Abstract
In a recent Staff Papers article, Corden (1988) constructed a heuristic framework to analyze the effects of debt relief on the incentives to adjust. Corden’s framework is particularly useful in disentangling the mechanisms by which debt relief can either increase the incentive of debtor countries to adjust (the “pro–incentive effect”) or, on the contrary, reduce this incentive (the “disincentive effect”). The purpose of this note is to build on Corden’s framework and to extend the analysis to the “financially open” economy—an economy in which domestic investment is not necessarily equal to saving and in which absorption is not constrained to be equal to production because capital flows can finance current account surpluses or deficits.
In a recent Staff Papers article, Corden (1988) constructed a heuristic framework to analyze the effects of debt relief on the incentives to adjust. Corden’s framework is particularly useful in disentangling the mechanisms by which debt relief can either increase the incentive of debtor countries to adjust (the “pro–incentive effect”) or, on the contrary, reduce this incentive (the “disincentive effect”). The purpose of this note is to build on Corden’s framework and to extend the analysis to the “financially open” economy—an economy in which domestic investment is not necessarily equal to saving and in which absorption is not constrained to be equal to production because capital flows can finance current account surpluses or deficits.
Corden righly notes that the introduction of capital flows in the analysis does not alter the main argument (Corden (1988, p. 629, footnote 2)). Nevertheless, this extension is quite fruitful. First, it enables one to break the identity between “more investment” and “less consumption” and thus reintroduces explicitly, at the core of the analysis, the main incentive countries have to protect their creditworthiness. An important implication of the extension proposed here is that, first, endogenous relief, in addition to reducing the cost of a “debt crisis” to debtors and existing creditors, also preserves the role of capital markets in efficiently allocating current world saving. Second, it adds another channel by which higher real rates of interest may be responsible for endogenous relief (a situation in which creditors have no choice but to recognize that the debtor’s capacity to pay falls short of its commitments). Third, the extension has implications for the specific forms of relief that may be appropriate to maximize the pro–incentive effect of each dollar of relief granted to borrowers.
I. The Financially Open Economy
Countries that preserve their creditworthiness have access to world capital markets and are therefore able to choose a level of absorption different from that of the national product. For these countries, the combinations of present consumption levels and future absorption capacity are not identical to the schedule representing domestic production net of service of the outstanding debt (the CC’ schedule of Corden’s diagrams). Figure 1 extends to the case of the financially open economy the framework proposed by Corden.
The Financially Open Economy
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
The Financially Open Economy
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
The Financially Open Economy
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
As in Corden, there are three periods: the past (period 1), from which the country has inherited a given stock of outstanding debt; the present (period 2), during which decisions have to be made about consumption, investment, and possibly net new borrowing abroad; and the future (period 3), during which the debt service payments fall due. As in Corden, it is assumed that debt service payments falling due now (period 2) are refinanced, so that the country is not currently making any net transfer of real resources on account of the debt. The horizontal axis measures output (OA), consumption, and investment in period 2 (with investment being measured leftward from A). The vertical axis measures output and absorption in period 3. As in Corden, the curve AB shows the levels of output in period 3 that correspond to various levels of investment in period 2; the curve CC’ shows what is left to the country from that output after deduction of the full service of the debt inherited from the past (period 1).
If the country is able to borrow and lend on world markets at the given real rate of interest r, its opportunity set is determined by the intertemporal budget constraint of slope –1/(1 + r) tangent to CC’ in Figure 1. The tangency point, J, determines the level of investment AJ’ necessary in period 2 to produce in period 3 an output J’J”, which, after the transfer of resources necessary to service the old debt, would leave an amount J’J that the country can use for current absorption (consumption and investment in period 3) or to service new loans contracted in period 2. Consumption in period 2 would be determined by the tangency point S between the relevant indifference curve of the decision maker and the budget constraint. At S, consumption in period 2 is OS’. Absorption in period 2 (OS’ + AJ’) exceeds domestic production (OA) by an amount J’ S’, corresponding to a noninterest current account deficit financed by new capital inflows. The amount available for absorption in period 3 will be S’ S (equal to J’ Q), leaving QJ" to service both the old debt (JJ” and the new debt (QJ). Note that the service of the new debt (QJ) is smaller than the additional output made possible by the investment of the real resources corresponding to the current account deficit financed by the new capital inflows. This additional output is QJ + ST, with QJ going to foreign lenders and ST available to the country for absorption or for servicing the old debt.
If, following Corden. the concepts of minimum consumption and of endogenous relief based on capacity to pay are now introduced, the frontier of the opportunity set facing the country becomes HVKA in Figure 2.1 Above the line LZ corresponding to the minimum level of consumption OL, the frontier follows the budget line described earlier (segment HV). Below the line, the country stops servicing its debt as agreed and therefore loses access to international financial markets. The country finds itself in what one could call a situation of financial autarky, and its opportunity set is bounded by the production possibility frontier (segment KA). If K is to the left of V, endogenous relief with financial autarky will always he inferior to creditworthiness and access to capital markets, and service of the debt will not be an issue. If, however, K is to the right of V, the country will choose between financial autarky at point K (with 100 percent endogenous relief) or creditworthiness at point S depending on which point lies on the highest indifference curve.
The Case for Exogenous Debt Relief
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
The Case for Exogenous Debt Relief
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
The Case for Exogenous Debt Relief
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
If K is the preferred point, we have Corden’s case for exogenous relief by the creditors: by reducing unilaterally the debt service payments owed on the old debt, creditors can induce the indebted country to service its remaining obligations voluntarily. All that is needed is to shift the budget constraint out, by an appropriate reduction of debt service payments, so as to enable the country to reach a point such as S’ on (or just above) the indifference curve corresponding to point K.
II. Exogenous Relief and the Efficiency of World Capital Markets
The scheme of “exogenous relief” advocated by Corden and applied to the case of the financially open economy in the previous section is a Pareto–efficient move on two grounds. First, as in Corden. it enables both the debtor and its creditors to be better off than in the alternative situation of endogenous debt relief: the debtor is offered the possibility of reaching a (marginally) higher level of welfare than under financial autarky at K, and the creditors recover some of the debt service payments owed to them rather than being faced with the loss of all their claims.
Second, exogenous relief, by putting the overall debt–servicing obligations of the country in line with its capacity to pay, enables the country to service fully any new loan to be contracted in period 2 to reach point S’ and, therefore, protects the country’s creditworthiness. Thus, by voluntarily purging the system of the excess debt burden that would otherwise induce the indebted country to opt for financial autarky, exogenous relief helps to maintain the unity of the capital markets necessary for an efficient allocation of world saving according to its most productive uses throughout the world. This outcome contrasts with the case of default or endogenous relief, which would segment world capital markets and prevent free flows of capital to the destinations with the highest real returns.
This second implication is particularly relevant to creditors, for two reasons. First, as net savers they have an interest in ensuring that world capital markets function efficiently and, specifically, enable them to allocate their new saving to investments with the highest possible return. Second. and more directly relevant to their position as creditors of the old debt, the ability of the indebted country to continue to raise resources on world capital markets to finance investment opportunities with a rate of return in excess of the real rate of interest on world markets increases the country’s capacity to service the old debt and therefore reduces the amount of exogenous relief necessary to prevent default or endogenous relief (Callier (1985, p. 60)). For example, in Figure 2, the additional resources available in period 3 as a result of the new borrowings by the country in period 2 amount to RT’. Had the country lost access to capital markets, an additional amount of exogenous relief would have been needed to bring the country on or above the indifference curve corresponding to K. (The curve CC’ would have had to be shifted enough to become tangent to that indifference curve, whereas with access to capital markets this is not necessary.)
This second aspect of the concept of exogenous debt relief conceived by Corden is important because it goes beyond the questions of the adjustment incentive and of the redistribution of the costs of the debt crisis between debtors and creditors of the old debt. All economic agents who rely on the market mechanism for an efficient allocation of the world’s savings—not only the indebted country and its creditors—have a stake in the success of exogenous relief in forestalling either unilateral default or endogenous relief.
III. Changes in the World Real Interest Rate
The extension of the analysis to the case of the financially open economy introduces a new channel by which changes in the real rate of interest on world markets can trigger a situation resulting in either endogenous or exogenous debt relief.
Corden (1988, Section VI. pp. 641–43) shows that an increase of the real rate of interest may trigger a situation in which endogenous or exogenous relief arises because of the expected increase in the cost of servicing the existing debt resulting from the higher rate of interest. This expected increase in the cost of servicing the existing debt comes from the cost of refinancing the obligations (including interest payments) falling due in period 2, if any. and possibly from the existence of past loans contracted at variable rates. As noted by Corden, this increase in the expected cost of servicing the old debt can be represented in Figure 2 by a downward shift of the CC’ curve because the distance BC increases. As can be seen from the diagram. the likelihood that, in the absence of exogenous relief, the indebted country will choose default or endogenous relief increases as the cost of servicing the outstanding debt grows.
Even if these effects did not apply (for example, because the country had contracted no loans at variable rates and had already arranged for a grace period expiring in period 3 only), however, the increase in the real rate of interest could still induce the country to default or to seek endogenous relief and financial autarky in the absence of exogenous relief. Abstracting from any possible effect of the higher real interest rate on the cost of servicing the old debt, a higher rate of interest will imply a steeper budget line tangent to CC’, such as H’V’ in Figure 3, which will represent the increase in the cost of contracting new loans to finance an increase in the current account deficit. The effect of this steeper budget constraint is to move point V to the left (to V’) and, as can be seen from the diagram, to create the possibility that the indebted country may choose financial autarky. Beyond the geometry, the logic of this mechanism is that the benefits of creditworthiness and access to world capital markets are reduced by the higher cost of borrowing, and a point will be reached at which these benefits of new borrowing will fall short of the costs of servicing the old debt (even if that cost remains constant). More relevant to the model, the increase in the cost of financing domestic investments by external borrowing reduces the amount of profitable investments that the country can make and therefore reduces its capacity to pay in the future.
Increase in the World Real Interest Rate
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
Increase in the World Real Interest Rate
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
Increase in the World Real Interest Rate
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
IV. The Inefficiency of Relief in the Form of Subsidized Loans of Fresh Money
Exogenous relief can take the form of a direct reduction in the payments due to service the outstanding debt—for example, through a remission of a fraction of the principal or a rollback of the interest rate charged on this debt. This restructuring of the obligations arising from the old debt can be represented by a vertical shift of the curve CC’, as in Corden. Alternatively, another scheme that could be used in the context of a financially open economy to forestall default by the debtor or the need for endogenous relief by the creditors is the provision of new loans at an interest rate lower than the market rate to finance the noninterest current account deficit.
Figure 4 compares the two approaches. It establishes that the first approach (restructuring of the old debt) is preferable to the second approach (provision of new money at a subsidized rate) from the point of view of the costs to be borne by the agents granting the relief. In Figure 4 the highest attainable level of welfare consistent with full debt servicing is reached at point S. The situation prevailing at S is inferior, from the viewpoint of the country, to financial autarky and endogenous relief on the ground of incapacity to pay at point K. Reducing the old debt through exogenous debt relief could bring the country to S’, however, on the same indifference curve as K. The amount of relief necessary to achieve this result can be measured by the vertical distance between the two parallel market interest rate lines passing through S and S’ This distance is JQ.
Debt Relief as Subsidized Interest Rate on New Money
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
Debt Relief as Subsidized Interest Rate on New Money
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
Debt Relief as Subsidized Interest Rate on New Money
Citation: IMF Staff Papers 1989, 002; 10.5089/9781451947045.024.A008
Consider now the outcome of exogenous relief granted through subsidized loans financing the noninterest current account deficit of the indebted country. If it is assumed that, by imposing appropriate conditionality, the lenders are able to avoid the distortions that would result from financing investments with a rate of return lower than the world real rate of interest. the new budget constraint still passes through point J, where the rate of return of the marginal investment is equal to the rate of interest on world markets. Its slope, reflecting the subsidy, is –1/(1 + r’), where r’ is the subsidized real rate of interest charged on the new borrowings of the debtor country. The subsidized interest rate r’ can be chosen to enable the country to reach, at point S”, the same level of welfare as under financial autarky and endogenous relief (at K) or under exogenous relief through debt reduction (at S’).
The cost of the implicit interest rate subsidy necessary to bring the economy at S" can be measured as follows. The current account deficit financed through subsidized loans amounts to the distance S"M in Figure 4. The cost to the borrower of these resources will be a debt service payment of MJ in period 3, but the opportunity cost of these resources to the lenders, computed at the world interest rate, is MN. The net cost to the lenders is therefore JN, which is higher than the cost JQ implied by the first approach to debt relief.
The reason for this higher cost of debt relief through interest rate subsidy is, of course, the curvature of the indifference curve: the substitution effect of lower rates of interest moves the optimum for the country downward to the right along the relevant indifference curve. The additional cost to the lenders results from the substitution of subsidized present consumption for future consumption that is due to the lower interest rate. By contrast, exogenous relief through a restructuring of the obligations arising from the old debt represents, in effect, a lump–sum grant that does not distort the borrower’s decisions. Exogenous debt relief is therefore superior on efficiency grounds.
REFERENCES
Callier, Philippe, “Public Goods, Collective Action, and the International Debt Question,” Revue de la Banque, Centre d’Études Financières (Brussels), Vol. 49 (February 1985), pp. 59–63.
Corden, W. Max, “Debt Relief and Adjustment Incentives,” Staff Papers, International Monetary Fund (Washington), Vol. 35 (December 1988), pp. 628–43.
The author is Associate Professor of Economics (on leave) at Concordia University, Montreal, and is currently a financial economist in the Finance, Industry, and Energy Division of the Economic Development Institute of the World Bank. The views expressed in this note are the author's own and do not necessarily reflect those of the institutions with which he is affiliated.
Endogenous relief is not necessarily identical to default in the legal sense. As explained by Corden, endogenous relief is simply the ex post recognition by creditors that the country is unable to service its debt fully. Endogenous relief is granted by creditors in preference to initiating formal default procedures so as to avoid the various additional costs that a formal default would entail. The two alternatives are similar, however. in that both formal default and endogenous relief force the country into financial autarky. In that sense. endogenous relief amounts to de facto default.
