In two recent articles Michael Dooley (1988a, b) has provided important analyses of voluntary debt reduction techniques. His argument parallels the well-known Modigliani-Miller (M-M) proposition that the market valuation of a given probability distribution of returns will be unaffected by the composition of claims upon it. For country debt, this distribution is based on the assumption that the country only fails to maintain contractual loan service through inability to pay. This commitment, combined with the (realistic) assumption that full repayment on the contractual terms is highly improbable, effectively transforms the original loan contracts into equity claims on the country’s net exports of goods and services (Dooley (1988a, p. 218)).
If an efficiently operating secondary market in country debt instruments is assumed, this framework ensures that the country must be largely indifferent to debt buy-back schemes. If the buy-back is financed by a third-party benefactor, the benefit will accrue primarily to existing creditors through the enhanced market value of remaining claims to the (unchanged) payments stream (Dooley (1988a, p. 214)). Self-financed buy-backs, however, pre-empt resources from this stream and therefore leave market values substantially unaltered (Dooley (1988a p. 717)).
Although these results provide a valuable reference framework, they share with the M-M propositions the need for essential qualification before policy conclusions can be safely drawn. With other authors already referring to buy-backs as a creditors “boondoggle,” it is important that the limitations of the underlying analysis be emphasized (Bulow and Rogoff (1988)). The interpretation of market discounts is crucial in, this connection.
These articles assume, with less empirical justification than in the M-M context, the framework of an ideally developed financial market. The earlier literature on domestic equity markets (where these conditions are approached) recognized that differential tax treatments compromise the basic proposition that financial structure is irrelevant to market valuation. The circumstances of different “clienteles” of investors had to be considered. Similarly, in the context of the still-developing secondary market for country debt, the relationship between valuation and the position of different groups of participants becomes critical in assessing the financial merits of buy-backs.
Banks, as the preponderant holders of country debt, must decide their optimal level of debt sales in the context of incentives that may be substantially independent of country payment prospects.For instance, “cleaning up” the balance sheet may generate financial benefits beyond the realization value of country loans. Although the banks effectively hold an equity claim on the debtor country’s net export earnings, the contracts are nominally in the form of loans. In poor years, payments streams will need renegotiation, and “concerted” funding will be based on existing “exposure.” These features constitute a tax on country loan income received by banksand should be expected to depress the price at which the debt is traded relative to the “gross” income expectations. Improved bank credit ratings are another possible gain. With such incentives, and aided by tax-deductibility arrangements, bank loan-loss provisioning has resulted in a significant increase in the amount of discounted debt offered to the secondary market. Thus, from an average 35 percent discount in early 1987, the figure reached roughly 60 percent by the end of 1988a development attributed by practitioners to intervening heavy provisioning rather than to changed country prospects (Morgan Guaranty (1988)).
With such incentives on the supply side tending to depress secondary prices, a fully developed market would elicit a demand response from less burdened, “tax-exempt” investors attracted by the prospects of an abnormal return. All the evidence suggests, however, that the secondary debt market is embryonic on the demand side, with few substantial investors willing to contemplate offsetting transactions on the scale required to prevent a fall in prices. It is this condition that offers the potential financial gain from buy-back schemes; governments using national resources or officially borrowed funds would help to “arbitrage away” such profit opportunities. The possibility of beneficial buy-backs when market prices fall below payments prospects therefore deserves stress (Dooley (1988b, p. 717)).
The above has argued the case for buy-backs solely on the basis of financial market considerations, as did the original articles. By questioning the proposition that secondary market prices always reflect country “fundamentals,” it is suggested that buy-back programs may have more merit than some recent articles have recognized. Having raised the issue of the separation of financial and real decisions in the M-M context, however, one must also stress that the major case for buy-backs and overall debt restructuring is probably to be found in the invalidityof that separation in this context. An active program for restructuring debt through the various paths currently being attempted should cut the “deadweight” costs of the debt overhang and its implications. The Bulow-Rogoff (1988, p. 691) condemnation of debt-equity swaps, for instance, seems to assume that the supply of foreign direct investment is likely to be unaffected by whether or not a country has a systematic policy in place for the removal of the debt overhang. Prospects for the real economy will be sensitive to the financial policies followed.
BulowJeremy andKennethRogoff“The Buyback Boondoggle,”Brookings Papers on Economic Activity: 2 (1988) The Brookings Institution (Washington) pp. 675–98.
DooleyMichael P. (1988a) “Buy-Backs and the Market Valuation of External Debt,”Staff Papers International Monetary Fund (Washington) Vol. 35 (June) pp. 215–29.
DooleyMichael P. (1988b) “Self-Financed Buy-Backs and Asset Exchanges,” Staff Papers International Monetary Fund (Washington) Vol. 35 (December) pp. 714–22.
* Mr. Snowden is Lecturer in Economics at the Management School of the University of Lancaster, England.