What do Jesse Helms, the Pope, and rock star Bono have in common? In recent years, they have all been calling on the wealthy nations of the world to relieve the debt of developing countries. The International Monetary Fund also has been working to garner support for a mechanism that would assist countries drowning in debt.
Is debt relief a viable solution to worldwide poverty or a waste of time and money? Arguments on both sides of the coin have appeared to be theoretically plausible and persuasive, making the debate particularly prolonged and acrimonious. “The problem,” says Peter Henry, associate professor of economics, “is that both sides hold strong views but have not bothered to look at the facts.” In a recent study titled “Debt Relief: What Do the Markets Think?” funded by the National Science Foundation and the Stanford Institute for Economic Policy Research, Henry and Stanford graduate student Serkan Arslanalp analyze data that may finally settle the question.
To evaluate the pros and cons of debt relief, Henry and Arslanalp employed a traditionally reliable source of economic information: the stock market. They examined how the stock markets of the 16 developing countries that reached debt relief agreements under the Brady Plan (named after former U.S. Treasury Secretary Nicholas Brady) between 1989 and 1995 responded to news of their own Brady agreement. The researchers found that the local stock markets of these countries appreciated by an average of 60 percent in real dollar terms in the year prior to the announcement-the period in which each country was outlining its debt relief strategy with the anticipation of being accepted under the Brady Plan.
For these countries, evidence shows that debt relief was beneficial because market participants expected it to have a positive economic effect. To determine whether the stock market reaction was a reliable predictor of real economic improvement or merely short-lived “irrational exuberance,” the study also considers whether the market increase accurately predicted a greater influx of foreign investment capital and higher levels of economic growth in these countries. “It turns out that the stock market was almost always right,” says Henry. “Within a year of each country’s Brady agreement, foreign capital began flowing back in, and robust economic growth resumed.
“The major problem for the Brady countries was that they ran into temporary difficulty servicing their debt,” Henry explains. “Creditors got worried and rushed to collect on their loans all at once. This meant that no one could be paid at all, which caused a complete economic standstill. Once some of the debt was relieved, it cleared the way for new funds to come from other sources. This provided the impetus the countries needed to stimulate investment and growth.”
While Henry’s research confirms the benefits of debt relief for the Brady countries, it reveals, surprisingly, that debt relief is not the best use of funds across the board. The study finds, in particular, that debt relief for what has been referred to as the “highly indebted poor countries” — a group of 42 of the world’s poorest countries, mostly in sub-Saharan Africa — will not produce the salutary effects that it did for the Brady countries.
“The reason,” says Henry, “is that these latter countries are very different patients, if you will. Whereas the Brady countries were suffering from a temporary inability to service their debt, exacerbated by creditors demanding payment all at once, the poorest debt-ridden countries suffer from a more fundamental problem. They lack much of the basic social infrastructure that forms the basis for profitable economic activity — things like well-defined property rights, roads, schools, hospitals, and clean water.”
To compare the social infrastructure of the typical Brady and highly indebted poor countries, Henry used a measure constructed by Stanford economist Robert Hall and Berkeley economist Charles Jones. According to the index, which ranks 127 countries, the United States has the best social infrastructure; the median Brady country ranks 63rd, while the median highly indebted poor country ranks a low 102nd.
“Since the principal problem of this latter group is a lack of social infrastructure, there is little to no scope for profitable lending to them in the first place,” explains Henry. “Hence, there is no reason to believe that debt relief there will stimulate a sudden rush of foreign capital that leads to higher investment and growth.”
What the study implies, then, is that highly indebted poor countries should be targeted not for debt relief but for direct aid that would assist such governments in building social infrastructure. “This is what would eventually make them attractive places for both domestic and foreign investment,” Henry says.
Moreover, the study indicates that debt relief would be most efficient in a number of countries that are not being considered for such programs at all. These include highly indebted (but not so poor) countries — such as Indonesia, Pakistan, Colombia, Jamaica, Malaysia, and Turkey — whose economic profiles resemble those of the Brady countries. “Given their level of infrastructure, it is much more reasonable to expect that economies such as these would respond positively to debt reduction,” Henry maintains.
“The message of the study is ultimately a hopeful one,” he concludes. “It indicates where and how international resources can best be used to help developing countries.”
