The Problem of Debt Overhand and How to Deal with It Senior Essay Seminar

Debt overhang in developing economies is an issue that must be addressed in order for these economies to grow. A debt burden that is high relative to the economy’s output results in a low credit rating by the rating agencies, which in turn leads to a higher price on further borrowing by the affected countries. Several remedies have been proposed (and used in practice) to resolve the problem of debt overhang. The purpose of this paper is to examine the proposed remedies with an emphasis placed on debt buybacks in the context of the existing models, as well as to attempt to add on to these existing models. Introduction A high debt burden generally means that a significant portion of government revenue must be devoted to debt servicing. Once options for short-term increases in revenue have been exhausted, other areas of government spending must shrink to accommodate debt servicing. One area of spending likely to be reduced is public investment expenditure. Reduced public investment can ultimately lead to lower growth rates in the following ways: i. A reduction in total investment (since public investment is often a significant proportion of gross domestic investment); ii. A reduction in private investment, because some private investment is complementary to public investment (Diaz-Alejandro, 1981) iii. A fall in the productivity of investment because of lost externalities from certain types of public investment (such as physical infrastructure). This relationship between the debt burden and growth, intermediated through the fiscal account, is called the “crowding out” effect (Serieux and Samy, 2001). The costs of debt overhang provide the basis for the necessity of a relief from it. The fact that high indebtedness is a problem that needs to be addressed is not a secret. Pattillo, Poirson, and Ricci (2002) examined the effect of foreign debt reduction on economic growth and concluded that this effect was significant. Their results are summarized in the following graph. Patillo et al. argue that their study empirically shows that reducing foreign debt burden of highly impoverished countries (HIPCs) leads to increased economic growth of these countries. Although the above graph cannot stand as evidence that eliminating debt results in higher growth and not vice versa, Patillo et al. note that there appears to be a growth differential of about 2% between HIPCs and countries with little debt (more than 95% of GDS and less than 95% of GDP, respectively). Thus, debt overhang seems to be an important factor in a given economy’s growth. In this paper I will discuss several schemes that could reduce debt overhang and bring about economic revitalization of the debtor. Particular emphasis will be placed on debt buybacks. Literature on debt buybacks varies significantly, and due to the difficulty of reliably quantifying costs of default, mathematical treatments such as the one by Bulow and Rogoff (1988) predict that buybacks, although beneficial for the creditors, are not in the debtor’s interest. This paper will attempt to show that at least under some circumstances, debt buybacks might, indeed, be beneficial for the debtor and in certain cases maybe the only plausible solution to the overhang problem. Debt Rescheduling (Refinance) Schemes Of the several ways to deal with the problem of debt overhang discussed below, debt rescheduling is the least promising. In fact, it is little more than window dressing used to mask the problem and postpone the inevitable (default) as long as possible (Sachs, 1989). Costs of such a postponement include withholding of new loans to finance good investment opportunities that end up being passed up, as well as the debtor engaging in risky ventures with high risk of default in an attempt to either succeed and enable itself to payoff the debt, or fail, thereby bringing on the inevitable default. It is the creditors and not the equity holders who stand to gain from the returns to a new investment. Indeed, the shareholders (in our case the sovereign debtor) can only benefit if the investment has a very high rate of return that re-establishes the firm (country’s) solvency. Thus, the shareholders will prefer highly risky investments that offer at least a small chance of a very large payoff. By undertaking a risky investment, the shareholders gain a small chance at re-establishing the value of their claims, while they impose a high expected cost on the creditors, who will suffer in the likely event that the risky investment flops. For these reasons, it is unlikely that existing creditors will be willing to make new loans to an insolvent debtor, unless the creditors are able to achieve some management control over the choice of investment projects. Debt Forgiveness and the Debt Laffer Curve A much more attractive and real solution is debt forgiveness. If the debtor nation can convince its creditors that forgiving some of its debt is beneficial not only for itself, but also for the creditors, then it can reduce debt overhang and negate some of its negative effects on the debtor’s economy. “Most of the inefficiencies of a debt overhang can be relieved by partial debt forgiveness. Importantly, since debt forgiveness overcomes economic inefficiencies that hamper the growth of the debtor, it is not surprising that debt forgiveness can be designed in such a way as to improve the position of both the creditors and the debtors” (Sachs, 1989). For an economy facing severe debt overhang, partial debt forgiveness can actually lead to an increase in eventual payments to the creditors by facilitating a higher rate of growth. The proposition that collective debt relief can benefit both the debtor economy as well as the creditors, was illustrated through a simple two-period model by Jeffrey Sachs (1989). First, it is assumed that the debtor economy is a two period function: ) ( ) ( 2 1 C bU C U + = We assume that n number of creditors, where n is large, are owed a total debt in the amount of T. The debtor can voluntarily make a schedule payment in the amount of S, or, if it fails to do so, creditors can force it to pay an amount P by seizing its assets, lawsuits, and other collection activities. Sachs notes that these collection activities are generally inefficient as they impose costs on the debtor that are much greater than what the creditors actually collect. It is assumed that the debtor is willing to pay its debts up to a fraction z of the second-period output Q2. If the debt payment due is less than zQ2, then the debtor satisfies its obligation. If the payment due is more than the zQ2, then the debtor pays up to that amount and partially defaults on the rest. In our notation T = payment due and S = actual amount paid, so: S = T if T ≤ zQ2 S = zQ2 if T > zQ2 The final assumption of this model is that the repayment S is divided among the creditors in proportion to their individual exposure. To study the behavior in the simplest way, a two-period set up is assumed, where the debtor enters the first period with an amount of debt due in the second period equal to D. The economy’s production technology is given by: Q 1= F(K2) Q 2= F(K2) K2 = K1 + I1 With the usual assumptions that F’ > 0 and F” < 0. The country may be able to attract new loans in period 1. The principal due on such loans will be denoted as D1. New creditors will only be willing to lend if they will be repaid fully, with the world interest rate r, or (1 + r)D1, in the second period. Since the total debt T due at the end of the second period will be D1 (1 + r) + R, where R is the amount due from the original creditors. The lending from new creditors will be limited by: D1 (1 + r) < zQ2 – R As long as the above equation holds, the new creditors will be fully repaid. The original creditors, with claim D, may agree to change D to some amount R < D. If they do not do so, then the debt due in period 2 remains D. The goal of the creditors is to maximize their ultimate repayment, which is given by S – (1 + r) D1, where S is the total repayment that the debtor can afford and (1 + r) D1 is the payment to first period lenders that expect full repayment. The creditors problem can be restated as: 1 ) 1 ( max D r S R + − subject to R < D The debtor has the choice of investment, consumption, and perhaps new borrowing, in the first period. The balance of payments constraint is: 1 1 1 1 Q C I D − + = Once the level of second-period debt R is decided by the original creditors, the debtor maximizes its utility. Let us now assume that the original debt D is so high that no new loans are forthcoming. If the creditors do not forgive any portion of the debt, part of the debt D will be defaulted in period 2. To choose the optimal level of investment I1 and thereby the amount of debt to be repaid, the debtor solves the following problem: ) ( ) ( max 2 1 C bU C U + Such that 1 1 1 ) ( I K F C − S I K F C − + = ) ( 1 1 2 Given that S = zQ2, we can also write ) 1 ( ) 1 ( 1 2 + − = K F z C . The interior solution