Analyses of debt buy-backs and alternative techniques of debt or debt service reduction have moved beyond the simple partial equilibrium framework developed in Dooley (1988a, b) in order to address the important issues raised by Snowden. An important lesson from more complete analysis is that, as with all economic problems, the ultimate test of a debt reduction initiative is whether it is an efficient use of scarce resources.
In the context of buy-backs, this criterion suggests several difficult questions. At what cost does a debtor obtain the resources to support debt reduction? After all, debt reduction even on favorable terms is an early retirement of external debt and will in most cases require current resources. Is there an alternative use of these resources that would better meet the debtor’s economic objectives? For example, some authors have argued that domestic investment in the debtor country is a relevant and potentially superior use of resources. What is the relevant bargaining power of debtors, creditors, and interested third parties? It has been argued, for example, that for a given amount of resources, greater debt reduction can be obtained if all creditors agree simultaneously to debt reduction. This would be a bargaining framework explicitly not considered in Dooley (1988a, b). Finally, what is the quantitative significance of the “investment effect” of reducing discounts in secondary markets for a country’s external debt? It seems to me that each of these questions can have different answers for different countries, answers that may change over time.
Although much work remains to be done, I do not share Snowden’s more basic objection to the use of secondary market prices as a useful starting point for any analysis of these issues. In particular, the view that “new money” is a tax on existing debt does not seem useful. In any time period in which the debtor makes partial interest payments, creditors necessarily increase their claims on the debtor by the difference between actual and contractual interest payments. These claims often take the form of new-money securities, but for credit-constrained debtors these claims have generally not involved a transfer of additional resources from creditors to the debtor. Moreover, the new instruments have a market value and thus would not be voluntarily forgiven by individual creditors.
Finally, although secondary markets are not as liquid and well-developed as some other financial markets, this does not mean that prices in this market are biased. Economists are not able to explain foreign exchange rates among industrial countries in terms of “fundamentals,” and individuals’ preferences for currencies undoubtedly reflect a bewildering array of regulatory and tax considerations; but in general one should not conclude from this that in assessing competitive conditions it would be wise to ignore market exchange rates.
Mr. Dooley is Chief of the External Adjustment Division of the Fund’s Research Department.