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 2005

 

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. -Eds.

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 STATUS

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. Once

 

 

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 industries.

2. CAFTA prevents states from paying salaries and pensions.

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 debtors.

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.

INVESTOR-STATE LAWSUITS

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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