Costs and benefits of debt and debt service reduction

The author evaluates the costs and benefits of debt and debt service reduction (DDSR) from the point of view of five countries that have concluded Brady deals: Costa Rica, Mexico, the Philippines, Uruguay, and Venezuela. He concludes that, contrary to widely held views, commercial banks have probably benefited from the operations. Commercial bank participation in DDSR is voluntary, so direct financial savings to the country are probably negative at present values. The benefit from DDSR is not that debt is bought at"bargain prices"at the expense of commercial banks. It appears difficult to justify a DDSR operation on purely financial grounds. A more realistic way to look at a DDSR operation is to view it as a"project"that involves a certain financial cost. The return on such a project is how the DDSR operation improves the macroeconomy, or contributes to development. The main purpose of DDSR is to establish a more efficient arrangement between debtor countries and commercial banks, leading to improved conditions for development. A DDSR operation that does not help development is costly and should not be undertaken. The impact of DDSR on development is usually measured by the increase in the growth rate of GDP, but it is too soon to measure that for these five countries. A suitable alternative is to look at the change in investment patterns. A strong policy framework is needed if debt and debt service reduction are to significantly improve development. In Mexico and, to a lesser extent, Venezuela, improved and sustained strong adjustment policies have generated the greatest development benefits. Gains have been less in smaller countries where policies were not as supportive. The author concludes that for a country to benefit from DDSR, it needs significant indirect benefits (such as increased domestic and foreign savings). Direct benefits are likely to be negative because of the commercial banks'financial gains and because DDSR operations are frontloaded. DDSR operations cannot be justified solely by direct benefits and savings in cash flow.Strategic Debt Management,Banks&Banking Reform,Economic Theory&Research,Environmental Economics&Policies,Financial Intermediation

The new wave of private capital inflows : push or pull?

Widespread private capital inflows to middle-income countries have surged over the past three years. At the same time, Brady-type debt reduction operations and domestic policy reform took place, indicators of country creditworthiness improved dramatically, and international interest rates plummeted. Which factors most fully explain the wave of capital inflows? How sustainable is it? Some see this new wave of voluntary capital inflows as being mostly"pulled"by attractive domestic conditions, which open new and profitable investment opportunities in the domestic economy and improve country creditworthiness. Under this interpretation, if successful domestic policies are maintained, capital inflows will be sustained. Others see these inflows as being mostly"pushed"by conditions (especially low interest rates) in industrial countries. Under this interpretation, capital inflows would diminish and possibly turn to outflows if international real interest rates returned to the higher levels of the 1980s. The author presents an analytical model of international portfolio investment in developing countries based on non-arbitrage conditions between external returns and domestic returns adjusted by country risk. The author uses the model to explain why the new wave of private capital inflows is mostly a middle-income country phenomenon. To analyze the issue of private capital inflows, he applies the model of data for a representative panel of middle-income countries. The main empirical result is that (except in Argentina, the Republic of Korea, and notably, Mexico), the surge of capital inflows appears to be driven more by low returns in industrial countries than by domestic factors. So recent levels of capital inflows would be unsustainable if global interest rates returned soon to higher levels and cautious policies should be followed. Two other important conclusions are obtained. First, depressed returns in industrial countries caused the improved creditworthiness in indebted countries through their effects on discount rates. Country creditworthiness was an important transmission mechanism for external shocks and is the key to reconciling the push and pull interpretations of market data. Second, a soft landing appears feasible. Stock adjustment does not appear to be a significant component of the adjustment mechanism manifested in the surge of capital inflows. In other words, the evidence so far suggests that gradual increase in international interest rates would result in less capital inflow, or moderate capital outflows in some countries, rather than massive capital outflows that quickly bring down the stock of foreign liabilities. By and large, if there are capital outflows, they are unlikely to match past inflows unless the reversal in external conditions coincides with a worsening of domestic conditions.Economic Theory&Research,International Terrorism&Counterterrorism,Macroeconomic Management,Environmental Economics&Policies,Banks&Banking Reform

The surge in capital inflows to developing countries : prospects and policy response

After being excluded from world capital markets during the debt crisis, many developing countries have experienced large capital inflows in the past five years. The challenges these inflows pose for domestice policy have generated a substantial literature. The authors review and extend that literature. They characterize the new inflows, assess their causes and the likelihood of sustainability, analyze the policy issues they raise, and evaluate the possible policy responses. Their conclusions tie desirable policy responses to characteristics of both the flows themselves and to those of the recipient economy. Regarding the forces driving the current episode, they conclude that generally, the role of foreign interest rates as a"push"factor driving capital inflows and determining their magnitude has been well-established. On the other hand, country creditworthiness has helped determine both the timing and destination of the new capital flows. Even if creditworthiness is maintained, the early level of inflows is unlikely to be sustained. The pace of reduction in flows to countries that have been receiving them since the early 1990s depends on the path of foreign interest rates and the role of stock adjustment. But a loss of creditworthiness caused by a deterioration in domestic policy would stop inflows quickly and, depending on the circumstances, inflows may be replaced by substantial outflows and an outright balance of payments crisis.What are the implications for policy in recipient countries? Briefly, the receipt of capital inflows may strengthen the case for removing macroeconomic distortions, either because such inflows aggravate the cost ofsuch distortions or because they ease the constraints that originally motivated their adoption. While direct intervention may not be feasible (because controls may be easily evaded), controls may sometimes be a second-best policy. To the extent that capital inflows are permitted to materialize, the desirability of foreign exhcange intervention depends on what is required for macroeconomic stability. Sterilized foreign exchange intervention to prevent overstimulation of demand with a fixed exchange rate may not be feasible or effective. A commensurate reduction in the money multiplier, achieved by increasing reserve requirements, may also have limited effects. The effectiveness of both measures depends on the structure of the domestic financial system. If domestic monetary expansion is not avoided, or if an expansionary financial stimulus is transmitted outside the banking system, the stabilization of total demand will require fiscal contraction.International Terrorism&Counterterrorism,Capital Markets and Capital Flows,Economic Theory&Research,Fiscal&Monetary Policy,Banks&Banking Reform,Economic Theory&Research,Macroeconomic Management,Banks&Banking Reform,Environmental Economics&Policies,International Terrorism&Counterterrorism

North-South customs unions and international capital mobility

The primary distinction in a North-South trade accord is likely to be that the Southern nation experiences more capital scarcity than its Northern trade partner. So the trade accord's impact on the Southern trading partner's ability to attract capital may have welfare implications for both nations. The authors extend the traditional analysis of customs unions to allow for international capital movements. Their results indicate that trade accords may affect the ability of Southern nations to attract capital and may divert capital between Southern nations. Moreover, the welfare implications of North-South trade accords may differ from those that predict the North American Free Trade Agreement's (NAFTA) minor third-country effects, holding factor endowments constant. The key implications of North-South trade accords such as NAFTA are generally perceived to involve their impact on investment flows. The authors try to understand the channels through which trade accords can affect North-South investment flows. A potential link between trade accords and investment flows may be how the accords affect the ability of the Southern partner government to make commitments about the treatment of foreign investment. They show that these accords can affect both the magnitude and pattern of inward foreign investment and production, implying the possibility that both trade and financial diversioncan stem from a bilateral regional trade accord. Novel effects that emerge under sovereign risk must be addressed when assessing the welfare implications of trade accords. The greatest gains from integration are still achieved when integration takes place between the countries with the greatest potential gains from trade. But the authors make a distinction: these gains now include both current trade and inter-temporal trade through foreign investment.Environmental Economics&Policies,Economic Theory&Research,Payment Systems&Infrastructure,International Terrorism&Counterterrorism,Fiscal&Monetary Policy,Trade and Services,Economic Theory&Research,Environmental Economics&Policies,TF054105-DONOR FUNDED OPERATION ADMINISTRATION FEE INCOME AND EXPENSE ACCOUNT,Trade and Regional Integration

A dynamic bargaining model of sovereign debt

This paper models a dynamic bargaining game between a highly indebted country and its commercial bank consortium, to analyze the determinants of the resulting re-scheduling agreements and the net transfer of resources over time. The bargaining game is based on the simple paradigm that if no agreement is reached for a current payment, the banks would apply default sanctions. The author found that under general conditions settlements would be reached and default sanctions would not be applied in equilibrium. But the default sanctions would be a credible threat underlying the negotiations and determining the equilibrium payments. These equilibrium payments in turn would determine the credit ceiling and the later commercial discounts on the debt market. Unlike other bargaining games, this one explicitly models the debtor country's economic structure, featuring an import-dependent economy subject to foreign exchange and fiscal constraints. Moreover, the model is truly dynamic in the sense that the future negotiating environment is endogenously determined by current bargaining outcomes. Under plausible refinements and assumptions, the author obtains a closed-form solution for net transfers, dependent on various structural and policy parameters.Economic Theory&Research,Environmental Economics&Policies,Banks&Banking Reform,Strategic Debt Management,Financial Intermediation

The Multilateral Response to the Global Crisis: Rationale, Modalities, and Feasibility

The paper reviews the case for a strong multilateral response to the global crisis in emerging markets (EMs). It discusses modalities and feasibility of intervention and its associated risks, depending on country circumstances of fiscal space and liquidity needs. The specific role of Multilateral Development Banks (MDBs) in ensuring the development effectiveness of the fiscal response is also discussed. The paper concludes by highlighting the international financial architecture issues raised by the global crisis that cannot be addressed immediately but will need to be dealt with once the current crisis has been tamed.Global Crisis, Latin America and Caribbean, Multilateral Development Banks, Policy Responses.

Recent experience with commercial bank debt reduction

The authors review the case for market-based debt reduction and concerted debt reduction. They explain the new menu-based approach to debt reduction and discuss why it may be preferred to market-based and concerted debt reduction. In a review of the five recent debt-reduction agreements, they find that the menu approach indeed achieved debt reduction at substantially lower costs than a comparable market-based operation. By one measure, the five countries may have saved more than $8 billion. Even a menu-based approach to debt reduction, however, is unlikely to directly benefit the debtor financially. They find that the debtors suffered financial losses equal to a few percent of their GDPs. Indirect benefits, or efficiency gains associated with debt reduction, are necessary to make the operation benefit the debtor.Strategic Debt Management,Economic Theory&Research,Financial Intermediation,Environmental Economics&Policies,Banks&Banking Reform

Output Collapses and Productivity Destruction

This paper analyzes the long-run relationship between output collapses—defined defined as GDP falling substantially below trend—and total factor productivity (TFP), using a panel of 71 developed and developing countries during the period 1960-2003 to identify episodes of output collapse and estimate counterfactual post-collapse TFP trends. Collapses are concentrated in developing countries, especially African and Latin American, and were particularly widespread in the 1980s in Latin America. Overall, output collapses are systematically associated with long-lasting declines in TFP. The paper explores the conditions under which collapses are least or most damaging, as well as the type of shocks that make collapses more likely or severe, and additionally quantifies the welfare cost associated with output collapses.Growth, recessions, productivity, recovery

Is the debt crisis history? Recent private capital inflows to developing countries

The outlook for economic development for an important group of middle-income countries has again been buoyed by substantial private capital inflows in the 1990s. As in the 1970s, this development has been met with cautious optimism. It is generally accepted that these countries need resource transfers from the rest of the world to support capital formation and growth. It is also generally accepted that these private capital flows make the allocation of resources more efficient. But there is concern that a rapid reversal of market sentiment could impose considerable adjustment costs on these same economies. The authors try to quantify what many consider to be the main reasons debtor countries have access to capital markets again: (a) Domestic policy reform in the debtor countries. (b) Debt and debt service reduction, usually associated with Brady Plan restructuring. (c) Changes in the external market, such as changes in interest rates in industrial countries. They argue that a useful barometer for access to new loans is the market value of existing sovereign debt. It follows that a quantitative analysis of the factors that caused the market value of sovereign debts to rise rapidly after 1989 would also improve understanding of the forces behind the renewed access to international capital. Empirical historical evidence suggests that fiscal reform, privatization, and debt reduction are useful in explaining relative improvements in the standing of debtor countries in international credit markets. Debtor countries with strong reform programs, in other words, are better prepared to withstand deterioration in the external environment. But the reduction in dollar interest rates since 1989 appears to be the chief factor in the debtor countries'renewed access to international loans. The authors estimate the effect of increases in dollar interest rates and conclude that the typical debtor country remains vulnerable to increases in interest rates that are well within the range of recent experience.Economic Theory&Research,Environmental Economics&Policies,Banks&Banking Reform,Strategic Debt Management,Financial Intermediation