalDevelopment

Projects

Case study: Triangular swap between UNICEF, Senegal and Argentina in 1993

THE STRUCTURE OF DEBT SWAPS FOR DEVELOPMENT

What is a debt swap?

A debt swap or debt conversion involves the sale of a debt by a creditor to an investor (non-profitorganisation) who buys the debt at a discount and swaps it with the indebted country at a price that will

enable it to obtain a profit margin. The swap is made either for shares in a local company or for localcurrency aimed at financing development projects either directly or via a counterpart fund

ix.

Source: UNESCO, 2006x

What sort of debt swaps exist?

Debt swaps vary according to their structure, content and objectives. A multitude of variations exist, butthe main models are the following:

Bilateral: the operation takes place directly between the creditor country and the indebted country. Thistype prevails in swaps for development.

Triangular, tripartite or with a third party: the creditor sells debt to an intermediary (NGO,development agency or other party), which in turn negotiates the repurchase value with the debtor (seediagram above).

Multilateral or multi-creditor: several governments perform the operation jointly and the swapped funds

are deposited in a single counterpart fund. The most representative case studies are those of the Eco-


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Fund, created between Poland and a group of creditors of the Paris Club, and to Debt2Health managedby the Global Fund. Both will be explained later.

This document focuses on debt swaps for development, where the swapped amount is used for socialinvestment. This type of swap includes swaps for projects, which finance a specific project, and swapsfor counterpart funds (CF), where the swapped amount is deposited as national currency in a trust fund.The following chart summarises the main swap models

xi:

Source: Debt Relief International, 2001

Type of swap Parties to transaction Eligible debt Use of swappedfundsDebt for equity swaps Three party

-creditor (government,bank, export creditagency (ECA)-private sector investor-debtor (government)

Private (bank loans,government bonds,Publicly guaranteedbilateral debt (ECA, ParisClub etc.)

Cash or bonds (monetarystabilization, debtconversion)Public sector assetsPrivate sector assets(equity shares, fixedinvestments, working

capital, privatization ofpublic companies)Three party-creditor-debtor government-non-profit investor (UNagency, NGO etc.)

Private debtPublicly guaranteedbilateral debt

Concessional bilateralxii

Cash, bonds, policyreformsDevelopment projectsEnvironmental funds

Debt for development(education, health,environment, nature,children)

Bilateral: debtorgovernment and creditorgovernmentMultilateral: variouscreditor governments

Concessional Bilateral(ODA)Publicly guaranteed (andnon guaranteed debt)

Cash (local currency)Development projectsCounterpart fundsEnvironmental funds

Three party: Creditorgovernment, debtorgovernment, and private

investor

Private Payment in local currencyfor exported goods fromcreditor nation

Debt for exports

Bilateral: debtorgovernment and creditorgovernment

Bilateral Clearing arrangement(exportations)

Debt for offsets Three party: debtorgovernment, creditor,private investor

PrivateBilateral

Offset against obligationsto debtor government(taxes, customs rights)

Debt buy-back -debtor government-commercial creditors- IDA debt conversionfund (which finances theoperation)

Private Cash (foreign currency),long term bonds, debt forequity bonds, debt fordevelopment option

Debt for debt -debtor government

-commercial creditors

Private (Brady bonds) Domestic bonds


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What types and what volume of debt can be swapped?

Debt swaps for development are primarily conducted with bilateral debt.

In 1991, the Paris Club established the model to be followed for swapping concessional bilateral debt(ODA) and publicly guaranteed private debt through export credit agencies (ECAs). The conversionclause which governs this framework has evolved over time and today sets ceilings on swappable debt.

A Paris Club creditor country may swap up to 100% of concessional bilateral debt (ODA). In the case ofnon-concessional debt there are restrictions, as shown in the following chart:

Maximum swap volumes of non-concessional debtLimits Low incomecountries Middle incomecountriesMaximum convertible20-30%* 10-30%*

Alternative maximumamount in nominal terms** US$13-18 millionxiiiMaximum general nominal

US$13-27 millionxiv

Source: Paris Club 2005

* In both cases, 30% is allowed in exceptional cases only.

** The Paris Club allows a maximum swap based on the % in the first row and the absolute figure given in thesecond row of the chart.

The Paris Club imposes these limits in order to guarantee its principles of equal treatment of debtors andof solidarity among creditors. This position highlights the priority of the Club in protecting the interests of

creditors. This limits the effectiveness of debt swaps: if they were more ambitious, swaps could to agreater extent address the need for debt relief in indebted countries. Few creditors reach the swapceilings, a fact that suggests that swaps serve to satisfy a political need for grand announcements butdeliver relatively little. As a result of these ceilings the volume of swaps is highly limited. According to astudy by the SES Foundation (a Latindadd member) of 60 swaps, only six were worth more than US$500million, as was the case of the US$571 million Eco-Fundwith Poland

xv.

Composition of external debt in middle income countries

13%

13%

74%

Multilateral

Bilateral

Private/commercial

Composition of external debt in low income countries

44%

31%

25%

Mutilateral

Bilateral

Private/commercial

Source: Global Development Finance, 2007

Most debt swaps for development are undertaken with bilateral debt. Given the fact that bilateral debtusually represents only a small part of developing countries external debt, this limits the potential scopeof swaps, as shown in the pie charts above. According to a report delivered by UNESCOs workinggroup on debt swaps for education, A major portion of the long term debt of developing countries is inprivate hands. This is important to note in the context of debt relief, because debt for development swaps

are generally carried out in bilateral debt programs. The implication of this reality is that even if countries

did hypothetically manage to cancel, or swap, the debt owed to bilateral creditors, it would have a minorimpact on the overall debt problem.


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Private debt: Unpaid private debt and debt which is not publicly guaranteed may also be subject toswaps if all parties agree, but private debt is rarely swapped in debt for development conversions. Ifprivate debt were to be swapped, what could be its potential value? In 2005, the total value of arrearswith private lenders was US$30.79 billion in middle-income countries and US$4.29 billion in low-incomecountries

xvi. Only in exceptional cases, such as Switzerland and Peru, have there been commercial debt

swaps for developmentxvii

.

Commercial debt swaps: a means of laundering illegitimate debt?

The main risk posed by a swap or any other relief or restructuring operation with commercial debt is that this maylegitimise the original debt. A swap or restructuring operation may launder a debt whose origins may containillegitimate components (white elephant projects; export promotion with no development goal, etc.).

There have been several cases where debtor governments have refused commercial debt swap proposals. In 2004,Norway offered Ecuador a swap for some publicly guaranteed commercial debt it held which had originallypurchased a number of shipping vessels. Norwegian and Ecuadorian civil society organizations succeeded instopping this process, arguing on the one hand against the low cancellation percentage of the operation, but moreimportantly that the original commercial debt had served Norwegian interests only and were thus illegitimate andshould be cancelled outright. By October 2006 Norway cancelled this debt to Ecuador, acknowledging it had beenan irresponsible loan that had aimed at rescuing Norways beleaguered shipbuilding industry and not at facilitatingEcuadors development. This case contains two important lessons: firstly, debt is not simply a matter of finance butone of justice. The origin of a debt is an essential component to be analyzed ahead of a debt swap. This is

particularly important when commercial debt is involved, as there are many cases like that of Norway. Had Ecuadoraccepted the swap, the debt would have been laundered and nobody would know today that this debt wasirresponsible and should have been cancelled. Secondly, this example shows that civil society can and should play afundamental role in pressuring governments not to accept all debt operations.

The Kenyan government recently refused to swap a UK publicly guaranteed commercial debt, an operation thatwould have involved the building of bridges across the country by UK firms. While no detailed information isavailable, Kenyas rejection seems to have been due to the deal serving UK company interests rather than Kenyangovernment priorities, or due to unfavourable conditions.

Who benefits from swaps for development?

Agreement on a debt swap depends on a negotiation between debtor and creditor within the Paris Clubframework. During this process the creditor determines whether the debtor will benefit from a swap,

depending on whether or not it can fulfil the Clubs criteria. One fundamental criterion, apart fromrenegotiation agreements with the Club, is for the debtor country to have a program with the IMF

xviii. This

implies a serious disadvantage for countries that are cutting ties with the IMF.

Currently some twenty non HIPC countries have benefited from concessional and non-concessional debtconversions. These include Ivory Coast, the Dominican Republic, Ecuador, El Salvador, Georgia,Guatemala, Indonesia, Jamaica, Jordan, Kenya, Moldavia, Morocco, Philippines, Peru, Serbia,Montenegro and Pakistan. Many more countries could benefit from swaps, but, as will be seen later on,political criteria drive the decision-making process and there is little transparency in decisions on theeligibility of beneficiaries.


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Stages in debt swaps for development

Bi-national committee: Once a debt swap is agreed, a bi-national committee is established to negotiatethe sectors that will receive the swapped funds and the modalities of implementation. The committee isusually formed by both countries ministries of finance, a fact that weakens the scope of a swap throughthe exclusion in most cases of important parties such as other relevant ministries (for example education,

health or the environment) and civil society.

Technical committee: A technical committee with a consultative remit is subsequently set up. This is madeup of technical experts from the ministries of finance and, in some cases, civil society representatives. Thiscommittee decides the allocation of funds and is in charge of monitoring and evaluation.

Counterpart funds: Generally, swaps are implemented through counterpart funds (CF). Essentially this isa fiduciary fund in which the debtor country deposits the swapped sum in local currency. The fund isadministered by a financial institution under the supervision of the technical committee. As a rule thedebtor country pays the sum into the fund in instalments to prevent liquidity problems. In principle, acounterpart fund should be managed by an independent national body to guarantee higher levels oftransparency.

The following graphic illustrates one of the most commonly used models in debt swaps for development.

The creditor cancels a bilateral debt worth US$100 million. This does not imply any payment but ratheran accounting operation. The debtor deposits the equivalent of US$60 million in local currency in acounterpart fund (in other words, with a 40% discount). This fund is managed independently and used tofinance social projects led by development agencies (such is the case of UNICEF). This last participant isnot always present: the projects may be implemented by local NGOs or NGOs from the creditor country.

SchoolsHealth CentersEtc

Financing ofprojects(local currency)

Creditor

DevelopmentFund

Debtor

Agency CF

Partial debt cancellation (incurrency)


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Conversion rates and discount rates

Once the amount of debt to be swapped is agreed within the confines of the Paris Club, an appropriatediscount rate is established. There are no rules for this and the rate depends largely on the creditorsgood will. A 20% discount (or conversion rate of 80%) means the debtor must spend 80% of the debtsvalue on social investments. In practice, discount rates currently applied by creditors are quite low,

ranging from a maximum of 50% generally applied by Germany to 0% applied by Spain or Italy.

For a swap operation to make sense both parties must benefit from it. It is therefore important that asufficiently high discount rate be applied that benefits the debtor as well as the creditor. The debtorseeks to reduce levels of indebtedness and invest more in development while the creditor aims torecuperate at least some unpaid old commercial debts and boost ODA levels. From the debtors point ofview, the bigger the discount rate, the more additionality there is in the operation: it allows the debtor tosave on budgetary resources that can then be used for national long term planning according to thedebtors sovereign priorities. At the same time, the debtor saves on the generally high transactionexpenses arising from the swap operation. On the other hand, the lower the discount is, the moreresources must be channelled to the counterpart fund. This involves not only implementation costs but alsoa higher conditionality in the use of these funds. A low discount rate creates budgetary pressures that contrary to the objective of a swap may increase a debtors need for internal or external finance,

weakening the economys sustainability. From a creditors point of view, a smaller discount does not implya lower ODA rate on its books, since the ODA value of a swap is generally the nominal value of thedebt. A lower rate also gives a creditor greater power to decide on the use of swapped funds,reinforcing conditionality. This raises a fundamental question with regards the debate on transparency,corruption and sovereignty. While it is true that corruption hinders development and that misuse of fundsmust be fought, this argument should not be used to justify the systematic use of low discount rates andhigh conditionality by creditors. On the contrary, it is time to abandon the corruption versussovereignity dichotomy and focus instead on creating a scenario of responsibility shared by both sidesand transparent administration, as many NGOs

xixhave suggested.

Some authors, such as Oscar Ugarteche, argue that for a swap to be economically beneficial for adebtor country the discount should be such that the value of the swappable debt is lower than that of theoriginal debt. If the opposite scenario is the case, the swap would be too burdensome for the debtorsbudget.

xx. In short, if the debt swap is presented as a development financing instrument and as a means

to reduce debt, it should have a higher level of concessionality and additionality, by means of moregenerous application of discount rates.

The secondary debt market

Commercial debts may be swapped through the secondary debt market. In these cases, the sale and repurchaseprice of the debt is given by the market as a function of probability of recovery of the debt. Therefore, if it isunlikely that the debt will ever be recovered its price will be lower than a debt whose repayment is more likely. Thegreater the likelihood of recovery, the closer the market price will be to the nominal value. In the field of debtswaps, the model used during the 1980s was that of an investor who acquired commercial debt certificates at asecondary market price and swapped them with the debtor country at a profit. The debtor government wouldexchange the agreed amount for shareholdings in national companies or invest the amounts in a special fund forenvironmental projects, depending on whether the investor was a private company or a non-profit organization. Inthis type of swap, the discount rate is set by the market value of the swapped debt and through a negotiation

between investor and debtor. Thus, a debt with a nominal value of US$100 million that was worth US$80 million onthe secondary market could be purchased by a nature conservation organisation that negotiates a swap price ofUS$90 million with the debtor country. The debtor pays this amount to the organisation, which in turn invests the sumin nature conservation projects. However, operations in the secondary market are not risk-free. While they facilitatepotentially beneficial swaps for development, they also allow for the activities of speculative funds that, like vulturefunds, purchase debt at a low price and demand their full recovery via judicial proceedings

xxi. In this sense,

secondary debt markets and, in general, capital financing markets are a high risk environment due to their highvolatility and the absence of regulation which prevails. Regulation that helps to block such practices is thereforenecessary.


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Use of swapped funds

According to a swap survey by the SES Foundationxxii

, swaps have been conducted largely within theframework of the HIPC initiative. This is regrettable since the advantage of swaps is principally thatthey can be extended to countries outside the HIPC framework. In practice, only a small number of swapshave taken place with non-HIPC countries. Whats more, HIPC countries should benefit exclusively from

cancellation and not from swaps.

Secondly, there are swaps for investment or for equity that involve all manner of projects and are notfocused exclusively on development. Swaps for nature worth about US$900 million occupy the thirdplace but it is worth remembering that a majority of this sum falls within one single fund, Polands Eco-Fund. This fund is an exception to the rule given its volume and coordination by creditors, as will be seenlater in this report.

The chart below illustrates that, once HIPC countries are excluded, the total value of debt swaps amountsto US$3.6 billion, an insignificant amount considering external debt levels of developing countries totalmore than US$2.8 trillion. The US$15 billion indicated in the chart represents the total amount ofcancelled debt (debt wiped from creditor accounts). The total paid by debtors into projects amounts toabout US$7 billion, according to SES Foundation estimates.

Use of cancelled funds Total cancelled debtin US$ million PercentageDevelopment660.18 4.4%

Education217.48 1.4%

Education & Public Investment50.00 0.3%

Investment1,236.43 8.2%

Nature872.50 5.8%

Millennium Development Goals567.00 3.8%

HIPC11,421.27 76%

TOTAL15,024.87 100%

Source: SES Foundation, April 2007


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WHY DEBT SWAPS FOR DEVELOPMENT?

It is worth asking what benefit there is in swapping debt for development. Why swap debt when thefastest and most legitimate solution according to many civil society organizations would be to cancel thedebt of all poor countries that urgently need it to finance their development. In this context, debt swapsseem only a partial solution since they do not notably reduce indebtedness and do not free up

additional resources by donors. They also create greater conditionality on the use of funds contributedby the debtor and entail high administrative costs. Swaps may be a useful solution for those countriesthat have been excluded from debt cancellation initiatives. In a simple debt swap scenario, all partiesshould benefit: the creditor recovers part a debt which would be unlikely to be repaid (in the case ofcommercial debts) and improves his ODA figures (in case of bilateral or publicly guaranteed debts). Theinvestor (if there is one) makes a profit between the debts purchase price and sale price to the debtor.The debtor country pays a lower amount in local currency than the nominal value of the debt and assignsit to social investments. Civil society groups participate in the implementation and monitoring of socialprojects. But clearly everything depends on the value and conditions of the swap as well as on theeligibility of debtor countries.

Why do creditors swap?

Because swaps create an opportunity to recover unpaid debt: In the event of non-concessional debts,it is advantageous for a creditor to swap a debt whose repayment is unlikely. This allows the creditor toavoid a build-up of arrears. By means of a swap debt operation, the creditor recovers at least part ofa debt in currency.

Because swaps boost a creditors ODA figures: A creditor can add the nominal value of a non-concessional debt to his ODA figure. In this sense, debt swaps help creditors achieve the goal ofcontributing 0.7% of GDP to ODA without paying out any additional funds. Essentially this is a way ofinflating ODA figures through a simple accounting operation. This is common practice even though itviolates the principle of aid additionality. As highlighted in a 2007 report by European NGOs on ODA,30% of aid contributed by European donors is not true aid as it includes debt cancellation and thefunding of foreign students and refugees seeking asylum in Europe

xxiii. NGOs believe such accounting

practices should end and that debt relief operations including swaps should be strictly additional to ODAas set down in the Monterrey Declaration.

Because swaps increase visibility: Swaps are a good instrument for increasing the visibility of a donorcountry in a given sector.

Because swaps guarantee an appropriate use of funds: The fact that the debtor country pays for theswap out of its own budget ensures greater care in how the funds are used than if the funds were agrant. On the other hand, swaps give creditors greater say in what sectors should be invested in,reducing the debtors power to decide on the use of the swapped funds.

Why do debtors swap?

Because swaps facilitate an open dialogue on debt with local civil society: As the African Networkon Debt and Development (AFRODAD) affirms, there must be political will at government level as well as

energy and empowerment on the part of civil society for this dialogue to be fruitful. After decades ofdiverting national resources to debt servicing, is it not now just that these resources should now be directedtowards programs to eradicate poverty and improve social services?

Because swaps strengthen the participation/involvement of local civil society: local organizationsbecome involved in new local development programmes by monitoring those projects that have beenapproved by governments. As the SES Foundation underlines, involvement in swap processes constitutes areal qualitative jump (for civil society groups in beneficiary countries), allowing them to enter into dialogue

with local authorities and ministries and significantly strengthening their ability to shape public policy.Localorganizations must take advantage of the opportunity posed by swaps for development and in this sensethere is still much to be improved.

Because swaps facilitate greater social investment: Instead of being paid to a creditor, funds remainin the country and are invested in key social sectors. This advantage is directly proportional to the

volume of the swapped amounts. The transfer of resources usually devoted to debt repayments toward


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social sectors constitutes an immediate relief from which tangible benefits can be obtained in the shortterm at a local development level.

Because swaps allow the reduction of debt in foreign currency: A debtor country reduces itsindebtedness in foreign currency when it swaps it for local currency. As in the previous case, the degreeof debt relief depends on the volume of the swapped debt and the discount rates applied. So in somecases, where a debtor country pays 100% of a debts value plus interest as in the case of Spains debt

swap with Ecuador, the burden on the debtors budget is high.

Because swaps facilitate debt relief for countries not included in the HIPC initiative: Official debtcancellation initiatives target only a limited number of countries. Only 40 countries currently benefit fromthe HIPC initiative and its off-spring, the Multilateral Debt Relief Initiative (MDRI). But many morecountries need debt cancellation since they spend a significant part of their budget on debt servicing tothe detriment of their social sectors. According to the United Nations Conference on Trade andDevelopment (UNCTAD), even a 100% debt cancellation for Sub-Saharan Africa would go only halfway to generating the resources necessary to reach the Millennium Development Goals

xxiv. In this context,

as long as debt cancellation initiatives exclude large numbers of countries, debt swaps for non-HIPCcountries represent a temporary solution provided the swapped amounts are big enough to have animpact on the social sectors in which they are invested, and provided that discount rates are sufficientlyhigh so as to generate a budgetary advantage for the debtor government.

Because swaps improve a debtors repayment capacity, creating indirect consequences: Thisconcerns above all swaps on commercial debt in arrears. As the likelihood of repayment increases, adebtor countrys credit rating improves. This in turn boosts the value of the debt on the secondary market,making operations more burdensome for debtor countries. It can be concluded that this advantage comesat a cost to the debtor: the investor benefits from the situation, using the higher cost to increase his profitmargin, but the debtor cannot benefit. Instead, the debtors accumulated arrears are reduced and debtrevalued, but he will have to pay more for its conversion.

For a swap to be truly advantageous in terms of financial relief and social investment it must be carriedout with non-concessional debts that they are being repaid. Otherwise, a swap may increase pressure ondebtors by raising the price of their other debts on the secondary market, and pressure from creditors torecover other debts in arrears. Concessional debts, on the other hand, should qualify for cancellation.


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Some examples and features of swaps according to creditorsxx v

Switzerland Canada Germany Italy Spain

Date 90s 80s & 90s 90s 2000s End of the90s-2000s

90s-2000s

Type of

projects

Social

Infrastructure,promotion ofsmall businesses

Nature,

Children

Nature,

Socialinvestment

Nature,

SmallBusiness

Social

Infrastructure,

N ofbeneficiarycountries

45 7 12 9 12

Discount rate 50%-80% 50-75% 50-70% 0% 0%

Type ofswap

CF CF Projects CFProjects

CF CF

Type of debt ECAguaranteed

ODA ODA ODA

Tied aid No No No Yes Yes

CSOparticipation

Partial Partial(TechnicalExecution)

High(Bi-nationalTechnicalCF)

Partial(TechnicalExecution)

Partial(Technical,execution)

Others Total amountswappedCHF700 million

Annual swaptarget ofEUR100million

Source: O. Ugarteche, 2006


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PROBLEMS FOUND IN DEBT SWAPS FOR DEVELOPMENT

Despite the potential benefits of debt swaps for development, civil society organizations haveencountered many problems with the way in which they have been implemented. Latin Americanorganizations (within the Latindadd network) and the Spanish section of the Global Campaign forEducation have therefore published several reports presenting both the potential benefits and keylimitations of swaps.xxvi The main problems raised by these organizations and by Eurodad are presentedin brief here.

The origin of the debt is not taken into account: The debate around the illegitimacyxxvii

of debt is takingshape in debtor countries as a result of citizens audits carried out on their foreign debt. The debate isalso gaining ground as creditors begin to acknowledge their own responsibility. For example, in October2006, Norway announced its decision to cancel US$80 million worth of debt with five countries

xxviiiwhich

had resulted from a series of irresponsible loans aimed at furthering Norwegian export interests. Incancelling these debts, Norway assumed its part of the responsibility for them. Meanwhile, the WorldBank and UNCTAD (United Nations Conference on Trade and Development) have recently published twostudies on the issue of odious debt.

xxixRecent parliamentary initiatives elsewhere have also supported

audits and tackled the question of odious debt head on.xxx

It is crucially important that debt reduction mechanisms, such as swaps, do not undermine the growingnumber of initiatives challenging the root causes of debt problems that is, the accumulation of loans ofdubious origin by debtor countries, for which creditors need to acknowledge their responsibility. In thesecond UNESCO working group on debt swaps for education in 2007, the representative of thePhilippine government recommended the incorporation of transparent audits on external debt todetermine which parts of the debt were illegitimate.

xxxi

Lack of additionality: Creditors have promised that debt relief should be additional to ODA. However,there are still doubts about how this is applied in practice. There needs to be a systematic evaluationthat shows the extent to which debt swaps arranged by creditor countries represent funds that areabove and beyond their ODA. From the debtors point of view, the swap is additional only if the fundsfinance investments over and above investments the country was going to carry out anyway.Additionality of resources will be greater the higher the discount rate applied. The larger the discount,the more additional funds can be used in a consistent and lasting manner, since the end aim is toguarantee the sustainability of social investment through a stable, long-term budget. In this sense, thecounterpart funds provide only a temporary solution.

Use of funds: One of the problems that education and debt NGOs have encountered in bilateral debtswaps for development is that a large part of the resources are assigned to cover current expenditures

This raises questions about the additionality of the swap in relation to national budgets. For example, in

the swap for education between Spain and Honduras, a significant proportion of the budget was

assigned to the ministry of security (police training) and financial services of the general administration,

from which a large part was set aside to pay wages and salaries.xxxii

This problem indicates that budgetary deficits are still of primary importance and that beneficiarycountries still need additional resources. As noted in the Sachs report of the United Nations, We stressthat no distinction should be made between funding capital and operating costs through official development

assistance, since poor countries cannot afford to fund operating expenditures, which account for a largeshare of total costs in health, education, and other sectors. To maintain macroeconomic stability, external

finance to low-income countries will need to be provided in the form of grants (Landau 2004)xxxiii

Thishighlights the urgent need for donors to contribute funding that is genuinely additional.

Low discount rate: Althought some creditors, such as Germany, apply discount rates of 50%, othercountries like Italy or Spain do not apply any discount or only a very low rate. In order to maximize thepotential benefits of debt swaps for developing countries, the discount rate has to be considerablyincreased so that the debtor country has a real budgetary incentive to swap debt for social investment.

Little clarity in the eligibility of beneficiary countries: To date, there are few countries that havebenefited from debt swaps. Some estimates suggest that around 50 have done so, but a largeproportion of these are HIPC countries that should not have received swaps but cancellation. In order tobenefit from a swap a country should, in principle, have an IMF program in place. But in practice, it is

creditors who decide who benefits from a swap: although debtors may show an interest in swappingdebts, some of them continue to be excluded on political rather than technical grounds.


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The IMF: sole guardian of swaps?

In practice, the decision over whether or not to swap a countrys debt depends on creditors political will more than

anything. This has led to double standards in a number of cases. For example, a country like Ecuador, which no

longer has a relationship with the IMF, has signed debt swaps for development with Spain and Italy, thus violatingthe requirement of an IMF programme in place. On the other hand, a country like Argentina, which has also cut ties

with the IMF, is facing many difficulties in obtaining a debt swap with Spain, despite actively requesting it.

However, this is probably due not only to the fact that it does not have a programme with the IMF, but also to the

on-going tense relationship between Argentina and this institution. It is worth remembering that Argentina paid its

debt to the IMF in advance and that in the latest renegotiations with the Paris Club it insisted on keeping the IMF out

of talks. Moreover, the Paris Club recently refused a swap arrangement with a concessional component for Angolaciting that it did not have a programme with the IMF. But likewise, in this case, the refusal was probably also about

political tensions with this country.

High administrative costs: One of the main disadvantages of debt swaps is their high cost, due to eachproject being dealt with separately. This dispersal leads to a multiplication of transaction andmanagement costs, which limits the efficiency of the mechanism at a global level. On top of this are theextensive political negotiations which accompany every swap that is negotiated bilaterally. One way ofovercoming these obstacles is to use multi-creditor funds, thus minimizing transaction and negotiation costsand creating greater synergies.

High conditionality/tied aid: Another problem identified by civil society organizations is the

strengthening of conditions by the creditor who can play a powerful role in defining investment prioritiesand in tying the involvement of their own domestic companies into projects that are financed throughdebt swaps. Despite donor commitments to reduce this kind of tied aid, it nevertheless continues tohappen. For example, debt swaps for education implemented by Spain have been tied to the purchaseof goods or services of Spanish companies. While the new debt law approved by Spain at the end of2006 prohibits such actions, most of the swaps were signed before the law came into force, and thusremain outside the new legal framework.

Tied aid in the EcuadorSpain swap

The swap for education signed between Spain and Ecuador under the previous Ecuadorean government resulted in afund of 50 million, of which 20 million was assigned directly to the education sector and 30 million tohydroelectric projects. This second set of projects has since been blocked by the current Ecuadorean government dueto the excessive level of involvement of Spanish companies. It is currently being renegotiated to include the

involvement of the Ecuadorean public sector. This example highlights two fundamental issues: first, that tied aidinvolving a subsidy for Spanish exports occurred, and second, that strong political will combined with negotiationcapacity, such as that expressed by the Ecuadorean government, can improve the conditions for debtor countries.

Lack of participation by civil society: The participation of civil society organizations, from both creditorand debtor countries, is essential throughout the swap process in order to guarantee greatertransparency in the definition of priority projects, as well as in their implementation, evaluation and toensure full accountability. Although civil society participation in the technical committees is increasing it isstill not enough, especially within beneficiary countries. The swap survey carried out by the SESFoundation shows that in more than 60% of cases there is no participation by civil society at any stage inthe process, whether in the negotiation phase, discussion on the use of funds, or in the management,implementation or evaluation of projects. On the creditor side, civil society participation mainly occurs atthe level of technical committees. For example, a swap between Germany and Peru involved Germancivil society representatives in the binational committee in charge of negotiating and defining the swap

operation.

Local NGOs: to what extent are they present?

In the debt swap for education between Spain and Ecuador, Spanish and Ecuadorean NGOs criticized the way inwhich civil society representatives were hand-picked by the binational committee for the technical committee. Theyalso criticized the fact that it was being paid, thus creating a conflict of interests.

In Peru, the government designated the board of university chancellors as its civil society members, despite the factthat this organization had no experience in implementing and monitoring projects.

In the swap between Italy and Kenya, local civil society was excluded altogther, leaving only the representatives ofItalian organizations.

In general, civil society organizations point out the existence of a controlled participation of local civil society that ischaracterised by secretiveness, late call to meetings, and a lack of transparency. (Jubilee Peru)


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Lack of coherence with national strategies/limited involvement of relevant ministries: It hasrepeatedly been shown that projects financed for swaps provide short-term measures that remainunconnected to national development programmes. For example, in Ecuador, the swaps for educationhave not been integrated into the national education plan. Bilateral negotiations have also invariablyexcluded key actors in the debtor country, such as the ministries of education in the case of swaps foreducation. In the SpainEcuador swap for education, the Global Campaign for Education reported that,the Ministry of Education and Culture of Ecuador was initially left out of the operation altogether. Since

then, it has been invited to the technical committee where its delegate will participate in discussions but will

not have the right to vote.xxxiv

An absence of any evaluation of the sustainability of the projects was alsopointed out.

Lack of sustainability: Due to the temporary nature of swaps and their focus on concrete projects, debtswaps often provide only a short-term fix, a kind of one-off solution, which in the long run can provecounterproductive for developing countries. They can also end up contradicting donors commitments toproviding efficient, predictable and lasting assistance as set out in the Monterrey Declaration onfinancing for development and later in the Paris Declaration on aid effectiveness. Debt swaps have beencarried out over varying lengths of time (according to some experts, an average of 5 years in the caseof debt for education) depending on the amount swapped. As previously seen, the amounts swappedare generally small, which suggests that the shelf life of the counterpart fund must also be relatively

limited. Therefore once the debt that is eligible for the swap is exhausted, the counterpart fund will runout, thus compromising the sustainability of investments. In the case of the PeruGermany swap thecounterpart fund is an investment or endowment fund, so the projects are longer lasting. This kind ofcounterpart fund is an exception to the rule, but it is potentially a way of guaranteeing longer-termsustainability.

Very small amounts: Debt swaps for development have mobilized very little funding in the vastmajority of cases.

Very little data has been collected regarding the total amounts swapped and so it is difficult to makecomparisons with official figures. According to the SES Foundation survey, the amounts swapped havegenerated a total of about US$7 billion for social investment. This figure is insignificant compared todebt for equity swaps, which in 1990 alone reached US$27 billion.

xxxv

The following chart illustrates the relative importance of debt swaps compared with other financial flows:

Financial flows and stocks In US$ billionsTotal debt swaps for development (amount generated up to 2007) 7

Debt service paid by developing countries (2005) 540.84

Debt service paid by low-income countries (2005) 34.811

Debt service paid by middle-income countries (2005) 505.274

Total Official Development Assistance (2005) 106

Amount cancelled via the HIPC framework (from 1996 to 2006) 17.088*

Developing countries migrant remittances (2005) 189.526

Source: Global Development Finance, 2007, and Debt Relief International, 2007.

*Based on a total commitment of US$62.115 billion.


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At the global level, the amounts involved in swaps are minor compared to the total burden of externaldebt. To make matters worse, swap funds are divided between numerous small projects, involving amultiplication of management costs and far greater inefficiency. According to the SES Foundation survey,more than a third of swaps are worth under US$10 million, just over a third are worth between US$11and 50 million, and only 11% are worth more than US$100 million. The swap agreement between Spainand Peru signed in 2002 generated a fund of 7 million with annual maturities of US$1 to 2.5 million.The ItalyPeru fund created in 2002 for a total of US$127 million, pays out US$25 million annually,

which, in the first round, has been assigned to 45 different projects of which more than half financeinfrastructure development.

It is important to remember, however, that very few evaluations of swap experiences, either past orcurrent, have been carried out. This makes it very difficult to measure the impact they have had on socialand environmental development, as well as on reducing indebtedness.

Debt swaps can be seen as a double-edged sword, then. In theory, if applied efficiently, they have thepotential to be highly beneficial, but in practice this rarely happens. Swaps will become much moreefficient and effective only when they achieve a balance between their dual objectives: to reduce debt,and to increase much-needed social investment.xxxvi

Swaps for development and principles of aid effectiveness

In 2005, donors committed themselves to improving the quality and effectiveness of aid in accordance with a seriesof principles outlined in the Paris Declaration. These principles are:

- Handing over ownership of development strategies and resource management to beneficiary countries;

- Donor alignment around the development strategies of recipient countries

- Donor harmonization to guarantee greater efficiency in the management of ODA funds,

- Ensuring results based assistance

- Mutual accountability of both donors and recipients

For swaps to be beneficial they have to follow these principles, thereby integrating themselves fully into nationaldevelopment strategies, promoting coordination and harmonization among creditors, ensuring that both parties areaccountable and that the entire process is transparent from the selection of beneficiary countries through to theevaluation of the projects.

Nevertheless, the implementation of swaps has, in many cases, failed to comply with these principles of aid qualityand effectiveness. This has led to problems highlighted by civil society organizations, such as tied aid, incoherencewith national strategies, limited participation of civil society, lack of coordination, and so on. For swaps to functioneffectively it is essential that donors apply the principles of the Paris Declaration at ever stage of the operation.


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SWAPS: NOT A SOLUTION TO THE DEBT PROBLEM

Debt swaps are becoming increasingly popular as a means of alleviating the pressure of external debton developing countries pressure that, for decades, has undermined governments ability to meet thebasic needs of their population. But the impact of swaps in reducing debt has been marginal andeveryone involved agrees that they are not an effective solution to the high levels of indebtedness of

developing countries.

It is no coincidence that swaps appeared just after the debt crisis that engulfed developing countries.Highly indebted to private banks, most of these countries were incapable of repaying their debts afterthe exponential rise in interest rates and the fall in the price of raw materials on the international market.In order to avoid a world financial crisis and to guarantee debt repayments, creditors launched a seriesof restructuring plans. Debt for equity swaps appeared at this time as a way of substituting unpayableprivate debts for shares in national companies.

But in spite of these restructuring plans and of loans granted by international financing institutions, theproblem of indebtedness still exists. The stock of the external debt of developing countries has grownfrom US$8 billion in 1960, to US$70.18 billion in 1970, and to US$540.92 billion in 1980.

xxxviiCurrently

it almost surpasses US$2,800 billion. Needless to say, therefore, resolving the endemic problem of debtin developing countries will require measures that are considerably more far-reaching than those put

forward up till now, including the HIPC initiative and the recent MDRI.

0

500

1000

1500

2000

2500

3000

1960 1970 1980 1990 2000 2005

Stock deuda externaPED, en miles demillones $ US


There is a general consensus that debt swaps are not a valid instrument for resolving this situation. As theWorld Bank states, There is no market solution for the debt crisis.

xxxviiiThis confirms the arguments of

civil society organizations who insist that the debt problem will continue to persist until more ambitiousinitiatives are taken that require stronger political will on the part of the creditors. Existing initiativesprovide only short-term solutions that relieve the symptoms but do not deal with the root of the problem.As a result, they serve to reinforce the dependency and vulnerability of developing countries.

The structure of global debt is as significant as its size. Over the past ten years, the internal domesticdebt of developing countries mainly those of middle income has reached around 50% of their totalpublic debt, according to UNCTAD. This phenomenon goes some way to explain the slower growth offoreign debt in recent years and the limited scope of debt reduction initiatives. Another importantimplication of this relative growth of domestic debt is that there will be fewer and fewer debts that canbe swapped in the future, especially bilateral ones.


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Comparison between debts swapped and the totalstock of debt US$ billions

Estimate of debt swapped for development 12.48xxxix

Total debt stock of low-income countries 379.239

Total debt stock of middle-income countries 2,363.139


While debt for equity swaps in the 1980s succeeded in reducing the indebtedness of developingcountries, swaps for development have had an insignificant impact in this sense. They are onlyworthwhile, therefore, in so far as they can supplement social investment, as will be seen in the followingsection.


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DEBT SWAPS AS A MEANS OF INCREASING SOCIAL INVESTMENT

Debt swaps for development can contribute valuable resources to social investment, but they have twomajor limitations: first, in financial terms, they are insufficient given the enormous needs; and second, theydo not deal with the origin of the problem of indebtedness.

Many more resources are needed to finance priority sectors:

According to UN projections, it is unlikely that, at the present rate of change, any of the MillenniumDevelopment Goals (MDGs) will be reached in sub-Saharan Africa by 2015. With regards low- andmiddle-income countries, the increase in inequalities means that many of these goals are also out ofreach for a large proportion of the population. Since 2000, the international community has repeatedlyclaimed that additional funds are needed to realise the MDGs. In this context, debt swaps can be seenas a way of channelling national funds into key social sectors such as education and health. The Sachsreport suggests that, in order to accomplish the MDGs, a low-income country must invest between US$60and 90 per person in capital expenditure from 2006, progressively increasing this investment up toUS$120160 by 2015. The report concludes that, Even with this, the MDGs in most low-income countrieswill have a financing gap of between 10% and 20% of GDP () Not even a substantial increase in themobilization of national resources by governments and families will be enough to finance (these)investments.Consequently, external ODA funds will be needed. The same report estimates a financing

gap of US$73 billion in 2006 and US$135 billion by 2015 in MDG financing. In other words, it isexpected that US$253 billion will be needed to cover MDG costs in 2006, rising to US$348 billion in2010, and US$529 billion in 2015. Given the magnitude of financial requirements, the contribution ofdebt swaps is clearly extremely limited.

The policies promoted by IFIs (International Financial Institutions), which created a chronic deficit insocial sectors, still stand:

The IFIs have played a central role in dismantling the health and education systems in the majority ofdeveloping countries. Ever since the application of structural adjustments programmes in the 1980s, thesecountries have suffered a chronic financing gap in their social sectors. With the enforcement of theWashington Consensus, education and health expenditures were radically reduced to give budgetarypriority to servicing debt repayments.

The following table shows clearly how Ecuador, for example, has prioritized debt payments since theimplementation of structural adjustment policies in the 1980s. This has been at the expense of health andeducation, producing a permanent deficit in these sectors that has steadily deepened since 2000, theyear of the financial crisis in this country.

Source: Jubilee Ecuador 2007

Since the late 1990s, the IFIs have increasingly focused on fighting poverty and embracing nationaldevelopment strategies, but the macroeconomic framework of the structural adjustment programmes stilllargely stands. Recent studies show that the IFIs continue to implement policies that restrict socialexpenditure, despite an improvement in the macroeconomic indicators of most low-income countries thatallow for more expansive policies in the public sector.

xlAccording to a report from the Center for Global

Development,the IMF has tended to favour the further decrease of domestic debt and increase of external

Distribution of the Ecuadorian state budget in %

0

10

20

30

40

50

60

1980 1990 2000 2005

Debt repayments

Education

Health


23/31


reserves instead of promoting the increase of public expenditure. The study also points to a cleardisconnect between fiscal and budgetary policies and those of the education and health sectors.

Another recent study on education by Action Aidxli

concludes that the IMF still decides where funds foreducation come from and still applies ceilings on public expenditure required for developing nationaleducation strategies.

Quantity vs quality

Many governments have abolished enrollment fees for primary education, which has led to a significant increase inthe number of children registered. However at the same time, they have not been able to recruit enough teachers toensure a good level of schooling. This limitation results from IMF pressure to enforce policies aimed at keeping therate of inflation below the level recommended by the Institution. Governments do not have the necessary politicalspace nor the technical support to make their own decisions about macroeconomic policies for promoting stable growth

and achieving national development goals (...) As a result, their policies remain divorced from the reality on the ground,

and fail to take into account the shortage of teachers and the devastating impact on the quality of education.

What can swaps do for social financing?

Due to the limited amounts of money involved, the short timescale of projects and the lack of coordinationbetween donors, swaps do not stand up to the structural needs of social financing in developing countries.

Such financing requires foresight, sustainability and coherence with national development strategies.However, there is no doubt that swaps offer much-needed extra contributions to chronically under-funded sectors such as health and education. In this sense, they are useful in so far as they provideadditional or supplementary financing to that already budgeted by the government. Swaps are alsoworthwhile in terms of their role in strengthening civil society participation in local development projects thus enabling civil society representatives to develop their role as monitors of government developmentpolicies. Positive examples include the Eco-Fund(see below), formed between Poland and the Paris Club,which is a long-term swap involving large amounts and in which the donors coordinated betweenthemselves to create an independent common fund to bring down costs. More recently, Debt2Health (seebelow also), which is run by the World Bank, provides an example of an effective swap in the healthsector. These examples deserve particular attention because important lessons can be learned from themthat can be applied elsewhere.

Need for predictable and good quality aid:

The lack of predictable and long-term aid is a key factor undermining the effectiveness of governments long-termbudget planning. Health and education require long-term measures that may not be productive investments it theshort run but will lay the foundations for a countrys sustainable economic development in the future. However, thefinancing of these sectors is invariably planned in the short term. One of the greatest difficulties faced by Southerngovernments is thus the unpredictability and lack of consistency in donor aid, which hinders long-term budgetplanning. Despite promises to make their aid more predictable and better coordinated, donors have done little toensure this in practice. All mechanisms for financing development, including swaps, should follow the criteria ofpredictability and sustainability.


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MULTI-CREDITOR SWAPS, AN EXAMPLE TO FOLLOW?

The Eco-Fund

After the fall of the Berlin Wall and the subsequent collapse of the communist block, Poland beganrenegotiating its bilateral debts with the Paris Club. Once it achieved the cancellation of 50% of itsbilateral debt, the Polish government proposed the creation of an independent fund (the Eco-Fund) tofinance environmental projects in exchange for an additional 10% cancellation its bilateral debts. Theensuing swap proved exceptional, due to the large amounts involved and the advantageous conditionsagreed upon for which the Paris Club was later criticized for giving preferential treatment to Poland.This illustrates once again that favourable or unfavourable conditions in debt swaps are ultimatelydecided according to political agendas.

The fund, made up of 10% of the outstanding debt, was held in an account in the Bank for InternationalSettlements. The fund was created in 1992 and will last until 2010. It has a total of US$571 million

xlii

which is for private sector investments in four project categories: reduction of atmospheric and cross-border pollution, reduction of pollution in the Baltic Sea, reduction of greenhouse gas emissions, andprotection of Polands biodiversity. The Eco-Fund is a pioneering debt swap because of its multilateralcharacter: a number of creditors were involved in both its negotiation and implementation. The most

important creditor is the United States, which represents over 70% of the total fund. The others areFrance, Italy, Sweden, Norway and Switzerland. In terms of coordination between donors and theconsequent reduction of operational costs the Eco-Fundhas been highly successful and provides a modelfor others to follow.

It has also, however, served to promote the interests of foreign companies in Poland. Research conductedat the University of Warsaw

xliiiconcludes that the Eco-Fundproject had the clear intention of benefiting

private companies from participating creditor countries. The study shows that Italian, Swedish and Frenchcompanies received revenues worth more than double the amount that their countries contributed to thefund, and that there was a specific intention that creditors would receive such compensation. On theone hand, then, this swap shows that it is possible and worthwhile to improve coordination among donors;but on the other, it makes it very clear that such agreements can strengthen tied aid and indirectlysubsidize exports from the creditor to the debtor country.

Debt 2 Health

The Global Fund against HIV/AIDS, tuberculosis and malaria was created in 2002, following theMonterrey Conference on financing for development. The Fund is an example of private and publicsectors coming together, at a bilateral and multilateral level, to find the necessary resources to fightthese pandemics, within the framework of the Millennium Development Goals. Since its creation, the Fundhas received donations of US$10.8 billion and since 2007 has set itself the task of tripling thesecontributions, raising them to US$8 billion a year by 2010.

xlivNevertheless, contributions have fallen far

short of expectations and the Fund currently suffers a budget deficit of some US$2.5 billion.xlv

This ishighly regrettable, as the Fund has had a very positive impact on health programmes in recipientcountries and its financing gap undermines the possibility of carrying out more ambitious projects.

xlvi

In searching for ways to increase its financing the Global Fund came up with the idea of launching a pilot

project of a debt for health swap. It selected a series of countries that, between 2007 and 2009, willconvert part of their debt into financing for projects carried out by the Fund at a national level. This pilotproject includes four countries (Indonesia, Kenya, Pakistan and Peru) that are outside the HIPC frameworkand thus do not benefit from other debt cancellation initiatives. During the G8 Summit held inHeiligendamm in June 2007, Germany promised to contribute to this initiative by cancelling 200 million,thereby becoming the first official bilateral donor of Debt2Health. To start, Germany will swap 50million worth of debt to Indonesia over the next two years, generating a fund of 25 million (with a 50%discount). In total, the pilot project in the four countries is estimated to amount to US$250 million worth ofdebt, which should create a counterpart fund of about US$125 million, with a maximum 50% discount.

xlvii

Advantages: The Global Fund has proven to be an effective body in managing and making use offunds, giving it credibility and legitimacy in managing debt swaps. It also has a flexible structure thatallows it to adapt to the different levels of institutional development in each country. Furthermore, theFund already contains of the structures needed for evaluation, monitoring and follow-up, which will

enable a better assessment of the impact and relevance of financed projects. Having these mechanisms


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in place also allows for a faster disbursement of funds and a reduction in administrative costs, in contrastto debt swaps that are carried out bilaterally (in the latter case, the debt is cancelled only after theproject has been implemented and evaluated). The Global Fund guarantees, to some extent, greatercoordination between donors as well as ensuring that projects are properly aligned with the healthpriorities of beneficiary countries. The Fund also ensures the active participation of civil societyrepresentatives from the decision-making stage (they are present in the Board) through to monitoring theswaps. Tied aid does not figure in this swap, as creditors cannot at any point decide how swapped funds

will be spent.

However another important point is that the question of the legitimacy of the debt remains ever presentin Debt2Health due to the different actors involved. Civil society organisations have to keep this issue tothe fore all the time while monitoring and evaluating the swaps.

Limitations: One of the key limitations of this fund is that it can only work with bilateral concessionaldebts, which considerably reduces its potential impact. One of the current challenges is to integrate non-concessional debts.

Through their active participation in Debt2Health civil society organisations have also noted some majordifficulties with the programme. Additionality is one of the black spots they have detected: the moneydisbursed by the debtor as a result of the swap is deducted from the additional contributions that itreceives from the Global Fund. The debtor country has little incentive to finance the Global Fund through

Debt2Health as this means a reduction in resources received by the Fund.

Another issue raised is that of eligibility. What criteria have been used to choose the beneficiarycountries? This point should be made more transparent.

But the most important limitation of this initiative is the uncertainty regarding the long-term financing ofthe Global Fund itself. The sustainability of the programme depends on this because even if the Fundopens up to other donors, Debt2Health itself will come nowhere near to making up its financing gap.Once again, more efforts to find funding are required. For this initiative to work, then, the commitment ofan annual US$10,000 million must be respected, since only consistent, long-term funding will allow it tofunction efficiently and have a real impact on the health sector.

Debt 4 Education

At its 33rd General Meeting in October 2005, UNESCO created a working group to evaluate theimpacts of debt swaps in the education sector and the possibility of applying them in UNESCOs field ofwork. The resolution stated that, there should be support for agreements on debt swaps within theframework of a transparent and effective administration of general funds, with the participation ofcreditors, debtors, international organizations and civil society representatives in the follow-up andevaluation of educational programmes arising out of these agreements.

Since then the working group, which brings together representatives from the finance and educationministries of creditor and debtor countries and civil society representatives, has met twice to discuss howbest to implement debt swaps for education. The involvement of civil society in the working group andthe leadership of both Spain (the creditor) and Argentina (the debtor) has been a positive force. But theprocess suffers from significant limitations: unlike the Global Fund, UNESCO does not have the capacityto administer resources effectively; more importantly, the initiative lacks funding. Despite these problems,

the process could move towards creating a fund to finance education in the style of the Global Fundsprogramme for health, or it could expand the fast track for education initiative (FTI) run by the WorldBank. The main priority, however, is to obtain real financial commitments. It is worth pointing out that theFTI suffers from a financing and absorption problem it received around US$52 million for 2005 and2006, of which less than half has so far been used, and of this only US$7.8 million has been effectivelydistributed. In other words, only 15% of FTI funds have been used to date.

xlviii

However, despite its financial limitations, UNESCO could and should perform an important role in debtswaps for education by participating in and monitoring swaps and ensuring that they respect nationalpriorities and acceptable criteria. During the working groups meeting in July 2007, the SES/LatindaddFoundation therefore asked UNESCO to play an active role in: legitimizing quality standards in theimplementation of swaps for education and to propose them to countries, facilitate the relationship betweencreditors and debtors to carry out swaps for education, to accompany the processes that are in force andsystematize experiences to identify best practice models to follow.


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CONCLUSION: TO SWAP OR NOT TO SWAP?

Swaps are not a solution for debt or poverty: They amount to an extra bit of help, which, if negotiatedand carried out effectively, may make the investment worthwhile and help promote participativedemocracy at a local level. In short, swapping is a support mechanism that by its nature is onlycomplementary and therefore not a sufficient solution on its own.

Despite their limitations, swaps can produce creative and participatory projects: Swaps can bebeneficial in terms of local development and small-scale projects. As suggested by some civil societyorganizations such as Jubilee Peru, swaps that are well conceived and carried out can re-energise localdevelopment and strengthen poorest communities by promoting projects that respond to local needs. They

can also strengthen participative democracy by offering local communities good opportunities.xlix

Swaps have not always been carried out effectively: Swaps for development have invariably beenvery costly processes in terms of the conditions attached to them, transaction and negotiation costs, thelack of coherence with national development strategies, and the lack of additionality and sustainability.

More ambitious measures are required at the national and multilateral level: Beyond existing debtrelief initiatives, a great deal more funding is required from donors, which has to be predictable, long-term and made good use of. Swapping, as a support measure, must be improved to make it a form of

efficient, consistent and long-term aid.

Debtor countries should not have to accept any swap offered them : Debtor countries must continueapplying pressure and using their negotiating power to demand better conditions and to reject swapsthat are not beneficial to them, as in the Ecuadorean case. Analyzing the legitimacy of the debt shouldalso be an integral part of any relief, restructuring and debt swap operation. The two processes are notincompatible. Likewise, civil society organizations have played and must continue to play a central rolealongside their governments.

Swaps must adhere to principles of mutual responsibility and effectiveness: Donors have promised toadhere to aid effectiveness principles

lin all aspects of their development financing policy, which should

therefore include debt swaps:

Mutual accountability

Analyzing the origin of the debt: Swaps should include first and foremost a debt audit in order todetermine the legitimacy of debts. Since this process is long and swaps are only a short-term measurethis could be problematic. However, solutions can easily be found, such as the creditor paying indemnitiesto debtors retrospectively based on the results of the audit. These kinds of proposals have been taken onboard not only by civil society but also by debtor governments.

Transparency and widening the eligibility criteria: In order to have greater impact, the swap initiativemust be expanded to include many more countries. So far, only a few middle-income countries havebenefited from it due to the eligibility criteria established by the Paris Club. IMF programmes should notbe a sine qua non condition for obtaining swaps with a discount. Transparency in the selection ofbeneficiaries is essential in order to avoid the exclusion of some countries on politically motivatedgrounds.

Participation

Civil society participation: Civil society organizations in debtor and creditor countries must berepresented at all stages of the swaps (negotiation, implementation, management and evaluation) andmust guarantee transparency and accountability throughout the whole process. Many organizations (suchas Jubilee Peru, SES Foundation, ActionAid, among others) actively work to promote best practice in civilsociety participation.

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Alignment of donors to national strategies

Coherence and sovereignty: Swaps must be fully integrated into national development plans. Theinvolvement of ministries corresponding to each sector of a swap not only finance ministries isessential.


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Conditions/tied aid: Swaps must be exempt from all conditions regarding the purchase of goods orservices from companies in the creditor country. Furthermore, they should not have to carry out policiesthat are inconsistent with nationally established priorities.

Harmonization

Harmonization and coordination among creditors: Coordination among donors must be strengthened in

order to minimize costs and establish synergies and a long term vision. Swaps carried out by Debt2Healthor Eco-Fundshould be held up as a model for this.

Reducing administrative costs and streamlining the process: High management and operational costshave proven to be a major weakness of swaps for development. One way to reduce these costs is fordonors to coordinate more effectively. In most bilateral swaps, debts have been cancelled only once thefinanced project has been carried out and evaluated. It is necessary to speed up this process and, as inthe Global Fund, cancel the debt when the counterpart fund is set up.

Results-based management

Additionality/concessionality by the creditor: Swaps must be strictly additional to ODA funding. Toguarantee greater additionality, swaps must be as concessional as possible; that is, with a high discountrate so that the actual net value of the amount swapped is the lowest possible given the actual net value

of the debt.

Additionality by the debtor: The amount swapped must be additional to the national budget to ensurethat swap investments are on top of already budgeted financing of the social sectors.

Size of swaps and increasing the number of eligible debtors: The limit on swappable debt must behigher, allowing beneficiary countries to swap the amount they consider necessary to reduce levels ofindebtedness while also financing key social sectors. For swaps to have a greater impact on a debtorsbudget, they must be made primarily from non-concessional debts that are being repaid rather thanfrom debt in arrears. There is the risk that private debts would be revalued, producing renewed pressureto repay them, which would worsen the situation of beneficiary country before a swap took place.Concessional debts, meanwhile, should be subject to cancellation.

Predictability and durability: Swaps must be predictable and programmed over the long term in order

to guarantee their effectiveness and to enable better budget planning. In this regard, counterpartinvestment funds such as those agreed between Germany and Peru are a model to aim for.


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USEFUL REFERENCES ON DEBT SWAPS

Aid in Action, Entreculturas & Intermn Oxfam. Navarro Marina. Lights and Shadows. An

analysis of debt swaps for education within the framework of Latin American Conferences.October 2006.

Cassimon Danny & Vaessen Jos. Theory, practice and potential of debt for devel

debt swaps eng(2)

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