Debt for Nonproliferation: The Next Step in Threat Reduction

James Fuller

Debt restructuring and reduction, whereby the terms of a loan are changed or part of a loan is forgiven, are common tools used by creditors for a variety of purposes. Wealthier creditor nations, such as the United States, often restructure and reduce debt owed by developing nations in order to bring about positive economic change in a debtor country. Similarly, the private financial sector restructures private debt owed by nations when it makes financial sense to do so. International nongovernmental organizations (NGOs) and others have also worked with government and private creditors to use debt reduction to accomplish more philanthropic goals that can benefit both public and private creditors in less tangible ways.

Indeed, “debt swaps”—a term used loosely here to denote a creditor forgiving monetary debt in exchange for specific actions by a debtor—have been an effective tool for improving global conditions in a number of ways.1 The international environmental community, in particular, has been very effective in encouraging and leveraging debt conversion to help meet global environmental objectives since 1984, when the World Wildlife Fund conceived of “debt-for-nature” swaps.2 In these exchanges, a portion of a country’s restructured debt—either commercial debt or official debt owed another country—is forgiven in return for the debtor dedicating an agreed-upon amount of local currency to an environmental project.3 Over the last two decades, nearly $1 billion in debt-for-nature swaps have been implemented.4

Another important area that would benefit from this relatively new and innovative funding mechanism is nuclear, chemical, and biological weapons proliferation prevention. Since 1992, the United States has directly underwritten about $10 billion in threat reduction activities in Russia and the former Soviet Union, but the situation demands even greater investment. Russia’s financial problems and security needs, which demand the formation of a sustainable Russian infrastructure to prevent the proliferation of weapons of mass destruction after direct U.S. assistance stops, both argue for increased involvement by other industrialized nations and the private sector. “Debt-for-nonproliferation” swaps are potentially powerful tools that could leverage current conditions to reduce further the security threat from Russia’s weapons infrastructure.

The Need for Increased Investment

Currently, there are more than 30 U.S.-Russian threat reduction programs administrated by three different U.S. departments, with a budget totaling $750 million for fiscal year 2001. But the September 11 terrorist attacks on the United States, the ensuing revelations as the war on terrorism progresses, and the use of anthrax in the U.S. mail system have called into question the pace with which threat reduction work in Russia is being completed. The human losses endured and the costs to the U.S. economy as a result of the September 11 terrorist attacks would likely pale in comparison to a successful attack using a weapon of mass destruction.

In January 2001, a bipartisan task force co-chaired by Howard Baker and Lloyd Cutler strongly recommended that investments in U.S. Energy Department nonproliferation activities be increased to roughly 1 percent of the annual U.S. defense budget over the next 10 years. Energy Department nonproliferation programs help Russia dispose of weapons plutonium; protect, control, and account for nuclear weapons material; stabilize the economic situation in Russia’s “nuclear cities”; and promote nuclear warhead safety and security. The importance of these programs cannot be overstated, and the Baker-Cutler report indicated that its 1 percent recommendation would total about $3 billion per year, or $30 billion over the ensuing decade.

However, neither the departing Clinton administration, nor the incoming Bush administration, nor the Congress has supported appropriations anywhere close to this level. Clearly, another funding mechanism is needed that will provide a substantial and immediate infusion of cash into Russia’s nonproliferation efforts. But the funding needs to minimize the characteristics of an international welfare program in order to promote a long-term, sustainable Russian proliferation prevention enterprise that will last after direct aid stops. A process is needed to ensure that, once the acute proliferation issues are successfully addressed, the people whose livelihood depended on the production of nuclear, chemical, or biological weapons have an alternative future. Further funding should be aimed at spurring Russian private-sector interest in the business of preventing proliferation.

A well-implemented debt-for-nonproliferation swap would have all these advantages. The processes that may be used to effect a debt swap can be grouped into four categories.

• Buy-Back. A debtor nation purchases debt directly from a creditor at less than face value and at the same time endows a fund in local currency to conduct work in the debtor country that is of value to both the creditor and the debtor.
• Write-Off. A creditor agrees to forgive some portion or all of an outstanding debt in exchange for the establishment by the debtor of the endowment as described above.
• Rescheduling. Creditors agree to reschedule the servicing of old debt by exchanging a large amount of paper for a smaller amount. In the case of official bilateral debt rescheduling, some portion, such as the interest payments, are re-directed into an endowment. In the case of commercial debt, principal and interest are often separated into derivatives, which can also be used separately.
• Tri-Party Arrangements. A third party such as an international nongovernmental organization receives a donation or purchases debt from a creditor and negotiates a write-off with the debtor nation.

By promoting self-investment, debt-for-nonproliferation swaps would encourage infrastructure building and therefore help to generate a sustainable Russian effort to prevent proliferation. A swap could also involve industrialized countries besides the United States, providing broader international participation in preventing proliferation from Russia than currently exists. The establishment of a fund would also probably be the most effective way to involve private and NGO stakeholders in forging public-private partnerships for nonproliferation. Such partnerships would have multiple benefits, such as promoting confidence in the accountability of funds and helping to establish a private-sector component in a long-term nonproliferation effort. Last but certainly not least, a swap would reduce Russian external debt without forcing Moscow to spend hard currency and draw down its Central Bank foreign reserves, thus serving the long-term goal of promoting economic stability in Russia.

In addition to process-related advantages, it makes extremely good political sense for the West to help Russia while it struggles in its quest for a market-based economy because Moscow has offered strong support for the U.S. war on terrorism and has held the Organization of the Petroleum Exporting Countries at arm’s length in its quest to control worldwide oil prices more strongly.

A wide variety of programs could benefit from a viable debt-for-nonproliferation program. Cleaning up Cold War nuclear waste could provide an extensive jobs program for former weapons specialists and would make Russian nuclear cities more attractive for outside investment. The long-term sustainability of the U.S. effort in Russian nuclear material protection, control, and accounting is another effort that would benefit from additional funding and greater commitment by Russia’s private sector. The evolving European Nuclear Cities Initiative is in need of the innovative financing that a successful debt-for-nonproliferation enterprise would offer. The decontamination of Russian nuclear-powered multi-purpose submarines is another activity that has yet to be underwritten by the West or the Russians.5

Russia’s External Debt

Of course, despite these benefits the idea of a swap would be less tenable if there were no financial basis for debt forgiveness. But Russia’s economic situation offers some genuine opportunities for constructive debt reduction. The collapse of the ruble in 1998, coupled with the size of Russian federal debt, has severely hampered Russia’s transition to a viable free-market economy, its capacity for making social-service and infrastructure improvements, and its ability to fund proliferation prevention and other security endeavors. Russian external debt totals $147 billion, nearly $71 billion of which is from the Soviet era. (See Figure 1. PDF file, requires Adobe Acrobat Reader.) Approximately $2.7 billion of this Soviet-era debt is owed to the United States.6 The debt amounts to almost 140 percent of projected revenue from exports and is roughly 42 percent of projected 2002 gross domestic product.7

Sizable amounts of Russian external debt are held by the Paris Club and the London Club, two separate ad hoc groups of creditors that meet with representatives of nations about to default on their debt. The Paris Club is currently comprised of 18 creditor nations (including all members of the G-8) and deals with official, bilateral debt instruments. The London Club is comprised of commercial banks. Both organizations meet with debtor nations in order to agree on the best terms for any debt restructuring. Although the United States could theoretically effect a debt swap itself, in reality a swap would involve these forums because unilateral U.S. action could harm the economic interest of other creditors left holding Russian debt.

There is some precedent for Russian debt forgiveness among these creditors, which have provided some debt relief to Russia. In August 1999, the Paris Club provided a framework agreement that postponed payment of debt principal under their auspices until after the 2001 Russian presidential election but continued interest obligations. In February 2000, the London Club agreed to forgive some of the Russian debt to commercial lenders. In this agreement, $31.8 billion in claims held by commercial creditors were exchanged for $21 billion in new Eurobonds. When combined with an eight-year grace period on payment of principal, plus a lower interest rate, total debt forgiveness amounted to 52 percent in present-value terms.8

The economic straits brought on by the collapse of the ruble have, until recently, been somewhat offset by the strong price of oil, which has bolstered Russian revenues. This improvement has somewhat weakened the financial case for debt relief because Russia is better able to service its debt obligations.Although Russia is maintaining a strong posture, saying that it will meet its $14 billion debt service obligations this year—a figure that amounts to about 37 percent of its foreign reserves—the economic forecast for Russia in 2002 is considerably less optimistic because of the significant drop in oil prices.9 It remains to be seen if Russia can maintain its current rate of positive economic growth and relative vitality or whether action by the Paris Club will be warranted. In 2003, substantially greater debt servicing will be required, and with a prolonged soft oil market, Russia could find itself in economic trouble.

It is easy to understate the problem of Russian sustainability of debt obligations. Russia has had both cash flow (liquidity) and budgetary (solvency) problems in the servicing of its external debt. Currently, the latter is the more serious problem. High oil prices resolved the liquidity problem with the buildup of dollar reserves in the Central Bank. Falling oil prices will especially affect the budgetary problem because the Ministry of Finance will need to buy dollars with rubles from the Central Bank to service the debt. The ruble appropriations required for servicing the debt will likely squeeze budgets for reform: revenues from oil and gas sales account for about one-half of the federal budget and gas and oil prices tend to go together.10

Despite this uncertain economic future, securing Paris Club participation in a debt swap would likely be a challenge. Germany, with most of the estimated Russian Paris Club Soviet-era debt, will chair any upcoming Paris Club meeting and therefore have substantial influence on the outcome. And the initial German position on debt forgiveness, formally announced by the German Paris Club representative after the 2000 London Club agreement, was that no previous debt settlement, especially the London Club agreement, established a precedent for Paris Club negotiations. Germany has publicly stated that it believes that Russia should be able to service its debt with improved economic performance, a better use of natural resources, and a return of capital that has left the country. The current German position does not acknowledge the benefits of a more liberal debt-relief agreement that might accrue to arms agreements, foreign policy cooperation, and other noneconomic issues.

U.S. Precedent and Current Legislation

Because of potential Paris Club reticence in writing off Russian debt, it is critical that the United States take a lead role in implementing a debt-for-nonproliferation swap—a role that makes particular sense because of extant U.S. involvement in Russian threat reduction efforts. The precedent for the United States using its financial leverage to effect positive change in other countries is well established, though traditionally the goals of such actions have been developmental rather than security-oriented.

From 1990 to 1999, the U.S. government engaged in almost $15 billion worth of bilateral debt-reduction activities with 39 countries, Russia not included. U.S. debt reduction programs are an important component of Washington’s international economic policy and have been used to help stabilize the finances of debtor countries and put them on a path of sustainable economic growth. The United States has accepted and supported the notion that debt reduction initiatives can “unlock resources for poverty alleviation, basic human needs, child survival, and environmental protection.”11 Special provisions have been associated with specific debt-reduction agreements that help to assure these objectives.

In three exceptional cases, the United States has reduced the debt of severely indebted lower-middle-income countries to promote not only economic reform but also U.S. national security interests. In 1991 the United States reduced Poland’s debt by 70 percent ($2.5 billion) in recognition of its strategic importance in stabilizing Eastern Europe and transforming Eastern European countries into market-oriented democracies and in recognition of the role Polish armed forces played in the Allied victory in World War II. Also in 1991, Congress supported the forgiveness of $7 billion for Egypt, its total military debt to the United States, in recognition of its key role in solidifying the Persian Gulf War coalition. Finally, in 1994, Congress enacted special legislation that forgave Jordan’s $700 million debt to the United States in recognition of the positive role it plays in stabilizing the Middle East.12

Each of these three special debt reduction cases required special legislation, and although in Russia’s case existing U.S. legislation does, technically speaking, contain authority for debt swaps for various purposes, the chances of a debt swap succeeding would be enhanced by obtaining the positive congressional endorsement that would be represented by new legislation targeted specifically at swapping Russian debt-for-nonproliferation commitments.

Fortunately, Congress has expressed considerable interest toward debt for nonproliferation in recent months. On December 20, the Senate passed by unanimous consent the Security Assistance Act, which contained the Debt Reduction for Nonproliferation Act of 2001 (DRNA). The DRNA was sponsored by Senators Joseph Biden (D-DE) and Richard Lugar (R-IN) and co-sponsored by Senator Jesse Helms (R-NC). It sets forth U.S. security interests in preventing proliferation and reducing weapon stockpiles, especially in Russia, and it recognizes that existing nonproliferation programs have made substantial progress but that the threat remains urgent.

More specifically, the DNRA states that new nonproliferation funding streams—such as debt reductions and exchanges—are needed and that the burden will have to be shared by Russia, the United States, and other debt-holding governments. It further states that Russia’s substantial Soviet-era debt burden severely stresses its budget, will do so even more in 2003 and thereafter, and is among the factors that have led Russian officials to recognize that its future lies with the West.

If enacted in its current form, the DRNA would authorize the president to establish an office at the Treasury Department to administer the debt reduction and authorize $300 million in appropriations in fiscal years 2002 and 2003 to offset the cost of the debt reduction to the U.S. Treasury. It would authorize the president to reduce the Lend Lease and agricultural portions of the Soviet-era debt and replace those obligations with new obligations defined in a “Russian Nonproliferation Investment Agreement” that would be negotiated with the Russians and potentially result in a ruble-based Nonproliferation Fund. It would allow the president to sell the debt to an eligible third-party or the Russian government, provided the required nonproliferation plans, commitments, and transparency measures were in place.

The DRNA would require that consequent nonproliferation programs and projects be approved by the U.S. government directly or via its representation on any governing board established to manage the funds, incorporate best practices from established threat reduction and nonproliferation assistance programs, be subject to U.S. audits, be free of Russian taxes, and that 75 percent of such funds be spent in Russia. Finally, the DRNA would instruct the president (or his designees) to seek the appropriate agreements and arrangements in the Paris Club and establish an interagency committee to ensure that U.S. public and private efforts are not in conflict and that public and private spending on these purposes is maximized, efficient, and furthers U.S. national security interests.

A Way Forward

The future of the DRNA now rests with the Republican-controlled House of Representatives, which will likely take its cue from the White House. The act is likely to be taken up soon after Congress returns early in 2002 in a Senate-House conference.

Because the United States funds Russian threat reduction programs already, it is logical for it to participate in a swap, but the importance of international participation must be stressed. That could be a challenge even if the United States takes the lead because, as explained, the strong oil market, until recently, stabilized the Russian economic situation. Certain creditors, particularly Germany, will likely therefore believe their debt can be serviced on schedule without any restructuring or forgiveness.

Indeed, for the immediate future it would appear that the financial arguments for Paris Club and London Club actions relative to Russia are not nearly as viable as they once were. But there is one special class of debt owed to Germany that could swing the door on debt-for-nonproliferation wide open: the money the Soviet Union once owed East Germany that Russia now owes the unified Federal Republic of Germany.

What is interesting about this debt— the exact amount of this debt is the subject of focused negotiation between the two countries—is that it is not included in the German federal budget, and it is highly improbable that this debt will be serviced through actual cash payments by Russia to Germany. In other words, if Germany were to swap this debt, it would be of minimal financial impact. The Germans have set the level of this debt at almost $7 billion; the Russians have set the level much lower. Informal settlement proposals have included debt for equity (Germany) and debt for investment (Russia), with neither proposal evidently striking the fancy of both parties. Debt for nonproliferation should be considered in this context, allowing Germany an attractive way of participating in any U.S. proposal to forgive debt in exchange for nonproliferation obligations.

For its part, the United States should begin by using authority provided by the DRNA to write off the remaining $480 million in Lend-Lease debt that Russia owes the United States from World War II—debt from a time when the United States and Russia were allies—in exchange for a ruble debt-for-nonproliferation fund. (See Figure 2. PDF file, requires Adobe Acrobat Reader.) The United States should join forces with Germany, which should dedicate a major portion or all of the East German debt owed by Russia to the same objective. In order for the United States to become a more equitable partner with Germany in this arrangement, the United States should strongly consider swapping all $2.7 billion of Russia’s Soviet-era debt to the United States and encourage other Paris Club members, such as Italy and France, to do the same. Agreement by these principals should be followed by the unsolicited offer of a debt swap to Russian President Vladimir Putin, subject to conditions on the construct and use of the proposed Nonproliferation Fund. In this manner, Russia’s investment potential is not questioned; new funds in the order of $20 billion become available to further enhance security around Russia’s nuclear, biological, and chemical materials and expertise; and Germany, which holds a disproportionate amount of Russian Paris Club debt, is not disproportionately affected by the actions of other G-8 members.

A debt-for-nonproliferation swap must be supported by the chiefs of state of the nations involved and must include proper surveillance and conditionality to assure operational costs and risks are relatively small and benefits are large and certain. By taking advantage of the lessons learned from highly successful debt conversion programs in bio-diversity and their extension to European economic restoration efforts, the U.S. government and the rest of the developed world have a tool to reduce further the Russian nuclear threat in a positive and constructive manner. Debt for nonproliferation could greatly enhance the funds available for proliferation prevention through broader multilateral participation and public-private partnerships, assist Russia in reducing its external debt without hard-currency transfers, and help expedite weapons-complex downsizing in Russia to the benefit of all parties.

NOTES

The author would like to acknowledge the assistance of John Hardt of the Congressional Research Service; the PNNL research team of K. Mark Leek, Jana Fankhauser, and Patricia Godoy-Kain; and Ron Bartek of Mehl, Griffin and Bartek, Inc.
1. There seem to be two conventions for use of the term “debt swap.” This article uses the more general terminology associated with the establishment of the Polish EcoFund in 1992. The more restricted definition is primarily associated with the tri-party agreement process. The more general term in this context is “debt conversion.”
2. T. E. Lovejoy, “Aid Debtor Nations’ Ecology,” The New York Times, October 4, 1984.
3. Commercial debt becomes available for debt swap when banks sell at a discount debt instruments of low market value. Banks may also donate such debt, typically in order to generate good will and take advantage of federal tax codes that allow banks to write off debt when donated to a not-for-profit corporation. M. L. Dionne, “Treasury Agrees to Construe Revenue Ruling on Debt-for-Nature Swaps Liberally,” Tax Notes, April 18, 1988. J. E. Gibson and R. K. Curtis, “A Debt for Nature Blueprint,” Columbia Journal of Transnational Law, 1990.
4. Ruth Norris, ed., The IPG Handbook on Environmental Funds. (Pact Publications: New York, 1999).
5. James Fuller and K. Mark Leek, “Debt for Ecology: A Concept to Help Stabilize Russian Nuclear Cities,” Pacific Northwest National Laboratory (PNNL-34546), presented at the International Forum on Energy and Environmental Opportunities in the Russian State Research Centres and Nuclear Cities in Como, Italy, April 2001; James Fuller, “Debt for Nonproliferation,” Pacific Northwest National Laboratory (PNNL-35638), presented at the Carnegie Endowment for International Peace Dialogue in Moscow, December 2001.
6. Official debt data from the Russian Ministry of Finance via Troika Dialog, Moscow, November 2001. Commercial debt data courtesy of Frank Russell Company, Tacoma, WA, October 2001.
7. “Russia: External Accounts on Good Footing,” Emerging Europe Monitor: Russia, CIS & Baltics, December 2001.
8. John P. Hardt, Russia’s Paris Club Debt and U.S. Interests, Congressional Research Service Report to Congress, Washington, D.C., June 6, 2001; author conversations with John P. Hardt.
9. “Russia: External Accounts on Good Footing,” Emerging Europe Monitor, December 2001; “Russia to pay $14.05 billion in foreign debt in 2002,” Tri-City Herald, December 12, 2001.
10. Hardt, Russia’s Paris Club Debt and U.S. Interests.
11. U.S. Department of Treasury, U.S. Debt Reduction Activities FY 1990 Through FY 1999, public report to Congress, February 2000.
12. Ibid.

James Fuller is director of the Pacific Northwest Center for Global Security at the Pacific Northwest National Laboratory in Richland, Washington.