The Costs of Debt Reduction

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The Costs of Debt Reduction

The costs of debt reduction to creditors can be considered from two perspectives:

(a) the economic cost, corresponding with the loss of income to the creditor; and

(b) the accounting cost, corresponding with the amount which the creditor needs to find to make its accounts balance.
From this perspective, debt reduction can be divided into three notional parts.
 Reducing debts to the value of payments which would otherwise have been made has no economic cost, in the sense that there is no reduction in the payments which are received by the creditor over the long term. This element of debt reduction is no more than a recognition of losses which have already been incurred, and the accounting cost should, in principle, be met from loan loss provisions. Since these do not form part of the base for new lending, capital flows should not be affected.
In practice, however, loan loss provisions may be inadequate to cover the reduction of debts to the level at which they would otherwise have been paid. While there is still no economic cost, the accounting cost will need to be borne sooner than would otherwise have been the case; and this will need to be met from some source other than provisions. This is likely to have some effect on new lending in the short term, in effect bringing forward an effect which would otherwise have occurred later (and possibly more gradually).
Any reduction in debt beyond the payable level will have both an accounting and an economic cost. This will need to be found from other sources, and is likely to have an effect on new financing which would not otherwise have occurred even in the long term.
In the context of IMF and World Bank debts, however, there is an added complication, in that any reduction implies a reallocation of costs (economic and accounting) to the Fund and Bank from bilateral creditors. The Bank and Fund have historically maintained the value of their debts by refusing to reduce them, leaving all the potential losses to be borne by commercial and bilateral creditors (who have tacitly allowed this). In the absence of multilateral debt reduction under the Heavily Indebted Poor Country Debt Initiative (HIPC Initiative), the costs of non-payment would therefore have been borne mainly by the bilateral creditors47. This is therefore the base-line against which the effects of the HIPC Initiative should be judged.

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