Financial markets bring important benefits to their participants. They enable economic units—households, firms, and governments—to maintain temporary imbalances between what they earn and what they spend. The transfer of resources from units with surpluses (those that are saving) to units with deficits (those that are dissaving) is essential: it allows households to choose an appropriate distribution of consumption over their life cycle; it overcomes the limitations that firms face if they must self-finance investment expenditure; and it enables governments to meet variations in their expenditures without frequent, disruptive changes in tax rates. Financial markets also enable economic units to adjust the types of claims they hold and issue, so that they can diversify their assets and obtain liquidity. Moreover, the payments system, an important aspect of the financial system, makes a wider range of transactions feasible, permitting greater specialization of economic activity.
To perform these essential functions, financial markets must permit economic units to maintain temporary imbalances between their receipts and payments. Yet how do markets ensure that these imbalances are temporary? What is to prevent some units from following an unsustainable path—borrowing without the means, or even the intention, of repaying? Market discipline is one force that may limit such abuse: as a borrower begins to incur debts that can only with difficulty be serviced, the lender’s response is first to require a higher interest rate—to compensate for the increased risk of default—and eventually to exclude the borrower from further borrowing, thereby depriving the borrower of access to financial markets.
Market discipline is a force whose effectiveness—or frequently whose alleged ineffectiveness—plays a pervasive role in financial policy. One example is the problem of ensuring sustainable fiscal policies in a currency union. This issue is of particular concern in recent European discussions of economic and monetary union (EMU), as there is a perceived need to rein in the mounting debts of some participants (see Figure 1). The Maastricht agreement to establish EMU provides for multilateral surveillance of, and eventually binding limits on, each member’s fiscal stance (Kenen (1992)). The rationale for this provision is that market discipline itself cannot induce countries to pursue sound fiscal policies. According to the Delors Committee report on EMU, “experience suggests that market perceptions do not necessarily provide strong and compelling signals. … The constraints imposed by market forces might either be too slow and weak or too sudden and disruptive” (Delors Committee (1989), p. 24).
Figure 1.Debts of Selected European Community Countries
Another instance in which the efficacy of market discipline is at issue is sovereign lending: can private lenders provide sovereign borrowers with appropriate incentives to pursue policies consistent with solvency? Yet another application pertains to the regulation of financial institutions: can markets induce financial intermediaries to lend prudently, or is direct supervision necessary? Finally, there is the “soft budget constraint” facing state enterprises in socialist economies: how can these enterprises be led to uphold their long-run solvency and to operate only if they are solvent?
This paper will show that market discipline in these and other disparate cases displays some common elements. Several conditions are needed for effective market discipline. Financial markets must be open. Information bearing on a borrower’s creditworthiness must be readily available to lenders. Markets must not anticipate that a delinquent borrower will be bailed out, which also implies that the borrower must not have access to central bank financing that would enable it to maintain an otherwise unsustainable position. Finally, for market discipline to work smoothly, the borrower must respond to market signals. Market discipline fails when these conditions are not met (Bishop, Damrau, and Miller (1989), Goldstein, Mathieson, and Lane (1991), Frenkel and Goldstein (1991b)).
When market discipline does falter, the alternatives are binding limits or surveillance. Examples of such policies include constitutional ceilings on government borrowing, multilateral surveillance of fiscal policies, and government regulation of financial institutions. These alternatives also typically entail some difficulties, as direct limits can often be circumvented and the borrower can influence the level of the limits. In general, the solution is that, where market discipline cannot work effectively, it must be supplemented with direct administrative controls, but care should be taken to help market forces buttress rather than undermine these controls.
I. What Is Market Discipline?
Market discipline means that financial markets provide signals that lead borrowers to behave in a manner consistent with their solvency. For example, effective market discipline would prevent national governments from incurring exponentially increasing deficits, which if continued would lead to default. Market discipline of sovereign borrowers would imply that future foreign exchange earnings will be adequate to service external debt. Market discipline of financial institutions—such as banks or savings and loan associations—would mean that these institutions could not make loans whose expected return is less than the cost of funds, nor could they continue to have access to deposits once they became insolvent. Market discipline of state enterprises would prevent these enterprises from borrowing to finance loss-making businesses if these activities are never expected to turn profitable.
Market discipline implies that the borrower is led to pursue sustainable policies—that the borrower follows a course of action that can be continued without eventual default or an abrupt change in policy (Horne (1988)). This implies that debt “grows asymptotically at a rate less than the interest rate. Debt, in other words, is not serviced indefinitely by borrowing” (Horne (1991), p. 5).1
Sustainability is not as ambitious a requirement as one that states the borrower’s behavior must be optimal: optimality is a stronger condition, the satisfaction of which also depends on the absence of nonpecuniary externalities and other distortions. For example, in a currency union, effective market discipline implies that no country would incur unsustainable deficits but not that the overall stance of policy be a global optimum. There might still be a need for policy coordination to the extent that one country’s fiscal policies affected other countries’ economies in ways not captured by market prices (Mussa (1991) and Masson and Melitz (1990)).2 Likewise, in the case of a sovereign borrower, even effective market discipline cannot guarantee optimal borrowing, in that the political process may not accurately reflect the public welfare. Even if the resulting path were consistent with solvency, for example, it might still require an excessive debt burden on future generations (Modigliani (1986)). For a financial intermediary, market discipline would not imply an efficient allocation of credit across sectors if lending is subject to distortions from taxes and subsidies. Likewise, given the agency problems associated with a lack of managerial incentives, a state enterprise’s managers may not maximize profits, even if market discipline ensures that it can survive only by maintaining solvency. Efficiency, in this case, would be achieved only with the enterprise’s privatization.
The responsive relationship between markets and borrowers is illustrated in Figure 2, which shows the supply of loans to an individual borrower. If the amount borrowed is small, lenders are prepared to make funds available at the risk-free interest rate, rf. As borrowings become larger, lenders insist on a higher interest rate to compensate them for the increasing risk of default: the possibility that future revenue may be insufficient to service the debt fully. Because both a larger debt and a higher interest rate increase the amount to be repaid in the future, additional debt raises the risk of default at an increasing rate. As debt increases, the point is eventually reached at which the supply curve is vertical. At this level of debt, Dmax, and at the corresponding interest rate, rmax, no increase in the promised interest rate can compensate for the accompanying default risk.3
Figure 2.Supply of Loans to a Borrower
This relationship between the interest rate and the volume of borrowing has been discussed in the context of credit rationing in domestic credit markets (Jaffee and Modigliani (1969), Jaffee and Russell (1976), Stiglitz and Weiss (1981)) and has also been applied to sovereign lending (Eaton and Gersovitz (1981)). The same general principle applies in a variety of contexts: as borrowing increases, the market initially insists on a higher interest rate spread and eventually excludes the borrower from further lending altogether.
For a government, the problem of market discipline is somewhat different from that for a private debtor, since there is no established way to determine a sovereign borrower’s net worth, and sovereign immunity implies that a sovereign borrower’s assets cannot be liquidated. It is also not clear what sanctions can be imposed on a delinquent debtor government, other than excluding it from further borrowing. Uncertainty about those sanctions also makes it harder for markets to assess default risk. Moreover, a government that borrows in its own currency need not actually default; it can monetize its debt. In this case, market discipline often takes a different form: higher interest rates may be associated with anticipated exchange rate depreciation. Under a flexible exchange rate regime, government deficits may be monetized, either immediately or over the longer run. To the extent that they are immediately monetized, inflation and exchange rate depreciation occur immediately so that in effect the government collects revenue through the inflation tax on both money and public debt. Nominal interest rates on debt denominated in domestic currency adjust to compensate for this inflation, becoming an indirect channel by which interest rate differentials reflect differences in fiscal policy. Even if deficits are not monetized immediately, markets may expect that sooner or later they will be, in which case interest rates will rise even before the monetization takes place (Sargent and Wallace (1986)).
Other factors also affect the relationship between borrowing and exchange rate depreciation, particularly under an exchange rate arrangement like the European Monetary System (EMS). As an illustration, consider the juxtaposition of debt ratios and interest rates in European Community (EC) member countries in Figures 3 and 4.4 Note, for example, that Belgium and the Netherlands, which have relatively high debt ratios, have small interest rate spreads, possibly attributable to the fact that the EMS limits these countries’ ability to monetize their debt. Within the EMS, or under any regime of fixed but adjustable exchange rates, the inflation rate—and thus the rate of money growth—in one country can differ from rates elsewhere in the same currency area to only a limited extent. Within such an exchange rate system, monetization of the debt is associated with a financial crisis in which the exchange rate must be devalued (Eichengreen (1990), Giavazzi and Pagano (1989)). In effect, the risk of crisis is the spur of market discipline. Thus, crises can have a necessary, even salutary, role in forcing governments to follow sustainable policies (Mussa (1991)); attempts to avoid crises by imposing exchange controls and other restrictions dull this spur.
Figure 3.Debts of European Community Countries, 1990 Figure 4.Interest Rate Spreads on Long-Term Government Bonds of European Community Countries Relative to Germany, April 22, 1991
Source: Bishop (1991).
Capital flight may be viewed as another mechanism whereby financial markets exercise a disciplinary role. Capital flight is an extreme form of market discipline: other forms of market discipline may exclude a country from further external borrowing, but capital flight causes domestic borrowers to lose access to their country’s savings. Capital flight often occurs in response to policies perceived to be unsustainable, policies that result in inflation, exchange rate depreciation, and perhaps heavy taxation. Conversely, when sustainable policies are adopted, flight capital frequently returns home. Such repatriation of flight capital has recently been observed in Argentina and Mexico.
On balance, then, market discipline may fail by being too lax—that is, by failing to penalize behavior that brings increased risk of default—or by being too harsh—that is, by excluding borrowers that are actually creditworthy. This may happen as a result of contagion effects, whereby all borrowers in a particular category—for example, developing countries in a specific region—are excluded from the market or subjected to a high interest rate spread, regardless of their performance. Such an overreaction can damage the efficient allocation of funds as much as an underreaction that permits unsustainable borrowing. For market discipline to be effective, both dangers must be avoided.
If increased interest rate spreads do not discourage the borrower from an unsustainable course of borrowing, it might be because the appropriate signals are not being sent: market lenders are not incorporating an accurate assessment of default risks into interest rates. It might also be that the borrower does not respond to the signals and so persists in unsustainable borrowing until excluded from the market. In examining the conditions required for market discipline, both possibilities must be taken into account.
II. Conditions for Market Discipline
Market discipline needs four general conditions to be effective. One is that financial markets be free and open. A second is that adequate information must be available about the borrower’s existing debts and the prospects of repayment. A third is that there be no possibility that lenders will be bailed out in the case of an impending default. A fourth is that the borrower respond to market signals before being excluded from the markets.
Free and open financial markets are required so that interest rates can respond to the level and nature of borrowing. In particular, the borrower must not face a captive market, in which lenders cannot deny it funds. In the important case of borrowing by a sovereign government, a free financial market rules out capital controls, which, if effective, might enable a government to increase its debt without driving up interest rates by limiting domestic residents’ ability to seek alternative assets abroad. Capital account liberalization may therefore play an important role in strengthening the market discipline of government policy, thus preventing unsustainable policies from being pursued.
Even where capital markets are generally open, market discipline of fiscal policy may be weakened if the government has access to privileged sources of financing. In some countries, for example, liquidity requirements for the banks create a captive market for treasury bills, providing the government with a source of borrowing at below-market interest rates. Some governments also have access to pension funds and can use them to finance deficits (Kitchen (1991)).
The importance of unrestricted capital markets can also be shown in other examples of market discipline. In the case of financial institutions, if legal restrictions to limit competition for deposits—such as restrictions on the geographic scope of activities or on the activities permitted to certain categories of institutions—give particular institutions a degree of market power, the market may be less able to discriminate between prudent and imprudent financial intermediaries, thereby rendering market discipline ineffective. In the case of state enterprises in reforming socialist economies, if financial institutions are directed by the authorities to lend to particular enterprises regardless of their creditworthiness, financial discipline is nullified. In all cases, financial market liberalization bolsters the market’s disciplinary function.
A second requirement for effective market discipline is that lenders obtain relevant information about a borrower’s outstanding debts. This is important in the case of borrowing by governments, although methodological problems complicate the choice of a relevant measure of the government deficit (Blejer and Cheasty (1991)), a problem frequently exacerbated by the widespread government practice of incurring off-balance-sheet liabilities. Governments in many countries do much of their borrowing through indirect channels, particularly when it is subject to legal restrictions or must be approved by the electorate. This off-balance-sheet activity includes the establishment of special agencies or foundations whose borrowing is not included in the state budget but is nonetheless an implicit or explicit obligation of the government. It also includes the use of government loan guarantees for particular activities in lieu of subsidies (Bennett and DiLorenzo (1983)). In addition, borrowing can take place in forms not included in conventional measures of government debt. For instance, one circumstance leading to the 1974 New York City default was the immense issue of so-called Tax Anticipation Notes and Revenue Anticipation Notes, which were issued—against future taxes and proceeds from the sale of goods and services by the city government—for the purpose of circumventing restrictions on borrowing and concealing the overall volume of government borrowing. These devices enabled the city to incur unsustainably large deficits, which eventually resulted in bankruptcy.
A similar issue arises in connection with sovereign debt. In this case, creditors are concerned not only with a government’s borrowing but also with the foreign borrowing of that country’s residents, the servicing of which is a claim on the available foreign exchange reserves. For lenders to provide effective signals to check unsustainable external borrowing, they must have accurate and timely information about such credit flows—that is, accurate data on international capital flows. If important information is not available to lenders, an unsustainable path of borrowing might go unchecked until the problem grows so serious that the debtor not only faces an increasing interest rate spread but is ultimately excluded from the market. An absence of reliable information also creates the possibility of contagion effects, as debt servicing difficulties by one borrower are perceived as signaling impending problems with all borrowers in the same category (Goldstein, Mathieson, and Lane (1991)). Contagion weakens market discipline by excluding all borrowers, solvent and insolvent alike, from the markets.
The importance of sound information can also be illustrated by the other two situations mentioned previously. First, good information is needed in the regulation of financial intermediaries, which might conceal their losses both from creditors and regulators by providing them with incomplete or faulty numbers. Some of the savings and loan scandals in the United States offer an example of intentional dissimulation by an institution regarding its financial state, and the alleged falsification of accounts by officials of the Bank of Credit and Commerce International (BCCI) is another cautionary illustration. A less extreme example is the practice of tobashi by some Japanese investment companies—selling bad assets with an agreement to repurchase, in order to dress up accounts at the end of the fiscal year.
A second argument for good information is found with state enterprises in socialist economies. The need for timely information to assess enterprises’ creditworthiness underlies the importance of training bank loan officers to find and process the relevant information. This has been given some priority in technical assistance efforts in Eastern Europe and the former Soviet Union (World Bank (1990)).
An obvious remedy to inadequate information is to improve the quality of information and disseminate it to the markets. This approach cannot fully address the deliberate concealment of information, but fraud poses the same problems for direct regulation as for market discipline. In the case of government borrowing within a currency union, or of sovereign debt, these considerations call for cooperation in gathering and releasing relevant data on government borrowing—both on and off balance sheet—and on international capital movements (Bishop, Damrau, and Miller (1989)).
A final reason that adequate information on a borrower’s status may not be fully incorporated into borrowing costs is that lenders may be locked into the terms of existing debt contracts. Even though higher borrowing results in an increased interest rate spread, as lenders consider default increasingly likely, the cost of servicing existing long-term debt may be contractually fixed; lenders who had provided funds previously then incur capital losses. This would be a particular problem in the absence of seniority rules, which give earlier borrowings priority in debt servicing. In this case, it is only the cost of new borrowing that reflects the recent information on the borrower’s financial status. As such, market discipline is weakened. This is an example of how the structure of public debt, and other features such as seniority rules, may affect markets’ ability to impose financial discipline. This effect may, in turn, be incorporated into the relative costs of borrowing at different maturities and sometimes into the lender’s willingness to provide funds at longer maturities.
Market discipline is only effective if market participants do not believe that the borrower would be bailed out in the case of an actual or impending default. This condition for market discipline is crucial, and its failure is probably the most important reason for the failure of discipline. What makes the no-bailout condition so difficult to achieve is the essential role of credibility: it is not enough that concerned third parties (such as governments) promise not to carry out a bailout, but market participants must also believe that the promise will be kept. Credibility thus depends not just on making a no-bailout commitment but on the incentives to abide by this commitment, which influence market participants’ perception of the probability of a bailout. In particular, if the borrower is perceived as “too big to fail,” it will be widely believed that, regardless of what the authorities say, a bailout will take place. In this case, interest rate spreads will not rise in response to unsustainable borrowing, and market discipline is thwarted.
The source of the credibility problem is time inconsistency. After the fact, bailouts are often beneficial, as they frequently compensate individuals for losses resulting from circumstances beyond their knowledge or control and may prevent one default from having systemic consequences. However, before the fact, the promise of a bailout leads to a moral hazard problem: it reduces the incentive to lenders to monitor and weigh the borrower’s behavior when making loans, as well as reduces the borrower’s incentive to maintain solvency. Therefore, a commitment to avoid bailouts may be appropriate even if each individual bailout is, in itself, defensible.
Bailouts can take a number of forms. One prominent recent example is the role of deposit insurance in recent failures of banks and savings and loan associations in the United States. If deposits are fully insured, depositors do not need to assess a bank’s solvency, since they will receive the full value of their deposits if the bank fails. Therefore, institutions approaching insolvency are not subject to market discipline in the form of exclusion from the markets or even a sharply rising cost of funds. Moreover, if an insured institution’s net worth is close to zero, it faces perverse incentives with regard to risk. If a large risky venture is successful, the institution’s owners benefit; if it fails, the losses are borne by the insurer (the taxpayer). Thus, risky ventures are undertaken even if their expected return is negative. As a result, in the presence of full deposit insurance, banks and savings and loans that are close to failure not only have access to deposit funds but frequently use them to engage in very risky activities, perhaps exacerbating their losses should failure occur.
Various proposals for deposit insurance reform have attempted to address this problem (Fries (1990)). One solution may be to change the deposit insurance scheme to provide only partial and limited coverage. Here the credibility issue enters again: even where insurance coverage has been partial, a larger bailout often occurs. For example, depositors in the Home State Savings Bank in the mid-1980s were compensated by the Ohio state government, though it was not legally obligated to do so. In Canada, when two regional banks failed in 1985, full compensation was provided for the depositors despite the fact that deposit insurance covered only the first $60,000 of deposits. In another example, the Bank of England bailed out the depositors in Johnson Matthey in the absence of any legal responsibility (Benston and Kaufman (1988)). Thus, limiting the bailout provided by deposit insurance is not straightforward.
One way to substitute for the market discipline lost through deposit insurance is to set risk-based deposit insurance premia. This approach would simulate the market’s role in pricing banks’ riskiness and in restoring their incentives for prudent behavior. It would have to be supplemented by an administrative decision to shut down a bank when its net worth reached zero or some other critical level. One way of implementing risk-based premia is to use the information embodied in the price of the bank’s shares traded on the stock market. Deposit insurance can be interpreted as an option of the bank’s owners to sell its entire portfolio of assets and liabilities to the deposit insurance corporation for a fixed price. Since a bank’s shares are valued at the market price of the bank’s portfolio (including the value of deposit insurance), the stock market can provide information on what constitutes a fair risk-adjusted premium (Fries and Perraudin (1991)). This deposit insurance premium would be determined together with a rule for governing when to shut down the bank, since the shutdown rule itself affects the bank’s share value and the relationship between the share price and the bank’s earnings (Brickley and James (1986)).
Bankers and policymakers, however, have resisted proposals to make deposit insurance premia depend on bank share prices because such prices are influenced by many factors, making them too noisy a signal to be useful (Benston and Kaufman (1988)). There may also be concern that the complementary rules for shutting banks down violate the owners’ property rights (Kareken (1988)). As a result, no country has established a risk-based system for pricing its deposit insurance premia. Another problem in the U.S. context is that the budgetary costs of the failures of banks and savings and loans, not to mention the political costs of additional closures, are so large that establishing an appropriate incentive mechanism is deemed too expensive, because it would initially mean shutting down more institutions than could be financed with the available resources. Failing some reforms, however, regulators might have to keep insolvent institutions open, and, given continued deposit insurance coverage, these institutions would face no effective market discipline.
The no-bailout condition is also relevant to government borrowing, as, for example, in the context of EMU. There has been concern that EMU may further weaken the fiscal balances of countries that have been following unsustainable fiscal policies.5 With EMU, governments of member countries borrow in their common currency, the ECU. If effective market discipline could be established, high-deficit countries would be subject to rising interest rate spreads reflecting the greater default risk associated with deficit policies, and these spreads would spur fiscal adjustment. There is some concern, however, that the possibility of a bailout may thwart market discipline. Although the Maastricht agreement explicitly prohibits bailouts, this prohibition may not be fully credible. As European investors’ portfolios become increasingly diversified as a result of EMU, the abolition of capital controls, and the Single Market program for financial services, it will become increasingly difficult for governments to stand back and watch another member government default: a bailout by member governments could therefore become more likely (Bovenberg, Kremers, and Masson (1991)). There is evidence that membership in the EC is itself associated with a perceived increase in the probability of a bailout. For instance, it has been argued (Xafa (1990)) that Greek membership in the EC may partly explain its escape from the kind of financial crises experienced by other countries with similar debt and debt service ratios (such as Mexico and Turkey). The deepening of the EC implies not only that member countries could have a stronger incentive to bail out a financially troubled member but also that a wider range of means could be available to do so discreetly. In particular, the increasing size of the EC’s budget and provisions for interregional transfers may permit a thinly disguised bailout. Moreover, the establishment of a European Central Bank (ECB) may provide the means for a bailout if the bank is not given adequate independence: an ECB could be pressured to support the price of a near-insolvent member’s debt or to provide financing for a more general bailout. These dangers point to the importance of ensuring a fully autonomous ECB, with a clear mandate for price stability and not subject to influence by member governments. This principle was formally recognized in the Maastricht agreement but requires concordant actions by member governments and the bank’s management to make the ECB’s autonomy credible.
Another important instance in which an implicit bailout may have thwarted market discipline is how international policy coordination may have protected the United States from the consequences of its fiscal policies in the second half of the 1980s. It has been argued that the coordination of exchange rate management since 1985 “has been the cover under which other countries finance the U.S. budget and trade deficits, thereby protecting the United States from the consequences of its fiscal policy” and preventing market forces from forcing it “into more fundamental fiscal contraction” (Fischer (1990), p. 107).
The origins of the debt crisis of the 1980s provide another example of bailouts and market discipline. The prospect of a bailout may have abetted the excessive lending of the 1970s, which set the scene for the crisis. Some element of bailout is built into creditor countries’ tax structures, in that loan write-offs are deductible. In some countries, notably France and Germany, provisioning against questionable sovereign loans is also tax deductible (Bird (1989)). In these respects, the fiscal authorities act as a “silent partner” in risky ventures. Deposit insurance may have played a similar role, because governments essentially guaranteed the deposit liabilities of creditor banks. Banks could also hope to benefit from official debt reduction through an increased probability of repayment of their own claims. Unless the principle of equal treatment of creditors is adhered to strictly, banks may expect official debt reduction to reduce their losses, and market discipline of bank lending would be ineffective.
Lending by international financial institutions (IFIs) would constitute a bailout if it enables banks to be repaid while the IFIs’ loans are not. To avoid the market distortion following from this kind of bailout means insisting that IFIs’ loans to heavily indebted countries be serviced in full and imposing conditionaliy on those loans. If the latter criteria are met, lending by IFIs might actually strengthen market discipline by facilitating the rescheduling of debt and thus reducing the probability that the borrower will escape responsibility for the debt through debt repudiation (Folkerts-Landau (1985)). Similarly, the IFIs’ support for debt reduction can either strengthen or weaken market discipline: if the funds set aside for this purpose are repaid, debt reduction can be a way of converting outstanding debt into a form whose servicing can be more readily enforced—or, at worst, a way of formally recognizing a situation in which debt is not being serviced. The availability of such facilities may increase lenders’ prospects of repayment and therefore may increase their willingness to lend to developing countries. If repayment ultimately comes from the debtor’s own resources, rather than from a transfer from the IFIs to other creditors, it can strengthen not weaken market discipline.
The prospect of a bailout is also a reason behind the “soft budget constraint” that typifies state enterprises in socialist economies (Kornai (1980)). Even as reforms in these countries proceed, banks often continue to lend to insolvent enterprises in the belief that the authorities will make good on the loans. Given the prospect of a bailout, managers’ and workers’ incentives for effort, initiative, and painful restructuring may be limited. Some of the results may be inefficiency, overmanning, and excessive risk-taking (Schaffer (1989), Hardy (1992)). Establishing market discipline in this context is difficult, however. First, there is the credibility problem: even if the authorities want to promote efficiency by committing themselves not to bail out insolvent enterprises, such a commitment may not be credible, since once a large enterprise’s failure is imminent, the government’s best response in view of the possible losses of output and employment may be to rescue the enterprise (Schaffer (1989), Hardy (1992)). Moreover, a commitment not to cover loan losses, if it is believed by lenders, may lead to a general contraction of credit in the economy (Calvo and Coricelli (1992))—particularly if there are contagion effects because enterprises’ creditworthiness cannot be accurately assessed. Borrowers may therefore not believe that the authorities will forsake an enterprise.6
The problem of establishing market discipline is exacerbated by the “bad loan problem” of banks in many formerly planned economies (FPEs): the legacy of lending on political principles, or lending for projects evaluated at prices distorted by subsidies, may have left many banks insolvent. It is widely agreed that a one-shot recapitalization of the banks is needed to shake off this legacy and make them viable, but how big a recapitalization is unknown. The size depends on what proportion of loans turns out to be nonperforming—which itself depends on the nature of the economic restructuring that takes place. Thus, no final solution has been found to the bad loan problem in any of the FPEs of central and eastern Europe (IMF (1992)). Attempts have been made, as in Czechoslovakia, to avoid the moral hazard problem by setting a cutoff date and committing the government to compensating banks only for loan losses incurred before that date. It is not clear how credible such cutoff rules will be, however, as banks may well believe that they will also be compensated if they run into serious problems at a later date.
Minimizing the moral hazard problem associated with a safety net can be viewed as a problem of setting the net at the right level. There are some individuals whose protection may be regarded as socially unavoidable or ethically desirable, while there are others who could withstand the associated losses and, if unprotected, could perform a valuable monitoring function. It is important to demarcate these groups and design rules for intervention accordingly. For example, the imposition of standardized, risk-based capital requirements on financial institutions may be viewed as a way to raise the safety net, so that losses are initially borne by holders of equity and subordinated debt, before the deposit insurance plan assumes any liability. Deposit insurance itself can be seen as a way of ensuring that depositors, not banks, are bailed out, so that banks’ other creditors must take their losses. Recent proposals by the U.S. Treasury would strengthen this mechanism in the United States by exposing non-deposit creditors to normal pro rata bankruptcy losses even if uninsured deposits are made whole by the Federal Deposit Insurance Corporation. The rates of return that banks must offer on nondeposit sources of financing then reflect the risks to which the bank is exposed: for example, in the United States the cost of raising subordinated notes has recently been 400–500 basis points above the rates on comparable U.S. Treasury notes (see Leipold and others (1991)).
A similar consideration is involved in the establishment of social safety nets in FPEs: how to bail out individuals but not enterprises. An unemployment insurance plan may be viewed as an essential step in making enterprise financial discipline credible, by making it more likely that the government would stand firm on a commitment not to bail out failing enterprises (Hardy (1992)). Federally supported social safety nets may play a similar role in reinforcing market discipline of state or provincial government fiscal policy, by establishing a mechanism whereby individuals’ incomes can be maintained without bailing out a government and its creditors.
Establishing credibility for a no-bailout rule is perhaps the most crucial task in establishing effective market discipline. In some cases, a bailout may be unavoidable, in some cases even desirable; as such, some degree of direct control over the borrower’s behavior may be necessary. In addition, any bailout should also impose sufficient costs on imprudent borrowers and lenders such that not all incentive for prudent behavior is destroyed. This means, for example, closing off avenues for implicit, discreet bailouts and ensuring that any bailout that does occur embarrasses the parties concerned.7
As mentioned earlier, market discipline involves two steps: initially, the borrower faces a rising interest rate spread; ultimately, access to further credit is denied. The second stage, although dictated by the logic of the situation, is harsh. Some argue that if market discipline depends on market exclusion it is not an acceptable mechanism of control (Delors Committee (1989), Lamfalussy (1989)). Thus, a condition for the smooth operation of market discipline is that borrowers respond to interest rates in time to avoid a crisis.
A rational agent, when faced with a higher interest rate, would respond with reduced borrowing in order to get back onto a sustainable path. Indeed, if a rational agent possessed as much information as the lenders did, it would not even wait for the market signal: a rational borrower would anticipate that further borrowing would lead to a higher interest rate spread, and, taking that knowledge into account, would refrain from unsustainable borrowing. In some cases, this anticipatory mechanism does appear to work—for example, the New York City government recently decided to cut its borrowing in order to uphold its bond rating (Purdum (1992)).
Why might a borrower fail either to respond to market signals or to anticipate them? There are two main reasons. First, if the borrower is a government, its response to market signals may not be the same as that of a private agent, depending on the nature of the public choice mechanism. In particular, governments may have excessively short time horizons—because they are primarily concerned with reelection—and may therefore have a bias toward excessive deficits, which leave their successors with a debt burden. This policy can also be undertaken intentionally. For example, a government might try to saddle its successor with a large public debt in order to tie the successor government’s hand and limit its ability to carry out spending that does not conform to the current government’s preferences (Persson and Svensson (1989); Alesina and Tabellini (1990)). It is also possible that if governments are assembled from weak coalitions of political parties, or of legislators representing various special interest groups, they may be less able to resist compromises that satisfy the coalition members’ demands for spending projects and tax relief, at the expense of increasing the overall deficit (Roubini and Sachs (1989)). These imperfections in the public choice mechanism also weaken government’s responsiveness to market discipline.
A second reason market discipline might fail because of borrowers’ behavior is that the borrower may not intend to repay the debt. In this case, a rising interest rate is immaterial. The problem of adverse selection—meaning that some borrowers do not plan to repay their debts and that the lender may not be able to identify these borrowers—has been used to explain credit rationing in private credit markets (Stiglitz and Weiss (1981)). There is no limit to how much a borrower who plans to be delinquent would like to borrow; thus, credit must be rationed. The same logic applies to borrowers who believe they will likely be insolvent: they have nothing to lose by borrowing, even at a high interest rate. To illustrate this principle, consider banks that are at or near the point of insolvency: even if they must pay high interest rates to attract deposits, this does not much affect their behavior since they do not expect to survive to pay these rates. Another example is the use of interest rates to ration credit in FPEs, where many of the state enterprises are near insolvency. In the absence of an adequate credit evaluation system, high interest rates may provide a disincentive for solvent enterprises to borrow, while insolvent enterprises will still want to borrow large amounts because they probably will not repay the loan in any event (Dooley and Isard (1991)). In short, market discipline does not work through interest rate spreads if borrowers are near insolvency; it can only work by excluding insolvent borrowers from the market.
In this section, it has been shown that many of the same principles apply to diverse examples of market discipline. Market discipline depends on open capital markets; on lenders’ having relevant information about a borrower’s existing liabilities; on no anticipation of a bailout; and on a borrower’s responding to market signals. These conditions are necessary to ensure that the markets reflect borrowing behavior and that borrowers remain on a sustainable path. In the next section, some empirical evidence will be brought to bear on the effectiveness of market discipline.
III. Some Evidence
It is difficult to establish empirically how well markets discipline borrowers. Evidence can be drawn from a variety of sources. One source is the experience of federal unions in which lower-level governments are subject to varying degrees of market discipline and direct regulation. A second pertains to sovereign debt, particularly the extent to which interest rate spreads, secondary-market prices, and market access reflect a debtor country’s fiscal decisions. A third type of evidence is drawn from tests of optimizing models of fiscal policy: if these models are consistent with the data, it would suggest that governments are more likely to respond to changes in the cost of borrowing.
The experience of federal unions offers a variety of different examples of the role of market discipline. The degree of autonomy granted to lower-level governments differs widely among countries. For example, in Australia, any borrowing by a state government must receive formal approval from a central government body. In Germany, likewise, the Länder have little fiscal autonomy (Lamfalussy (1989); Bishop, Damrau, and Miller (1989)). In the United States and Switzerland, the deficits and debts of the states or cantons are not restricted by the center, but other restrictions do exist: all but 12 of the U.S. state governments are subject to formal fiscal restraints, consisting of balanced-budget requirements, debt limits, or both. In Canada, there are no legal limitations on borrowing by the provincial governments or their agencies.
Thus, international experience reflects a combination of fiscal rules and market discipline. The diversity of rules itself suggests that there is no clear case for constitutional limits on or binding central control of the deficits of lower-level governments. Moreover, when different countries are compared, those with stricter rules do not generally have more appropriate fiscal policies. If anything, the opposite tendency is true. In Australia, whose state governments have perhaps the least autonomy among those mentioned, there has been chronic concern at the excessive borrowing of the two most populous states (New South Wales and Victoria). In Canada, by contrast, market-based fiscal discipline appears to have worked relatively well in the absence of binding restrictions.
The same lack of systematic beneficial effects of binding rules appears when comparing different states within the United States, with its diversity of fiscal rules. Von Hagen (1991) found that states with more stringent fiscal rules differed little in their levels of debt or borrowing and that more stringent limits were actually associated with a greater frequency of extreme outcomes (very high or very low levels of debt or borrowing).
Market-based discipline requires that interest rate spreads reflect the differences in credit risk associated with differences in fiscal laxity. In federal states with some reliance on market discipline, markets do differentiate among government units. For example, in Canada, there are noticeable spreads among bonds issued by different provinces and their agencies, as illustrated in Figure 5.8 Anecdotal evidence suggests that budgetary policies affect these spreads—as witnessed by the downgrading of Ontario’s Aaa rating in the wake of its 1992 budget.
Figure 5.Canada: Provincial Bond Yield Spreads, January 3, 1992
Source: The Financial Post (January 3, 1992).
Some have argued that these spreads are too small to have a significant effect on fiscal policies (Bredenkamp and Deppler (1990))—perhaps suggesting that bailout (explicit or implicit) is perceived as likely if any province were on the verge of default. However, the narrowness of the spreads may also reflect the anticipatory behavior discussed in the previous section: governments do not wait for their deficits to cause increased spreads but try to maintain a sustainable fiscal stance in order to avoid increasing borrowing costs. This argument is supported by the frequency with which “preserving the province’s credit rating” has been given as a rationale for fiscal austerity (Maslove, Prince, and Doern (1986)). This interpretation can be examined with reference to the actual fiscal performance of the provinces as shown in Figure 6. Although some observers have complained of the rising burden of provincial debt, Figure 6 suggests that even the three most heavily indebted provinces (with the possible exception of Quebec) have not seen sharply rising debt ratios. Moreover, by the standards of national governments, the overall debt ratios are quite low, and provincial budgetary imbalances are dwarfed by those of the federal government (see Figure 7). Thus, the low interprovincial spreads may simply reflect the fact that the differences in debt ratios are not enough to cause substantial differences in default risks. This seems to support the view that “fiscal prudence is inversely proportional to the authorities’ leverage over monetary policy, that is the access to the inflation tax” (Bredenkamp and Deppler (1990, p. 363)).
Figure 6.Canada: Debts of Selected Provinces, 1969–88
Source: Ip (1991).
Figure 7.Canada: Debts of Federal Government and Provincial-Local Hospital Sector
Source: Ip (1991).
In the U.S. context, some formal empirical studies have explored the sensitivity of yield spreads to fiscal behavior. The spreads faced by the state governments are shown in Table 1. Liu and Thakor (1984) examined a cross section of 38 U.S. states and found that both total and per capita debt had a significant effect on both a state’s bond rating and the interest rate spread it faced. Goldstein and Woglom (1992) examined the determinants of yield spreads for general obligation bonds issued by state governments. They found not only that fiscal variables had the predicted effect on the interest rate spread but that this effect increased with the amount of borrowing, as implied by the backward-bending supply curve shown in Figure 2. In another paper, Goldstein and Woglom (1991) examined a sample of U.S. municipalities, seeking to explain the yield spread facing them. They found that the ratio of debt to GDP, the deficit, and the trend growth rate of the municipality’s debt all had significant explanatory power in accounting for the yield spread. These and other similar results indicate that interest rates do incorporate information about the borrowing government’s behavior and the resulting credit risks.
How should one interpret the experience of federal unions in assessing the likely strength of the market discipline of other governments—in particular, of the national governments in EMU? Like a federal union, EMU would deny national governments access to central bank financing. Some observers have pointed out, however, that fiscal imbalances typically have been larger among European countries than among government units in most federal states, taking this as evidence that market discipline in the EC would have to deal with much larger imbalances than in most federal states (Lamfalussy (1989)). Policy discussion has focused on convergence among the substantial existing divergences in fiscal positions, it being argued that the imbalances are too great for market forces to rectify, particularly because, with EMU, countries will lose access to seigniorage as a source of financing. It has also been pointed out that the EC budget is small—compared with the federal government budgets of federal states—implying that the EC’s budget may be inadequate to smooth adjustment among the member countries’ economies without generating large budgetary imbalances for the national governments (Eichengreen (1990)). These considerations have led some to argue that budgetary imbalances among member states under EMU would be too great for market discipline to keep in check.
The differences between the circumstances of the EC and federal unions have other interpretations, however. First, the wide differences in the member states’ existing budgetary imbalances partly reflect the differences in these countries’ cost of debt servicing, associated with differences in inflation rates. A convergence of inflation rates under EMU would therefore do much to reduce the member countries’ budgetary imbalances. The assiduous pursuit of price stability by a European Central Bank would reduce these imbalances still further (Bishop (1991)). A second point is that the existing imbalances may also reflect the existing lack of market discipline, as the governments of some member countries (notably Italy and Belgium) have until recently had access to “captive” capital markets, owing to capital controls, and all have had access to bailout through debt monetization. The Single Market program, together with EMU, may therefore strengthen the forces of market discipline. Finally, the small size of the EC budget may actually increase the credibility of the no-bailout clause in the Maastricht agreement, as the resources available for a bailout may be smaller. This consideration suggests the possibility of stronger market discipline in the EC than in many federal states.9
Nevertheless, there is a risk that EMU will still entail a substantial weakening of market discipline. The increased solidarity among the participants in EMU may make a bailout more likely. It is also possible that some heavily indebted EC countries could be viewed “too big to fail,” so the no-bailout commitment included in the Maastricht agreement may not be credible. The loss of exchange rate flexibility inherent in EMU cuts both ways: removing the “soft option” of a partial default through debt monetization and exchange rate depreciation may enforce fiscal responsibility, but it also eliminates the warning signals that exchange market pressure might otherwise provide.10 In summary, although evidence from federal unions suggests that market forces may play an important role in disciplining borrowing in a common currency area, and there is reason to believe that these forces could also be important in Europe after EMU, it is certainly not a reason for complacency about member countries’ fiscal imbalances.
A second source of evidence on the probable effectiveness of market discipline pertains to sovereign lending. The 1980s debt crisis involving developing countries is sometimes cited as evidence that markets cannot discipline borrowers (Delors Committee (1989)). This interpretation is somewhat simplistic, however. To begin with, the external shocks—to commodity prices, interest rates, and economic activity in the industrial countries—to which many indebted developing countries were subjected in the early 1980s were unquestionably large.11 Moreover, the provision of adjustment financing by international financial institutions, by tiding over heavily indebted countries until their ability to service debt was at least partially restored, enabled loans to developing countries to be rescheduled rather than canceled. This financing limited the potential losses for which interest rate spreads needed to compensate (Folkerts-Landau (1985)). There were also elements of a prospective bailout: the creditor banks’ deposit liabilities were guaranteed by deposit insurance, and the tax deductibility of loan losses implied a partial bailout of lenders through the tax system.12 These factors may account for how slowly loan spreads rose in response to the deterioration of the creditworthiness of many sovereign borrowers.
Recent experience also suggests that markets are becoming increasingly effective at discriminating among sovereign borrowers. Country risk analysis generally takes account of variables, such as debt and debt service ratios, that have a bearing on a sovereign borrower’s ability to repay (see Figure 8). One criticism leveled at banks has been that, although they make use of much pertinent information, it is analyzed and interpreted using arbitrary techniques with little scientific basis and little evaluation of the results’ sensitivity to the underlying assumptions. Banks’ risk assessment practices may be improving, however (Bird (1989)).
Figure 8.Criteria for Risk Assessment
Source: Bird (1989), pp. 38–39.
One requirement for effective market discipline is that markets discriminate among borrowers. The restoration of voluntary market lending to some, but not all, Latin American countries—and in particular, to Mexico, Argentina, and Chile (El-Erian (1992))—is an example. Similarly, the markets clearly distinguish among the countries of central and eastern Europe: Hungary and Czechoslovakia, by fulfilling their current debt service obligations, have been able to maintain access to voluntary market financing; Poland, because of its debt servicing difficulties, has been able to obtain only short-term financing; still others, with more serious payments difficulties (Bulgaria and Romania), have been denied market access altogether. At best, however, this discrimination among borrowers is a necessary, but not a sufficient, condition for market forces to play an effective disciplinary role. It is no guarantee that the right borrowers have access to the market nor that borrowers are given the proper incentives to change their behavior.
Attention has also been turned to interest rate spreads and the extent to which they reflect credit risks. Some recent variations in these spreads for selected developing countries are shown in Table 2. The determinants of spreads have also been systematically studied. For example, Sebastian Edwards (1986) tests a simple model of borrowing, using interest rates on both bank loans and bonds for 26 countries in the 1976–80 period. His results are generally supportive of a positive relationship between interest rates and credit risk, and, in particular, they confirm the model’s prediction that the interest rate spread increases with increased borrowing. He also finds that the determination of interest rates is significantly different for bonds and bank loans, consistent with the view that the possibility of rescheduling, as well as the potential for cooperative behavior among banks belonging to a syndicate, reduces the scope for default, implying that the risks associated with bank loans are different from those associated with bonds.
|Average for Eastern European countries||49||50||—|
Another aspect of sovereign debt is the pricing of debt in the secondary market. Evidence shows that the secondary-market valuation of debt responds to debt restructuring arrangements, including both general developments, such as the Brady plan, and country-specific agreements, as well as to variables that bear on these countries’ capacity to service debt (Stone (1990)). Secondary-market valuations of Latin American countries’ debt have recently increased, as these countries’ debts have been restructured and their capacity to service debt has increased (Collyns and others (1992)).
The recent trend toward securitization of lending and the declining role of banks and other financial intermediaries may impinge on financial markets’ ability to discipline borrowers. To the extent that these developments are associated with financial market liberalization, market discipline may be enhanced as the access of sovereign and other borrowers to “captive markets” decreases. However, intermediaries may also be able to specialize in gathering information about borrowers and collaborate in enforcing debt contracts. This consideration suggests that disintermediation may weaken financial discipline, although even more specialized agencies, such as credit-rating agencies, may be doing much to fill the gap. Bailouts are perhaps less likely in a securitized financial system, because the risks associated with particular borrowers may be widely dispersed, reducing the political pressure for a bailout and making it more difficult to implement or justify a discreet, indirect bailout.
One of the critical requirements for market discipline to function smoothly is that a borrower must respond to market signals. In cases in which the borrower is a government, its spending and taxing decisions must be influenced by the interest rate, which determines the intertemporal trade-off between present and future taxes.
Recent empirical work bearing on this issue has centered on testing the hypothesis that government borrowing is consistent with intertemporal optimization. Robert Barro (1979) presented a simple model of optimizing behavior by an infinitely lived government and showed that the model implies tax smoothing—that is, given the assumption that the distortionary effects of taxes increase with the tax rate, a government would appropriately maintain relatively stable tax rates in the face of variations in both government spending and national income. An optimizing government would therefore incur debt during periods of unusually high expenditure (such as wartime) and during cyclical downturns. Barro found that the tax-smoothing hypothesis was borne out by U.S. data since World War I (Barro (1979, 1986)). However, as pointed out by Franco Modigliani (1986), these results are also consistent with other models of fiscal policy, which do not imply that government behaves like an infinitely lived optimizing agent. In particular, Barro’s results largely reflect the observation that U.S. deficits rose during both world wars—a fact that would be unsurprising to many who would nonetheless be skeptical about the optimality of fiscal policy.
Several further explorations of the optimizing model of government have been made recently. Gregory Mankiw (1987) found some results supporting the tax-smoothing hypothesis using U.S. data, but other authors found that these results could not be extended to other industrial countries (Roubini and Sachs (1989), Grilli (1989)) or to developing countries (Roubini (1991)). Thus, evidence in favor of the optimizing model must be characterized as weak and limited.
One potentially important reason that the time paths of government spending, taxation, and borrowing might fail to be optimal is some weakness in the country’s political structure. A study by Nouriel Roubini and Jeffrey Sachs (1989) examined the influence of political structure on a country’s fiscal stance—examining, for instance, whether weak coalition governments have an inherent tendency to run deficits. Their empirical results using Organization for Economic Cooperation and Development data for the 1970s and 1980s provide some confirmation for the hypothesis that political structure matters. Roubini (1991) found similar results using data from developing countries. These results suggest that political factors may make governments behave in nonoptimal ways.
Thus, the optimizing model of fiscal policy finds only limited support from the data. Of course, confirmation of this model is not needed for the notion that governments respond to their borrowing costs to have some validity. This returns to the point, made earlier, that sustainability of policy is a weaker condition than optimality: although optimality generally implies sustainability, the reverse is not true. It is quite conceivable that the distribution of taxes over time is far from optimal—for example, by giving insufficient weight to the tax burdens faced by future generations—but that the policies will not lead to a total collapse of the state’s finances. In short, there is no conclusive evidence on whether a government is likely to respond to market signals, or whether it is likely to pursue unsustainable policies until fiscal adjustment is forced by the market’s denial of further credit.
Market discipline means that signals from the financial markets can deter a borrower from maintaining an unsustainable path of borrowing. Four general conditions are required for market discipline to be effective and to work smoothly: open capital markets; good information about a borrower’s existing liabilities; no prospect of a bailout; and a borrower’s responsiveness to market signals. The evidence suggests that these conditions may be met under some but not all circumstances. The no-bailout condition appears to be the Achilles’ heel of market discipline, particularly because it is difficult to make such a commitment credible.
Where the conditions for market discipline are not satisfied, there may be a case for direct control or supervision. Care must be taken, however, since some of the conditions that undermine market discipline may also thwart direct controls. For example, the kind of government that is likely to be unresponsive to market discipline, one that persistently incurs unsustainable deficits and limits the information available to lenders, is also likely to seek ways of avoiding surveillance and of circumventing any direct legal limits on its deficits. It is important to remember, for example, that the New York City default of 1974 took place despite a constitutional balanced-budget requirement.
Therefore, one must not view coordination, surveillance, and legal restrictions on borrowing as an alternative way to prevent unsustainable policies. Rather, where these nonmarket mechanisms are needed, they should be complemented by the strengthening of market forces. For example, capital market and capital account restrictions should, where possible, be removed in order to prevent a captive market and strengthen the market’s role as a disciplinarian. The relevant information bearing on a country’s creditworthiness should be disseminated to market participants so that it can be incorporated into market prices. The costs and benefits of a bailout should be evaluated, as well as the circumstances under which a bailout would occur; the scope of such a bailout should also be determined with a view to limiting the likelihood and size of a bailout, as well as the attendant moral hazard problems.
Although one cannot rely solely on market forces to prevent unsustainable behavior, the financial markets have the potential to play an important disciplinary role. The greater the extent to which institutions are designed to work with market forces, rather than suppress them, the more likely it is to increase their effectiveness, as well as enhance the efficiency and stability of the financial system.
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This rules out a situation in which a borrower follows a Ponzi game (see Bartolini and Cottarelli (1991)). It does not require that default never occur—it may still occur if the debtor is hit by unusually large adverse shocks.
In Kenen’s (1992) terminology, market discipline can address only the solvency problem and not the stabilization and the policy mix problems.
The upper part of the backward-bending curve reflects the fact that if the interest rate were at a level higher than rmax this would further increase the default risk and further reduce the amount that lenders would be prepared to provide at that rate. This part of the curve is economically irrelevant, though, since the corresponding points on the lower part of the curve offer the same return to the lender at a lower cost to the borrower.
Nominal rather than real interest rate spreads are shown because, within the EMS, the former reflect the risks of realignment that might be associated with divergent fiscal positions.
Corsetti and Roubini (1991) suggest that Italy, Belgium, Ireland, and Greece might fall into this category.
Governments’ ability to follow through may also be limited. For example, anecdotal evidence from Poland suggests that in some cases the courts may be unwilling to enforce debt contracts, even though the government itself has stated the intention of making bankruptcy possible.
A contrary idea of “constructive ambiguity”—deliberately creating uncertainty about the scope of a possible bailout—is sometimes expressed (see Leipold and others (1991)). The point is debatable, but it would appear to be more difficult to establish credibility for an ambiguous commitment.
The spreads shown in Figure 5 are for bonds whose maturity is eight or nine years. This range was chosen because of the availability of comparable data for all ten provinces.
Another typical aspect of many federal systems is an elaborate structure of conditional and unconditional intergovernmental transfers. This structure, however, may also tend to undermine fiscal discipline, since it dissociates the collection of taxes from the provision of services and, in the case of conditional grants, subsidizes the expenditures of the lower levels of government.
For a discussion of these issues, also see Frenkel and Goldstein (1991a).
Moreover, in the 1970s there was not yet a wide range of market-based hedging instruments with which indebted developing countries could hedge against such shocks; see Mathieson and others (1989).
This applies to any bank lending, not just sovereign lending.