logo logo

CAFTA’s debt trap

All the versions of this article: [English] [Español]

Foreign Policy In Focus Special Report | June 3, 2005

CAFTA’s Debt Trap

By Aldo Caliari

Criticism of the Central American Free Trade Agreement (CAFTA) currently being considered by
the U.S. Congress has focused heavily on concerns that the treaty would devastate Central
American farmers who would be forced to compete with heavily subsidized U.S. agribusiness. [1] In
addition, many Central Americans fear that the deal would perpetuate a low-road approach to
development based on low wages and lax environmental enforcement and undermine government
authority to ensure basic services and access to medicines. These are all valid concerns, but there is
yet another danger posed by CAFTA that deserves greater attention.

Buried in the technical language of the investment
chapter of the agreement are rules that would make it
more difficult for the six nations that have signed the
trade deal with the United States to escape heavy
debt burdens or to prevent or recover from debt
crises. The investment provisions of CAFTA, like
other deals such as the 1994 North American Free
Trade Agreement, are based on the argument that
strong protections for private foreign investors will
help encourage investments needed for economic
growth. To this end, they require governments to
comply with a long list of investor protections and
grant private foreign investors the right to sue
governments for damages if these obligations are

For example, governments are required to treat foreign
investors at least as favorably as domestic ones.
This principle is known as “national treatment.”
They must also ensure what is called “most favored
nation” treatment, meaning that they cannot discriminate
against (or give special preferences to) the
investors of one country that is a party to the agreement
without granting the same treatment to
investors of other parties to the agreement. These
rules mean that governments cannot favor domestic
interests (or investors from a particular country) even
if doing so would support social goals or other
national interests.

The NAFTA investor protections cover a sweeping
array of types of ownership interests, including loans
and securities. [2] But the CAFTA rules go even further
by extending the application of such protections to
sovereign debt. Under NAFTA, sovereign debt is
explicitly excluded. [3] It is worth noting that the
explicit exclusion comes after the use of the words
“for greater certainty” which could be construed as
meaning that the explicit exclusion was not necessary
in the light of the other wording.

This is not the first time that a trade deal has covered
sovereign debt. In the 2003 U.S.-Chile
Agreement, specific principles on investment are
explicitly made applicable to sovereign debt. The
U.S.-Chile FTA contains a broad definition of investment [4]
that follows the standard adopted by the U.S.
in its most recent BIT Model. [5] This definition generally
includes “bonds, debentures, loans and other
debt instruments“ [6] In what represents a significant
departure from NAFTA, the treaty explicitly makes
the provisions applicable to sovereign debts issued by
the Chilean government. [7] These same rules are
included in CAFTA. [8]

The rest of this article explains how the extension of
CAFTA investment rules to sovereign debt places
huge constraints on the ability of indebted countries
to exit from a debt crisis or to protect the basic needs
of its citizens.

National Treatment and MFN in the Context of
Sovereign Debt Problems

The principles of Most Favored Nation and
National Treatment were originally born in agreements
dealing with trade in goods. The extension of
these principles to investment is, therefore, neither a
straightforward proposition, nor one exempt of
controversy. [9] The impacts of the insertion of these
principles in investment treaties have also been widely
analyzed and criticized. [10] The application of these
principles to sovereign debt is, in general, susceptible
to the same critiques that have been made of their
application to other forms of investment.

However, the extension of National Treatment and
MFN principles to sovereign debt raises a number of
specific issues that could prove far more harmful than
the traditional application of those principles to
investment in the past. Some of these issues are listed

1. Dismantling tools needed for the recovery of the
local economy in post-crisis situations

The application of the National Treatment principle
would restrict the ability of the debtor government to
use tools needed for the recovery of the local economy
in post-crisis situations. Applying the principle of
National Treatment to sovereign debt essentially
means that foreign creditors should be offered no less
favorable treatment than that offered to domestic

This is important in the context of the developing
country signatories of CAFTA, since, with the exception
of Honduras, an important share of public debt
in all these countries is owed to domestic creditors.
In some of them, like Costa Rica, domestic debt is
actually higher than external debt.

There are a variety of reasons why a country having
to restructure its sovereign debt in order to prevent or
exit a financial crisis might need to resort to offering
preferential conditions to domestic creditors.

In a financial crisis, domestic creditors often suffer a
“double adjustment.” First, they are typically forced
to accept a “haircut” on their claims, meaning that
the value of their loans is reduced by a certain percentage.
Second, they often suffer the costs related to
the internal adjustment, such as high interest rates. [11]

In fact, the impact of the restructuring on the domestic
capital markets and, in turn, on the resumption of
growth and repayment capacity, are important factors
to take into account. [12] Along similar lines, the IMF
has said 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.” [13]

Third, dealing with domestic debt before dealing
with the foreign might also allow the sovereign
nation to rapidly return to domestic capital markets
during what is likely to be a sustained interruption in
access to international capital markets. [14]

Fourth, the debtor might also need to accord priority
to domestic debt in order to protect the financial
system. In this sense, it has been pointed out that
sovereign debt restructuring has a double impact on
the financial system. On the one hand, the impact on
assets of the reduction in the value of bonds held as
part of their capital by financial entities. On the
other, the general increase in uncertainty, which
could affect the overall credibility of the system. [15]

The IMF has also stated that in these cases special
treatment to domestic debt might enable the debtor
to 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.” [16]

Last, a sovereign debtor might need to accord special
treatment to domestic debtors for the same legitimate
reasons that can lead it to accord special treatment
to national sectors and industries, within the
context of a national development strategy and in
order to achieve development goals. [17]

2. Preventing the State from paying salaries and
pensions in a debt crisis situation

The application of National Treatment to sovereign
debt means that, under CAFTA, the government will
be unable to prioritize domestic debt consisting of,
among other things, wages, salaries, and pensions. In
other words, the government is bound to treat these
debts the same way it deals with foreign debts held
by transnational banks and institutional investors. If
its resources are enough just to cover a portion of its
debts, the state will not be able to choose to direct
those funds to pay wages and salaries (at least not as
long as it does not devote equal amount to pay foreign
creditors). CAFTA would deal a setback to
states’ capacity to prioritize their obligations to basic
human rights and comprehensive development above
the claims of foreign creditors.

Unlike an indebted private company, an indebted
sovereign nation has human rights obligations and
social responsibilities toward its people. This means
that, in dealing with sovereign debt there are issues
that cannot be addressed by strict analogies with
bankruptcy principles applicable to the private sector.

That is why civil society proposals for a rules-based
framework have typically called for analogies to be
made rather with frameworks that contemplate this
special mission that the state is called to fulfill, such
as Chapter 9 of U.S. Bankruptcy Law (applicable to
municipalities). Whether civil society proposals call
for the restructuring to preserve the ability of the
state to finance the achievement of the MDGs,
human rights, human needs, etc., a common element
is the call to give priority to this ethical mission
embodied by the state. In fact, even the IMF’s muchcriticized
Sovereign Debt Restructuring Mechanism
proposal excluded “Wages, salaries and pensions”
from its application. [18]

3. Reducing the leverage of debtors in a debt

By first gathering a number of supportive domestic
creditors, a government’s debt restructuring offer can
gain considerable clout. The offer of preferential conditions
to these domestic creditors might be critical
in order for the state to garner support from these
creditors. This is especially so because some governments
may find that it is easier or more advantageous
to the economy that such incentives be offered to
local holders of debt rather than foreign ones. If the
principles of national treatment are applied to sovereign
debt, as mandated by CAFTA, any incentive
offered to domestic creditors would have to be
offered to the foreign creditors, effectively foreclosing
this avenue for the indebted country.

The offer of preferential conditions to domestic
creditors was, in fact, a crucial element in enhancing
the government’s leverage in Argentina’s negotiation
with its private creditors after its December 2001
default (the largest sovereign default in history). In
September 2003, the government released its initial
proposed debt restructuring conditions, which
included a 75% cut for bondholders. The government
contended that this was the size of the reduction
that would enable it to recover sustainable
growth while ensuring that the promises of payment
were kept. Some groups of bondholders quickly
rejected this offer, claiming that it was woefully insufficient
and, in the light of the country’s latest growth
figures, below the capacity of the country to repay.

The creditors also strongly lobbied the G7, which,
directly and through the IMF, put more pressure on
Argentina to improve its offer. [19] With pressure
mounting from the G7 and the IMF, Argentina
turned to domestic pension funds that represented an
improvement over the offer made to the other bondholders. [20] By granting them preferential conditions,
Argentina was able to reach agreement with creditors
holding more than 17% of its total debt. This was a
critical first step in garnering the support of a majority
that, eventually, totaled 76% of the creditors.
Obviously, the space for the government to treat
domestic bondholders differently from foreign ones
was crucial to reaching this agreement. Such resort
would have been out of reach if the government had
been bound by a National Treatment of foreign debt
principle. [21]

4. Creation of a privilege for the debt owned (or
acquired) by creditors from the Party

CAFTA is technically a collection of bilateral
treaties between the United States and each of the six
developing nations. Thus, by requiring national treatment
and MFN only for creditors from the country
that is a party to the treaty, the agreement, in fact,
grants seniority to the foreign investors from that
country over investors from other countries. [22]

In addition, the treaty would affect the rights of
bondholders from non-Parties to the treaty without
their consent since they are, by definition, excluded
from intervening in the negotiation of the bilateral
agreement. For these bondholders, the bilateral can
be de facto equated to an involuntary debt swap by
which they might suddenly find themselves holding a
downgraded instrument.

Investor-State Lawsuits and Sovereign Debt

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. [23]

Such “investor-state lawsuits” are highly controversial
for a number of reasons. [24] Many arbitration tribunals
operate with an absolute lack of transparency,
having no obligation to disclose relevant documents
or allow any form of public participation. [25] The system
for choosing arbitrators has also drawn criticism,
as arbitrators can be drawn from the ranks of practicing
investment lawyers, without any obligation to
appoint people who will be independent in the sense
of not having any stake in the treaty interpretation. [26]

Neither do arbitral tribunals have to pay regard to
legal precedents. [27] This feature, which creates a lot of
uncertainty in the investment arena, can become particularly
troublesome when applied to potential or
actual sovereign debt crises. Indeed, the main rationale
for a sovereign debt bankruptcy system has been
the need to provide some degree of rationality and
predictability for both debtors and creditors in the
messy process of exiting or sorting through a sovereign
debt crisis. Clearly, an arbitration tribunal would
do a poor job of addressing those concerns and
would become an added element of uncertainty into
the existing system.

The application of the principles of national treatment
and MFN to sovereign debt will open new
frontiers that might give these tribunals the authority
to define difficult questions that arguably belong
under the domestic jurisdiction of states.


CAFTA’s application of controversial investor protections
to sovereign debt would suppress the few
options available to countries trying to prevent or exit
from debt crises. As shown by the experience of
countries undergoing such crises, inability to exit a
crisis situation might cause economic losses that far
outweigh any commercial gains achieved through
signing a treaty. Debt campaigners are urged to join
forces with trade campaigners to raise public attention
to this issue and ensure it remains front and center
in the debate.

Central American activists must call on their governments
to reject CAFTA. In the U.S., activists
must urge Congress to also reject CAFTA on the
basis that congressional support for CAFTA means
condemning Central American countries to a perpetual
incapacity to escape their debt problems.

Members of Congress who boast of supporting the
reduction of external debts for Central American
countries must be reminded that most of these countries
also have large stocks of private debt. CAFTA
will tightly tie the hands of these countries to deal
with such debt.

FPIF (online at policy analyst Aldo
Caliari is Coordinator of the Rethinking Bretton
Woods Project a the Center of Concern (online at


Action Aid (2003). Unlimited Companies: The Development
Impacts of an Investment Agreement at the WTO.

Chang, Ha-Joon and Duncan Green (2003). The Northern WTO
Agenda on Investment: Do as We Say, Not as We Did. South
Centre/ CAFOD.

Correa, C. (1999). Key Issues for Developing Countries in a
Possible Multilateral Agreement on Investment in International
Monetary and Financial Issues for the 1990s, Vol. X.

IMF (2003). Proposed Features of a Sovereign Debt Restructuring
Mechanism. Prepared by the Legal and Policy Development and
Review Departments In Consultation with International Capital
Markets and Research Departments. Approved by Francois
Gianviti and Timothy Geithner, February 12.

IMF (2003a). IMF Discusses Possible Features of a Sovereign
Debt Restructuring Mechanism. Public Information Notice No.
03/06, January 7.

IMF (2002). Sovereign Debt Restructuring Mechanism-Further
Considerations. Prepared by the International Capital Markets,
Legal and Policy Review Departments In Consultation with Other
Departments. Approved by Gerd Hausler, Francois Gianviti and
Tinothy Geithner. August 14.

IMF (2002a). The Design of the Sovereign Debt Restructuring
Mechanism. Prepared by the Legal and Policy Development and
Review Departments In Consultation with International Capital
Markets and Research Departments. Approved by Francois
Gianviti and Timothy Geithner, November 27.

IMF (2002b). IMF Board Discusses Possible Features of a New
Sovereign Debt Restructuring Mechanism. Public Information
Notice No. 02/106, September 24.

IMF (2003). Proposed Features of a Sovereign Debt Restructuring
Mechanism. Prepared by the Legal and Policy Development and
Review Departments. Approved by Francois Gianviti and Timothy
Geithner, February 12.

Khor (2002). The WTO, the Post-Doha Agenda and the Future of
the Trade System: A Development Perspective.

Machinea, J. (2004). Reestructuración de la deuda: nuevas propuestas
para viejos problemas in Gobernabilidad e integración
financiera: ámbito global y regional. ECLAC. Santiago, Chile.

Oxfam (2003). The Emperor’s New Clothes: Why Rich Countries
Want a WTO Investment Agreement.

Peterson, L. (2004). UK Bilateral Investment Treaty Programme
and Sustainable Development. Briefing Paper No. 10, The Royal
Institute of International Affairs, Sustainable Development
Programme (UK). February.

Peterson, L. (2004a). Bilateral Investment Treaties and
Development Policy-Making. International Institute for Sustainable
Development (Canada). November.

Ugarteche, O. (2004). Veinte Años Después... La Deuda de los
Países Andinos.


[1CAFTA is a bilateral treaty signed by the United States and the Central American countries of Costa Rica, El Salvador, Guatemala,
Honduras, and Nicaragua, as well as the Dominican Republic.
CAFTA follows closely the model of other Free Trade Agreements
recently signed by the U.S., which are comprehensive in scope.
From the U.S. government’s perspective, CAFTA represents a relatively
small percentage of trade. However, just as the plethora of
bilateral and regional agreements that the U.S. has recently signed
or is currently negotiating, the value of CAFTA is not as much economic
as political. It is meant to pave the way for completion of the
Andean FTA and the FTAA, and add momentum around trade
negotiations at the WTO.

[2See NAFTA Art. 1139.

[3In conformity with Art. 1416:
“investment means ‘investment’ as defined in Article 1139
(Investment Definitions), except that, with respect to ‘loans’ and
‘debt securities’ referred to in that Article:
(a) a loan to or debt security issued by a financial institution is an
investment only where it is treated as regulatory capital by the Party
in whose territory the financial institution is located; and
(b) a loan granted by or debt security owned by a financial institution,
other than a loan to or debt security of a financial institution
referred to in subparagraph (a), is not an investment;”
It then adds that, “for greater certainty:
(c) a loan to, or debt security
issued by, a Party or a state enterprise thereof is not an investment

(bold is ours).

[4This definition has become the standard blueprint for the U.S.
negotiating position in treaties. “Investment means every asset that
an investor owns or controls, directly or indirectly, that has the characteristics
of an investment, including such characteristics as the
commitment of capital or other resources, the expectation of gain or
profit, or the assumption of risk. Forms that an investment may take
(a) an enterprise;
(b) shares, stock, and other forms of equity participation in an
(c) bonds, debentures, loans, and other debt instruments;
(d) futures, options, and other derivatives;
(e) rights under contract, including turnkey, construction, management,
production, concession, or revenue-sharing contracts;
(f ) intellectual property rights;
(g) rights conferred pursuant to domestic law, such as concessions,
licenses, authorizations, and permits;11 and
(h) other tangible or intangible, movable or immovable property,
and related property rights, such as leases, mortgages, liens, and
pledges; but investment does not mean an order or judgment
entered in a judicial or administrative action...”

[5See U.S. 2004 Model BIT, Art. 1.

[6Usually with a footnote that clarifies “Some forms of debt, such as
bonds, debentures, and long-term notes, are more likely to have the
characteristics of an investment, while other forms of debt, such as
claims to payment that are immediately due and result from the sale
of goods or services, are les likely to have such characteristics.”

[7See Annex 10-B (Annex to the chapter of the treaty that deals with
investment): “The rescheduling of the debts of Chile, or of its
appropriate institutions owned or controlled through ownership
interests by Chile, owed to the United States and the rescheduling
of its debts owed to creditors in general are not subject to any provision
of Section A other than Articles 10.2 and 10.3” Articles 10.2
and 10.3 in the Treaty refer to National Treatment and Most
Favored Nation.

[8See also Ugarteche 2004, 14-18 and 34-35.

[9See Khor 2002 (“It is certainly not clear that the principles of the
WTO (including National Treatment and Most-Favoured-Nation
treatment) that apply to trade in goods should apply to investment,
nor that, if applied, they would benefit developing countries.”)

[10See for instance Chang (2003), Action Aid (2003), Oxfam (2003).

[11Machinea 2004, 188.


[13IMF 2002, 13.


[15Machinea 2004, 188-9.

[16IMF 2002, 13.

[17See also IMF 2002 13 agreeing, while on different grounds, with
the possible need for the government to shelter domestic investors
from the full impact of the restructuring. The IMF argues this
might be necessary in order to “garner support for an ambitious
adjustment program.”

[18IMF 2003, 24.

[19As per its IMF agreement, the Argentine government had promised
to “negotiate in good faith;” Argentina was singled out by name in
some G7 statements as not complying with such pledge. Private
creditors have said negotiations in good faith mean an agreement of
80% of the creditors, while the government claimed that something
above 65 or 70% would do. It would have, of course, sounded
weird and unfair that the IMF or the G7, being some of the creditors,
be able to unilaterally define what a condition subscribed by
Argentina meant in terms of an exact percentage. However, that is
perfectly possible in real political economy terms.

[20The offer consisted of inflation-linked bonds.

[21This without mentioning that improving the offer to the pension
funds will translate into improvements in the retirement benefits of
a population hit by the crisis where the privatization of the pension
system left people without other option than pension funds.

[22It is unclear and will be the matter of interpretation whether the
definition of foreign debt has to do with debt belonging to the creditor
originally or by acquisition. In the case of bonds, where the
holder is entitled to the payment, this distinction might be irrelevant;
in the context of debt from other sources the distinction might
be applicable.

[23Peterson 2004, 3.

[24For a survey of issues arising from Treaty-based arbitration disputes
see Peterson 2004 and 2004a.

[25Peterson 2004, 4.

[26Peterson 2004a, 12.

[27Peterson 2004, 6.