In this section, an analytical framework is developed for examining the implications of debt buy-back operations for the economy of a “typical” middle-income, heavily indebted country. This framework, if developed and extended to an individual country case, holds the promise of allowing one to analyze how a debt buy-back operation might be expected to affect such a country’s external position, capital formation, and rate of growth, as well as how these macroeconomic effects might feed back to the market price of external debt. As matters stand, the quantitative results are only illustrative.
It should be recognized at the outset that the approach used is but one of several possibilities. It should also be emphasized that the discussion is preliminary and that results will need to be reassessed as less restrictive assumptions are employed and as our understanding of the important economic relationships involved improves. Nevertheless, the virtue of explicitly setting out the important economic linkages is twofold: it permits us to initiate a debate and to monitor developments as they unfold.
Historical Perspective
In order to gain some insight into how a buy-back might be expected to help a heavily indebted country, it is useful to consider what macroeconomic forces were involved in the original evolution of the debt crisis. Nearly ten years ago, the external positions of a number of developing countries began to deteriorate sharply. In some cases, this was due largely to events beyond their control: drops in commodity prices, which led to (non-oil) terms of trade losses; increased interest rates in the industrial countries, especially in the United States; and a dramatic increase in the price of oil. In other cases, factors that were within the countries’ control—excessive growth in public sector expenditures relative to revenues, and domestic policies that had adverse structural effects—contributed to the increased burden of debt service.
As these countries found it increasingly difficult to meet their contractual obligations on external debt, the market price of their debt declined significantly.5 The fall in market prices can be viewed as akin to a rise in the contractual interest rate, since if contractual payments were made, the creditors would realize a higher rate of return on the funds they had invested. Downward pressure on exchange rates was consistent with the need to improve the non-interest portion of the current account and, in turn, to make required debt-service payments. The tax bases of many countries were apparently viewed as increasingly inadequate to meet future liabilities, both domestic and foreign, thereby raising the prospect of higher rates of taxation of real and financial assets by the government, as well as other changes in the economic environment that would reduce expected rates of return. For example, it was feared that efforts by the debtor government to meet an ever-increasing debt-service burden might lead to expectations of higher rates of inflation, uncertainty about exchange rates, foreign exchange shortages and controls, and uncertainty about access to trade credit and export markets. This had an adverse affect on domestic real investment and, consequently, on real growth, as foreign financial assets became increasingly more attractive relative to real domestic assets. The stylized facts that summarize these were real exchange rate depreciation, an increase in exports, a decrease in output relative to potential, a fall in real wages and real wealth, higher domestic interest rates, and an increasing discount on external debt.
The Model
The small simulation model developed below incorporates these stylized characteristics of the adjustment process. The model is designed to analyze medium-term scenarios for heavily indebted countries and can be seen as the marriage of a debt-pricing model and a small macroeconomic model. The two sub-models are linked in one direction by the effect of a debt buy-back on the price of debt, investment, and growth, and in the other direction by the effect of growth on the funds available to make debt-service payments.
Financial markets in this model are forward-looking. Investors are assumed to be risk-neutral and to fully discount expected future payments to obtain the current market value of debt. The price of debt is therefore defined as the ratio of the market value of debt to its total contractual level. The stock of outstanding contractual debt and its price are jointly determined in the model, with the former equal to the contractual value of debt at the beginning of the period augmented by any arrears or new lending that occurred and decreased by the amount of any buy-backs evaluated at the market price.
As discussed in Section II, a buy-back reduces the contractual value of the debtor’s external debt. It is assumed that the rise in the price of external debt is transmitted to the market for domestic government debt.6 The intuition behind this assumption is that a lower stock of external debt makes it less likely that the debtor government’s payments to foreign creditors will come at the expense of payments to domestic creditors. The rate of return on domestic securities demanded by investors will, therefore, fall to some extent, reflecting this improved outlook. The tentative nature of this linkage in the model, however, should not be overlooked. It is known that real interest rates in many indebted countries are quite high, and it is clear that this is related to uncertainty about expected inflation and other forms of taxation of domestic financial assets. But much less is known about how much domestic interest rates would fall as the overhang of external debt was reduced. Since this is the only explicit link between debt and economic activity, it can be thought of as a reduced-form estimate of the potential benefits of debt reduction that were discussed previously.
The link between internal and external debt is important because it provides a link to domestic investment in the debtor country. If it is observed that the domestic debt of the government carries a high real yield, it is also likely that other earning assets within the jurisdiction of the government are viewed as subject to taxation intended to generate revenues with which to satisfy foreign creditors. Moreover, earnings on investment are also subject to uncertainty about inflation and the other economic conditions discussed previously. In the model developed here, it is assumed that private investors in plant and equipment in the debtor country also consider the overhang of foreign debt in establishing an acceptable rate of return on domestic investment.
To summarize, expected returns on assets held by foreign and domestic residents are linked by arbitrage in world capital markets, and they may also be related as a result of government policy.7 In the event that a country is forced to default on its contractual payments, the authorities may choose to tax the assets of domestic residents in the same proportion as they tax those of foreign lenders. As the price of debt is increased through a buy-back operation, and the discount on external debt is reduced, the expected return on domestic assets rises and real investment increases. Unless the country is completely constrained on the supply side, output will rise by some multiple of the initial increase in investment.
Turning to the external position, the increase in investment brought about by a buy-back, among other things, raises capacity in the export sector and thus allows the country to maintain a higher level of debt-service payments than before the buy-back. This tends to raise the price of debt further, reinforcing the buy-back’s initial impact.
Preliminary Simulation Results
Table 1 presents the results of a simulation of a debt buy-back using the model. The amount of the buy-back is assumed to be $70 billion, which is 10 percent of the stock of private debt.
Simulation Results for Buy-Back of 10 Percent of Private Debt Stock
(Deviations from baseline)
Simulation Results for Buy-Back of 10 Percent of Private Debt Stock
(Deviations from baseline)
| 1989 | 1990 | 1991 | 1992 | 1993 | |
|---|---|---|---|---|---|
| Market price of debt (percentage increase) | 22.7 | 23.8 | 24.9 | 25.9 | 27.0 |
| Market price of debt (U.S. cents) | 8.6 | 8.6 | 8.6 | 8.5 | 8.4 |
| Stock of private debt | –151.1 | –164.2 | –178.8 | –195.0 | –213.1 |
| billion U.S. dollars | |||||
| Stock of buy-back borrowing | 70.3 | 70.3 | 70.3 | 70.3 | 70.3 |
| Funds available for debt service | 0.5 | 0.6 | 0.7 | 0.7 | 0.8 |
| Interest paid on private debt | –2.0 | –1.8 | –1.6 | –1.5 | –1.4 |
| Interest paid on buy-back debt | 2.5 | 2.4 | 2.3 | 2.2 | 2.1 |
| percent | |||||
| Real GDP growth rate (annual) | 1.7 | 0.8 | 0.4 | 0.2 | 0.1 |
| Investment/GDP ratio | 1.2 | 1.2 | 1.2 | 1.2 | 1.2 |
| Inflation rate (annual) | –0.1 | 0.0 | 0.0 | 0.0 | 0.0 |
| Dollar exchange rate | 0.7 | 0.4 | 0.3 | 0.2 | 0.2 |
Simulation Results for Buy-Back of 10 Percent of Private Debt Stock
(Deviations from baseline)
| 1989 | 1990 | 1991 | 1992 | 1993 | |
|---|---|---|---|---|---|
| Market price of debt (percentage increase) | 22.7 | 23.8 | 24.9 | 25.9 | 27.0 |
| Market price of debt (U.S. cents) | 8.6 | 8.6 | 8.6 | 8.5 | 8.4 |
| Stock of private debt | –151.1 | –164.2 | –178.8 | –195.0 | –213.1 |
| billion U.S. dollars | |||||
| Stock of buy-back borrowing | 70.3 | 70.3 | 70.3 | 70.3 | 70.3 |
| Funds available for debt service | 0.5 | 0.6 | 0.7 | 0.7 | 0.8 |
| Interest paid on private debt | –2.0 | –1.8 | –1.6 | –1.5 | –1.4 |
| Interest paid on buy-back debt | 2.5 | 2.4 | 2.3 | 2.2 | 2.1 |
| percent | |||||
| Real GDP growth rate (annual) | 1.7 | 0.8 | 0.4 | 0.2 | 0.1 |
| Investment/GDP ratio | 1.2 | 1.2 | 1.2 | 1.2 | 1.2 |
| Inflation rate (annual) | –0.1 | 0.0 | 0.0 | 0.0 | 0.0 |
| Dollar exchange rate | 0.7 | 0.4 | 0.3 | 0.2 | 0.2 |
Financing for the buy-back is assumed to be provided by official creditors at an average rate below the contractual interest rate.8 All other policies are held constant in order to focus on the effects of the reduction in debt. In practice, a well-designed buy-back policy would be but one element of a total adjustment program designed to restore the external viability of the country. Many factors besides excessive borrowing led to the present problems of the heavily indebted countries, and debt reduction alone cannot solve them.
As shown in Table 1, the price of debt rises by nearly 23 percent, from $0.38 to $0.46. The stock of contractual debt held by private creditors falls by a similar proportion as buy-back resources are used to repurchase debt at a substantial discount. Real investment rises by 1.2 percent of gross domestic product (GDP) throughout the simulation period. The increase in investment leads to an increase in output through the familiar multiplier/accelerator mechanism. The growth rate of GDP rises initially by 1.7 percent, and then declines steadily to its original value (leaving the level of output higher than it would have been in the absence of debt reduction). This growth in output generates additional funds available to finance debt service, which is reflected in a higher initial price of debt. The exchange rate appreciates marginally, in both real and nominal terms.
In general, the direct effects of reduced debt-service payments to private external creditors are modest, at least in the first few years of a program. Payments financed from the debtor’s non-interest current account may change less than would payments financed through new money or arrears. In addition, payments to official creditors or to others that finance the debt or debt-service reduction will generally rise. Having said that, we would emphasize that the incentive effects of debt reduction are potentially important and significant. A task of further research will be to build upon the existing analysis in an effort to obtain a clearer and more comprehensive accounting of the effects of debt reduction.