Credit: Artificial Fiscal Intelligence (AFI)

Revocable Debt Relief Lending Instruments

How to achieve better governance and cost-effective aid.

Is there a way to make debt relief and concessional lending more effective at securing governance reforms and socio-economic development goals that last the test of time? A recent paper from Artificial Fiscal Intelligence (AFI) argues that a new revocable debt relief lending instrument may offer a way to achieve these outcomes.

Revocable debt relief means that debt that has already been relieved can be revoked or cancelled under certain conditions. Or in other words, it can be brought back on the balance sheet if compliance conditions are not met. This proposed new lending instrument when structured appropriately could help to incentivise inclusive, sustainable, and accountable governance and secure more cost-effective aid over the longer-term.

Evidence presented in the paper indicates that current debt relief mechanisms do not deliver good value for money. They cost a lot and deliver little in terms of improved governance and better economic and poverty reduction outcomes. Providing the fiscal space for governments to meet demands for investment and frontline services is an important policy outcome but in the absence of governance reforms arguably establishes both a moral hazard and allows poor governance to become entrenched.

Debt relief is not a major source of aid now, but it has been in the recent past. Between 1996 and 2020 around US$200 billion of aid-related debt relief was provided to various countries, mostly between 2002 and 2010. By 2020, the three largest beneficiaries of debt relief (Iraq, Congo DRC, and Nigeria) accounted for a third of all relief provided over the past two decades.

Preventing poor countries from borrowing may have some unintended consequences. Free money in the form of grants does not appear to incentivise improvements in how money is managed or how policy is administered. Indeed, there does not appear to be any direct link between receiving grants and achieving and sustaining reforms. But this does not need to be the case. The paper argues that a revocable debt relief instrument based on debt relief might improve the incentives for reform.

On the face of it, it seems reasonable to give free money rather than loans to poor countries. And there are grounds to limit access to loans in environments that are heavily exposed to risks of debt financed corruption or make poor use of borrowed funds. On deeper inspection the “grants first” policy may not be the best approach, but it requires a long view to appreciate the difference. This is the basis for the revocable debt relief lending instrument where a long view is embedded into the borrowing arrangements.

The AFI paper argues that a new revocable debt relief lending instrument may be much better at improving the cost-effectiveness of aid interventions. The following figure provides a high-level example of how such an instrument could work.

Figure.  Example of a Revocable Debt Relief Borrowing Process


The idea of revocable debt relief was first formally raised in a note published in April 2017. The main mechanism for revocability is that once debt relief has been secured by complying with agreements, an amount of debt relief remains revocable for a set period. In other words, a portion of the debt can be brought back on the balance sheet. As the chart shows, only after a longer period has passed, when policy goals and reforms have been sustained, would the debt become irrevocable. Technically, the amount of debt relief provided would become a contingent liability for the recipient government (i.e., the debtor) and a contingent asset for the donor (i.e., the creditor).

Since the world is grappling with debt problems caused by the 2008 financial crisis, wars, climate change, COVID-19, and more recently rising inflation, new mechanisms for debt relief need to be explored. Revocable debt relief lending instruments could be an important part of the aid, fiscal and monetary tool kit available to governments and International Financial Institutions. Further research is warranted on how debt relief has worked in the past and how it can be improved in the future. The paper aims to contribute to that work.