Financial institutions and developing countries’ debt cancellations: How to get rid of moral hazard?

Abstract

The purpose of the paper is to shed light on the looming risk of developing country debt defaults for financial institutions in the wake of the pandemic crisis. There are mounting calls to delink debt relief and conditions on developing countries so that debt cancellations should be delivered immediately without performance criteria or record of accomplishment. To date, however, debt cancellations have not sufficiently distinguished developing country beneficiaries according to their performance in sustainable development policies, neither have cancellations taken into account commitments towards improved governance trajectories, despite the requirements of poverty reduction programmes involving civil society. International financial institutions thus face the risk of large write-offs at a time of portfolio fragility due to an environment of low interest rates, meager profitability and weak economic growth. This paper argues that much of the resistance of private creditors comes from deeply rooted skepticism as to whether debt relief and write-offs lead to sustained improvement in creditworthiness. Accordingly, prudent risk management requires resisting calls for blanket debt relief when there is little scope for improved governance. Financial institutions should insist on strict criteria regarding inclusive development policies. As new legislation to facilitate debt-restructuring agreements, likely at the expense of private financial institutions, is currently being discussed, the insistence on ‘fair burden sharing’ between official and private creditors should be a wake-up call for banks. A range of financial risk management instruments could link debt relief with enhanced governance commitments, including debt swaps, recapture clauses and the monitored recycling of debt-servicing relief into high-priority projects. The pandemic crisis provides financial institutions with an opportunity to transform debt relief into a leverage for improving sustainable development prospects, hence better creditworthiness.