European Network on Debt and Development WHAT GOES DOWN MIGHT NOT COME UP. How declining commodity prices could undermine the HIPC Initiative

Transcription

1 EURODAD European Network on Debt and Development WHAT GOES DOWN MIGHT NOT COME UP How declining commodity prices could undermine the HIPC Initiative October 2001 Address: Rue Dejoncker 46, 1060 Brussels, Belgium Tel: Fax: info@eurodad.org Web site: Eurodad has members in Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

2 WHAT GOES DOWN MIGHT NOT COME UP How declining commodity prices could undermine the HIPC Initiative This paper looks at what will happen to the debt sustainability of the HIPC group of countries if export earnings are lower in the coming decade than currently projected. The analysis shows that, for most HIPCs, commodity export earnings are key to export growth, and that current assumptions about the future prices and production volumes of commodities are overoptimistic, making projections on debt sustainability highly unlikely to be met. The paper shows that given the current outlook for the world economy and its impact on world commodity prices, most HIPCs will not achieve debt sustainability unless they receive substantial additional debt reductions. 1. Introduction When a country is eligible for debt reduction under the HIPC Initiative, a Debt Sustainability Analysis (DSA) is performed to ascertain how much debt reduction it should get. The basis for debt reduction is the use of an indicator that links the amount of debt on a net present value basis to the value of the country s exports. When the ratio of the NPV of debt to exports is 150% or greater, this is defined as an unsustainable debt level, and the HIPC Initiative aims to reduce the debt level to 150% or less by cancelling debt stocks 1. As part of this DSA, a projection is made of the future prospects for debt sustainability over the next ten years or so. This involves making predictions of the likely level of both debt and the value of exports. For most HIPCs, the NPV of debt-to-exports ratio is projected to decline significantly below 150% by But as Eurodad has already pointed out 2, we feel that the export projections on which these DSA projections are based are too optimistic. In particular, the assumptions relating to both commodity prices and volumes, on which most HIPCs economies depend, are unrealistic. The following sections show why commodities are so important for debt sustainability, why we think the commodity price and volume projections being used in DSAs are unrealistic, and what would happen to export growth rate projections if commodity prices do not go in the direction predicted. The conclusions are three-fold: There is a very significant chance that by the end of this decade, the HIPC Initiative will have failed to achieve its own limited objectives of delivering debt burdens of 150% of exports. The IFIs have recognised the problem, and have stated that HIPCs may be able to get additional debt relief at completion point if they can demonstrate that the increase in debt levels was due to external factors that last for at least three years. Yet this commitment provides only an ad hoc fix to a structural problem, and hence makes it very likely that such fixes will be required repeatedly in the next decade. Rather than waiting for HIPCs to slip back into indebtedness, and a new round of debt restructuring exit strategies, it is already time to consider new ways to finish the debt crisis once and for all. It is vitally important for long-term poverty reduction that HIPCs move away from reliance on export of a few commodities and into higher value-added industries and services. This means among other things that Northern markets must be fully opened to all products, and subsidies removed. When considering the macro-economic plight of LICs, one must distinguish between policy failings, where inappropriate policies are to blame for development failings, and structural failings, where HIPCs are victims of unavoidable external shocks. However, it appears that HIPCs will be required to compensate for these external structural shocks through internal economic policy adjustments. We do not see this as an appropriate response: it would be better for the international community to adopt a new poverty reduction oriented approach to debt sustainability. 1 For more background information explaining the HIPC Initiative framework, please see and 2 See (spring meetings 2001 paper)

3 2. HIPCs prospects in a slowing world economy For most of the HIPCs that have so far made it to Decision Point, export growth projections for the next decade are much higher than their ten years historical averages. A recent joint World Bank / IMF Board paper shows that the average export growth in was 4.2%, but that the average projected growth for is 8.9%, which implies export performance more than doubling 3. Some of the projected increases in export performances are staggering: The Top 10 of Optimism Country Historical annual average export growth rate ( ), % Projected annual average export growth rate ( ), % Rwanda Zambia Niger Cameroon Burkina Faso Guinea Sao Tome & Principe Honduras Guinea-Bissau Senegal Source : The Challenge of Maintaining Long-Term External Debt Sustainability, IDA, March 2001 There are a couple of mitigating factors here. Some of these countries faced particularly alarming terms-of-trades shocks in the late 1990s, as a result of the global financial crisis, which dragged down their average export performance figures. It is also true that a couple of HIPCs are predicted to have lower rather than higher average export growth rates over the next ten years 4. But on balance these numbers are unrelentingly optimistic. These export growth rates are, however, key to HIPCs reaching and maintaining debt sustainability. The Bretton Woods institutions admitted in a recent paper 5 that if HIPCs did not achieve the growth rate targets set out in the DSA projections and instead achieved only the growth rates of 1990 to 1999, then HIPCs would on average see their NPV of debt-to-exports ratio rise to 170% by This average figure of 170% also hides some differences between individual countries; as the same paper notes, the impact of lower growth targets would, of course, vary from country to country. It is thus quite likely that if the growth rates of the decade are repeated, then several countries will find themselves with NPV of debt-to-exports ratios significantly over 170%. Moreover, for seven countries out of eighteen analysed (Bolivia, Burkina Faso, Malawi, Mali, Niger, Rwanda, and Tanzania), these ratios will stay above the 150% threshold at Completion Point and beyond, even with the optimistic export growth scenarios used in the DSAs. The IFIs justify this situation by claiming that this would be a temporary phenomenon in most cases. these ratios are subsequently reduced by, among other factors, the anticipated growth in exports. However, we are not convinced that this confidence is entirely justified. The optimistic export projections are based on projected recoveries in the prices of commodities which form the backbone of HIPCs exports. Given the current global economic situation and prospects we feel that the decline in commodity prices that has occurred since 1997 may not so easily be reversed. The following sections show why commodity prices are so vital for HIPCs export prospects and what might happen if commodity prices do not recover as predicted. 3. The impact of commodity price fluctuations on debt sustainability HIPC export economies rely mainly on commodity extraction. This makes them very susceptible to external price shocks over which they have no control. Value-added industry and service sectors account for a minimal share of exports in HIPCs. Making progress in these less commoditised markets 3 Weighted average. See The Challenge of Maintaining Long-Term External Debt Sustainability, World Bank, March 2001, table 5 for a full list of export growth projections. 4 e.g. Uganda s export growth is projected to drop from 14.6% to 10.3% 5 The Challenge of Maintaining Long-Term Debt Sustainability, World Bank, March

4 will be key to shielding HIPCs economies from dramatic price fluctuations in international markets. This shift toward new markets, however, will require structural changes in economic activity that will take time to occur, and which will crucially depend on an opening of Northern markets and the elimination of subsidies Moreover, HIPC economies are currently highly undiversified, relying on just a few key commodities each. 6 As the recent IMF World Economic Outlook notes 7, at least 11, out of 23 HIPCs at Decision Point, are highly dependent on just a few commodities 8, as the following table shows: Country % of total exports of goods and services derived from main commodity % of merchandise exports derived from main three commodities 1 Main commodity Guinea Bissau Groundnuts Uganda Coffee Zambia Copper Mauritania Iron Ore Mali Cotton Rwanda Coffee Chad Cotton Burkina Faso Cotton Benin 38 Over 90 Cotton Guyana Gold Tanzania Coffee 1 Merchandise exports (1998). Source : WEO (IMF), Debt Relief International. The World Economic Outlook also points out that the impact of commodity prices swings on debt sustainability works in three ways: First, because of HIPCs dependence on a few commodities, export earnings are directly affected by a fluctuation in world commodity prices. As a consequence, debt sustainability, as expressed by the NPV of debt or debt service to exports ratio decreases mechanically as commodity prices fall. Second, shocks on commodity prices also have an effect on domestic income and government revenues and therefore on the fiscal position. When this occurs, the IMF usually recommends that the country s adjustments include a reduction in domestic absorption [e.g. a reduction in government spending and/or an increase in taxes] accompanied by a real exchange rate depreciation (or temporary borrowing if the terms of trade shock is not seen as a permanent one) 9. Finally, devaluing the exchange rate has the knock-on effect of stoking inflation, which in turn makes interest rate rises more likely. This slows economic growth, further diminishes fiscal revenue and thus removes much needed resources from social and poverty related expenditures. 4. What have been the recent trends in commodity prices? The recent trend in commodity prices has not been encouraging. The IMF calculates that from 1998 to 2000, adverse terms of trade variations due to the decline in commodity prices induced an average loss of nearly 15% of their annual export earnings This concentration makes it less likely that declines in the prices of some commodities will be offset by price rises in others. 7 World Economic Outlook, p.63-83, IMF, November Countries for which the share of at most three commodities in total exports exceeds 40%. 9 For example, in Uganda, the drop in coffee prices, induced a 3.5 % reduction of domestic demand, the government had to cut drastically on public expenditures and the national currency was devalued (WEO, Nov. 2000, page 80). 10 Unweighted average for 12 countries of the change in export earnings due to changes in the price of their three main commodities from 1998 to

5 The following chart shows what has happened to three key commodities coffee, copper and cotton in recent years. Coffee, Cotton and Copper: Recent price trends 225 cents per pounds / kilos Coffee cents per pound Copper High Grade Cotton NCE Source: Global Commodity Index Price Prospect (2000, 2001), London Metal Exchange, International Cotton Advisory Committee. And these dramatic downward movements in commodity prices have not been limited to just a few commodities. Partly as a result of the Asian financial crisis of 1997, the prices of virtually all commodities have dropped. Over the long term, these three commodities prices moved in a broader range, but both coffee and cotton have reached years lows. The aggregate economic impact on Low Income Countries has been clear, as the following table shows: Change in terms of trade 1 Oil import dependency Country (% of total exports) average Uganda Rwanda Madagascar Honduras Tanzania Mali Chad Burkina Faso Benin Sao Tomé & Principe Zambia Guyana Notes: 1. Change in terms of trade is defined as the average price change of each the main three exported commodities relative to the base period, weighted by the commodity s share of total exports in the base period. Changes are shown as percent of total exports. Source: World Economic Outlook, IMF, November Moreover, one of the few commodities whose price has increased is oil. Yet most HIPCs are net oil importers, and the table above shows the additional negative impact that this has had on terms of trade. 5. DSAs optimistic assumptions on world commodity prices and their impact on future debt sustainability Despite this dismal recent history, the IFIs are remarkably confident that world commodity prices are likely to recover in the short-term. The following chart shows what projections for key commodity prices are for the coming decade 5

6 380 Bouncing back? recent price trends and projections - selected commodites 3000 cents per kg Historical Projections dollars per metric tons Cotton Coffee Copper Sources: Global Commodity Index Price Prospect (2000, 2001) London Metal Exchange, International Cotton Advisory Committee. For most commodities, World Bank 11 and IMF staff project that prices will recover to average levels by 2010 or earlier. However, there are strong reasons to believe that this target, upon which most DSAs assumptions are based, is unlikely to be met. Some of the evidence comes from other departments of the IFIs. Firstly, long-term projections have rarely been matched by actual price movements in the past. Take cotton: the World Bank projected in 1990 that prices would reach 240 cents per kg by But its average value merely reached 120 cents. Even a smaller margin of error on current projections would certainly result in unsustainable levels of debt for major cotton producers such as Benin, Chad, Burkina Faso or Mali. Secondly, projections were made assuming that rapid economic growth. [would] fuel a recovery in the next several years. Given the current global context, revised figures would certainly put key commodity price forecasts 10% lower - or more - than World Bank projections up to The IMF itself warned in the World Economic Outlook published last November that a weakening global demand can be expected to put generalized downward pressure on prices, exacerbating the problems of many poor nations as prices are not expected to return to average levels in the near future. 12 Moreover, as Debt Relief International has pointed out 13, individual commodities could also be subject to falling prices due to a fallacy of composition, i.e. many countries increasing production simultaneously in the absence of any major increase in world demand. This is particularly true for commodities like coffee, cacao, gold or tea for which HIPCs exports represent a sizable share of total exports. In the case of coffee, the charts below shows that prices have been negatively correlated with an increase in production 14. Milllions of bags (60 kilograms) Fallacy of composition: Coffee price and production Cents/kg Price Production Source: Global Commodity Price Prospect, April 2001, World Bank. 11 Global Commodity Price Prospects, World Bank. 12 World Economic Outlook, Nov. 2000, p. 78, IMF. 13 Long term debt sustainability for HIPCs: How to respond to shocks, Debt Relief International, January Coffee constitutes a significant source of export earnings for 16 HIPCs (Burundi, Cameroon, Cote d Ivoire, Ethiopia, Honduras, Kenya, Lao, Madagascar, Nicaragua, Rwanda, Sao Tome, Sierra Leone, Tanzania, Togo, Uganda and Viet Nam). 6

7 Most commodities also carry high fixed costs and are not easily substituted by other export products, which typically means that adjustments of production levels in the event of a fall in price are slow, putting further downward pressure on global prices. The current prices of commodities and their future outlook looks even more dubious after the recent events as the prices of commodities such as coffee - already declining early this year have dipped sharply since September 11 as is often the case at times of falling general world demand. This threatens very poor commodity exporters [ ] with sharp deterioration in their terms of trade the ratio of export to import prices - and hence their real wages and capacity to service external debt 15. The World Bank also warns that commodity prices were already forecast to fall 7.4 percent on average this year, and are now likely to fall even more as a result of reduced global demand the most affected being African commodity dependent countries 16. DSAs projections on commodity prices even more optimistic than IFIs research In theory, the export growth rate projections contained in the DSAs for HIPCs are based on these commodity price projections. Yet, on closer inspection, it is clear that in some cases the projections in the DSA are even more optimistic than those published by World Bank and IMF. Mali s DSA, for example, assumes that cotton prices will grow at an annual rate of 10% from 2000 to , much higher than the World Bank Global Commodity Prospects and International Cotton Advisory Committee (ICAC) 18 estimates of 4.4% and 1.1% respectively. As a result, Mali s DSA states that terms of trade are projected to improve after 2000 until 2005 by about 3¼ percent annually largely reflecting the recovery of world cotton prices and a decline in petroleum prices from 2000 [and to] remain stable for the remainder of the projection period. This is clearly inconsistent with ICAC s projections. DSAs have also set very ambitious targets for export volume growth over the next decade. But historical data suggest that production levels are very volatile and very sensitive to exogenous shocks such as droughts in the case of food commodities that limit their medium-term growth performance. Moreover, given the high fixed costs associated with commodity extraction or cash crop plantation, investment and therefore future production are highly dependent on current and anticipated prices. Hence the low level of current prices acts as a deterrent to investment which will certainly limit output growth in the coming years 19. In Mali s DSA, for example, income generated by cotton and textile exports, which account for more than 80% of total merchandise exports, is expected to grow at an annual rate of 10% from 2001 to Yet if you use independent price projections for cotton 21, achieving this 10% annual income growth target would require increasing output by 9% per year, compared with annual average output volume growth of 6% in the last decade, already described by many observers as exceptional. As the increase in cotton yields has been very limited in the past in West Africa, this would imply plantation area nearly doubling by All in all, this seems highly unlikely given the fact that marginal profits are negative at current prices. Moreover, it is not only commodities export projections that are optimistic. The residual component of exports, i.e. all goods and services other then commodities, are also projected to grow at impressive annual rates, sometimes even higher than the commodities component itself. The basis for this optimism in non-commodity export values is often entirely unclear and actually contradicted by more recent World Bank statements warning about the vulnerability of this class of exports to the current global slowdown which will extend beyond commodities [..] to non-traditional exports [as] emerging industries in these countries must cope with reduced demand, higher insurance and security costs, 15 Financial Times, October 12, World Bank Press Review, Thursday October Decision Point document, BOX 7. Mali: Main Assumptions in the Debt Sustainability Analysis, , p the International Cotton Advisory Committee publishes the Cotlook A index used as a base for projections by several organisations including the World Bank. 19 This effect is already at work in Mali where the latest cotton harvest has only produced tons of grain cotton, half of last year performance, because farmers reacted to current low prices by planting other crops deemed more profitable. Partly as a result to this, Mali s economic growth will slow this year to 1.3% from 4.3% in 2000 compared with projected annual export growth rates of 6.3% for Decision Point, page Cotlook A index price projections from ICAC 7

8 and customs delays 22. From a longer-term perspective, high growth rates in this residual component of exports will require in most HIPCs a marked structural shift in the economy towards the production of non-traditional goods and services. Although this shift is essential for HIPCs long-term growth, it will certainly take more time than what is assumed in current DSAs. 6. What would happen if prices and volumes do not increase at the rates projected? Burkina Faso and Zambia are two countries for which we have detailed data on volume and price projections for the main commodities taken from decision point documents. We have repeated the DSA exercise using alternative - less optimistic - scenarios. The results show that the DSA predictions on both export levels and debt sustainability ratios could be missed by quite a way. Note that we are not being overly pessimistic in these analyses: we are assuming that the prices and volumes of the main commodities stay at recent levels and that in the case of Burkina Faso, the residual component of exports also follows historical trends. Yet the results are still telling. For Burkina Faso, the simulation shows that if production growth follows historical pattern and cotton prices do not recover from their current levels, the debt-to-export ratio will still reach nearly 260% by 2010, whereas 150% is considered to be a sustainable level. Similarly for Zambia, a moderate growth in the volume of copper exports (as opposed to the highly optimistic IFI projections) would leave the country above sustainable debt ratios, while the repetition of last decade s trends in volume and price for copper exports would lead the debt-to-export ratio over 270% by Hence, to achieve the export growth rate targets set out in the DSAs, these countries will need an unlikely combination of sustained performance in the production of their main commodity, strong recovery in world market prices, and a structural shift of their export base toward nontraditional exports. If either one of these conditions is not met, debt levels are unlikely to be below their sustainability thresholds by Less optimistic scenarios about future commodity exports, as shown above, make it clear that many HIPCs face the risk of seeing their NPV debt-to-export ratios exceed 200% by This result contrasts strongly with IFI analysis that concludes that even if these countries were to fall short of the higher growth targets, and do no better than maintain the export growth rates of the past 10 years the aggregate NPV of debt-to-exports ratio of the 22 HIPCs, while above the 150 percent, would stay well below 200 percent during the projection period. There is, therefore, a safety margin that would protect HIPCs from debt servicing difficulties even if the DSA projections were not to materialize fully 24. Whilst we only have had sufficiently detailed data to analyse a couple of countries here, we assume that similarly optimistic projections have been used in most other commodity-dependent HIPCs DSAs. 22 World Bank Press Review, Wednesday, October Sadly, recent trends seem to corroborate these less optimistic hypotheses as copper prices reach there lowest levels since 1987 on the London Metal Exchange (FT 22/10/01) while Zambian copper production declined in The Challenge of Maintaining Long-Term Sustainability, World Bank / IMF, 2001, p.23. 8

9 Future exports: alternative scenarios Burkina Faso Average annual growth: 10.4% NPV debt-to-export by 2010: 135 % Total value of exports (million dollars) Average annual growth: 8.2% NPV debt-to-export by 2010: 155 % Average annual growth: 2.3% NPV debt-to-export by 2010: 257 % DSA Baseline scenario Eurodad scenario 1 Eurodad scenario 2 Scenarios on future prices and volumes and resulting average annual growth rates ( ) Cotton volume Cotton price Gold volume Gold price Residual value DSA baseline scenario 6% 3.4% 9% 3% 9.7% Eurodad scenario 1 2% (90-99 average) 0% 5% 0% 9.7% Eurodad scenario 2 2% 0% 5% 0% 2.4% (90-99 average) Zambia Average annual growth: 9% NPV debt-to-export by 2010: 117% Total value of exports (million dollars) Average annual growth: 5% NPV debt-to-export by 2010: 181 % Average annual growth: 1% NPV debt-to-export by 2010: 272 % DSA Baseline scenario Eurodad scenario 1 Eurodad scenario 2 Scenarios on future prices and volumes and resulting average annual growth rates ( ) Copper volume Copper price Residual value DSA baseline scenario 6% 4% 9% Eurodad scenario 1 3% (moderate projection) 0% 9% Eurodad scenario 2-7% (90-99 average) 0% 9% 9

10 6. Conclusions The analysis above suggests that there is quite a high probability that commodity prices will not recover in the way that is expected. If lower than expected prices and volumes materialise, some countries are in serious danger of missing the 150% mark by quite a way. A sensible solution would be to reduce the debt burden of these countries further. The Bank and the Fund acknowledged this, and are now contemplating granting additional debt relief at Completion Point for those countries that still have debt burdens over the 150% target. However, this is only the case if they can demonstrate that the increase in debt levels was due to external shocks whose adverse effects have lasted for at least three years. 25 While this initiative certainly goes in the right direction, it only provides a one-off fix that still fails to address a problem that is structural and, hence, very likely to occur repeatedly in the next decade 26. It needs to be recognised that the path of commodity prices are beyond the control of HIPCs. These are external structural factors, not policy factors that are within the scope of the country authorities 27. We feel that it is unfair that countries should have to pay for the impact of extraneous structural factors by undertaking further policy adjustment. Moreover, such economic adjustment would inevitably have some sort of fiscal contraction component, with the potential for disproportionate impact on the poor. In our view, external structural shocks should generally be responded to with external structural responses rather than internal policy adjustments. Our proposed structural response is to approach the issue of debt sustainability in LICs in an entirely different fashion, where the focus is not on exports but on the poverty situation country-by-country, and on the fiscal constraints that countries face in dealing with them. The accompanying briefing Putting poverty reduction first - sets out new approaches to the debt crisis. An equally important question concerns the policy responses needed to deal with the parlous state of HIPCs export economies. Centrally-planned and implemented industrial policies have failed in the past Tanzania and Zambia amongst others are witness to that - but little remains in their place. The manufacturing sector in most LICs is negligible. Most exports have next to no economic value-added: raw commodities are exported, and expensive processed items and manufactured goods imported. This failure to develop pro-poor value-added export industries is one of the key dilemmas facing LICs. Ever greater production volume of basic commodities in order to earn foreign exchange is not a sustainable solution. Additional debt reduction, to reduce the immediate need for foreign exchange, must be accompanied by a re-think of long-term export strategies accompanied by an immediate opening of Northern markets for all goods and services and elimination of subsidies. 25 Completion Point Considerations, World Bank 2001, paragraph This actually already happened in the case of Burkina Faso which benefited from additional debt reduction when it reached Completion Point under the original initiative due to overoptimistic DSA projections at decision point and finds itself once again directly affected by the fall in cotton prices. 27 To distinguish structural and policy related factors, some economists have suggested that for commodity dependent HIPCs, a component of debt repayments should be linked to the price of each country s main commodity. This recapture clause would work both ways, reducing or increasing debt payments in proportion with variation of a commodity s price. For details, see HIPC Debt Relief and Policy Reform Incentives, Jean-Claude Berthélémy, August