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Working Paper Summaries (WP/93/55 - WP/93/95)
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Summary of WP/93/56: “Sovereign Debt: A Survey of Some Theoreticaland Policy Issues”

Author(s):
International Monetary Fund
Published Date:
January 1994
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The debt crisis of the 1980s raised a number of issues that invited new research. This paper surveys the recent literature on some of these issues in order to provide a synthesis of the main results.

The distinction between the ability-to-pay problem and the willingness-to-pay problem is seen to be important for understanding a debt crisis. In the case of a willingness-to-pay problem, in which a country that has the resources to repay its debt may find it optimal not to do so, there is a strategic interaction between the borrower and lenders, and the level of debt repayment is endogenously determined. The paper discusses several conceptual frameworks used for analyzing a willingness-to-pay problem, in which the potential penalties for debt repudiation are seen to play an important role in determining the repayment outcome. In particular, if the borrowing country has access to asset markets in a third country, potential intertemporal penalties, such as the denial of future credit by private lenders, may not be sufficient to deter debt repudiation, while potential intratemporal penalties, such as trade sanctions, may prove more effective. If the costs of debt servicing and debt repudiation are distributed unevenly across the population, political considerations may give rise to a recurrent cycle of debt and default.

If a borrower has a debt level that exceeds in an intertemporal sense the resources available to it to repay that debt, it has an ability-to-pay problem. However, if a country’s debt to GDP ratio is used to assess its ability to repay the debt, some additional information is needed, including the share of tradable goods in GDP and the level of the real exchange rate. Moreover, if the government is the major borrower, as in the recent debt crisis, the government’s intertemporal budget constraint, rather than that of the country as a whole, is appropriate for assessing the ability to repay. Domestic economic policies, in particular fiscal consolidation, can thus play an important role in averting a debt crisis. The existence of an ability-to-pay problem suggests a need for debt reduction. However, another argument in favor of debt reduction--that the existence of a “debt overhang” lowers a country’s investment, growth, and repayment capacity--encounters conceptual as well as empirical difficulties.

Debt reduction can be effected through debt relief or debt restructuring. The incentive problems typically associated with plans for debt relief can be overcome either by coordination by a special institution or by a market solution, such as the provision of tax credits to private creditors in exchange for debt relief. Perhaps the most common method of debt restructuring is for the debtor country to repurchase its debt at a discount in the international market. These “buy-backs,” which might not on their own be an efficient means of debt reduction, are seen to play an important role in a broader debt-reduction strategy.

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