Preventing future illegitimate lending in Ecuador

25 May 2007 by Joseph Hanlon


Ecuador will need to borrow money for infrastructure development. Indeed, it is actively promoting a Banco del Sur for just this purpose. How can Ecuador avoid the errors of the past and assure that such loans are “legitimate” and can and should be repaid? If Ecuador is to repudiate past illegitimate loans, how can lenders be sure that future loans will be legitimate and be repaid?

This is directly linked to the debt audit and the demand to renegotiate past illegitimate debt. If Economics Minister Ricardo Patiño (and future economics ministers) can stand up in public and say “this loan is legitimate and must be repaid” then it establishes a series of important precedents, provides a grounding for renegotiating past debts, and allows Ecuador to claim the moral high ground.

Most importantly, it makes a clear statement that some lending is legitimate and that Ecuador is not trying to repudiate all past debt. Second, by creating procedures to avoid illegitimacy, Ecuador establishes benchmarks by which past loans can be judged. Third, the government accepts checks on its own actions, which bar it from negotiating secret and dubious loans and instead require a broad degree of transparency and agreement. By committing itself to openness, Ecuador also forces the lenders to be more open about conditions and evaluations of projects.

Finally, even though it is a high priority to audit Ecuador’s debt and challenge illegitimate loans, it is actually better to start by looking forward. Debt audits are partially narrow and technical, and illegitimacy may hinge on specific and arcane features of loans. It will be easy to become bogged down in minutiae. Looking forward requires a broader thinking about what practices need to be prevented, and thus sets a broader moral and practical base for both future legitimacy and past illegitimacy.

When is a loan ‘illegitimate’?

Lenders and borrowers share Share A unit of ownership interest in a corporation or financial asset, representing one part of the total capital stock. Its owner (a shareholder) is entitled to receive an equal distribution of any profits distributed (a dividend) and to attend shareholder meetings. responsibility for a loan. Both must act in good faith. The lender has a fiduciary responsibility to ensure that the borrower is competent to take the loan, that the purposes of the loan are reasonable, that repayment is possible, and that onerous conditions are not imposed. When the lender fails in this fiduciary responsibility, then the loan is “illegitimate” and the lender had no right to collect. This is different from insolvency or force majeure, where an unexpected change on the side of the borrower, such as natural disasters or commodity price falls, make it impossible to repay the loan.

Of course, it is the nature of any loan that there is always a risk, for example that the project turns out badly or the borrow proves unable to pay. The issue here is to create systems of co-responsibility that prevent malfeasance, misfeasance and simple incompetence and ensure that shared risks, conditions and restrictions are clear and understood.

The broad areas of illegitimate lending are:
Odious and dictators loans , made to military governments, dictators, etc who are oppressing their own people, independent of the use of the actual loan.
Illegal loans , made in violation of local law, such as those requiring central bank Central Bank The establishment which in a given State is in charge of issuing bank notes and controlling the volume of currency and credit. In France, it is the Banque de France which assumes this role under the auspices of the European Central Bank (see ECB) while in the UK it is the Bank of England.

ECB : http://www.bankofengland.co.uk/Pages/home.aspx
or parliamentary approval, or where the loan decision involves corruption or collusion.
Corrupt loans, where the money is used improperly, for kickbacks, capital flight, or a use different from that established in the loan contract.
Usury , where excessive interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
are charged.
Improper conditions , where a condition of the loan requires policy changes in the borrowing country which are inappropriate or improper, such as structural adjustment Structural Adjustment Economic policies imposed by the IMF in exchange of new loans or the rescheduling of old loans.

Structural Adjustments policies were enforced in the early 1980 to qualify countries for new loans or for debt rescheduling by the IMF and the World Bank. The requested kind of adjustment aims at ensuring that the country can again service its external debt. Structural adjustment usually combines the following elements : devaluation of the national currency (in order to bring down the prices of exported goods and attract strong currencies), rise in interest rates (in order to attract international capital), reduction of public expenditure (’streamlining’ of public services staff, reduction of budgets devoted to education and the health sector, etc.), massive privatisations, reduction of public subsidies to some companies or products, freezing of salaries (to avoid inflation as a consequence of deflation). These SAPs have not only substantially contributed to higher and higher levels of indebtedness in the affected countries ; they have simultaneously led to higher prices (because of a high VAT rate and of the free market prices) and to a dramatic fall in the income of local populations (as a consequence of rising unemployment and of the dismantling of public services, among other factors).

IMF : http://www.worldbank.org/
conditions imposed by the IMF IMF
International Monetary Fund
Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.

When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.

As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).

The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.

http://imf.org
or World Bank World Bank
WB
The World Bank was founded as part of the new international monetary system set up at Bretton Woods in 1944. Its capital is provided by member states’ contributions and loans on the international money markets. It financed public and private projects in Third World and East European countries.

It consists of several closely associated institutions, among which :

1. The International Bank for Reconstruction and Development (IBRD, 189 members in 2017), which provides loans in productive sectors such as farming or energy ;

2. The International Development Association (IDA, 159 members in 1997), which provides less advanced countries with long-term loans (35-40 years) at very low interest (1%) ;

3. The International Finance Corporation (IFC), which provides both loan and equity finance for business ventures in developing countries.

As Third World Debt gets worse, the World Bank (along with the IMF) tends to adopt a macro-economic perspective. For instance, it enforces adjustment policies that are intended to balance heavily indebted countries’ payments. The World Bank advises those countries that have to undergo the IMF’s therapy on such matters as how to reduce budget deficits, round up savings, enduce foreign investors to settle within their borders, or free prices and exchange rates.

.
Poorly designed or executed projects , where a loan is for an identified project, often promoted by the lender, and where a development bank or export credit agency Export Credit Agency When private businesses of the North obtain a market in a DC, there is a risk that economic or political problems may prevent payment of bills. To protect themselves, they can take out insurance with an Export Agency Credit such as COFACE in France or Ducroire in Belgium. If there is a problem, the agency pays instead of the insolvent client and the Northern business is sure of getting what is owed.

According to the Jakarta Agreement for the reform of public export credit and credit-insurance agencies, they “now the greatest source of public funding in the world, underwriting 8% of global exports in 1998, i.e. 391 billion dollars of investment, mainly for big civil and military projects in the developing countries. It is far more than the annual average of Official Development Assistance (…) which approaches 50 billion dollars. The outstanding debt of the Export Credit Agencies represents 24% of the debt of developing countries and 56% of public credits held on these countries.”

One of the main criticisms lodged against them is that they are not very fussy about the nature of the contracts insured (arms, infrastructure and huge energy projects such as the gigantic Three-Gorges Dam project in China) nor about their social or environmental consequences. They often give their support to repressive and corrupt regimes (like Total in Myanmar (formerly Burma) which means implicitly supporting fundamental human rights violations.
fails in its fiduciary responsibility to ensure that the project is viable, that proper tender procedures are followed, and that the work is carried out correctly.
Damaging projects , where a loan is for a project such as a dam or oil development which causes unacceptable environmental damage or where population displacement is not correctly dealt with.
Foolish or unpayable loans, which no prudent lender would make. These are typically political loans, for example to support capital flight resulting from an artificial exchange rate, of where loans are made to a country already so indebted that there is no realistic possibility of repayment.

There are, in turn, five broad methods to avoid illegitimacy:
Transparency must be the starting point. If the entire process of developing a project proposal and agreeing a loan is fully open, then it is much more difficult to hide corrupt practices and improper conditions.
Independent evaluation of social and environmental impact and of the project’s viability and likely profitability provide an essential check on the inevitable over-optimism of the project’s promoters.
Civil society involvement provides a key check. Most civil society groups represent interests - trade unions, environmentalists, peasants, business associations, etc - and as such will look closely to ensure that the interests of their members are not harmed, or where some harm is inevitable, that it is mitigated and compensated.
Congressional or parliamentary approval is essential for legitimacy and to prevent odious and illegal lending. The whole process of Congressional hearings allows questions raised by civil society and independent evaluators, as well as conditions imposed by lenders, to be debated, and for risks to be assessed. Lenders and promoters of projects must be prepared to defend the loans before Congress. Finally, Congress represents the entire nation, not narrow sectarian interests, and is based placed to openly balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. various needs and justify a loan.
Independent monitoring of projects while they are being carried out and afterward, as quality assurance, to prevent corruption, and to quickly catch unexpected problems. Monitoring must be three fold - by professional inspectors, by local people, and by civil society and pressure groups.

In addition, future loan contracts should include:
Fixed interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. rates . Variable interest rates and the sharp increase in rates were the main cause of the debt crisis of the 1980s. That means it is essential that interest rates should either be fixed or have a cap linked to the export price of Ecuadorian commodities Commodities The goods exchanged on the commodities market, traditionally raw materials such as metals and fuels, and cereals. such as oil, prawns or bananas.
Fair adjudication systems . Future loan contracts should including fairer dispute settlement systems. These must include where and how disputes are settled, preferably by arbitration, and that fairness and legitimacy must be part of the settlement process. There should be collective action clauses, specifying that if a certain percentage of creditors (75% or 85%) agree to a negotiated revision of the loan contract, this is binding on all lenders (to prevent vultures). Where rescheduling or renegotiation takes place, it must be clear that any successor loan carries with it the properties of the original loan (and thus its legitimacy or illegitimacy). The contract must be clear about the context in which loans can be factored, sold, or otherwise transferred, and that legitimacy and illegitimacy as well as collective action clauses carry forward; this will be a special issue where negotiable bonds are issued, perhaps as part of domestic borrowing.

The essential moral and practical underpinning of making lending legitimate is to substantially broaden the degree of responsibility. The lender and the finance minister lose their chance to make a quick and cosy deal. A loan is illegitimate if the lender failed to show prudence and should not have made the loan in the first place, so we demand much more participation and co-responsibility of the lender. At the same time, however, the government must bring in a wide range of independent actors, including Congress, civil society, local communities and independent professionals, and must act with complete transparency. Of course it will be more difficult having all these people picking over the details of a potential loan. But it will be worth the effort if the result is a legitimate loan for a successful project which is then repaid. The history of illegitimate lending in Ecuador and elsewhere in Latin America shows the very high cost of pushing through loans without proper consideration, consultation and evaluation.

For its development, Ecuador needs to borrow money. But that development will be successful only if the lending is legitimate.

Joseph Hanlon
e-mail: j.hanlon at open.ac.uk




Joseph Hanlon

Joseph Hanlon is visiting senior fellow at the Department of International Development of the London School of Economics. He is author of Galinhas e cerveja: uma receita para o crescimento (with Teresa Smart, 2014) and Do bicycles equal development in Mozambique? (with Teresa Smart, 2008). He is editor of the Mozambique Political Process Bulletin. In 1998-2000 he was policy officer for the Jubilee 2000 campaign to cancel the unpayable debt of poor countries and has written extensively on illegitimate debt.
j.hanlon at lse.ac.uk

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