Odious Debt: When Dictators Borrow, Who Repays the Loan?

Michael Kremer and
Michael Kremer
Michael Kremer Gates Professor of Developing Societies - Department of Economics at Harvard University
Seema Jayachandran
Seema Jayachandran
Seema Jayachandran Professor of Economics - Northwestern University, Former Nonresident Senior Fellow - Global Economy and Development

March 1, 2003

When the international community wants to put pressure on a government that suppresses democracy and human rights, it commonly imposes economic sanctions. Traditional sanctions, however, are often either ineffective or inhumane. Targeted governments find ways around the sanctions, which offer third parties—smugglers and even other national governments enticed by the promise of large profits—incentives to evade them. And when the sanctions work, they often harm the targeted government’s people, impoverishing them further through the loss of national income. We propose a new form of sanction—a loan embargo.

Unlike a trade sanction, a loan embargo would be self-enforcing. Not only would it not offer third parties incentives to evade it, it would eliminate the existing incentive of some creditors—banks, bondholders, or governments—to collude with dictators, issuing loans that enrich themselves. Because a loan embargo would be self-enforcing, it would be more effective than trade sanctions—and thus could help pressure dictators to undertake needed reforms by limiting their ability to borrow abroad and then loot borrowed funds—or use the funds to finance the repression of their people. At the same time, a loan embargo would protect the people’s interests by freeing them of the obligation to repay the accumulated debts after they finally rid themselves of their illegitimate government. The key to a loan embargo is a concept known as “odious debt.”

Odious Debt

By law, in most countries, individuals do not have to repay money that others fraudulently borrow in their name. Similarly, a corporation is not liable for contracts that the chief executive officer enters without the authority to bind the firm. But international law does not exempt citizens of a dictatorship from repaying a debt incurred by a dictator for personal and nefarious purposes.

This inequity has not gone unnoticed. As early as the 1898 peace negotiations after the Spanish-American War, the U.S. government contended that neither the United States nor Cuba should be held responsible for debt incurred by Cuba’s colonial rulers without the consent of its people and without regard for their benefit. Although Spain never accepted the validity of this argument, the United States prevailed, and Spain took responsibility for the Cuban debt under the Paris peace treaty. The Soviet state repudiated tsarist debt in 1921 using a similar rationale. Legal scholars subsequently elaborated a doctrine of “odious debt,” arguing that sovereign debt should not be transferable to a successor government if it was incurred without the consent of, and without benefiting, the people. Some scholars added the requirement that creditors must have been aware of these conditions when they issued the loans to repressive or looting governments.

Beginning in the late 1990s, a worldwide campaign called Jubilee 2000 attempted to call attention to the concept of odious debt by enlisting spokesmen as diverse as the pop star Bono and Pope John Paul II in a mass mobilization to eradicate Third World debt. But the doctrine of odious debt has gained little momentum in international law, which continues to hold countries responsible for repaying illegitimate debt.

The apartheid regime in South Africa, for example, borrowed from private banks through the 1980s, while a large share of its budget went to finance the military and police and otherwise repress the African majority. Today the South African people bear the debts of their repressors. The Archbishop of Cape Town has campaigned for apartheid-era debt to be declared odious and written off. South Africa’s Truth and Reconciliation Commission has voiced a similar opinion. But the post-apartheid government has deferred to the current international norm and accepted responsibility for the debt out of fear that defaulting would hurt its chances of attracting foreign investment. Indeed, its top ministers recently denounced a lawsuit seeking reparations from banks that loaned to the apartheid regime, because “we are talking to those very same companies named in the lawsuits about investing in post-apartheid South Africa.”

Similarly, although Anastasio Somoza was reported to have looted $100 million-500 million from Nicaragua by the time he was overthrown in 1979, and the Sandinista leader Daniel Ortega told the United Nations General Assembly that his government would repudiate Somoza’s debt, the Sandinistas reconsidered when their allies in Cuba advised them that repudiating the debt would unwisely alienate them from Western capitalist countries.

Numerous other dictators have borrowed from abroad, expropriated the funds for personal use, and left the debts to the population they ruled. Under Mobutu Sese Seko, the former Zaire accumulated more than $12 billion in sovereign debt while Mobutu diverted public funds to his personal accounts (his assets reached $4 billion in the mid-1980s) and used them to retain power by paying cronies and military expenses. Similarly, when Ferdinand Marcos lost power in 1986, the Philippines owed $28 billion to foreign creditors, while Marcos’s personal wealth was estimated at $10 billion.

In 1996 the World Bank indicated a willingness to depart from traditional international lending practices by launching the Heavily Indebted Poor Countries initiative, which provides debt relief for poor countries on the basis of the level of a country’s debt and its income. The initiative, however, does not take into account the circumstances under which the debt was incurred. As a result, South Africa and the Philippines, for example, are not on the current list of debt-relief candidates despite plausible claims that their debts are illegitimate.

Policies to Curtail Odious Debt

One potential solution to this problem is for the international community to empower an independent institution to assess a regime’s legitimacy and to declare any sovereign debt subsequently incurred by an illegitimate regime “odious” and thus not the obligation of successor governments. In this new setting, debtor countries would no longer need to fear that their ability to borrow from abroad or to attract foreign investment would suffer if they refused to repay debts fraudulently incurred in their name. Creditors, both private and public, would curtail loans to regimes identified as odious, knowing that successor governments would have little incentive to repay them. Such a reform would not only limit the debt burden of poor countries but also reduce risk for creditors and hence lower interest rates for legitimate governments that borrow.

Two enforcement mechanisms could help eliminate lending to odious regimes. First, new laws in creditor countries could make it illegal to seize a country’s assets for nonrepayment of odious debt. Odious debt contracts, in other words, could be made legally unenforceable. Second, foreign aid to successor regimes could be made contingent on nonrepayment of odious debt. Donors could refuse to give aid to a country that, in effect, was handing the aid over to banks that have illegitimate claims. If the foreign aid were valuable enough, successor governments would have incentives to repudiate odious loans, so banks would refrain from originating them.

As noted, repudiating odious debt is self-enforcing. Successor governments will have incentives to repudiate odious debt as long as creditors and investors are willing to continue lending to and investing in the country after its legitimate government refuses to repay the odious debt. Banks will think twice before lending to an illegitimate, repressive regime if the world’s leading powers, international organizations, and financial institutions declare the regime odious and announce that they will consider legitimate successor governments justified in repudiating any new loans the odious regime incurs.

Because more countries engage in foreign trade than in sovereign borrowing, limits on borrowing could not be applied as widely as trade sanctions. Nonetheless, the move could have a significant impact. Franjo Tudjman of Croatia, for example, was arguably an odious ruler, having suppressed the media, instigated violence against political opponents, and looted public funds. In 1997 the International Monetary Fund cut off aid earmarked for Croatia because the United States, Germany, and Britain were concerned about the “unsatisfactory state of democracy in Croatia.” Commercial banks nevertheless lent an additional $2 billion to the Croatian government between the IMF decision and Tudjman’s death in December 1999. Had the loan-embargo system been in place, creditors might not have granted Tudjman that $2 billion in loans, and the Croatian people would not bear the debt today.

Incentives for Truthfulness

One reason for the international legal community’s reluctance to accept the doctrine of odious debt is the fear that debt will be declared odious after a loan has already been made, making it impossible for a creditor to be repaid. If creditors anticipate being unable to collect on even legitimate loans, they will be wary of lending at all, raising the possibility that the debt market will shut down. To overcome the risk that creditors’ loans might be declared odious after the fact, the newly empowered institution could be authorized to rule only on future loans to a government and not on existing debt.

Another concern about the doctrine of odious debt is that an institution charged with assessing the legitimacy of debt might be more mindful of the welfare of the people of developing countries than of that of banks and other creditors. But if the institution rules only on future loans, it will be more likely to make accurate, impartial judgments. Even if it weighs more heavily the welfare of debtors than that of creditors, it would have every reason to judge a regime impartially because an accurate judgment would benefit the population. If the institution wrongly calls a legitimate government odious, it deprives a country of profitable investments financed by loans. If it wrongly calls an odious government legitimate, the repressive government can borrow and loot the country.

Requiring the institution to rule on the legitimacy of loans only before they are incurred limits the potential for favoritism in yet another way. Before a loan is issued, it offers only small expected profits for banks, which have many alternative uses for their capital. Once a loan has been made, however, outstanding debt is a zero-sum game between creditors and debtors. A biased institution can help whichever party it favors in deciding whether the loan should be repaid. False rulings about debt that is yet to be issued can hurt the people in borrowing countries and cannot substantially help creditors. Thus, an institution empowered to rule only on future lending is unlikely to make biased judgments in favor of either.

Still another possibility for institutional bias involves a lack of evenhandedness toward certain governments. If the major powers regard a country as an important trade partner or a strategic ally, the institution might fail to brand the government odious regardless of misdeeds. It would, for instance, be unlikely to label either China or Saudi Arabia odious. Because such regimes with powerful friends can borrow at present, biased decisions in their favor would not be a change for the worse; they would simply maintain the status quo. But what if instead the institution makes a judgment against a government for foreign policy reasons, cutting that government off from lending even though it has the consent of the people or spends for their benefit? For example, the United States might wish to block loans to the current government of Iran regardless of whether the government satisfies the definition of odiousness. If the Iranian government were to be blocked from borrowing money that would have been spent for the benefit of its citizens, the citizens would be worse off than under the status quo. Requiring unanimity or at least a two-thirds vote to declare a regime odious could safeguard against that possibility.

Who Should Assess Regimes?

A key question for the international community is which institution to empower to rule on odiousness. The United Nations Security Council, which already imposes sanctions against governments, is a natural candidate. The United States and the other permanent members of the council might prefer this option, for it would give them a veto power. Another option is to create a new international judicial body to hear cases brought against particular regimes—a court similar to the newly established International Criminal Court in the Hague.

Major creditor countries could also implement this system using solely domestic institutions. If the United States changed its laws to prevent seizure of the assets of a foreign government that repudiated odious debt, if a U.S. court ruled that a regime was odious, and if the U.S. government announced it would oppose IMF or World Bank aid packages to a successor regime that repaid illegitimate debt, then banks (both in the United States and abroad), other governments, and even the international financial institutions would likely be reluctant to lend to that regime, fearing that successor governments would not repay.

It might also be possible for civil society to begin putting pressure on banks not to lend to illegitimate governments. If a highly respected nongovernmental organization like Transparency International—or a panel including prominent citizens like Nelson Mandela, along with international lawyers and human rights scholars—were to identify odious regimes and promulgate a list of them, creditors might be reluctant to lend to governments on the list.

Looking Ahead

If the international community were to empower a global institution to rule that a country is not responsible for odious debt issued after the ruling—and if creditors were therefore to refuse to issue odious debt—both legitimate debtors and their creditors could benefit. All creditors would gain from knowing the ground rules. If odiousness were declared in advance, banks would avoid lending to odious regimes and would have no fear that a successful popular debt-relief campaign would arise to nullify their outstanding loans. Greater certainty would also ensure lower interest rates for legitimate borrowers. Most important, dictators would no longer be able to borrow, loot the proceeds—or use them to finance repression—and leave the debt for their ill-treated citizens to repay.