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Joseph Hanlon

Preventing future illegitimate lending in Ecuador

by Joseph Hanlon

11 May 2007

Preventing future illegitimate lending in Ecuador

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 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 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 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 conditions imposed by the IMF or World Bank.
• 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 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 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 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 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
7 Ormonde Mansions
100a Southampton Row
London WC1B 4BJ, England
tel: +44 20 78 31 57 98

8 May 2007

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