The international capital market is presently characterized by effective credit rationing to developing countries. Most developing countries cannot obtain new credits from the international banking system. This situation contrasts sharply with that in the 1970s, when the international banking system engaged willingly in substantial resource transfer to the developing countries. This remarkable switch from a functioning international credit market to a market characterized by credit rationing reflects the growing awareness of the country risk involved in further lending to developing countries. Most developing countries have reached a point where their willingness or ability to service their debt is questionable, thereby increasing the reluctance of the international banking system to extend new credits. This situation is further complicated by the drop in export prices experienced by the developing nations in recent years, a process that has further reduced their ability and willingness to service their debt.
A significant literature has evolved in recent years that attempts to study the unique characteristics of international country risk. The lack of simple enforcement mechanisms for international debt repayment tends to reduce the international credit market to an equilibrium in which the volume of international credit is limited by the effective penalties associated with defaults. These penalties are potential embargoes that restrict the flow of both temporal and intertemporal trade (that is, trade in goods and financial assets, respectively).1
While the above literature has provided clues regarding the problems of country risk, it has raised important policy questions of what can be (or should be) done in the present situation characterized by “over-borrowing” and debt overhang.2 An open question is the degree to which the international system is capable of revitalizing the resource transfer for investment purposes from the developed to the developing nations.
This paper identifies conditions under which renewed lending may benefit both the developed and the developing countries. We evaluate how endogenous terms of trade, that is, terms of trade between debtor and creditor nations that are significantly affected by the financial flows between them, affect the conditions for the existence of beneficial lending. This analysis has special relevance because a competitive international banking system does not internalize terms of trade effects and may not revitalize lending for investment purposes, even in cases in which renewed lending is socially desirable. This may suggest an important role for policymakers in imposing appropriate conditionality (that is, in imposing guidelines for domestic policies that should follow renewed lending). We will attempt to evaluate conditions under which such a role is desirable.
The relevance of terms of trade effects for the debt situation depends on the answer to the following question: Do debtor countries face a downward-sloping demand curve for their export products? There are two reasons to believe that they do. The first is that although perhaps all debtor countries can be considered small economies, often they are all simultaneously affected by the same shocks, and their joint response is of a large magnitude. For example, the increasing unavailability of foreign borrowing since 1982 affected most debtor countries; their response included a general increase in exports, and a terms of trade deterioration followed.3 This means that even if the actions of each individual debtor country cannot affect its terms of trade, on occasions the debtor country may find falling prices every time it tries to increase the volume of its exports because other debtor countries are doing the same.
The second reason is that an increasing portion of debtor countries’ exports are manufactured products, the markets for which are, in many cases, well described by a differentiated-products structure. In a differentiated-products framework (such as Spence (1976)),4 there is a whole continuum of goods that can be produced by a given industry, each of them differing only slightly from the point of view of consumer preference. With increasing returns, each firm will specialize in a different product on the continuum, and it will command a certain degree of market power.5 If this is the case, the manufactured exports from debtor countries will face a downward-sloping demand curve, irrespective of size considerations.
Econometric studies of the elasticity of demand for developing country exports by industrial economies have usually taken developing countries as a group. Estimates of this import demand elasticity range from somewhat less than 1 to over 4.6 The studies use, however, different aggregations for the definition of the import commodity and different aggregations for the importer economy, apart from different sample periods. Despite that fact, it appears that a number slightly above 1 is a reasonable synthesis of econometric estimates of import demand elasticity. It is remarkable that the median (across products) elasticity estimated by Grossman (1982) is equal to 1.2, the median (across countries) elasticity estimated by Marquez and McNeilly (1988) is also equal to 1.2, and the elasticity estimated by Dornbusch (1985) for the aggregate of non-oil developing countries is also equal to 1.2.7 Such a figure is also in line with estimates of import price elasticities for industrial goods irrespective of the country of origin of exports (see Goldstein and Khan (1985)). This elasticity applies, however, to the aggregate of developing country exports, although for some particular goods a few exporters account for most of the supply.
We start our analysis by describing a model of the international credit market characterized by insolvency on the part of debtor countries. This means that repayments do not suffice to cover all obligations and therefore become more closely related to available resources in the debtor economy than to existing debt. As a consequence, the debtor countries cannot borrow as much as they would like to8 and find themselves credit rationed. In these circumstances, we assume that debtors and creditors negotiate agreements, which we will call contracts, by means of which creditors offer increased lending and debtors pledge to undertake certain actions concerning productive investment and debt repayment. This simple framework is intended to capture some of the main features of the current rescheduling negotiations.
The debt negotiations are assumed to take place in the context of a two-period, two-good world economy composed of two blocks of nations: creditors and debtors. Each block produces one good and consumes both. In the first period, debtors and creditors try to reach a deal, or contract, to increase lending. The contracts are defined as a resource transfer to the developing nations in the first period that specifies a marginal propensity to invest out of the transfer and a marginal propensity to repay out of the proceeds of the new investment in the second period. A contract is a Pareto-improving contract if both blocks of nations benefit from the marginal resource transfers. We obtain the conditions for the existence of Pareto contracts and describe them.
In the absence of terms of trade effects (perfect substitutability between the two goods) the key results can be summarized in the following way. The condition guaranteeing the existence of Pareto contracts is that the marginal productivity of capital in the developing countries should exceed that in the developed countries. In the absence of distortions (other than the situation of international insolvency) this condition is identical to the requirement that the interest rate be higher in the developing than in the developed nations. The larger the excess of the marginal productivity of capital in the developed countries, the larger the range of Pareto contracts. The presumption is that this condition is indeed satisfied because the interest rate in the heavily indebted countries tends to be higher than in the industrial countries. Nevertheless, in a real world situation, the marginal resource transfer will not occur in the absence of either appropriate incentives or conditionality on the debtor country.
We turn then to the analysis of the consequences of endogenous terms of trade adjustment owing to limited goods substitutability on the region of Pareto contracts. We show that the Pareto region is enlarged for strict conditionality contracts (contracts that require high marginal propensity to invest in the debtor country) and is reduced for contracts requiring low marginal propensity to invest on the part of the debtor country. We also analyze an alternative type of contract between debtors and creditors. In this case the amount of the repayment is the only variable to be agreed upon, and investment is assumed to be undertaken in an optimal manner by the developing country. We show how, in this framework, the existence of endogenous terms of trade modifies the region of Pareto-improving contracts.
The terms of trade effect is not internalized by the international banking system, with the result that in the negotiation process the interests of the banking system may diverge from those of a representative consumer in the creditor country. This possibility may suggest an important role in the debt renegotiation process for governmental institutions that may provide the international banking system with the proper incentives needed to implement the desirable contracts.
Some Derivations and Extensions
This Appendix provides the details of the derivation of two expressions used in the text of the paper and extends the application of the model to the case in which terms of trade are not fixed in the second period.
The first expression concerns the effects of increased lending on utility. Differentiating the utility functions (7) and (8), we obtain
We assume that marginal rates of substitution are given by the standard optimality conditions:
Making use of these marginal rates of substitution, we obtain
Differentiating the budget constraint (3), we obtain
Finally, from equations (42) and (44), and making use of our assumptions regarding marginal investment and repayment rates in the debtor country, we obtain expression (9) in the main paper, and an entirely parallel procedure applied to the developed economy leads to equation (10) of the text:
The second expression this Appendix is concerned with is the change in the terms of trade generated by an increase in lending, dQ/dB. Recall that the system can be represented in the following way (the equation numbers are the same as in the text):
These equilibrium conditions determine the value of the following endogenous variables: the first-period terms of trade, the interest rate in the developing nations, and investment in the developed countries (Q, r*, and I). The levels of net borrowing B and of investment by the debtor country I* are exogenously determined in the debt negotiation process. Differentiating the system, at Q = 1, we obtain
It can be seen that there is some recursivity in the system, in that the variable r* can be determined after the rest of the system is solved. The role of r* is only to ensure that spending in the debtor economy, is equal to the resources available in the first period, and only the level of matters for the rest of the equilibrium. Collecting terms in equation (47), we obtain
And some further transformations produce equation (29) in the paper:
with Ω = ah + αh (a + E1).
Extension: Endogeneity of Terms of Trade in the Second Period
We consider now the case in which there are terms of trade movements in both the first and the second period. We will show that terms of trade are likely to deteriorate for the debtor country in the second period, which enlarges the area of Pareto contracts relative to the case of no terms of trade effects.
From equation (11’) it is apparent that, if terms of trade deteriorate for the debtor country in the second period (dQ2/dB < 0), the potential for Pareto-improving lending contracts increases. This is because second-period consumption is less valuable (more heavily discounted) in the credit-constrained debtor country.
In order to obtain the sign of dQ2/dB, we need to solve the general equilibrium system, which now includes an additional second-period market clearing condition because of the differentiation of goods Y2 and X2. The system can now be represented by
with Ω = αh ( + E2) + h > 0. We solve first for the change in investment in the industrial country:
We can now obtain:
with Ω3 = Ω2 + (1 – h)R/(1 + f) > 0. It is apparent that dQ2/dB < 0 always. This is because the additional lending increases investment and the supply of second-period debtor country good. Since there is no investment in the second final period and we are assuming no differences in preferences, the sign of dQ2/dB is well determined.
This implies that allowing for endogenous terms of trade in the second period will expand the region of Pareto-improving contracts. In terms of our diagrams, the terms of trade changes in the second period shift both curves toward the origin, but the shift in DD (the debtors indifference curve) is of smaller magnitude, which enlarges the Pareto region. This can be seen from expressions analogous to equations (14) and (15) in the text of the paper:
Note that, since r* > r (that is, since the debtor country is credit constrained), the shift generated by dQ2/dB is of larger magnitude in equation (15′); that is, for the creditor country.
As for the change in terms of trade in the first period, it will be the same as in the case of constant terms of trade in the second period if R = 0 or, alternatively, when the terms of trade change does not affect the value of repayments previously agreed to.24 Therefore, the total effect of terms of trade endogeneity is an increase in the region of Pareto-improving contracts relative to the case of fixed terms of trade.
Bergsten, C. Fred, William R. Cline, and John Williamson, Bank Lending to Developing Countries (Washington: Institute for International Economics, 1985).
Dornbusch, Rudiger, “Policy and Performance Links Between LDC Debtors and Industrial Nations,” Brookings Papers on Economic Activity: 2 (1985), The Brookings Institution (Washington), pp. 303–68.
Feldstein, Martin S., and others, “Restoring Growth in the Debt-Laden Third World: A Task Force Report to the Trilateral Commission.” Triangle Papers, Report 33 (New York: The Triangle Commission, April 1987).
Fischer, Stanley, “Resolving the International Debt Crisis.” NBER Working Paper 2373 (Cambridge, Massachusetts: National Bureau of Economic Research, September 1987).
Frenkel, Jacob A., and Assaf Razin, Fiscal Policies and the World Economy; An Intertemporal Approach (Cambridge, Massachusetts: MIT Press, 1985).
Froot, Kenneth, David Sharfstein, and Jeremy Stein, “LDC Debt: Forgiveness, Indexation, and Investment Incentives,” NBER Working Paper 2541 (Cambridge, Massachusetts: National Bureau of Economic Research, March 1988).
Goldstein, Morris, and Mohsin S. Khan, “Income and Price Effects in Foreign Trade,” Chapter 20 in Handbook of International Economics, Vol. 2, ed. by Ronald W. Jones and Peter B. Kenen (Amsterdam: North-Holland; New York: Elsevier, 1985).
Grossman, Gene, “Import Competition from Developed and Developing Countries,” Review of Economics and Statistics (Amsterdam), Vol. 64 (May 1982), pp. 271–81.
Khan, Mohsin S., and Malcolm D. Knight. “Import Compression and Export Performance in Developing Countries,” Review of Economics and Statistics (Amsterdam), forthcoming 1988.
Krugman, Paul R., “International Strategies in an Uncertain World,” in International Debt and the Developing Countries, ed. by Gordon W. Smith and John T. Cuddington (Washington: World Bank, 1985), pp. 79–100.
Krugman, Paul R., “Private Capital Flows to Problem Debtors,” paper presented at the NBER Conference on Developing Country Debt (unpublished; Washington: 1987).
Marquez, Jaime, and Caryl McNeilly, “Income and Price Elasticities for Exports of Developing Countries,” Review of Economics and Statistics (Amsterdam), forthcoming 1988.
Spence, Michael E., “Product Selection, Fixed Costs, and Monopolistic Competition,” Review of Economic Studies (Edinburgh), Vol. 43 (1976), pp. 217–36.
Van Wijnbergen, Sweden “Fiscal Policy, Trade Intervention, and World Interest Rates: An Empirical Analysis,” in International Aspects of Fiscal Policies, ed. by Jacob A. Frenkel (Chicago: University of Chicago Press, 1988).
Mr. Aizenman, a consultant in the Research Department of the Fund, is Associate Professor of Economics at the Hebrew University and was formerly Associate Professor of Business Economics at the University of Chicago, He is a graduate of the Hebrew University and received his doctorate from the University of Chicago.
Mr. Borensztein, an economist in the Research Department of the Fund, is a graduate of the University of Buenos Aires and received his doctorate from the Massachusetts Institute of Technology.
The authors thank Sebastian Edwards, Elhanan Helpman. Assaf Razin, Sweder van Wijnbergen, participants in the NBER conference on “International Trade and Finance with Limited Global Integration” and in a Research Department seminar, and colleagues in the Fund for helpful comments.
The literature on solutions to the debt situation is also quite impressive. Important studies that summarize advantages and disadvantages of existing proposals include Krugman (1985), Dornbuseh (1987). Fischer (1987), Feldstein and others (1987). and Bergsten and others (1985).
The link between real commodity prices and debt service is suggested in Feldstein and others (1987).
An extensive analysis of this market structure in the context of international trade can be found in Helpman and Krugman (1985).
Alternatively, the differentiation could arise from reputational or learning problems.
That is, as much as necessary to equate the domestic interest rate to the international rate.
Credit rationing would prevent the exploitation of arbitrage oportunities that would emerge from different rates of return to capital and a fixed relative price for the two goods.
We abstract from monitoring problems, assuming that contract conditions are perfectly enforceable.
Note that the consequence of credit rationing is under-investment in the developing nations relative to the first best. The distortion wedge is measured by the interest rate differential. The change in welfare is the result of multiplying the distortion by the change in the distorted activity.
But contracts with (β, x) outside the unit square are also possible, and some of them benefit the debtor country.
Otherwise, the implication is that the debtor country could increase its utility by borrowing and investing 100 percent of the loan. For such value of x, there would hardly be any reason for credit rationing of the debtor country. Furthermore, one could support the above condition on an empirical basis. The sudden tightening of international borrowing conditions at the beginning of the debt crisis raised r* without much short-run effect on m, which depends on the existent capital stock. (Notice that the above condition will hold if 1 + r* ≥ m.) Also, if domestic capital markets are not very distorted, one could imagine m moving back to a value close to that of 1 + r*.
This analysis is not fully correct because dQ/dB will itself depend on the parameters β and x.
The case of a = 1 corresponds to the case in which there is no local habitat and the demand functions are the same in both countries. The case of a < 1 corresponds to the case in which each country prefers its own good.
We assume that the range of values of Q is such that hg(Q) < 1 always.
This linear technology serves the purpose of isolating intertemporal marginal rates of substitution in the developed economy from feedback from international lending to the developing world, which reflects our feeling about the magnitude of any such linkage. Our analysis can be generalized to the case where r is endogenously determined, without affecting the logic of our discussion.
The derivation is contained in the Appendix.
Note that, for a < 1, in the absence of new investment we get an improvement in the terms of trade of developing countries owing to the local habitat effect. This is in line with the classical transfer criterion (for analyses using transfer considerations, see Frenkel and Razin (1987) and van Wijnbergen (1988)). Note also that, with a unitary marginal investment (β = 1), the terms of trade adjustment is independent of any local habitat effect.
The closer substitutes goods X and Y are, the smaller the terms of trade change that would occur, and the smaller the shift in the CC curve. This can be seen from equation (32). where the elasticity of substitution is positively associated with Ω. Also, the larger the local habitat effect (represented by a smaller value of the parameter a), the larger the impact of the terms of trade change on the location of the Pareto region (that is, the larger the shift in curve CC).
We thank Elhanan Helpman and Assaf Razin for comments that led to the present subsection.
In fact, the optimal policy for the creditor is dependent on the nature of uncertainty in the model, and on the possible existence of asymmetric information, as the results in Krugman (1987) and Froot, Sharfstein, and Stein (1988) show.
That is, prior to the new loan contract (ε, x) other payments from debtor to creditor might have been scheduled for the second period. We require that the value of those payments not be affected by the change in terms of trade. Such would be the case, for example, if those repayments were denominated in the currency of the creditor countries and the terms of trade change did not affect inflation in the creditor countries. If this is not the case, the sign of dQ2/dB will still be indefinite and it will be more likely to be positive the larger the value of pre-scheduled repayment R.