FOREIGN AID AND SOVEREIGN DEBT

FOREIGN AID AND SOVEREIGN DEBT: THREAT OF AID WITHDRAWAL HAS NO EFFECT ON LIKELIHOOD OF DEFAULT

Threatening the withdrawal of foreign aid is not used as a way of ensuring that foreign debts are paid. That is the central finding of research by Jana Brandt, presented at the Royal Economic Society’s 2013 annual conference.

The study asks if the threat of withdrawal of development aid from creditor countries is a key factor in a country’s decision over whether or not to default on its debt. Previous research has shown that countries are reluctant to default on debt from countries they have a trade relationship with as to do so would risk future trade. The research asks whether the same rule applies for countries that want to continue to receive foreign aid.

To answer this question, the research compares donor countries with countries that are also creditors. It finds that during times of distress for the debtor country, donor countries increase aid by 15% but that creditor countries also increase their aid by 6.4%.

Even when considering the possibility that some of this aid might be debt relief, the research still finds no evidence that the threat of withdrawal of aid is used as a ‘punishment’. The author notes:

‘An explanation for our findings may be that a defaulting country suffers from bad economic conditions. A reduction in aid would make this situation even worse.

‘Donors may therefore refrain from cutting their aid disbursements because of altruistic reasons or just because they want to avoid further credit losses.’

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This study investigates whether foreign aid could function as an enforcement mechanism for sovereign debt. For that to be the case, countries relying heavily on aid must be afraid of losing access to this type of support if they do not service their debt. We should therefore observe a withdrawal of aid disbursed to the defaulting country.

Up to now no study examines whether donor countries really use aid as a punishment instrument for sovereign defaults. This study tries to fill this gap by looking at the reaction of donor countries to a default. The findings clearly reject the hypothesis that aid is used in this way.

To see why the research question is important, think of an investor who wants to invest in secure assets. In times of financial turmoil, this is a difficult task because even sovereign borrowers with high credit ratings might choose to default in these circumstances. So investors need additional indicators to find out which country has a high incentive to pay its debt even in times of economic hardship and which country may find it more attractive to default on its liabilities.

Obviously, the default decision depends on the related consequences. The willingness of a country to repay its debt depends on the default costs. As previous research suggests, it gets more difficult for a defaulting country to export goods. Therefore, a country will try to avoid defaulting on loans coming from countries they have tight trade relations with. Also countries that depend highly on external financing and FDI will have a lower default incentive. The reason why this is the case is quite intuitive: a country that does not pay it liabilities loses access to financial markets and its FDI inflows are reduced.

The loss of foreign aid would be an additional type of default costs. To analyse this kind of costs, the researchers distinguish between donor countries that are also creditors and suffer directly from the default and donors that are not affected by the default. One might expect that the former group of donors has a larger incentive to punish.

The researchers find that donor countries that are not affected increase their aid disbursement by 15% on average. Surprisingly, affected donors also increase their aid flows given to the defaulting country but to a smaller degree and temporally delayed. Overall the amount of aid allocated to the delinquent country increases by 6.4%.

One may see defaults of very poor countries as a debt relief. The study therefore excludes these countries from the analysis. The results remain. There is also no evidence for punishment controlling for changes in donor behaviour over time.

The researchers therefore reject the hypothesis that foreign aid is used as a punishment instrument for sovereign defaults. Aid cannot function as an enforcement mechanism for sovereign debt repayment. Dependence on aid could even raise the incentive for a country to default.

An explanation for these findings may be that a defaulting country suffers from bad economic conditions. A reduction in aid would make this situation even worse. Donors may therefore refrain from cutting their aid disbursements because of altruistic reasons or just because they want to avoid further credit losses.

ENDS


Contact:

Jana Brandt: 0049(0)157-79724268 (Jana.Brandt@wirtschaft.uni-giessen.de)

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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