Chapter

Market Valuation of External Debt

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

Investment in debtor countries depends upon residents’ and nonresidents’ expectations about the future. The market discount on existing debt also reflects the expectation that existing creditors may share a loss. Because it is difficult in international credit arrangements to differentiate between new and old debt, it may not be possible to insulate returns on new investment from an expected loss on existing debt. This inability to “let bygones be bygones” is a potentially important market failure that may lead to misallocation of domestic savings and constrain growth in debtor countries.

FOR 15 HEAVILY INDEBTED COUNTRIES, real gross investment relative to GNP has fallen by about one third in recent years compared with its level in the three-year period before 1982. While many factors have contributed to this decline, the markets’ valuation of the existing debt of these countries may have been an important independent factor in discouraging investment. This argument is based on the proposition that, in evaluating new physical investment opportunities in an indebted country, a resident or nonresident investor must consider his standing relative to existing creditors. When the “property rights” of existing creditors are poorly defined, it is impossible to spell out clearly the rights of new creditors. Since a new credit cannot be convincingly differentiated from existing credits, potential investors must assume that the market value of their new claims will immediately become identical to the value of existing claims. This value is summarized by the market discount on existing debt. The cost of new capital goods does not depend upon the price at which financial claims on existing capital are currently traded. Thus, the fact that claims on new capital will trade at roughly the same discount as existing claims has the result of restraining real investment.

The relevance of market valuation of existing debt to new real investment decisions is a fundamental issue in analyses of the debt crisis. Much of the analytical work on the debt issue has focused on the determinants of countries’ ability and willingness to service their external debts. While such analysis may be useful in choosing among policy options that would alter the debtor’s ability or willingness to service its debt, it tends to distract attention from the fact that the market’s current evaluation of the debtor’s situation is summarized in the price of existing debt. More important, it is this market valuation of existing debt that determines economic behavior.

I. Valuation of Debt

The contractual value of a debt can be defined as the present value of the stream of payments set out in the initial contract between the debtor and creditor on the assumption that such payments will be made with certainty. The market valuation of that contract is the present value of the market’s expectation of the stream of payments that will actually be made under the contract. In most cases the contractual value will be somewhat above the market valuation to cover the possibility that, at some future date, the debtor may be unwilling or unable to carry out his obligations as set out in the contract. For example, if a country pays a 2 percent premium over LIBOR (London Interbank Offer Rate) on a floating rate credit, the contractual value of its debt instruments is above the market’s valuation even at the inception of the contract.

The fact that a country’s debt “sells” at a discount relative to its contractual value is always a problem in the sense that the country would have a larger stock of investment projects that are profitable if there were a smaller discount. This condition, which holds to some extent for most countries, can become a crisis in circumstances where most new domestic investment projects are unprofitable when “penalized” by factors equal to the market discount on existing debt.

Although it seems natural to focus on external debt, it is argued here that all existing debt of residents (private and official) of the debtor country represents a claim on the future output of that country. For this reason substantial market discounts on external debts can be associated with high real interest rates in the debtor country’s domestic credit markets. If external credits are traded at a discount that reflects the expectation that contractual obligations will not be completely satisfied, it is very likely that all existing credits to residents of the debtor countries, including those held by other residents, are also subject to some doubt. In fact, all activities and forms of wealth that are potentially taxable by the debtor country should earn a rate of return that reflects the expected effects of those future taxes. If external debt carries a higher market yield (larger discount) than internal debt, residents should attempt to sell internal debt and purchase external debt (thereby making it internal) until their yields (discounts) are equalized. This arbitrage would be unprofitable only if resident and nonresident investors expected equivalent penalties on similar credits.

II. Existing and New Credits

The importance of the market valuation of existing debt derives from the earlier stated proposition that claims on new physical capital will immediately fall to the same discount as the existing claims. In fact, the problem is even more serious if potentially successful investments are likely to be more heavily taxed in order to satisfy “old” creditors.

The institutional framework that allows such a situation to persist is seriously deficient. In circumstances in which contractual obligations are not expected to be honored, property rights among creditors and debtors are poorly defined. In normal circumstances the hierarchy of claims is established by contract. But if it is expected that all such obligations cannot or will not be discharged, there is no way to tell who will suffer the expected loss. This situation creates uncertainty among new investors as to whether they will be forced to share an expected loss, and is therefore disadvantageous for the borrowing country.

The inability to subordinate existing credits to new credits is the factor that distinguishes the current international debt crisis from the more familiar problems presented in domestic financial arrangements. It is quite common for debtors and creditors to enter into agreements that, in some future circumstance, will be impossible to carry out. The value of such agreements is that they are simple and not dependent, or “contingent,” upon the large number of factors that might affect the debtor’s willingness or ability to carry out the terms of the agreement. The development of contracts that do not depend upon a large number of future conditions facilitates secondary trading of the obligation, thus making such contracts more attractive to creditors. Should the debtor be unable to satisfy the terms of the contract, however, both parties would be uncertain as to how the situation would be resolved.

In the case in which both debtor and creditor share a national legal residence, the conflict is resolved by the courts in a bankruptcy proceeding. Since the general outlines of this solution are known to both parties at the outset, it is reasonable to include this mechanism as an implicit element of the original agreement. Moreover, in the event that some contracts are subordinate to others, it is known how the courts will enforce the property rights of various creditors. The procedure by which a debtor asks the courts to “protect him from his creditors” serves to free the debtor (at perhaps considerable cost) from his obligations.

The view that this procedure “benefits” the domestic debtor derives from the fundamental problem faced by such a debtor in obtaining new credits. In the absence of a bankruptcy proceeding, the debtor’s problem in obtaining new finance is that all potential new creditors will be subject to sharing in the existing “expected” loss, the difference between the market’s valuation of the debtor’s obligations and their contractual value. Regardless of the debtor’s willingness or ability to fulfill his obligations, the behavior of creditors is shaped by the market valuation of the debt. It may be possible to assure some new creditors that their investments will be protected from the legal claims of existing creditors, but it seems unlikely that such assurances would be completely or widely credible as long as substantial discounts on existing credits remain.

The above argument suggests that a key ingredient in the current international debt crisis is the lack of a legal structure that comes into play in cases in which the market valuation falls to a point at which the debtor country is unable to attract new investments in productive capital. In fact, it is not clear which of several national legal systems would decide the property rights of various creditors. In this environment it is impossible convincingly to subordinate existing claims to new claims regardless of what forms these new credits might take.

III. An Investment Problem

The inability to shield the returns on new investments from being tainted by the expected loss on existing credits may result in a slowdown of new investment. Because the debt crisis occurred at a well-defined point in time it seems natural to assume that once some threshold of creditworthiness is reestablished, the situation will return to normal. The “best” solution to the investment problem would be to alter the market valuation of existing credits by improving the outlook for the debtor country. In particular, in cases in which changes in economic policies or structures can contribute to such a revaluation, the implementation of a sound adjustment program is the first priority.

Nevertheless, while some changes in the economic environment could lead to an immediate return to a normal investment climate, not all eventual cures for the debt problem will have this property. In particular, solutions characterized by gradual amortization of debt and a slowly rising market value for remaining debt may not change for a long time the depressed state of domestic investment in debtor countries.

IV. Four Approaches

The distinction between the “investment problem” and the “debt problem” can be illustrated by considering four strategies that could be undertaken by debtors or creditors. Each strategy might eventually eliminate or allocate the expected loss on existing debt, and in that sense resolve the “debt problem,” but these strategies will have different effects on the climate for future real investment in debtor countries. One way to calculate the success of a given strategy in dealing with the “investment problem” would be to consider whether the strategy would alter the market discount on existing debt in order to encourage rates of capital accumulation consistent with acceptable targets for economic growth.

Wait and see. The commercial banks that hold the debt may have strong incentives to carry the existing debt at book value and limit new lending to a portion of accrued interest payments. A popular explanation for this stategy is that, given time, the banks and debtor countries will eventually grow out of the debt problem. Here a distinction must be made between real interest payments and payments that, although classified as interest, in reality reflect accelerated amortization owing to inflation. In an inflationary environment, commercial banks could shrink their exposure by diverting amortization payments implicit in the inflation premium to the purchase of alternative investments, even though the nominal value of the banks’ claims continue to grow at a rate less than the rate of inflation.

For banks whose capital might be exhausted by realizing (writing off) the losses on existing credits, there is no doubt that the strategy of waiting to see whether a good outcome for the country could save the bank from liquidation is preferred to a solution that would involve realizing expected losses immediately. In the interim, as long as governments implicitly or explicitly insure the value of bank liabilities, the banks can continue to attract deposits and carry on normal business. Moreover, by postponing action the nonbank public also avoids the disruption to the payments mechanism that might accompany the failure, or expected failure, of one or several money center banks.

The “wait and see” strategy has an important negative impact on the debtor country. As argued above, the expected but “unallocated” loss on existing external credits will affect current investment decisions. Nonresident investors will assume that their claims will be merged with existing credits. Perhaps more disturbing are the implications for the decisions of residents in allocating their savings. If the government is not expected to be able to service its internal and external debt, a successful domestic investment project would provide an attractive tax base for a hard-pressed fiscal authority. To avoid this potential tax liability residents might choose to send their savings overseas or to direct them to unproductive domestic investments that are difficult for the debtor country’s fiscal authority to tax.

Thus, even as this strategy is successful in “wearing down” the debt, it involves a smaller capital stock for the debtor country for an extended period in cases in which the gap between the market value of existing debt and its contractual value narrows slowly as the existing debt is amortized. The consequences for the capital stock can be quantitatively important because debtor countries stand to lose not only new foreign savings but also some part of the productive domestic investment made possible by domestic savings.

Creditors share expected losses. If creditors were to write off the expected loss without altering the debtor country’s legal obligations, their capital would be partially or completely lost. This strategy is generally not in the interest of the creditor banks. Moreover, the debtor country is no better or worse off as compared to the “wait and see” option discussed above since both the market and contractual values of existing debts are unchanged.

The nonbank private residents of creditor countries may be better off since the uncertainty as to how losses will affect various institutions is removed. Nevertheless, they would also suffer whatever ill effects are associated with the impact of the losses realized by commercial banks on the payments mechanism. This solution does not seem to be clearly in anyone’s interest.

Loss-sharing and debt relief. A third strategy would be for the creditors to write off the expected loss and to relieve or forgive debtor countries’ legal obligations to pay. As argued above, some level of forgiveness would in most cases create conditions under which physical investments profitable in their own right would be undertaken. It seems unlikely that existing creditors will see it in their interest to undertake such an action voluntarily, either as individuals or as a group. It follows that some third party would have to force creditors to take the loss and renegotiate the credits, or what seems more promising, purchase the existing credits and then forgive some part of the debt.

One plan would be to offer to purchase a certain type and amount of debt at an auction where sellers submit offers to sell various amounts at different prices. The purchaser of the debt could also announce that it would replace the existing debt with obligations that had a present value somewhat below the current contractual value, perhaps equal to the auction price. Market participants would anticipate the need to revalue debt not sold and this would of course affect their offers. By manipulating the size of the offer to buy at the auction, the discount on existing debt could be reduced to a level consistent with real investment objectives. The cost of this operation would be the difference between the buying and selling prices obtained by the purchaser.

As part of this strategy, new credits could be better designed to reflect the risks inherent in the debtor’s ability to pay. The value of such credits, however, would probably not be much higher than the expected value of existing credits. Thus, a restructuring of the debt toward equity-type instruments might serve to avoid future problems, but would not in itself significantly reduce the loss that must be realized in order to restore the desired climate for real investment.

This strategy is clearly attractive to the debtor country. Moreover, if we consider banks and nonbanks of creditor countries together, they may, as a group, be better off. A difficult question is whether such a write-off would damage existing debtors’ reputation regarding their willingness to pay or lead other debtors to demand similar treatment. Such considerations may be sufficient to make this an unattractive alternative.

Unilateral partial default. A debtor country could partially default on its obligations in that some payments would be made but the existing legal contracts would not be fully honored. The creditor banks would retain a legal claim on the country, and although this claim would probably be judged “nonperforming” by the regulatory authorities, it is unlikely that the debt would be formally forgiven by creditors. The debtor country would suffer a reduction in its reputation as a potential borrower. Thus, although a partial default might make the country a good risk in terms of ability to pay, creditors (old and new) might doubt the country’s willingness to pay. Moreover, the legal claims on the debtor country would remain and continue to threaten new creditors. The greatest problem with a repudiation strategy is that the long-term reputation of the debtor is damaged.

V. Overview

The market value of existing debt plays a central role in the analysis presented above. This value is important because it summarizes the forecasts of many actual and potential owners of claims on a debtor country. Thus, it provides a ready guide and frees creditors from the need to calculate the true value of external debt. It is useful to provide a model of the factors that might lie behind the market valuation of debt since this allows analysis of the factors that might alter that valuation. But ultimately market valuation depends on the collective wisdom (or ignorance) of those who are willing to risk their wealth in acquiring claims on debtor countries. This is the forecast that will determine the economic behavior of debtors and creditors.

It is sometimes argued that the market value of the external debt of developing countries is depressed by the behavior of existing creditors. For example, commercial banks may face regulatory constraints over the amount of loans to individual countries, creating uncertainty about future lending to a country. If all banks reach this position, or if their desired position is for some reason reduced, the country might be said to have experienced a liquidity crisis. If no new creditors enter the market at this point, the market value of the country’s debt will fall and voluntary new credits will stop. It has been argued that new creditors will not enter the market because, while the new credits will increase the value of the existing credits, most of the benefit will go to the existing creditors who are sometimes called free riders.

This idea is intuitively appealing but ignores straight-forward arbitrage opportunities. Suppose that the market value of claims on a country has fallen to 50 percent of its contractual value, not because the outlook for the country has changed, but because existing creditors are unwilling or unable to provide new credits. A potential new creditor knows that new credits would increase the present value of the existing debt. His strategy should be to agree to buy some of the existing debt at the market discount and then advertise and grant additional new credits. This would cause the market value of existing debts to rise. The new creditor would realize capital gains until the market value of debt again reflected the unchanged outlook for the debtor country. It follows that if an arbitrage opportunity exists, that is, if the expected value of existing debt is above the market valuation, it will be exploited by new creditors. Free riders would be bought out.

Finally, the market value of existing debt is not a good indicator of the extent to which the contractual value of debt would have to fall in order to restore the debtor to normal status in credit markets. At a minimum, as the discussion above suggests, the market’s valuation of debt remaining after a default or some forgiveness of existing debt would depend on a whole set of new expectations about the future behavior of the debtor country and its creditors.

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.

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