Chapter

An Introduction to Analytical Issues in Debt

Editor(s):
Peter Wickham, Jacob Frenkel, and Michael Dooley
Published Date:
March 1989
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Author(s)
JACOB A. FRENKEL, MICHAEL P. DOOLEY and PETER WICKHAM* 

IN THE AUTUMN OF 1982 Mexican banks in New York encountered increasing difficulties in meeting their obligations to repay maturing interbank loans. This announcement sent a strong pulse through the delicate web of international financial markets. A liquidity crisis for a debtor as important as Mexico placed the economic viability of other developing countries in doubt as well and threatened to disrupt the trust that a modern credit market operates on. While Federal Reserve officials took the threat very seriously, there were well-known and tested procedures to handle such contingencies. The Fed quickly stepped in to protect the system and provide time to find a more permanent solution.

After eight years, the international economic system is still in search of a lasting solution to the debt problem. The general outlines of the problem are by now familiar. Countries that the Fund classifies as having recent debt-servicing difficulties have seen their external debt grow from US$538 billion in 1982 to US$726 billion at the end of 1988. To get some feel for the size of this debt, the end-1988 debt total was equal to about 47 percent of GNP for these countries. Interest payments made equaled about 18 percent of exports. For a variety of reasons the economic performance of these countries has been far below their historical norms. Real GNP has grown at an average rate of only 2 percent since 1982, while per capita GNP has grown even more slowly. Inflation has in many cases soared as fiscal authorities have attempted to cope with internal demands and debt service payments.

The management and staff of the Fund have focused much of their effort in recent years on coming to grips with these problems. Even a cursory investigation of the issues immediately points up the diversity of problems facing debtor countries. Low income countries in Africa, owing the bulk of their debt to official creditors, face problems fundamentally different from those of middle income countries in Latin America with heavy debt to commercial banks. The Fund’s case-by-case approach in assisting member countries reflects the fact that no rigid and universal prescription will fit the needs of all member countries.

Nevertheless, research efforts in the Fund have also focused a great deal of attention on the common analytical elements that might be useful in clarifying thinking about the debt problem. A sample of this work, a sample that we hope will have lasting value, is reproduced in this volume. The last chapter is not a simple blueprint for a solution to the debt problem. We do not believe that a simple answer exists. But we do believe that, as we go to print in the summer of 1989, new initiatives involving debt and debt-service reduction techniques hold the best promise thus far in finding a lasting solution to the problems of debtor countries. We hope that the reader will be struck by the development of thinking on the problem and recognize that the end of the volume is not the end of the story. The support given to research at the Fund will continue to allow further development of these important analytical problems.

The selection of papers for this volume was difficult and involved a degree of arbitrariness. We have tended to favor papers dealing with the conceptual issues involved in analyzing debt problems, at a cost, however, of having to omit papers dealing more directly with operational issues and implications. We would like to acknowledge in particular the work undertaken in the latter area by colleagues in the Fund’s Exchange and Trade Relations Department under the direction of Alan Whittome (Counsellor and Director) and Helen Junz (Deputy Director).

The following section of the introduction contains a guide to the book with a summary of each paper and an examination of the links to be found between them. A final few paragraphs bring matters up to date.

About two years had elapsed since U.S. Secretary of the Treasury Baker’s speech at the 1985 IMF-World Bank Annual Meeting in Seoul when Max Corden and Michael Dooley wrote the first paper in this volume. The Baker Plan, as the proposals on the debt strategy made in the speech became known, was concerned with the disappointing growth performance in heavily indebted developing countries and argued for more comprehensive programs of reform by the debtors, which, together with substantial additional financial support from official and private creditors, would permit countries to grow out of their debt problems. Against this background the authors set out to review the options for dealing with developing countries’ debt. The paper they prepared, a revised version of which appears here, served as a basis for a seminar of the Fund’s Executive Board held in February 1988. Starting out with a review of the debt situation as they then saw it, the authors next examined how a country might grow out of debt and what effect concerted lending by commercial banks and “better” policies might have in heavily indebted countries. They followed this with an examination of market-based ways of transforming debt (e.g., debt buy-backs and debt-equity swaps), before turning to debt relief, and the possible establishment of an international debt facility. Many readers will find this nontechnical paper an excellent and evenhanded overview of the issues involved in the “debt crisis.”

Joshua Greene reminds us in his paper that while much of the literature has concerned commercial debt and the debt problems of middle-income countries, mounting debt and debt-servicing difficulties in low income countries, where official debt predominates, have become worrying. His paper focuses particularly on the situation in sub-Saharan Africa, detailing both the origins of the problem, its size, and the initial response to it from countries in the region and the international community. He then looks at recent initiatives from the Fund and the World Bank to provide concessional finance for adjustment programs, as well as the June 1988 Group of Seven agreement in Toronto to reduce debt-service obligations. His paper concludes by analyzing further steps that might help countries in the sub-Saharan region.

Concern with the fall of investment in many of the heavily indebted middle-income developing countries after 1982 motivates the next paper in the volume. Michael Dooley argues that the markets’ current valuation of existing debt may well have discouraged real investment in these countries. Potential investors must consider what will happen to their new financial claims if existing claims are trading at a discount in the market. The cost of investing in physical plants and equipment will not be affected by the discount, but since new financial claims will not be subordinated voluntarily to old financial claims, their prices will be equalized at near the market discount. Many domestic investment projects that would have been viable when claims were valued at par become unprofitable when there is a market discount; the result will be a fall in real gross investment.

There follow two theoretical papers that extend the literature on international lending and country risk. In the first of these, Joshua Aizenman starts from the premise that country risk associated with lending to sovereign states brings about an equilibrium in international credit markets in which flows are limited by the default or repudiation penalties. The best approach that a borrower can take to attracting funds appears to be a pre-commitment not to default on contracts, but the author considers that the commitment cannot be regarded as credible since a time-consistent policy would weigh the costs and benefits of default at each point in time. Default penalties take the form of restrictions on trade in goods, services, and financial assets, and can be expected to be higher the more open the economy is to such trade. Aizenman then argues that policy measures to increase the openness of the economy, can, by making potential default penalties higher, influence the calculus of creditors and lead to larger flows of foreign credit to the economy than would otherwise take place.

In the second of the two papers, Aizenman and Eduardo Borensztein start from the position in which country-risk considerations have already led to effective credit rationing and to low investment in developing countries. The authors seek to identify conditions under which renewed lending may benefit both developed and developing countries by taking advantage of the trade repercussions of financial flows. The latter stem from the fact that an increase in lending generates an increase in the debtor countries’ demand for imported capital goods. Therefore, a basis exists for mutually beneficial loans, provided a substantial part of these resources is used for investment. To ensure this, it may be necessary to attach conditions to the new loans. Even then, a further obstacle must be overcome. The increase in export demand, or more generally a favorable shift in the terms of trade, made possible by the new loans, benefit the creditor countries overall but not the banks directly. Aizenman and Borensztein therefore conclude that there may be a policy role for creditor country governments to induce the private banks to be forthcoming with new loans.

A third paper by Michael Dooley provides a framework for analyzing market pricing of external debt, which can be used to evaluate proposals to execute buy-backs or similar debt operations. Central to the paper and to others that follow in this volume is the notion that the aggregate market value of claims on a debtor country reflect the expected present value of transfers that will be made available over time by the country to creditors. With buy-backs financed by third parties, additional resources are available to a debtor country. As a result, the buy-back operation will not only reduce the contractual value of debt but will reduce the market discount, leading to capital gains for creditors and a possible increase in domestic investment. Self-financed buy-backs, on the other hand, do not increase resources available to the debtor, so that such operations, while reducing the contractual value of debt, may not improve the investment climate and can increase the market discount.

Max Corden makes his second contribution to the volume with his “An International Debt Facility?” paper. He was intrigued by the various proposals to set up a facility or authority that would buy up debt at a discount and write down its contractual value. But, in typical fashion, he wondered whether the pros and cons had been fully thought through: note his insistence on a question mark in the title. The result of his musings is the present dispassionately argued paper, which analyzes how the debtor countries, the creditor banks, and the “owners” of the debt facility are each affected by the debt transactions undertaken. Particular attention is paid to the prices at which debt transactions may take place, whether remaining debt held by creditor banks is subordinated or not, whether debtor countries’ access to the facility should have strings attached, and how the problem of moral hazard can be confronted. The reader will appreciate the importance of these issues in light of proposals to modify the debt strategy that attracted so much attention at the Spring 1989 Meetings of the Governors of the International Monetary Fund and the World Bank.

The next three papers examine the nature of debt contracts associated with loans to sovereign countries and the theoretical issues concerned with modifying or renegotiating the terms of the contracts. In the first of these, Guillermo Calvo shows that in drawing up debt contracts there may be incentives for lenders to settle on relatively low default penalties and thus for the borrowers to take on more debt than they otherwise would. But even if contracts are optimal in terms of interest rates and default penalties, it is argued that they are bound to be time inconsistent because it will always be in the interest of creditors to maximize the probability of repayment by raising the stakes after the contract is signed. There is strong reason, it is argued, for an arbitrator to exercise caution if called in by the contending parties in a contract dispute. The author then proceeds to argue that debt relief could very well be a characteristic of optimal debt contracts. First he considers that contracts are normally contingent on the likely “states of nature.” If actual events are widely out of line with expectations held when the contracts were entered into, then there is a prima facie case for reexamining the contract’s provisions. In the case of bad “states of nature” from the borrower’s viewpoint, this reexamination means considering debt relief. The argument can be strengthened further if recognition is given to the notion of implicit contracts in international lending agreements.

Jeremy Bulow and Kenneth Rogoff extend their earlier work on debt recontracting to include multilateral bargaining among debtors, private lenders, and creditor-country governments. Each of the parties faces different benefits and costs in the event of debt repudiation. The repudiating debtor risks losing future access to international financial markets and being forced by sanctions to trade inefficiently. Apart from arguments based on the need for a response “pour encourager les autres” to keep paying, private creditors do not gain directly from cutting a country’s access to the international financial markets. However, exporters and consumers in creditor countries may well suffer if trade sanctions are imposed, so that, in the interest of many of their constituents, creditor-country governments may regard debt rescheduling as desirable. Creditor-country governments may even be tempted into making sidepayments to encourage rescheduling, although to which of the other parties the benefits accrue depends critically on whether the sidepayments are anticipated or not.

In his paper on debt renegotiation, Kenneth Kletzer examines the issue of whether in the face of recalcitrant behavior by sovereign debtors the optimal response by creditors is to provide additional loans. He considers the argument that additional loans can reduce the probability of default on outstanding debt. With symmetric information, he finds in his model that renegotiating contracts will reduce current debt service but will never result in additional inflows. Under information asymmetries, an equilibrium may exist in which new inflows occur but this will depend on the occurrence or otherwise of good “states of nature” over time.

The next group of papers explores theoretical aspects of voluntary debt reduction and relief and centers on incentives facing creditors and debtors. These papers consider whether debt reduction or other forms of debt relief increase the incentives for a debtor country to “adjust” and invest (reform) to the benefit of debtors and creditors alike. Max Corden analyzes the concept of “capacity to pay,” which he defines as the excess of income over some minimal consumption level with debt service and investment forming claims on the excess each period. Using simple graphical tools he shows that in certain circumstances it may indeed be advantageous for creditors to grant relief. However, he also shows that the conditions required will not necessarily be satisfied.

Paul Krugman organizes his thoughts about debt forgiveness around the idea of a “debt relief Laffer curve.” Just as governments may sometimes actually increase revenues by reducing tax rates, creditors may sometimes increase expected payments by forgiving part of a country’s debt. The argument that debt relief benefits all parties presumes that the debtor country is over the hump and on the wrong side of the “debt relief Laffer curve.” Krugman then considers various market-based schemes for debt-reduction, which are often pictured as being able to harvest secondary-market discounts to the benefit of both creditors and debtors. He concludes that this will be the case only if the debtor country is again over the hump in the Laffer curve, the same circumstances under which unilateral debt forgiveness is in the interests of creditors.

Elhanan Helpman’s paper provides a painstaking and systematic approach to the issues involved in voluntary debt reduction. His model shows that debt reduction may raise or lower investment, depending on the degree of international capital mobility and the degree of risk aversion. In addition, the possibility of multiple equilibria at different investment levels cannot be excluded. Understanding these interactions can help to identify circumstances in which voluntary debt reduction in the collective interest of creditors may take place. The author then considers if cooperation among creditors is necessary in order for creditors collectively to provide any debt reduction warranted. This will not be the case, he argues, if multiple equilibria are absent and the face value of debt is sufficiently high.

There follows in the volume a series of more narrowly focused papers dealing with the means and ways of transforming or reducing debt.

Michael Blackwell and Simon Nocera provide a concise appraisal of how debt-equity swaps operate, who benefits from them, and how they influence the country operating the program. While acknowledging the benefits that creditors and indebted countries can realize from debt-equity swaps, the authors point out that such conversions do not necessarily provide additional foreign funds and can, through the implications for monetary and fiscal policy in the debtor country, lead to inflation.

Debt buy-backs and exchanges are the focus of attention in the next two papers. Carlos Rodriguez considers the case in which a country runs a fixed trade surplus which it devotes to debt service, an amount that falls short of that required to fully service outstanding debt. There is thus excess debt which will grow over time through interest rollovers with consequent effects on the price at which debt can be traded. The country is assumed to have an additional amount of cash which it can use for buy-backs now and in the future. Competitive creditors are assumed to have full information on the excess debt buy-back strategy which brings with it the implication that the debt can be recovered not at a discount but only at par. Only if creditors are myopic or if they have less than full information about the debtor’s buy-back plan can excess debt be repurchased at a discount.

The paper by David Folkerts-Landau and Carlos Rodriguez analyzes the Mexican debt exchange operation undertaken in 1987. It prices the new partly secured bond using the observed market price on restructured bank debt and derives the reduction in the existing stock of debt achievable through the exchange of secured for unsecured debt. The main lesson from the paper is that, in general, debt exchange operations are equivalent to cash buy-backs in terms of debt and interest rate reduction with a given amount of resources.

The penultimate paper in the volume considers the additional difficulties faced by countries with debt-servicing problems caused by the increased volatility of international interest rates during the 1980s. The interest cost of bank debt to these countries is largely tied to LIBOR, but considerations of creditworthiness and a lack of readily available international reserves have denied indebted countries the opportunity to hedge their exposure to the volatility in LIBOR. David Folkerts-Landau discusses this problem and suggests the use of modified interest rate swaps as a solution to interest rate risk management by indebted developing countries. He shows that credit risk can be virtually eliminated from the swap contract by marking the swap to market periodically. Unlike many other derivative markets, the swap market has enough depth, liquidity, and sufficiently lengthy maturities to accommodate large scale use by sovereign debtors. Hence, it may be the most promising avenue for risk management currently available.

The final paper in the volume by Michael Dooley and Steven Symansky is also a revised version of a paper prepared for a seminar of the Fund’s Executive Board held in January 1989. The paper outlines a framework for evaluating debt reduction in cases where a debtor country is expected to continue to rely on creditors to finance some part of its debt service obligations. It argues that a partition of payments between interest payments on contractual terms and buy-backs of debt and market terms can be thought of as a basic renegotiation of existing contracts. Once this blend of debt reduction and contractual payment is established, market participants can, and presumably do, price alternative menu instruments by equating their expected market values. Thus, the exchange ratio between two financing instruments can be established by pricing their attributes relative to existing debt, for which there is an easily observed market price, and cash.

A renewed sense of urgency in dealing with the debt strategy and the debt situation was underlined by U.S. Secretary of the Treasury Nicholas F. Brady shortly before the April 1989 meeting of the Interim Committee of the International Monetary Fund. At that meeting, it was agreed that the Fund and the Bank should provide appropriate financing to help debt reduction operations in countries undertaking sound economic reforms. In May 1989 the Fund’s Executive Board adopted broad guidelines for the provision of Fund support, and by late July 1989, Fund arrangements involving debt reduction operations had been approved for Mexico, Venezuela, Philippines, and Costa Rica. A general description of the Fund and Bank’s approach to the challenges raised by this new initiative can be found in the August 1989 issue of Finance and Development (Washington: International Monetary Fund and World Bank).

Needless to say, many of the different analytical issues raised in this volume remain in the forefront. A few that seem particularly important include: the “free rider” problem that limits collective behavior by creditors; the negotiating structure and the role of third parties in shaping bargains; the relationship between the “domestic debt problem” and the “extended debt problem”; the relationship between debt reduction and access to new credit and that between debt-service reduction implied by a reduction in the stock of debt and similar relief brought about by a reduction in the rate of interest. Moreover, the linkages between internal and external credit markets and, more generally, the economic linkages among debt, external credit markets, and economic performance in debtor countries deserve further study.

Indeed, in such an important and rapidly growing subject, it is difficult to pause to take stock of existing knowledge. What we know, or think we know, is frequently overtaken by events. We hope this volume spurs others to join in the search for better understanding of these problems and ultimately to write a final chapter to the debt crisis.

Mr. Frenkel is Director of the Research Department of the International Monetary Fund.

Mr. Dooley, Chief of the External Adjustment Division in the Research Department of the IMF, is a graduate of Duquesne University, the University of Delaware, and the Pennsylvania State University.

Mr. Wickham is Assistant to the Director of the Fund’s Research Department. He did his undergraduate work at the University of Essex and pursued his graduate studies at the University of British Columbia and the Johns Hopkins University.

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