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There are some specific historical factors behind the large debt of developing countries today. Let me note some of these.

Several factors in the 1970s contributed to a substantial rise in sovereign debts owed by developing countries. Non-oil producing developing countries experienced a rising overall trade deficit. The largest share of this deficit was due to a deficit in trade with the industrialized countries. A smaller, but nonetheless important, share was due to the rise in oil prices (GATT 1980: 8ff). Moreover, interest rates were relatively low, making it cheap to borrow. Loans were used to finance the deficit.

At the start of the 1980s, interest rates shot up. Many of the major industrial countries were running budget deficits at the time, and were consequently borrowers. This pushed up the interest rates (World Bank 1985: 5). Previously negative real interest rates turned into historically high positive rates. Since a large share of sovereign debt was at variable interest rates, the burden of debt service rose substantially (Raffer and Singer 2001: 160).

Yet the developing countries could not service the greater debt burden by running consistent trade surpluses. For, they faced substantial protectionism by the major export markets, the developed countries (World Bank 1985: 6). They turned to new loans to finance existing debt payments.

Bail-outs and insulation from risk

Commercial banks regularly monitor sustainability of clients’ borrowing. They have risk management to ensure the overall portfolio of loans extended is not too risky. Supervisory authorities regulating commercial banks also have a brief to monitor their portfolios for the same reason. Banks are regulated because they take on excessive risk at the prospect of profit. Riskier clients are charged higher interest and are therefore more lucrative, as long as the debt is ultimately serviced. Management may discount warnings from risk managers especially as most banks are corporations with shares on the stock market and whose management is paid according to stock price movements which usually reflects short term profit performance and may place insufficient emphasis on long term viability of the portfolio (Herman 2008: 11).

Prudent conduct would see private creditors put aside part of the higher interest rate charged to riskier clients in a loan loss reserve. This reserve would compensate for cases in which the debtor is unable to repay a loan. Indeed this is part of the reason for charging higher interest in riskier loans – it allows compensation for the cases in which the risk does not pan out for the lender.

Risk insulation and over-lending have played a role in the history of developing country debt accumulation. While European banks generally maintained loan loss reserves with respect to sovereign debt, US and Japanese banks generally did not. In part this may be because of the different incentives attached to reserves in the different countries. Loan loss reserves are tax deductible for European banks, while US banks pay tax even on these (Raffer 2007: 91).

This propensity towards greater risk taking was not curbed by the big creditor governments. As we have noted, they bailed out banks. One reason for the bail outs may be that governments felt that the absence of loan loss reserves would make debtor defaults particularly painful for banks and that this justified mitigating the damage. Other reasons may be geo-political motives, and political lobbying of government decision makers by financial interests.

It was believed in 1983 that US lawmakers might require banks to refund excessive fees collected from Latin American countries. The banks charged high fees under the justification that there was a high risk that the countries might default. If they nonetheless did not really expect default – if they expected bail outs, based on previous government action – then they gouged prices (Raffer and Singer 2001: 163).

The final major factor contributing to the large debts of many developing countries occurred during the 1980s debt crisis.

Illiquidity and insolvency

Poland defaulted in 1981. Mexico declared itself unable to honour its debts in 1982. This marked the beginning of the debt crisis of the 1980s. Many countries were unable to service their debts and defaults threatened and occasionally occurred.

For most of the 80s, the overriding perception among the Bretton Woods institutions and the creditor governments was that these debt problems were a sign only of illiquidity and not insolvency. The problem was taken to be the effect of a temporary inability to pay, i.e. illiquidity. The temporary illiquidity would be resolved as debtors experience greater economic growth and export revenues. Debtors were expected to grow their way out of debt in the long run. In this view, debtors simply needed to be supported in the interim period and did not need debt forgiveness.

The support in the interim period took the form of additional loans to resolve temporary liquidity. If a country had trouble making an interest payment, it found ready access to another loan to allow it to do so. The new loans came from commercial banks as well as from multilateral institutions. A large group of commercial banks would form a syndicate and would, together, lend to a borrowing country. With debt servicing problems in the 1980s, many of the banks in the syndicates wanted to stop lending. These banks had perhaps only wanted to loan for a given period and did not want to make further loans to pay for the servicing of existing loans. Some of these banks left the syndicates, selling their claims to others on a secondary market. Others were convinced to keep lending by those syndicate members who did not mind a longer term engagement with the debtor country so long as payment eventually occurred. This ‘concerted’ or ‘forced’ lending thus kept the loans performing[1]. That is, when a debtor country was in arrears, the lenders made new loans to clear these arrears so that, at least on paper, the loans were being repaid on schedule. The WB noted in 1988 that concerted lending from 1982 onwards had mostly been to clear the substantial arrears on interest payments rather than forward looking loans for productive investment (World Bank 1988: xxiv).

Moreover, during this time, multilateral institutions were becoming increasingly important as creditors. While, concerted lending by commercial banks played its part in the refinancing of interest payments to ward off temporary illiquidity, the bulk of the refinancing was done by the multilateral institutions. By 1988, the WB was the principal net lender to the group of countries known as the heavily indebted countries (World Bank 1988: xxix).

This was, in effect, a bail-out. Commercial banks (like any lender in a well functioning credit market) had taken the risk that their loans might not be repaid or repayment may be delayed. When that possibility eventuated, they were effectively relieved of the burden of the risk as the multilateral institutions made new loans to ensure continued repayment. The multilateral institutions assumed the risk by bailing out the private creditors. Meanwhile, the cost of this for the debtors was substantial. Between 1982 and 1989, long term debt of all developing countries roughly doubled. The refinancing of loans relieved immediate liquidity problems, but it did so by increasing the present values of debt (Raffer and Singer 2001: 172).

What is worse for debtor countries is that, until recently, the BW institutions were less willing than private banks to reduce or reschedule claims. To maintain the image that the multilaterals do not reschedule loans, at times, the WB would lend to enable a debtor to meet the repayment deadline to IMF, thus freeing up the IMF to lend to the country again to meet the WB’s repayment deadline. OECD governments also acted as intermediary financiers on occasion (Raffer and Singer 2001: 169).

Contrast how the countries would have fared if their situation were judged to be one of insolvency rather than of illiquidity. It would have been clear that the refinancing of loans would only raise the debt burden higher.

Countries which cannot service their debts and who do not want to undertake new loans can sometimes force creditors to the negotiating table. Argentina, for example, did so in 2002 when it realised that continuing debt repayment meant tremendous sacrifice for its populace. It announced that it was unable to meet its debt obligations. It then negotiated with its creditors to convince them that it was preferable to receive some repayment rather than none at all. In 2005, 76% of its creditors settled for a repayment of approximately 34 cents on the dollar. However, Argentina prevailed only with immense negotiating skills and resolve and also faced considerable cost in that investors are put off investing in an economy in limbo, as was the case with the Argentinean economy in the years it took to reach a settlement. Most developing countries do not have the negotiating skill or resolve and may not be able to bear the cost (Stiglitz 2006: 215).

The existence of an adequate sovereign bankruptcy mechanism would make the process orderly and swift. It would also make this an option accessible to all developing countries. In the absence of a legal framework for sovereign bankruptcy, debtors may fear that declaring themselves insolvent or defaulting will drastically narrow options for future loans. The fear is that the debtor must maintain the perception of being credit-worthy in the eyes of potential lenders and that this perception may be damaged by default.

Legal and ethical liabilities of creditors

In well-functioning credit markets, creditors also have legal liabilities. Borrowers have a right to compensation if the lender was negligent in some respect and if this led to unlawful damage. This is part of the balance of rights and obligations legally distributed over creditors and debtors.

There is no adequate international legal mechanism governing sovereign borrowing. Accordingly, if a sovereign country feels wronged, it has no means of seeking redress against foreign creditors.

A discussion of liabilities in this political philosophical context must distinguish between two sorts of issues. One relates to negligence of the creditor qua lender in issuing the loan. Another relates to a broader sense of liability concerning the culpability of creditor governments and the BW institutions not qua lenders, but rather qua political agents who can shape the options available to debtor countries in borrowing and servicing. The protectionism of developed countries in areas of competitive advantage of exporting developing countries shows some degree of culpability of the developed countries in the large and growing debt burden of the developing. This is not a liability qua lender, but rather qua political agent more broadly.

There are links between these two in cases where the liability involves a bilateral or multilateral lender taking objectionable actions qua political agent which should arguably have led it to different actions qua lender. For instance, it may be argued that the bilateral creditors should have realised that their own trade protections made it hard for debtors to increase export revenue in order to service their debts. Accordingly, it might be argued that the creditors should not have treated debt problems of the 1980s as a matter of illiquidity and simply lent greater amounts at least unless they were also willing to reduce their protections.

Both bilateral and multilateral creditors have bailed out private creditors and have done so at the expense of large increases in the debt burden of the debtor country in trouble. It can be argued that they should have noted the signals this sent to lenders about being careless in risk assessment and that they should have expected this could result in over-lending. They can also reasonably be faulted for not giving more weight to the possibility that the debt problems in the 1980s were indicative of insolvency rather than temporary illiquidity. Accordingly, they should have allowed the worst affected countries to default or to negotiate reductions rather than offering new loans to them.

The possibility that the countries with debt problems were potentially insolvent and not merely illiquid has been voiced by many over the decades, especially given that the indebted countries had dim prospects of enjoying substantial export surpluses and national income in the existing economic situation. Abbott (1972) notes that in the 1960s, many countries in sub-Saharan Africa were accumulating debt faster than their economies or foreign exchange earnings were growing (Abbott cited in Raffer and Singer 2001: 163). Pearson et al. 1969 (a report prepared at the request of the World Bank) had strongly recommended debt relief while a debtor experienced balance of payments difficulty (cited in Raffer and Singer 2001: 158).

Consider the prospects for growth in export revenue, and in national income, that the developing world overall faced in the 1980s and onwards. The existence of certain factors significantly reduced these prospects. One, greater export revenue and income would depend substantially on access to the large export markets of the industrialised countries. Yet, as we have noted in passing, there was significant protection of these markets in the sectors most relevant for developing countries (World Bank 1985: 6). Two, expansion of export industries in developing countries required investment capital which, for most of these countries, would have to be sourced overseas. Yet, as we noted above, soon after start of the debt crisis of the 1980s – and certainly by 1988 – new lending to sovereign debtors had mostly been to clear the substantial arrears on interest payments rather than forward looking loans for productive investment (World Bank 1988: xxiv).

There is a second distinction between two senses in which we can discuss liabilities. One is as a legal term, the other an ethical judgment. Legally, the absence of an international legal mechanism or international agreement on sovereign debt establishing rights and obligations of both lenders and creditors makes the issue of liability difficult. If legal redress is sought for alleged liability such as negligence of lender, it is unclear how successfully this could be done under domestic laws of creditor countries, using precedents for cases of loans not made to sovereign states. If an international mechanism for handling sovereign debt were to be constructed, it should make provisions for certain sorts of liabilities and protections relevant to the issues mentioned above. Surely, debtors will want to seek retroactive redress for loans which have already occurred. Whether the international mechanism allows for this is a matter of political negotiation between debtor and creditor governments in the design of the mechanism.

In terms of the first distinction, the legal notion of liability likely applies only to liability of a lender qua lender. It does not also apply to reprehensible action by bilateral and multilateral creditors qua political agents more generally.

An ethical judgment of liability may help build a case for a particular course of action in relation to debt reduction. Debate around cancellation of odious debt is the prominent example. The demand that the creditors bear the cost of being denied repayment is bolstered by ethical judgments of liability. Ethical considerations about liability for past actions may also figure in negotiations between creditor and debtor governments in the design and construction of a mechanism for handling sovereign debt. It can do this by, for instance, allowing poor debtor countries to extract more concessions from the creditor governments in defining the appropriate balance of creditor and debtor interests and protection.

In terms of the first distinction, ethical judgments of liability encompass both liability of lenders qua lender and also liability of official creditors qua political agents who shape the options available to debtors.