Can the vicious circle of dependency be broken?

Michael Prest argues that the World Bank's plans for a trust fund to reduce Third World debt are ultimately unfeasible.

World Bank officials yesterday played down the importance of the leaked document which set out plans for an $11bn (pounds 7.3bn) trust fund to help reduce the external debts of some 40 of the poorest countries.

The plan, officials insisted, was neither final, nor the only option, nor the sole view of the development agency's president, Jim Wolfensohn.

Most important, the Bank, mindful that it finances much of its operations by raising up to $10bn (pounds 6.7bn) a year from bond sales, stressed that the plan did not propose writing off Bank debt at the risk of undermining its AAA credit rating.

But the Bank's reaction has been unduly defensive for the world's biggest development agency, which lends about $20bn (pounds 13.3bn) a year.

There is no question about the seriousness of the issue. Forty of the world's poorest, mainly African, countries owe a total of $160bn (pounds 106.7bn) to foreign creditors. These countries had per capita incomes of below $695 (pounds 463) in 1993. They are known as SILICs - Severely Indebted Low- Income Countries. Not only do they owe more than the size of their economies, but debt servicing guzzles up to three times more than their export earnings.

Or debt servicing would guzzle that much if they paid. There have been more than 8,000 reschedulings of African debt since 1984. But only commercial loans and bilateral loans from countries that include Britain, have been affected. Loans by multilaterals such as the Bank have not been rescheduled, in the time-honoured principle that the Bank is the senior creditor and does not reschedule.

As a result, the loans from multilateral agencies now account for about 20 per cent of the stock of SILIC debt. Bilateral lenders account for a further 44 per cent. And because repayments on multilateral debt have not been rescheduled, they represent almost half of debt servicing. This is all the more worrying because about a quarter of multilateral debt is owed to the International Development Association, a part of the World Bank Group, which makes interest-free loans to poor countries over a 35- to 40-year period.

It is very tough for countries to make progress under these conditions, especially when they are so poor in the first place. Essential investment in physical infrastructure and in health and education is pre-empted. Private investors - who have flocked to the emerging markets of Asia and Latin America - shy away. A vicious circle of dependency often develops, in which lenders throw good money after bad to prevent blatant defaults and to try and keep the show on the road.

For several years the Bank, and other lenders, have been under mounting pressure to act. A year ago, the All Parliamentary Group on Overseas Development issued a report on Africa's multilateral debt. Kenneth Clarke, the Chancellor of the Exchequer, has argued at meetings of the Bank and Int-ernational Monetary Fund that IMF gold reserves should be sold to finance debt reduction.

At the UN Social Summit in Copenhagen last March, Bank officials were accused of being responsible for the debts which supposedly so exacerbated the social problems of poor countries. When the Group of Seven met in Halifax, Nova Scotia in June, they urged the Bank and IMF to tackle SILIC debt.

Resolving the problem is tricky, however. Since multilateral agencies such as the World Bank will not countenance write-offs from their balance sheets, the funds for debt reduction must come from elsewhere. As it is, the Bank is increasing its reserves to reassure the market about the quality of its loan portfolio. But aid is scarce. It has, at best, remained static in real terms for several years. In the US, the Republican Congress would like to slash aid to IDA.

Some of the biggest donors, such as Germany and Japan, have severe misgivings about debt relief which appears to reward countries for being indigent and incompetent. And the IMF, which holds about a fifth of SILICs' multilateral debt, has traditionally taken an even harder line than the Bank.

Attempts within the Bank to reconcile these differences are based on three criteria: that all other methods have been exhausted; that "moral hazard and contagion" - rewarding countries for bad behaviour - is avoided, and that the Bank does not take a hit on its balance sheet.

Debt reduction would be financed through a separate fund, albeit one managed by the Bank. The $11bn would be raised from bilateral donors, Bank profits, repayments to IDA, and possibly gold sales. Once set up, the fund would pay interest and principal on multilateral debt as they fall due. The anticipated rate of reduction is $400m (pounds 266.7m) a year for the first five years, $300m (pounds 200m) annually for the next five years, and $100m (pounds 66.7m) a year for the final five years. Only countries which pursued policies approved by the Bank would be eligible.

Kevin Watkins, the debt expert at Oxfam, said: "It shows the seriousness with which the Bank appreciates the problem." But how much of a dent can $11bn make, when it is committed to repay both interest and principal on a rising debt of $160bn? Given that much of the finance for the fund is likely to be diverted from existing aid budgets, is this the best use of taxpayers' money? The answers are, respectively, "not enough" and "maybe".

The crucial point, however, is that this discussion is taking place in an institution which has always stuck to the line that its balance sheet is sacrosanct.

Michael Prest was senior editorial counsellor at the World Bank