When a country encounters external debt problems, the question at the center of the policy debate is usually whether the problems are temporary or permanent, or, in other words, whether the country is illiquid or insolvent. Voices sympathetic to the debtor usually claim that the problem is il-liquidity, and that creditors would do well to provide new financing. Other voices caution against throwing good money after bad and encourage creditors to cut their losses and “exit” as soon as possible.1 If liquidity is not provided voluntarily, involuntary rescheduling or the accumulation of arrears follow, sometimes accompanied by emergency loans from foreign governments or international institutions. In the aftermath of the crisis, the debtor country usually improves its external accounts but only at the cost of a severe recession that worsens the country’s creditworthiness. A vicious cycle that perpetuates the initial debt problems then starts.2 Because a temporary external debt problem may lead to long-run economic disruption, the possibility that a liquidity shortfall will trigger a crisis should be a source of serious concern. Furthermore, policies that maintain creditworthiness may not be sufficient in these circumstances to avoid debt problems, and the question arises of whether an appropriate debt-management strategy or the intervention of multilateral institutions, such as the International Monetary Fund (IMF) may be necessary even for countries that normally have full access to world capital markets.3
In this paper, I examine under what circumstances debt crises owing to illiquidity may arise. The most common argument used to dismiss concerns about liquidity problems is that rational creditors should always be willing to provide financing to a creditworthy borrower. Cooper and Sachs (1985) and Sachs (1984, 1995) challenge this view, arguing that a creditworthy borrower may be unable to obtain liquidity because creditors have “pessimistic” beliefs that become self-fulfilling: creditors do not lend because they think that the debtor will not repay. Without the option of rolling over some of his debt, the debtor ends up defaulting, thus validating the pessimistic expectations. This view seems to imply a model of sovereign borrowing with multiple rational expectations equilibria and no mechanism to ensure that the Pareto-superior outcome will be selected.4
Pursuing this line of inquiry, the first part of the paper explores potential liquidity crises arising from self-fulfilling beliefs. The first result found is that, if loans are negotiated by a few large banks, as in the case of the syndicated loans of the 1970s, “bad” equilibria can be easily avoided through coordination and communication among creditors.
As most of the existing literature on sovereign debt adopts a representative creditor framework, it is no wonder that the possible existence of multiple equilibria has generally been ignored.5 As sovereign debtors in developing countries are financing an increasing share of their external debt through bonds, it is important to consider the case in which the creditor side of the market consists of a large number of small claim holders. As it turns out, liquidity crises owing to self-fulfilling pessimistic beliefs can arise under these conditions in a very standard model of sovereign debt. Two distinct mechanisms can generate the multiplicity of equilibria: the first is that pessimistic expectations on the part of creditors increase the risk premium charged to the country. With a larger burden of debt service, the probability of a future default also increases, and a large enough increase can validate the expectations. This mechanism has been highlighted by Calvo (1988) in a model of domestic government borrowing in which the debt is nominal and default takes place through “surprise” in flation.6 Liquidity crises of this type can be avoided if the debtor can prevent the creditors from setting too high an interest rate; one such way is to offer a given amount of bonds for sale and let investors determine the price. Pessimistic expectations on the part of the creditors would then affect only the size of the proceeds from the bond issue but not the cost of future debt service, and the “Calvo mechanism” would not generate multiple equilibria.
A second mechanism can lead to self-fulfilling liquidity crises: if the proceeds from the bond issue are small because creditors have pessimistic beliefs, the borrower is less liquid and may cut investment to prevent current consumption from falling by too much. Lower investment leads to smaller future output and to a higher probability of future default. If the liquidity effect is strong enough, pessimistic expectations can then be validated even if they do not affect the cost of debt service. However, the sovereign borrower can also avoid the bad equilibrium possible under this mechanism by declaring that the bond issue will be automatically withdrawn if the average price is below an appropriately chosen minimum price. This solution can work if all the external debt is issued by a centralized agency, such as the treasury, but it would be difficult to implement in countries where provincial governments or public enterprises also issue substantial amounts of external liabilities.
These results suggest that liquidity crises driven by self-fulfilling beliefs may be an unfortunate by-product of the recent trend toward debt securitization in developing country financing. Although designing the debt issue appropriately can greatly reduce the danger of a crisis, the potential for multiple equilibria is one of the factors that makes access to emergency loans from the IMF or from foreign governments an important safeguard in international capital markets (Masson and Mussa (1995)).
Liquidity crises involving sovereign debtors can arise because these countries cannot make credible policy commitments to their creditors. If the debtor could ensure lenders that a certain amount of policy effort would be undertaken regardless of how much liquidity the country received from abroad, the “crisis” equilibrium would disappear. Credibility can be achieved by developing a reputation. For instance, Diamond (1989) shows how a borrower can improve his access to the credit market by building a reputation for being a “good risk” over time. From the perspective of Diamond’ s model, countries with recent histories of defaults and rescheduling owing to bad policies or countries that do not have long track records of international borrowing should be more vulnerable to liquidity problems. Because the cost of losing a good reputation is relatively small for these countries, modest increases in the (economic or political) costs of policy adjustment could destroy their credibility. Thus, creditors may be discouraged from lending even if other “fundamentals” do not appear to have changed.
The second part of the paper briefly explores another source of potential liquidity crises: disruptions in the bond market. Various studies in corporate finance have highlighted events that may temporarily “short-circuit” security markets, including the bankruptcy of a major issuing house, the default of a major debtor in the market, and a large drop in security prices that renders highly leveraged traders illiquid. When such events occur, external funds are likely to dry up temporarily for even creditworthy borrowers. The analysis briefly reviews past experience with security market disruption, evaluates the possibility that similar problems will arise in the emerging sovereign bond market, and discusses implications for external debt management.
The paper is organized as follows. Section I develops a simple model of sovereign borrowing in which output is exogenous and shows that multiple equilibria can arise because pessimistic beliefs can increase the cost of debt service, which, in turn, increases the probability of default. In the model of Section II, output is a function of policies undertaken in the previous period (that is, output is endogenous). In this model, pessimistic beliefs on the part of creditors can reduce liquidity in period 1, crowd out the policy effort, and increase the probability of a future default. (This is the second mechanism, as discussed above, that can generate multiple equilibria.) Ways to reduce the potential for this type of liquidity crisis are discussed. Section III contains an overview of factors that can disrupt bond markets, and Section IV summarizes the paper.
The necessary first-order condition for a maximum in equation (9) is
The sufficient second-order condition is
Because the utility function and the output functions are increasing and strictlyconcave and the default state z* is decreasing in the policy effort x2, the expressionabove is unambiguously negative. Because of equation (A3), it is sufficient to show that the derivative of the left-hand side of equation (19) with respect to ℓ1, is positive to prove that dΧ/dℓ1 > 0. This derivative is
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Enrica Detragiache is an Economist in the IMF Research Department. She received a Ph.D. in economics from the University of Pennsylvania. Before joining the Fund, she was an Assistant Professor at Johns Hopkins University.
Even if the country has lost its creditworthiness, providing new money may be optimal for creditors who are already exposed because such a strategy (sometimes referred to as “defensive lending”) may increase the value of loans already outstanding. The analysis in the paper focuses on situations in which the borrower is creditworthy, meaning that new lending is profitable also for creditors who are not exposed yet. The potential coordination failures in the provision of defensive loans are the same as in the provision of debt forgiveness and are well-known.
For a recent, comprehensive account of the developing countries’ debt crisis of the 1980s, see Cline (1995).
On new mechanisms to deal with sovereign illiquidity and insolvency, see Eichengreen and Portes (1995).
Sachs (1995) argues that the Mexican crisis prompted by the peso devaluation in December 1994 was a liquidity crisis of this sort. He suggests that the international community should create a new institution along the lines of an international bankruptcy court for sovereign debtors.
In his paper, Calvo suggests that the literature on sovereign debt has ignored multiple equilibria because the usual assumption that the cost of a default is not increasing in the degree of default yields a unique equilibrium. The analysis in his paper shows that multiple equilibria are possible also with afixedcost of default.
If debt could be renegotiated at no cost, the locus would have a vertical asymptote and no backward-bending portion. However, if debt renegotiation involves some deadweight costs, the locus always has a backward-bending portion.
The outcome is not first best for two reasons: first, by assumption, the only financial asset is debt, so state-contingent contracts are ruled out; second, potential default limits the possible debt contracts that can be written. As the option to default de facto makes debt repayment state contingent, the two distortions may partially offset each other.
Because the indifference curves need not be concave everywhere, the same indifference curve may have more than one tangency point with the zero-profit locus. In this case, there would be more than one Pareto-efficient contract. Obviously, this type of multiplicity is not very interesting because both the creditor and the debtor get the same utility in all equilibria. To avoid confusion, I will neglect the possibility of multiple Pareto-efficient contracts in the rest of the analysis.
To be precise, the creditor needs to impose a strict seniority covenant to control the probability that her loan will be repaid. This issue is discussed in detail in Detragiache (1994).
In Calvo’s model, all debt is internal, and it is denominated in domestic currency. The government can “default” by following a monetary policy that leads to high inflation, thereby reducing the real value of its liabilities. There is no randomness in the economy, but the interest rate includes a premium to compensate creditors for a future partial default. Partial default is optimal in equilibrium because the cost of default is increasing in the rate of inflation.
Bad equilibria may not occur if bonds are sold through underwriters who take on all of the placement risk. This possibility will be discussed further below.
Another way to eliminate the bad equilibrium is for the borrower to set a ceiling on the interest rate that he is willing to accept (see Calvo (1988)).
In contrast to the exogenous output case, the zero-profit locus here would have a backward-bending portion even if debt could be renegotiated at no cost.
Recent work in corporate finance indicates that the inability to commit to invest in sound projects may also force borrowers to finance long-term projects with short-term instruments (Flannery (1994)).
These doubts do not mean that conditionality is not useful, of course. Agreeing on a borrowing program accompanied by conditionality may help a government overcome domestic opposition to its desired policy course, for instance.
For a recent attempt to classify financial crises and to connect theories with case studies, see Davis (1995).
Spreads on junk bonds widened considerably starting in March 1989 when Drexel’s junk bond king Michael Milken was indicted. Drexel filed for bankruptcy in February 1990. For an account of Milken’s activities, see, for instance, Akerlof and Romer (1993). On the collapse of the junk bond market, see also Davis (1995). Davis contends that the collapse of the Euromarket for floating rate notes in December 1986 shared the same basic features as the crisis in the junk bond market.