CAFTA's Debt Trap
The trade agreement will make
financial crises more likely and more devastating in Central America.
by Aldo Caliari
Dollars and Sense magazine, July/August
The proposed Central American Free Trade
Agreement (CAFTA) would create a trade and investment block that
includes the United States, Costa Rica, El Salvador, Guatemala,
Honduras, Nicaragua, and the Dominican Republic. Modeled on the
failed 11-year-old North American Free Trade Agreement (NAFTA),
the deal aims to liberalize trade among the signatory countries
by removing barriers to the flow of goods, services, and capital.
CAFTA is widely viewed as a stepping stone to the creation of
a larger Free Trade Area of the Americas. The Senate voted to
pass CAFTA in June, and the House is expected to follow suit.
Critics of the Central American Free Trade
Agreement have focused on concerns that the treaty will devastate
Central American farmers by forcing them to compete with heavily
subsidized U.S. agribusiness. Others point out that the deal will
perpetuate low-road development based on poverty wages and lax
environmental enforcement, while undermining governments' authority
to ensure basic services. These are all valid concerns, but CAFTA
poses yet another danger that deserves equal attention.
Rules buried in the technical language
of the investment chapter of the agreement would make it more
difficult for the six Central American nations to escape their
heavy debt burdens or recover from debt crises should they, for
example, find themselves unable to meet their obligations to holders
of government bonds and other creditors. The investment provisions
of CAFTA-like the 1994 North American Free Trade Agreement between
the United States, Canada, and Mexico-are based on the argument
that strong investment protections encourage foreign private investment.
CAFTA subscribes to this same precept, and, like NAFTA, it would
require governments to comply with a long list of investor protections
and even grant foreign private investors the right to sue governments
for damages if those obligations are violated.
Both treaties require governments to treat
foreign investors at least as favorably as domestic investors,
a principle known as "national treatment." Governments
must also ensure "most favored nation" treatment for
other treaty members, meaning they cannot give special preferences
to, or discriminate against, the investors of any one country
that is a party to the agreement. As a result, member governments
can no longer favor domestic interests or investors even to support
social goals or other national interests.
But whereas NAFTA's investor protections
explicitly exclude "sovereign debt" (the bonds, loans,
and other securities issued from or guaranteed by national governments)
from investor protection rules, CAFTA specifically includes these
forms of public liabilities.
As the U.S. House deliberates on CAFTA,
it's important for the public to recognize that in subjecting
government bonds and other forms of sovereign debt to stringent
investment protections, the deal would place huge constraints
on indebted countries' ability to prevent or survive debt crises
-and to protect the basic needs of their citizens.
NATIONAL TREATMENT AND MOST FAVORED NATION
The "national treatment" and
"most favored nation" principles were originally born
in agreements dealing with trade in goods, only later extending
to investment. Their application to sovereign debt introduces
a number of serious problems.
1.CAFTA dismantles essential tools governments
need to recover from crisis.
Requiring that foreign creditors be offered
favorable treatment equal to domestic creditors is dangerous for
the developing-country members of CAFTA, since they all, with
the exception of Honduras, owe a significant share of public debt
to domestic creditors. In some countries, including Costa Rica,
domestic debt is actually higher than external debt.
When undergoing a debt restructuring,
a government makes an "offer" to all creditors, typically
reducing the value of outstanding bonds and loans substantially.
the offer is agreed to, the country can
regain its footing and restart the flow of investment.
There are a variety of reasons why a country
might want to offer domestic creditors preferential conditions
in restructuring its sovereign debt. In a financial crisis, domestic
creditors often take a double hit. They're forced to accept a
reduction in the value of their loans, and they face high interest
rates and other costs. Yet domestic capital markets are critical
in a recovery. By addressing the needs of domestic investors first,
a country will be better able to return to domestic capital markets
quickly during what is likely to be a sustained interruption in
access to foreign capital. This can feed a resumption of growth,
which, in turn, can facilitate repayment of other obligations
and reverse the precipitous fall in a country's standard of living
that typically accompanies a debt crisis. Even the International
Monetary Fund (IMF), a staunch defender of the rights of foreign
private investors, acknowledges that "the restructuring of
certain types of domestic debt may have major implications for
economic performance, as a result of its impact on the financial
system and the operation of domestic capital markets."
Prioritizing domestic debt may also be
necessary to protect a country's banking system. Argentinean economist
José Luis Machinea has pointed out that sovereign debt
restructuring has a double impact on domestic holders of debt:
On the one hand, the value of their bonds is reduced. On the other,
they suffer the general impact of the crisis on the real economy
and on their access to finance. The IMF has stated that in crises,
affording special treatment to domestic debt might help protect
"a core of the banking system by ensuring the availability
of assets required for banks to manage capital, liquidity, and
exposure to market risks."
More generally, countries may need to
provide special treatment to domestic debtors as part of their
national development strategy-that is, for the same legitimate
reasons that can lead them to accord special treatment to domestic
2. CAFTA prevents states from paying salaries
Under CAFTA, member governments would
no longer be able to prioritize domestic debts consisting of,
among other things, wages, salaries, and pensions. This could
have dire ramifications for state workers. According to the national
treatment principle, governments are bound to treat these obligations
the same way they treat foreign debts held by transnational banks
and foreign investors. If the state has only enough resources
to cover a portion of its debts, it will be prohibited from choosing
to direct those funds first to wages and salaries. In this way,
too, CAFTA would deal a setback to national governments' ability
to prioritize their obligations to the basic human rights of their
citizens and put their own economic development above the claims
of foreign creditors.
Unlike a private corporation in bankruptcy,
an indebted nation has human rights obligations and social responsibilities
toward its people. That's why civil society groups have called
for developing new debt-crisis protocols that take into account
the broader mission of the state and its role in society. Models
already exist-for example, Chapter 9 of the U.S. bankruptcy code
which applies to municipalities. Even the IMF's proposed rules
for restructuring sovereign debt excluded "wages, salaries
and pensions" from their application.
3. It reduces the leverage of domestic
A government's debt restructuring offer
can take on added clout if it has first cut a deal with supportive
domestic creditors. Giving these domestic creditors preferential
terms is a way for the state to win back their support. If the
principles of national treatment are applied to sovereign debt,
however, any incentive offered to domestic creditors would have
to be offered to the foreign creditors as well, effectively foreclosing
this avenue of recovery.
Argentina's offer of preferential conditions
to domestic creditors was a crucial element in enhancing the government's
leverage in negotiating with its foreign private creditors after
it suffered the largest sovereign default in history in December
2001. In September 2003, the government released its initial proposed
debt restructuring conditions, which included a 75% cut in the
value of its bonds. Some groups of bondholders quickly rejected
this offer, claiming that it was woefully insufficient and, in
light of the country's latest growth figures, below what the country
could repay. The creditors also strongly lobbied the G7 group
of industrialized countries, which, both directly and through
the IMF, put more pressure on Argentina to sweeten its offer.
With pressure mounting from the G7 and the IMF, Argentina turned
to its domestic pension funds. By granting domestic pension funds
preferential conditions, Argentina was able to reach an agreement
with them. The funds held more than 17% of the country's total
debt and their coming on board was a critical first step in Argentina's
eventually garnering the support of a full 76% of its creditors.
The government's ability to treat domestic
bondholders differently from foreign ones was crucial to reaching
an agreement with the majority of creditors. This option would
have been out of the question if the government had been bound
by CAFTA's national treatment principle.
Under CAFTA, governments that violate
these investor protections, can face expensive lawsuits. As under
NAFTA and numerous bilateral investment treaties, CAFTA grants
private foreign investors the right to bypass domestic courts
and sue governments in international tribunals.
Such "investor-state lawsuits"
are highly controversial for a number of reasons. First, many
arbitration tribunals operate with an absolute lack of transparency,
having no obligation to disclose relevant documents or allow any
form of public participation. The system for choosing arbitrators
has also drawn criticism, as the arbitrators can be chosen from
the ranks of practicing investment lawyers, with no obligation
to appoint people who will be independent, that is, who have no
stake in the treaty interpretation. These unelected tribunals
may well rule on difficult questions with far-reaching social
and economic implications that rightfully belong under the domestic
jurisdiction of states.
* * * * *
CAFTA's application of investor protections
to sovereign debt would suppress the few options available to
countries trying to prevent or exit from debt crises. History
shows that the inability to exit a crisis situation causes economic
losses far outweighing any commercial gains achieved through a
free trade agreement.
Central American activists are already
calling on their governments to reject CAFTA. In the United States,
activists must also urge Congress to reject CAFTA because in addition
to all the concerns that have been voiced already, it will tightly
tie the hands of member countries in dealing with their large
stocks of external debt.
Aldo Caliari is coordinator of the Rethinking
Bretton Woods Project at the Center of Concern <www.coc.org>.
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