Chapter

3 Debt and Asset Management and Financial Crises: Sellers Beware

Editor(s):
D. Folkerts-Landau, and Marcel Cassard
Published Date:
July 2000
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Author(s)
Michael P. Dooley

The analytical framework presented below suggests that there may be good reasons for most governments to follow the ultra-conservative debt management strategy observed in industrial countries. Further research and empirical work is needed to translate the model into policy recommendations. I offer one interpretation that seems to me worth careful consideration.

In practical terms, the government should limit its debt to a homogeneous long-term, domestic currency-denominated liability. Moreover, the government should avoid leverage that is generated, for example, by sterilized exchange market intervention. Implicit or contingent liabilities are particularly important to identify and control. In cases where leverage is useful, for example, most net debtors will want to hold foreign exchange transactions balances; the covariance between assets and liabilities should be exploited to minimize the variance of net worth.

The primary reason for advocating a single class of debt is to avoid an adverse selection problem for sovereign credits. When there is more than one class of creditor and when there is some chance of a default, the expected value of a credit to the creditor depends on his or her bargaining power during recontracting. It follows that as the probability of default rises, “tough” creditors will offer better terms. The problem for debt management in developing countries is that these relatively good terms are easily confused with good terms that are justified by better commitment mechanisms. Market prices for alternative debt instruments are not a reliable guide to the risk to the debtor; market prices for a single class of debt are more informative. A straightforward way to exploit this information is to issue only one class of debt.

The debt should be denominated in domestic currency because unpredictable changes in real exchange rates generate large changes in the foreign currency value of government receipts. The obvious problem with a single class of domestic currency debt is that it exposes all creditors to domestic inflation. This is true, but surprise inflation is the likely way that small amounts of foreign currency debt will be serviced in any case. Most countries will not find it optimal to denominate all their debt in foreign currency. Partial commitment to price stability is no commitment at all. Foreign currency debt shifts the inflation tax to remaining domestic currency debt or to some other class of less easily observed liabilities.

It follows that the main job of portfolio management policy is to minimize the chance that the marginal contribution of debt is mis-priced from the point of view of the debtor. Long-term domestic currency debt seems to be the best vehicle from this perspective.

Debt Management in Industrial and Developing Countries

Setting out a theory of optimal asset and liability management for governments of developing countries is a challenge. There are at least two reasons why we cannot take analytical tools developed for debt management policy in industrial countries “off the shelf” and apply them to emerging economies. First, if we ignore default, there is little agreement in the literature about the optimal level of debt, what type of debt government should issue, and what role, if any, government should play in financial intermediation. Second, even if we could agree upon the “right” model for industrial countries, there are good reasons to believe that the uncritical application of the model to emerging markets, where default is an option, would be a mistake.

The experience of industrial countries is also an uncertain guide. Industrial countries have followed conservative debt management policies. As financial innovation has changed the nature of private financial markets, industrial country governments have, for the most part, chosen to continue to issue fixed-interest securities and to hold a narrow range of financial assets, often composed of securities issued by other governments. Industrial countries have also been cautious in acquiring contingent liabilities in the form of guarantees of private debt. An important exception is deposit insurance, but even here they have been careful to control the risk associated with such commitments. There might be good reasons for this conservative approach, but it might also be the case that debt management “rules of thumb” were developed in an era when international and derivative markets were quite limited; inertia might account for debt managers’ apparent lack of imagination.

Debt management policies for governments of emerging markets are less constrained by tradition and the presumption that the government should avoid the more exotic corners of the financial markets. In fact, participation in a richer set of debt management techniques seems natural in an environment in which hedging activities and risk management are seen as a responsibility of any economic entity with significant assets and liabilities.

While industrial countries have not deviated much from a traditional approach, economists have discussed a number of theoretical arguments for welfare-improving departures from the conventional policies. To begin to build a framework for evaluating the options for developing countries, we can build on an understanding of lessons drawn from this literature. Some of the important papers in this literature are cited in the references; in this paper, only a few of the arguments that seem to be important for emerging markets are highlighted.

The story that emerges from this literature is that optimal debt management policies can, in principle, mitigate distortions to first best competitive equilibria. If distortions differ across countries, so will the implied debt management policy. Recent contributions to the literature emphasize the possibility of self-fulfilling expectations, and these models suggest quite different implications for debt management.

Economists have a difficult time in considering more than one distortion at a time. This paper develops the idea that losses in output that follow government default is the distortion that “should” dominate debt management policy in emerging economies. The reader should remember that there is little in the way of empirical evidence that would allow a ranking of distortions according to the welfare losses they generate or the ability of debt management policy to amplify or mitigate these losses.

Overview of Debt Management Policy and Plan of Study

Debt management policy regulates three distinct characteristics of a government’s balance sheet. These are the government’s net debt, its stock of gross debt and gross assets, and the composition of its assets and liabilities. Changes in the net debt of the government are generated by fiscal deficits and by capital gains and losses on assets and liabilities. Stocks of gross assets and liabilities are independent of the net position (a given level of net debt or net assets determines the difference between gross assets and liabilities but not their level) and are important because leverage alters the expected returns and the variability of net worth. One way to measure leverage is the ratio of gross assets to net worth. A convenient way to think about the composition of assets and liabilities is to measure change in net worth that results from changes in variables such as interest rates or exchange rates. Exposure of the portfolio clearly depends on changes in the value of individual assets and liabilities and the covariance of changes. We call this the economic exposure of the portfolio.

In the next section, a variety of theoretical arguments relevant for debt management policy are reviewed. The objective is to carefully set out how management of the government debt “affects” welfare. The “easy” place to start is a neoclassical model in which debt management policy is powerless to affect equilibrium values of economic variables. Modifications of the neoclassical model introduce distortions to a first best equilibrium that might be corrected through debt management policy. Some of these are familiar. Distortions to labor and capital markets imply that net debt management might help smooth fluctuations in output. If taxes are distortionary or costly to collect, an optimal path for net debt will generally involve some smoothing of tax rates over time.

Distortions that might favor alternative types of government debt and asset portfolios, and the leverage of those portfolios, are less familiar but may be more relevant for debt management policy. While many potential distortions have been examined in the literature, this paper considers only a subset that is likely to be important for emerging markets.1 The more important models focus on the effects of incomplete financial markets, time consistency of government policy, multiple equilibria, and political markets for distributional shares.

Later, we go on to develop the idea that, while these models are interesting and informative, the distortion most likely to be important to developing countries is not explicitly considered in the context of industrial countries. For emerging economies, a dominant distortion has been the loss in output and growth that has followed financial crises.

At the end, we explore the distinction between the portfolio that is managed and the much larger portfolio to be optimized. Although only a subset of the government’s assets and liabilities are actively managed, sensible debt management policy is concerned with the value of the entire portfolio and the effects of changes in its value on residents’ welfare. The widespread practice of establishing a “benchmark” portfolio for foreign currency-denominated assets and another benchmark portfolio for foreign currency-denominated liabilities seems likely to violate this fundamental rule. Benchmark portfolios are usually derived from historical relationships between levels and variability of yields on the set of instruments included in the portfolio. Dooley, Lizondo, and Mathieson (1989) show that the straightforward merging of asset and liability portfolios for developing countries provides a much different picture for what countries are accomplishing and should be trying to accomplish by managing the currency composition of their financial assets and liabilities. The problem with separating asset and liability portfolios is that there is a perfectly predictable covariance of minus one between the value of otherwise similar assets and liabilities denominated in the same currency.

But considering financial assets and liabilities together clearly does not go far enough. Domestic currency debt is also an important part of many governments’ portfolios. Moreover, governments have one dominant asset: future tax receipts. There is no practical way to manage this asset except in rare cases where revenues from oil or another commodity can be hedged. Markets for future tax receipts simply do not exist. It follows that a government with one dominant undiversified asset may not find it optimal to diversify its net financial liabilities.

Debt Management Policy

Management of net debt is straightforward if Ricardian equivalence holds. The key assumption in this class of models is that the government debt is treated by taxpayers as if it were their own.2 Government spending matters for household behavior but the time profile of taxation and borrowing does not. Any pattern of taxes and borrowing that does not lead to insolvency is optimal because a representative, perpetual household anticipates future tax burdens and hedges its exposure by adjusting private savings.

It should be noted that taxes are special in the conventional model in that it is assumed that the government will manipulate tax rates (or government spending) in order to honor its net debt. The expected present value of conventional net tax receipts is the principal asset that the government holds. Perhaps we can think of this as an assumption that a well-defined set of taxpayers have an equity position in the government—in that they hold the residual asset or liability position. If the effective tax rate is bounded by either political or economic constraints, it is clear that in some circumstances the value of net liabilities can exceed the present value of net taxes and the value of some liability will have to be reduced. We will refer to the allocation of losses across net nontax liabilities as a crisis and the reduction in the value of alternative liabilities as a default. The standard assumption in the context of industrial countries is that surprise inflation is the relevant default technology available to the government.

Net Debt Management in an Imperfect World

Empirical work seems to be quite hostile to the idea that the private sector systematically offsets changes in the government’s net debt.3 Moreover, there are several theoretical frameworks in which government deficits do matter. Blanchard, Dornbusch, and Buiter (1986), for example, present an intertemporal model in which deficit finance can make an important contribution to stability and growth. For the purposes of this paper, the implication is that net debt management policy is likely to be dominated by concerns about economic stability.

Nevertheless, the stock of net debt is an important problem for the debt manager. As the stock of net debt (or net assets) rises or is more highly leveraged, capital gains and losses on that net position become more important relative to the flow of fiscal deficits in generating changes in the government’s net worth. The working assumption for this paper is that stabilization policy is, or at least is thought to be, too important to be delegated to a debt manager. We focus, therefore, on the management of the portfolio.

Portfolio Management Policy

A time path for net debt restricts the difference between the expected present value of the government’s assets and liabilities at each point in time but does not restrict the scale of the government’s portfolio of gross assets and liabilities or the composition of either gross assets or liabilities. For convenience, we will refer to the management of gross assets and liabilities (both on and off balance sheet) given net debt as “portfolio management policy.”

There are two issues to be resolved. The first is the optimal leverage of the portfolio. The second is the composition of the portfolio. Some readers will find it useful to think of the government as a financial intermediary that inherits a net worth position, issues liabilities to acquire assets, and manages the economic exposure of assets and liabilities to maximize a risk-return trade-off. The intermediary also manages off balance sheet risks in order to protect its net worth.

The counterpart to Ricardian equivalence for net debt is a “Modigliani Miller” theorem for the scale and structure of gross debt. The conditions under which this neutrality result holds have been carefully set out in the literature.4 If there is no uncertainty, and if representative, perpetual households consider the government’s portfolio their own, it seems clear that any gross position the government takes would be fully offset by the private sector.

With uncertainty, the private sector must also offset the expected variability of their net tax liabilities generated by changes in the market value of the government’s portfolio. For example, if the government takes a highly leveraged position by issuing domestic currency debt in order to acquire foreign currency assets, the private sector would have to be able to offset the government’s position in the same or equivalent markets. This is the basic reason why sterilized intervention, or any other changes in the economic exposure of the government’s portfolio, has no economic effects in a “neoclassical” model.

One of the many strong assumptions necessary for this result is that households must be able to forecast their share of taxes associated with the government’s capital gains and losses, as well as the gains and losses on their share of government liabilities. Clearly, the household cannot manipulate its portfolio to offset its contingent tax liability if it does not know what that tax liability will be.5

Portfolio Management in an Imperfect World

If the private sector does not seem to offset net government debt, it seems even less likely that gross positions are systematically offset. If, for a variety of reasons discussed below, the private sector cannot offset the exposure and leverage of the government’s portfolio, portfolio management policy can contribute to or detract from residents’ welfare.

Incomplete Markets

One of the more interesting distortions emphasized in the literature is associated with incomplete credit markets. By issuing various “new” types of debt, the government can provide vehicles that allow the private sector to increase welfare. In some cases, the new asset allows trade between generations.6 In others, the new asset has a desirable covariance with risks that cannot be hedged using existing markets.7 The idea is that, once established, a liquid market for a new asset, such as a fixed interest nominal bond of varying maturities, provides free information about market expectations to the private sector. Since the information is free to all, there may be underinvestment without government intervention. If such debt really is useful to the private sector, then investors will hold it at a lower yield. This suggests that minimizing debt-service costs is a good indicator that the government is providing welfare-improving debt instruments.

For emerging markets, it seems likely that this argument is relevant for optimal portfolio management policy. Emerging markets lack many of the financial markets that are potentially useful to the private sector. For example, the development of a liquid market for long-term, fixed-interest government debt may fill an important gap in the ability of residents to finance long-term investment.

Credibility

Another interesting class of models points to debt management as a way for the government to commit to utilize conventional taxes rather than surprise inflation to satisfy the government’s budget constraint.8 The government can commit price stability by issuing assets and liabilities that would not benefit from surprise inflation. This idea seems particularly relevant as the stock of debt grows as it has recently in several European countries.

These models imply that the government can reduce real debt-service costs by shortening the maturity of domestic currency debt, indexing returns to inflation, or replacing domestic currency-denominated debt with foreign currency debt. This is clearly at odds with the idea that the government should develop a long-term domestic bond market to complete the market. But we are not done with this issue yet. In the next section, we review an important reason to lengthen the maturity of domestic currency debt.

Multiple Equilibria

The lesson from the previous section is that private expectations concerning future inflation determine this period’s debt-service costs if the government issues debt that is subject to the inflation tax. This raises the possibility that changes in private expectations can quickly generate a crisis in the sense that market interest rates on short-term debt can rise quickly and call into question the government’s willingness and ability to finance debt-service obligations.

These shifts in private expectations can, in some cases, lead to multiple equilibria and self-fulfilling expectations of high rates of inflation.9Calvo (1988) summarizes the implications of the argument as follows: “The implications for policy could be staggering: for our results suggest that postponing taxes (i.e., falling into debt) may generate the seeds of indeterminacy; it may, in other words, generate a situation in which the effects of policy are at the mercy of peoples’ expectations—gone would be the hopes of leading the economy along an optimal path.” If there are real costs associated with financial crises, the government should avoid short-term domestic debt and spread refinancings evenly over time. In this context, lengthening maturity minimizes the chance that the debt will have to be rolled over just when expectations are at a bad point.10

There is an obvious conflict here. The inability to commit to low inflation means that the private sector will not give up its option to alter the inflation risk premium by buying long-term bonds unless they are induced to do so by a steep yield curve. But the possibility of a shift in private expectations means that government should avoid relatively cheap short-term debt if it wants to avoid a crisis.

Default Risk

While inflation is clearly a default option for developing countries, we have considerable evidence that outright default on some types of financial obligations is also an option. Even countries that have never defaulted are exposed to expectations that such an option is available. This additional option makes portfolio management for emerging markets more difficult and more important. Any debt management policy must be evaluated for its contribution to probability that a default will occur and for the costs of the default if it does occur. The universal assumption that inflation is the relevant default technology for industrial countries is consistent with the idea that alternative types of default are too costly to deserve serious consideration.11

While this is a more important issue for large net debtors, even countries with modest net indebtedness should avoid capital losses that might reduce net worth to levels that make insolvency a possibility. Open economies are subject to shocks from commodity prices, real exchange rates, international interest rates, and losses in their domestic banking systems. When combined with highly leveraged structures of financial assets and liabilities, these shocks can generate capital gains and losses for the government that call into question their ability and willingness to roll over their financial obligations on market terms. In the remainder of the paper, we develop the implications of this possibility for debt management policy.

An analogy with the earlier discussion of fiscal policy might be useful. It was argued above that the welfare effects of net debt management were too important to be entrusted to debt managers. In this section, we develop the view that the natural preference of debt managers for maximizing returns on assets and minimizing costs of debt service should be subjugated to a more important objective. If financial crises are costly, debt and asset management should focus on one objective: avoiding capital losses that call into question the government’s willingness and ability to roll over existing debt on market terms.

Developing countries have defaulted on both internal and external debt. Further, developing countries have defaulted differentially on “domestic” and “foreign” debt and have defaulted differentially on different types of debt within these two classes. This makes the analysis of optimal debt management much more difficult for developing countries. Private investors have to consider the possibility of surprise inflation and devaluation, but also must consider the possibility of outright default. This makes the market yield on internal and external debt highly interdependent. For this reason, the distinction between internal and external debt for developing countries has lost much of its meaning. As residents of developing countries have gained access to international credit markets, they have chosen to hold their government’s foreign currency-denominated debt. In recent years, it has become common for nonresidents to hold developing country governments’ domestic currency debt.

To start to understand debt management in such a world, Dooley and Stone (1993) developed a model of “implicit seniority” to understand why governments are able to borrow at different interest rates even when payment on all classes of debt comes from the same expected stream of government revenue. In their paper, they argued that it is difficult for the government to credibly commit in advance to treat one class of creditors better than another. If some default will be necessary in some states of the world, it is reasonable to assume that the government at that time will opt for the least costly form of default. There are a long list of options. Since the government will certainly consider the whole list when trouble comes, lenders will consider their relative standing in different states of the world when setting the terms on alternative instruments.

A positive theory of the government’s choice of default would simply be that it is unable to commit before the event to any rule and, after the event, minimizes the losses and penalties associated with each option. We can say a few things about this process. First, the revenue gained from a given rate of default depends on the tax base or the initial size of the position. It is often argued, for example, that foreign currency sovereign bonds are safer than other forms of debt. We suspect this is simply because international bond issues have been small as compared to domestic debt and alternative international debt. If there are fixed costs to default, rational governments would avoid defaults that yield little income.

The interdependence of the value of sovereign debt suggests an important and somewhat counterintuitive problem for portfolio management in emerging markets. The marginal contribution of a given asset or liability to the risk faced by the government will normally appear in the market valuation of other assets and liabilities. Suppose, for example, that the accumulation of foreign currency-denominated debt, and retirement of domestic currency debt, exposes the government to a capital loss that the market considers quite likely. But suppose also that in the event the loss occurs, foreign currency debt will be first in line for payment. The incidence of the expected loss might fall, for example, on entitlements for older residents. The fall in the market value of these entitlements will be difficult to observe. Moreover, we have little faith in the view that residents will immediately increase their own retirement savings although the tendency for this response is clear enough. So the government faces a difficult task. A simple lesson is that if the present value of expenditures is not affected by changes in the terms of trade, then the present value of debt should also not depend on terms of trade. In short, domestic currency debt is the preferred financial obligation. If the government wants to hold some foreign exchange assets for liquidity, it should hedge these with a foreign currency debt.

But why would the “market” accept the counterparty risk associated with a government that might become insolvent? If a small subgroup of creditors believes that they will do well in states of the world where the government becomes insolvent, it might be in their interest to offer risky positions (to the government) at low-risk premiums.

Policy Toward Instruments and Creditors

A general way to express this result is that the government must be concerned both with the contribution of a credit to the probability that some creditor group will find it in their narrow interest to refuse to roll over debt, thereby forcing a renegotiation, and the contribution of that creditor group to the bargaining that will occur following a default. The optimal strategy for a sovereign “manager” is to choose a debt portfolio (rather than an optimal contract) that on the one hand makes strategic default unattractive, but on the other hand attempts to minimize the damage associated with bargaining that will follow an unavoidable default.

A portfolio that makes a strategic default unattractive would allow for frequent calls for rescheduling probably through short maturities and rescheduling that would be costly to the government. If the probability of a bad state is zero, the government will simply choose the portfolio that generates deadweight losses to itself following a strategic default that equals the payment necessary to generate a competitive rate of return for the creditor. This is a form of commitment that makes lending possible. In the sovereign debt case, high deadweight loss credit structures are associated with “slow” settlement. But as the probability of a bad state rises, the optimal debt structure involves quick settlement so that the creditors get some payment before the investment depreciates.

If the only observable difference between the two types of defaults is the liquidity of the government, then the crucial point is the ability of the government to buy back its debt following a strategic default. Clearly the government would want no buyback rules for commitment. But in an unavoidable default, this would make settlement more difficult.

Countries with little or no risk of an unavoidable default will favor debt structures that ensure maximum punishment following a strategic default. The problem in both the corporate and sovereign cases is to determine how different numbers or types of creditors affect the optimal debt structure. The corporate case proceeds as follows. All the managers, potential managers, creditors, and potential creditors look forward to the bids that each will make following a seizure of the firm’s assets. The composition of debt “matters” under any set of assumptions where the value of the asset to individual participants in this game depends on the behavior of the other participants. Bolton and Scharfstein (1996) assume that new managers earn lower returns on the asset and incur costs of evaluating the assets. To distinguish between one and many creditors, they also assume that each creditor has the right to seize a well-defined asset and that these assets are worth more when used together than separately. The ability of a creditor to block coalitions that can best utilize the seized asset provides the result that the number of original creditors “matters” for the expected value of the investment to the initial manager.

The structure of the game that determines the equilibrium for different debt structures is quite specific to the assumptions that seem appropriate for corporate finance. These assumptions do not travel well to the case of sovereign debt. But the intuition we want to pursue for the case of sovereign debt does emerge in this formal model. In general, the government and the corporate “manager” must consider both the contribution of a given debt structure to the probability that a default specified in the optimal contract—and the costs of that default should it occur.

The key assumption that makes the model interesting is that which ensures that conflict resolution generates deadweight losses for all the participants. In the corporate finance model outlined above, this is a static problem in which the salvage value of the company’s assets depends on the structure of debt. For sovereign debt, it seems natural to model the deadweight losses that result from the passage of time during which the creditors and debtors argue about the division of future income. During this interval, we will assume that the ability of anyone to utilize the asset is impaired. Thus, we have a coordination problem that is related to the structure of the debt. This can be modeled as a war of attrition (Drazen and Grilli, 1993) where creditors’ uncertainty about the attributes of other creditors generates delay in settlement.

In applying these ideas to the sovereign debt case, we are both more and less ambitious. We are less ambitious in that we will not try to solve for an optimal contract but assume that the government chooses among a limited set of conventional contracts in order to assemble the optimal debt portfolio. We are more ambitious in that we attempt to describe the incentives for repayment in a new manner.

The existing sovereign debt literature has interpreted the fact that seizure of assets is impossible as suggesting that the punishment for nonpayment is unrelated to the assets acquired through the issue of debt. This makes the corporate debt literature of little direct use. The lack of collateral or the means to seize it means that some alternative threat is necessary to provide an incentive for repayment. The typical threats that have been modeled involve trade sanctions or prohibition of future borrowing. The trouble with these enforcement mechanisms is that the former has never been observed and the latter seems weak relative to the amount of debt observed. Moreover, if countries had the ability to impose such sanctions, they should do so regardless of the debt.

The assumption is that nonpayment triggers the “right” to impose these sanctions that are always in principle desirable. This has proven to be a useful assumption, but here I propose alternative ad hoc assumptions that seem to me more useful as a way to understand sovereign debt management. The main feature of this specification is that the threat available to creditors is the ability to block the use of assets acquired by the debtor government. The threat obviously evaporates as the assets depreciate. This provides an end to the recontracting game that seems more consistent with experience. Sovereign debt reschedulings are eventually resolved.

A Sovereign Debt Model

Assume a world that lasts for three periods. In the first period, a foreign creditor lends the government K to buy some assets where K is a dollar amount. The risk-free interest rate is assumed equal to zero.

The government uses K to import an asset that in the second period yields x with probability Θ and zero with probability 1-Θ. The government can also import unproductive assets that yield zero. This behavior is not observable by the creditor. The asset lasts for one more period but depreciates uniformly during the period and yields a certain return y. The government agrees to pay Z in the second period. If the government pays less than Z, the creditor has the right to impair the government’s use of the asset until a new agreement is reached for a share of the residual value of the asset, y.

During the third period, the asset cannot be used by the government if a negotiation for sharing y is in progress. The value of the asset declines during the third period from y to zero. This specification of the punishment technology is appealing because it means that the creditor(s) is only able to interfere with the government’s ability to utilize the assets acquired with the foreign funds and for only as long as the assets last. The alternative interpretation that the creditor(s) can punish the debtor forever and without regard to the seriousness of the offense is less appealing. One might think of a subsistence economy lifted temporarily to a higher level of output by an infusion of foreign capital, but once the capital depreciates, the creditor has no way to push output below the initial level.

If the government can pay, which occurs with probability 0, it will consider a strategic default. The temptation to keep z, the contractual payment in period 2, is compared to the value of y that the government expects to capture following a negotiation with the creditor(s). The incentive constraint for the government to pay z if x occurs is:

where gyts is the expected share of y that goes to the government following a negotiation lasting 0<ts<1.

The value of strategic default depends on the expected duration of the negotiation in period 3. If the government cannot pay, which happens with probability (1-Θ), there is a similar negotiation. The difference is that following a strategic default, the government has “secret” resources that can be used to overcome the coordination problem and speed a settlement. The creditor must expect to make a fair rate of return:

where cytb is the share of y that goes to the creditor following an unavoidable default. Note that gy, cy, ts, and tb are a complicated function of the structure of debt and that ts will generally not be equal to tb

The problem for the government is to design a debt structure that maximizes its net revenue from investment. The general form of the government’s net revenue function is:

Substituting (1) and (2) into (3), we arrive at:

The first three terms of (4) are the first best expected return on the asset if there is no default. The fourth term is the deadweight loss associated with rescheduling. A full description of how a portfolio of debt might be designed to maximize the expected value of (4) is difficult. Analytic and simulation solutions for this problem are topics for future research. In principle, the key parameters could be estimated from data on how long it takes to renegotiate different debt structures and how costly the renegotiation is. A result that stands out, however, is that the optimal portfolio is clearly related by the probability that the investment will fail for reasons beyond the control of the debtor government.

At the start of the third period, it might be natural to assume an immediate meeting of the minds. Clearly if there is one creditor and one debtor, they might assess each other’s bargaining power and rather than watch the asset melt will divide the spoils.12 However, if the two sides are uncertain about the other’s preferences or have different expectations about a “fair” division, some waiting and deadweight losses are likely. The equilibrium condition is that each creditor and, if not liquidity constrained, the debtor compares the marginal cost of waiting with the marginal benefit of winning. The benefit is the probability that the other side will concede in the next instant times the difference between the winner’s and loser’s share of what remains of the asset. If there are a “few” creditors, they will have to assess the others’ expected returns for delaying a settlement. If there are many creditors, it might be difficult to arrange any agreement for a long time.

It is important to remember that the actual coalitions that emerge following a default may be difficult to predict, and the behavior of coalitions may be difficult to predict. A natural assumption is that classes of liabilities—for example, all foreign currency-denominated liabilities—would be natural attractors for a coalition. But foreign currency-denominated bondholders might find it in their interest to be free riders on an agreement between other large creditors. It follows that the number of types of liabilities issued might not be a good predictor of the number of coalitions that would form following a default.

An important aspect of the problem facing the government is that alternative credits cannot be evaluated according to the explicit contractual terms since these are only relevant in nondefault states of the world. Moreover, credits or creditors cannot be evaluated according to their marginal contribution to the probability that a default will occur. Once default is a possibility, a credit influences the probability that a default will occur—and the expected cost to the debtor, and the deadweight loss suffered by the debtor associated with adding that credit to the bargaining game.

The difficulty of evaluating the welfare implications of alternative debt structures is illustrated by the substitution of dollar-indexed, short-term debt (tesobonos) by the government of Mexico for short-term domestic currency debt (cetes) in the months leading up to the December 1994 crisis. The existing literature on debt management would emphasize the fact that by indexing the liability, the government altered its incentives to inflate and devalue the currency. Thus, the probability that a default in the form of inflation and devaluation would be optimal was reduced. Our model emphasizes a different aspect of the same policy. The substitution of tesobonos for cetes changed the nature of the rescheduling exercise that followed the 1994 crisis. The recontracting in this case was resolved quickly by forceful intervention by official creditors. In retrospect, the issue of tesobonos was a good idea if the decision of official creditors, in this case the U.S. government and international organizations, to lend quickly and in large amounts was due to their unwillingness to fight a long costly war with a well-organized and powerful group of holders of tesobonos.

A reasonable conjecture is that creditors that expect to do well in the bargaining game are those best positioned to delay settlement. Other things being equal, such creditors will offer relatively good terms as the probability of default rises. Because the tough bargainer does not internalize the deadweight loss that it will impose on others, assumed market prices are distorted and are a misleading guide for the government. In fact, as default becomes more likely, a debtor might be tempted to choose debt that minimizes the probability of a default in that it offers reduced contractual payments. This would be a mistake if this type of debt was associated with high costs to the debtor if the default occurs.

It might be optimal to create as few instruments and classes of creditors as possible. If there are no “niches” in which particularly hostile creditors can gather, they might self-select out of the credit supply. The industrial countries have adopted just such a rule. In general, industrial country governments issue one class of liabilities with a range of maturities but with no implicit or explicit seniority among credits or creditors.

Why Domestic Currency Debt?

The above discussion suggests that the debt manager might want to limit the ability of interest groups to form by issuing only one type of debt. But the analysis does not help determine what type of debt would be best. In our view, the dominant consideration is governments’ limited ability to generate changes in the foreign currency value of tax revenue. It follows that governments cannot afford to issue foreign debt, or more precisely foreign currency-denominated debt, even if that debt helps commit the government to price stability.13 Foreign currency debt exposes the government to changes in its net worth resulting from changes in the real exchange rate. As far as we know, these real exchange rate changes are unrelated in a statistical sense to other changes in the government’s wealth.

Even small amounts of external debt can be costly, not because a developing country will choose to default on its external debt, but because external debt service can increase when the foreign currency value of government revenues falls. This often induces the government to default on its internal debt through inflation. Residents’ expectations of this reaction generate the extraordinary increases in domestic real interest rates and capital flight that precede financial crises in developing countries.

Is Default Risk a Problem for Countries With Reserve Assets?

Industrial country governments have generally been conservative in leveraging their portfolios because they are quite sensitive to the political problems associated with capital gains and losses generated by highly leveraged positions. For example, the relative unwillingness of the government of the United States to intervene in foreign exchange markets is partly explained by the unwillingness of the Treasury and Federal Reserve to accumulate reserve assets that fluctuate in value relative to the domestic currency debt that necessarily finances such accumulations.

Developing country governments have been much more inclined to leverage their positions. Sterilized intervention has created large asset and liability positions that are sensitive to exchange rate changes. Moreover, governments in developing countries are probably more exposed to capital gains and losses than they realize. At a minimum, governments that manage exchange rates must consider the implicit liability to guarantee the domestic currency value of assets and liabilities in the domestic banking system. If a government decides to liberalize its domestic credit markets, prudent debt management policy would immediately recognize an implicit liability that will arise if important institutions prove not viable in this new environment. If the insured institutions are sensitive to increases in international interest rates, it is important that the government’s other liabilities not be sensitive to these factors.

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For an excellent review of the formal literature, see Missale (1994).

Tobin (1971) provides sophisticated reasons for believing that changes in the stock of net debt and its composition matter for the timing of consumption and investment. In particular, tax liabilities are uncertain and not traded while government bonds are liquid assets to the holder.

See Stiglitz (1983) and Chan (1983).

See Bohn (1988), (1990a), and (1990b) for models that evaluate different types of government debt, including foreign currency-denominated debt.

See Calvo (1988); and Calvo and Guidotti (1990).

In the literature, default is generally referred to as a capital levy. A one-time surprise tax on holders of debt is equivalent to a default on that debt. Capital levies were extensively discussed as an option for reducing the large debts accumulated during World War II. See Eichengreen (1990) for an excellent discussion of the economics and political economy of this era.

This type of bargaining is assumed, for example, in Bulow and Rogoff (1989). In that model, the adversaries evaluate one another and immediately agree to a payment.

An exception would be a credible currency board as might evolve, for example, in Argentina. In this case, the exchange rate risk has been eliminated so it makes sense to issue foreign currency liabilities.

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