Palgrave Macmillan Journals International Monetary Fund

An International Debt Facility? Author(s): W. Max Corden Source: Staff Papers - International Monetary Fund, Vol. 35, No.
3 (Sep., 1988), pp. 401-421 Published by: Palgrave Macmillan Journals on behalf of the International Monetary Fund Stable URL: http://www.jstor.org/stable/3867179 . Accessed: 12/03/2014 11:48
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An International Debt Facility?

W. MAX CORDEN*
debtfacility to buy the debt of The proposal to set up an international a countries at discount and then mark down its contractual developing value is analyzed. The paper considersthe centralquestionof how the creditor debtorcountries, banks, and ownersof thefacilitywould be what redistribution would in ofgainsand lossesthere affected; particular, and the are be among them. The "market "ceilingeffect" price effect" is whether debt retained banks A crucial consideration by distinguished. to debtboughtby thefacility. is subordinated
countries' PROPOSALdesignedto deal withthedeveloping COMMON debtfacility" debtproblemis thattherebe setup an "international thatwould buy debt at a discountand thenmarkdown its contractual could be envisagedeither debtrelief. Thisfacility value, henceproviding as a major schemethatwould, over a period,deal withmostor all outor as a debt owed or guaranteedby governments, commercial standing small of with modest more only portions debt, arrangement dealing of particular possibly only that which is owed by the governments countries. Many suchproposalshave been advanced. Theyvaryin theirdetails,1 some major. Nevertheless, thefrequency and thereare manydifficulties, withwhich such proposals are made makes it worthexaminingthem in theirmanypermutations. carefully *Mr. Corden on leavefrom in theResearch is Senior Advisor Department, ofEconomics. He is where he is Professor National theAustralian University, ofEconomics andtheLondon School oftheUniversity ofMelbourne a graduate
and at variousAustraat OxfordUniversity and PoliticalScience. He has taught and colleaguesin theFund for He thanksKen Rogoff lian and U.S. universities. helpfulcomments. As faras I am aware, the first proposalsof thisgeneralkindwere advanced
Kenenin in Business Week 28, 1983)andbyPeter (February byFelixRohatyn hasbeenmadebySachsand Times TheNewYork 6, 1983).Theproposal (March of the WorldBank (in The formerly Huizinga(1987) and by PercyMistry, 401
402
W. MAX CORDEN
I. Main Issues There are three principalparties to the proposed transaction-the the creditor debtorgovernments, banks, and the "owners" of the facilhow is would accrue to The central the costs and benefits ity. question various parties. Is there an element of "foreignaid" or of a "bank would the banksgiveup something? Could all bail-out"?Alternatively, threepartiesgain or, at least, could some gainwithout theotherslosing if at all? In otherwords,is theresome systemic benefit? significantly, The proximateredistributive effects-and possiblyalso the systemic on threeprices:thepriceat whichthedebt effects-will dependcrucially is bought,the price or value to whichit is markeddown, and the price or perceivedvalue to whichremaining debtthatis retained in theprivate ofthewholeoperation.The fulleconomiceffects sectormovesas a result willdepend, of course,on how the variouspartiesreactto or deal with the proximate gains or losses. In considering the detailsof such a schemethereare manychoicesto be made. * The debt mightbe bought by the facility at the minimum price it might be boughtat requiredforthe banks to partwithit voluntarily; currentmarketprices; it mightbe bought at the marketprices that existed at some earlier "cut-off" date; or it mightbe boughtat some discounts on thecontractual value. Conotherset of pricesrepresenting it even be contractual value. at its ceivably might bought * Purchased debt mightbe marked down to the cost at whichthe facility boughtit, or to a higheror lowervalue thancost. * The debt thatis not sold by banks might maintain its presentcontractualstatus; it mightbe subordinatedto the debt that the debtor or it might will now incurto the facility; be markeddown by countries the debtorsto an extentthatwould forcethe banksto sell all theirdebt to the facility. would be financed.Here, also, A crucialquestionis how the facility the thereare differences various among proposals,and the possibilities will be discussedshortly.
ofthis nature havebeen Banker, 1987).In 1988,proposals September general of the Fund,and by James an Executive Director made by Dr. Sengupta, ofthis Chairman ofAmerican Thereis an analysis kind of Robinson, Express. in Feldstein andothers TradeandCompetitive(1987).The Omnibus proposal included a ness Act of 1988,passedby bothhousesof the U.S. Congress, fortheSecretary to "study thefeasibility oftheTreasury and advisprovision an "International Debt Management ofestablishing Authority." ability"
AN INTERNATIONAL DEBT FACILITY?
403
II. A Simple Scheme

that onedebtor thescheme toany Letussuppose The applies country. andoffers tobuygiven ofdebt.In amounts facility goesintothemarket the detailedexamplespelledout below,it willbe assumedthatthe ofdebt.Ofcourse debt tobuy half thestock isnothomogeoffers facility various decisions wouldhaveto be madeon which debt neous,so that that would thefacility havetopaymore than the tobuy.It is quitelikely that the market but one can assume would debt initial facility price, buy ofwhat from thecontractual value.Theimportant ata discount question itwould theprice, andinwhich direction will determine be would move, taken later. up with newbonds debt for thepurchased Thefacility guaranteed by pays ofdebtwith theoriginal The banksare thus able to dispose itsowners. in exchange risk fordebtof to default is subject valuethat contractual to much valuethatis subject a lowercontractual lower, zero, possibly that sellcouldnotbe worse is that those risk. One'sfirst default thought there is no compulsion in is voluntary; After off as a result. all, selling andwillhaveto be Thisconclusion is notnecessarily this scheme. true, IV. lookedat againin Section thecontractual valueofthedebtor then mark down would Thefacility It marks thedebtdownto thecost it has acquired. debtthat country's valueofthenewbondsithas issued to it-thatis, thecontractual price ofthefacilfrom theowners are thusrequired to thebanks.No funds that have underwritten the the But,of is, facility. ity-that governments because ofthe newassetsare somewhat thefacility's and, course, risky been it this risk has taken over on the bonds has issued, by guarantees there willbe a potential needfor owners. Giventhisrisk, thefacility's wishto finance whomayactually theowners, funds from contingency A for the risk. to allow overreserves major,and possibly specifically of is the a reluctance of to the establishment obstacle facility whelming, A to be discussed below such risks. is to assume question governments or eliminated. thisrisk can be reduced whether becausethecontractual benefits value The debtor country apparently be as Butthegainto itwillnotnecessarily ofitsdebthasbeenreduced. view is that the at first. market's as it seem One possible might great wasjustified led to theinitial which ofdefault discount, risk, perception of default. In other the true this inthesensethat probability represented the not in case that would a chance there was words, country any good of its debt. the contractual value full contractual the Reducing repay wouldnotnecessarily of thefacility of theoperation valueas a result of actual the actualpayments reduce expected payments (or probability
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W. MAX CORDEN
askwhether one might is there to be made)to thesameextent. Indeed, at all. to be anygainto thedebtor country likely
III. HowDebtor and BanksMayGain

ofthepossible andalso to thebanks, Thismatter gainto thedebtor, iftheconcept ofthedebtor's moreprecisely can be analyzed "capacity Thisis defined as theability to makeresource to pay" is introduced. abroadto cover interest andrepayment ofprincipal. transfers payments over a on onthecountry's of its Itdepends minimum time, output period and on its to transform into level, ability consumption output tradables and togenerate thetransproducts) (exports import-competing required on theterms oftrade. fer.It also depends It willbe supposed at thisstagethat to paycan vary as the capacity of various uncertain events-such as terms of trade result exogenous, of in not the of does because vary changes developments-but policies which are taken as is thedebtor This the itself, country simply given. of"exogeneity." Itwill alsobe assumed for themoment that assumption about to are the same market among parexpectations capacity pay andthedecision ofthefacility. debtor makers This countries, ticipants, of"uniformity ofexpectations." Thesetwosimplifying istheassumption are important for theanalysis ofgainsandlossesfrom the assumptions of a facility and therefore willbe reconsidered in Secestablishment tionVII. intheanalysis. I show First thebanks Therearetwosteps why might I show ofthefacility, andthen thedebtor why might gainattheexpense on uncertainty. crucially depends gain.The secondeffect Gain to the Banks isthe"market To begin there effect."2 Itcanbe shown that with, price willgainat theexpense ofthefacility, thebanks that thedebt provided is notsubordinated tothemarked-down that retain debtthefacility they is that nowholds.The reason themarket ofthedebtwillrise(the price discount willfall).The argument is quitesimple when there is complete to pay(or repay). aboutthecapacity certainty that thecontractual Let us suppose debtis US$1,000 andthecapacity to payis $600.Assumeat thisstagethatthelatter is fixed. Hence the willneither debtor it pays country gainnorlose; whatever happens, ofas a single sumpaidina single future the $600.Thisis thought period,
2Thisdiscussion builds on Dooley(1988).
405
contractual or debtrelief is then inevitable. The "default debt,default ratio"wouldbe 40 percent. Thefacility then tobuya proportion offers ofthe$1,000 incontractual debtfrom thebanksat a discounted Here it will be assumed that price. it buyshalfthedebt($500) and that thepriceitpaysis 80 cents to the dollar.Hencethefacility thedebtithas acquired pays$400and marks downto itscostprice.The contractual valueofthetotaldebtowedby isthus thedebtor reduced to$900.With thesamecapacity topay country of thedebtit holds,thusmaking a lossof repayment get66.7 percent The banks will for the debt have retained a $133. get$333 they (with valueof$500),andwhen contractual is combined this with the$400they from received thefacility end up with is an improve$733,which they ment of $133on whatthey wouldhavereceived ifthefacility had not andmarked downsomeofthedebt.The discount on debtheld bought from 40 percent to 33.3 percent. bythebankshas fallen is 80 cents butthemarket thefacility's In this price purchase example The to cents. could from 60 cents 67 hasrisen purchase price only price value toa bigger decline inthecontractual be reduced, therefore leading rise in the market and, hence,to a further price.The equilibrium be are equal) wouldactually and market prices purchase price(where a greater centswhenthefacility 70i buyshalfthedebt.If it bought can be derived as Theseresults thepricewouldbe higher. proportion, follows:
C2=C(1q)+ Cqp (1) as before,thedefault ratiobecomes 33.3 percent.The facility willfinally
sum consistingof principaland interestcombined. Given the initial
p =RIC2, where value contractual C1= initial valueafter debtrelief C2= contractual = of debt byfacility q proportion bought
(2)
as prop = purchase price(equal to market priceafter purchase) of initial contractual price. portion Fromequations (1) and (2),
R/C = (1-q)p + qp2. (3)
R = capacityto pay
Fromequation (3),
P=
- (1 - q) + V(1 - q)2
2q
+ 4qR/C
406
W. MAX CORDEN
from the facility to the banks. All this There has been a pure transfer will be reflected in the marketprice rising(discountfalling)when the entersthe market.It has to pay a higherprice than the initial facility price to induce the banks to sell any debt to it. The banks will foresee thatdebt not sold would rise in value when some marking down takes and hence will sell at a they only sufficiently place, higherprice. The not to would rise its value and necessarily equilibrium immediately, price could also overshoot, sincebanksand othersin themarket wouldnotbe in advance. The accountgivenhere,with able to predict thisequilibrium its impression of precision,merelyindicateslikelytendencies. The essentialpointcan be restatedas follows.When the contractual value of the total debt is reducedwhiletotal capacityto pay staysconof contractual debtmustbe worth morein the stant,each dollar'sworth marketthanbefore,providedthatall dollarsof contractual debt would be treatedequally if therewere some default. Gain to the Debtor about capacityto pay and the "ceilingeffect" can now be Uncertainty introduced.3 The mean expectedrepayment be but it could might $600, to also be greater, a of of $1,000, and it ceiling completerepayment up could be less, witha floorof zero. There is thusbothupside and downside risk,and thiswill be takeninto accountin the market price. If the contractual value of the debt is reduced,say, to $900, the ceilingwillbe of trade,forexample,turnout to be quite loweredto $900. If the terms to payis actually so thatcapacity will favorable, $950,theactualpayment value had stayedat its initiallevel. be $50 less than if the contractual froma markdown Thus the debtorgains at the expense of creditors of the contractualvalue because the downside risk remains as before, whereasthe offsetting upside risk(or gain) becomes less.4
3 In several has discussed theuncertainty see papersPaul Krugman aspects; Krugman (1985). especially thathas been usedis quitesimplified, to 4The example sufficient although As noted is thought make themain ofas a single sum earlier, points. repayment future there is certainty) thesumconsisting ($600,when paidina single period, ofprincipal andinterest combined. Theanalysis could be elaborated toallow for ofinterest inwhich a stream andamortization over casethesum time, payments ofas thepresent is then should be thought value.There inthe scopefor changes ofpayments. In that casea distinction between interest andprincipal time profile effect in reducing wouldhaveto be made.Debt relief mayhavean immediate ifcapacity topayintotal is really eventhough, interest interest fixed, payments, willincrease later.Changes in thetimeprofile of or amortization payments thepresent oramortization that do notalter valueleave either interest payments theanalysis aboveunchanged. Themarket discount is causednotonly presented of default or forced debtrelief as usually understood but by theprobability
407
IV. Subordination: Can a Gain to the Banks Be Avoided? An interesting is whether a gainto thebanks at theexpense question ofthefacility-that be avoided. Thekey here is,a "bankbail-out"-can is subordination of thedebtretained the banks relative to the debt by nowownedbythefacility. Whenone talks abouta gainto thebanks, one meansa gainrelative to theinitial situation when there wasalready a discount inthemarket. of the banks incurred a loss once the ofsome Earlier, course, probability or forced default debt relief was perceived or them the market. by as longas the banksget less than$1,000they willhave Presumably, incurred somelossas normally even the above defined, though margin the Londoninterbank rate (LIBOR) theycharged offered originally must havetaken intoaccount thepossibility ofsomedefault orofheavy to provide somerelief. pressure thedebtandmarks half itdown again,thefacility Supposethat, buys tocost.Itbuys itat80cents andso pays total contractual $400, perdollar thusmarked downto $900as before. One nowproceeds debtbeing in twostages.First, let us assumethatthere is no doubtat all thatthe to paywillbe at least$400. capacity If itcouldbe firmly is thecapacity-to-pay established whatever that, wouldalways above$400,thedebtheldbythefacility be paid outcome first-that be "senior" debt-then thefacility would notmake is,would wouldrunno risk.But the bankswouldlose a loss, and its owners the and debtors has gain,becausethe "ceiling payment" potentially, the maximum the banks could beenreduced. have Previously payment was $1,000,whereas now it is $500 forthe debttheyhave received from havealready received thefacility. retained If plusthe$400they to turned out to be the banks would have $950,previously capacity pay received the $950, but now theycan onlyreceive$900. In contrast, remains minimum can receive $400. they debtretained debtthus Subordinating by thebanksto facility-held that thefacility neither losesnorgains, on no ensures while risk, taking countries attheexpense ofthebanks thedebtor because gainpotentially oftheceiling effect. lossto thebanks wouldbe reflected The expected in themarket in a decline price.5
of forced to participate in new also bytheprobability pressures rescheduling, ofchanging thetime and andso on. Theseareall ways profile packages, money valueofrepayments. thepresent reducing forthevarious 5An issuethatis clearly is whether it important proposals forexisting wouldbe legally debtthatis retained possible bythebanksto be to thatacquiredby the facility. Of coursetherewouldbe no subordinated insuchsubordination ifitwere donewith theagreement ofthebanks. difficulty
408
W. MAX CORDEN
to be shared for someofthelossto thebanks with Ifitweredesired the latter could markdownthe debtby morethanthe the facility, hence a clear lossnow.Alternatively, discounted making price, purchase Here there is scopefor of its debt be seniority. might given onlypart in of the details such a and these variations scheme, mayhave many for the on or banks and the effects the losses gains significant facility. is that thebanksandthefacility combined must The keypoint makea loss-that the benefits of a favorable is,forgoing very potential capacityThe risk ofan unfavorable outcome. outcome hasnotbeenelimto-pay of a very favorable return butthepossibility inated, (above$900)has. Thesecond oftheanalysis that istoassume topaycould stage capacity case there would be somepossibility be lessthan that even $400.In that senior wouldnotbe fully debtgiven status repaid.Hence riskforthe wouldnotbe completely eliminated. The conclusion thatsubfacility ofdebtretained dination to thedebtowned bythebanks bythefacility eliminate for allrisk thefacility ontheassumpwould hinges completely someminimum total tionthat to thevalueofthedebt payment-equal has bought thatthefacility assured. ($400 in theexample)-is utterly But thelarger theproportion of theinitial totaldebtthatthefacility takesoverandmarks itis that all risk for thefacilthelesslikely down, be it would eliminated debt the holds senior status. Ifthe bygiving ity had all the no one but the could assume debt, facility bought up facility therisk. Therecan never be utter aboutprospective to pay, certainty capacity so that somerisk for thefacility is inherent inthescheme. Thisimplicit isparticularly for risk relevant that would havethefacility take proposals overa largepartof theforeign debtof a country. The inevitable risk to the of of reluctance creditor countries to governments helps explain for a such facility. support proposals V. Reduction of Uncertainty Another worth becauseitis implicit in possibility, carefully exploring someproposals, cannowbe considered. Thesuggestion is that theFund or World Bankmaybe able to increase or ensure ofpayment certainty atthenew, marked-down valueofthedebt.Theassumption maintained theactual so far-that outcome onexogenously repayment depends only to pay,subjectto the "ceiling" determined capacity imposed by the value-is relaxed. contractual can also depend on policies. Repayment themeanexpected to paywas $600, Supposethatinitially capacity with a probability ofcreditors more orless.Ifthetotal debtwere getting downto $600,there marked wouldthen be a $600ceiling to therepay-
409
Bankwereable to In addition, ment. supposethattheFundor World Thisassurance that$600also becametheminimum ensure repayment. have been obtained withthe aid of conditionality. Giventhis might a necessary lossto thebanksand the there is no longer arrangement, from ofa reduced theimposition becausethat combined ceiling facility with theimposition of a raisedfloor. is associated ceiling Upsideand risk haveboth hasbeenobtaineddownside beeneliminated. Certainty or at leastuncertainty has beenreduced. a netgainforthebanksand thefacility comCertainty represents are risk that averse. With the of whole subordination, bined, given they in would to the banks the first case thisgainfrom certainty go just in which a minimum sufficient to cover thedebt discussed, repayment wasinany Butinthemore heldbythefacility caseensured. case, general has carried someof theriskpreviously in which thefacility (whether or becausethere was ensured was no subordinabecauseno minimum the the would to tion), gain facility. go partially Itis often indebtrelief that themarked-down value implied proposals toit(orvery little ofdebt would havenomore risk attached because risk) be closeto theexpected to pay.It is doubtful itwould whether capacity is is to this realistic. The that willingness repayassumption implication to makethenecessary and theresolve notexogenous adjustments-is inreturn for debtrelief. butrather canbe mademore "certain" Perhaps a commitment thatwouldsuccessfully reduceperceived default risk from insomeway orother. couldbe obtained thedebtor Debtor country could makecertain No doubtthe governments policycommitments. a rolehere.Conditionality Fund's canplay can conditionality procedures and default it can surely reduce risk, conceivably uncertainty although noteliminate them. A reduction in uncertainty ofrepayment without necessarily anynet in the mean is a to the banks and change expected repaymentclearly gain thefacility. Butitis notnecessarily a gainfor thesystem as a whole.If inthecapacity topay-forexample, interms of uncertainty uncertainty be reduced, thatwouldbe a netgain.But if trademovements-could incapacity topaycontinues while becomes more uncertainty repayment certain to has been a there transfer in the owing conditionality, simply burden of uncertainty toward For thedebtor if country. example, the oftrade turned outto be particularly terms thecountry would adverse, havetobearthewhole burden instead ofsharing itwith thebanks orthe some of default or debt relief. facility through degree Thisapproach assumes that themeanexpected orwillingness capacity
to pay staysunchangedbut thatthe flooris raised and the ceilinglowered. There are also two otherpossibilities.
Thefirst is rather similar totheonejustdiscussed. Conditionality may
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W. MAX CORDEN
thefloor: itmayraiseexpected raisethemeanwithout raising capacity inpolicies. an about the topaythrough improvement Although bringing theceiling then nevertheless bankslose through effect, they may gain. theprobability is that ofrepayThe other, possibility quitecontrary over debt.As justnoted, when thefacility takes is actually reduced ment withthe it is usually associating conditionality arguedthat,through ofrepayment canbe improved. ofa facility, thecertainty establishment that is subject to political a facility viewis that But a contrary pressure to it maybe a less effective available and thathas no strong penalties thewithdrawal which canthreaten of than debtcollector banks, private credit as a potential trade penalty.
oftheDebtor and MoralHazard VI. Interests Countries

in which Thereare several thedebtor ways country might gainfrom beenreferred Somehavealready willnow thearrangement. to,butthey be brought together. Reducingthe Default Ratio A gainthat seemsobvious at first butturns outto be primarily sight inthedefault Thedefault isthereduction ratio. cosmetic ratio, D, equals R is theactualdebtrepayment 1 - RIC, where made-thatis, theretransfer-and C is thecontractual valueofthedebt.D is reduced source value is marked whenthe contractual the actual down,eventhough has been to be assumed so (which exogenous far)does not payment change. ifthis matter default ratio to zero,when Does itreally falls, possibly transfer remains One that theresource theeffect unchanged? might say If an emperor has fewclothes, is itreally cosmetic. is purely necessary this thefact? itcanbe argued toproclaim that debt Against convincingly is the creditors better than default. relief voluntarily by always provided on thepart ofthedebtor be a preference There would clearly country if penalties wereassociated withdefault. overdefault fordebtrelief ofcurrent hencefuture Evenintheabsence reputation-and penalties, be influenced whether there has beenformal creditworthiness-may by Notethat ithas beenassumed rather than debtrelief. default herethat on to hence default purely exogenous capacity pay; depends penalties ratio would seemlesslikely orreasonable. tothedefault Because related to determines actual there would repayments, capacity paycompletely in thecreditors be no point imposing penalties.
411
Loweringthe Ceiling The debtor to the"ceiling effect." As has been country gainsowing if to payturns outto be particularly favorableout, capacity pointed abovethenewcontractual value-thegainwould rather gotothedebtor thanto thecreditors becausetheceiling forpotential has repayments been lowered. This benefit to the debtor (and could might disappear eventurn intoa loss)ifconditionality alsotoraisethefloor for manages therepayment, moreof the risktoward thedebtor shifting country.6 MarkingDebt Down Below Cost The facility mark thedebtdownbymore than thecostprice to might much more-and the contractual value then fall it-possibly by might belowthecapacity topay,evenwhen thecapacity topayturns outtobe low. At the the debt be marked down to zero. This limit, quite might a would from transfer the owners of the representstraightforward facility to thedebtor countries-acase offoreign assistance. It is equivalent to funds tothedebtor theowner countries tobuybackits donating country debt. Asymmetric Expectations A fourth kind ofgainhasnotbeenreferred to so farbutis implicit in muchadvocacy of debtrelief and could be important. The markets, thebanks, be pessimistic andbelieve that there is some specifically may ofdefault. Hencethere is a market discount onthedebt.But probability ofthedebtor thegovernment haveno intention ofdefaultcountry may to pay,after all,is ing.Thereare "asymmetric expectations." Capacity notsomething clear-cut. The government foresees difficulties and adandseeksdebtrelief for fear ofpenaljustment problems but-possibly everto default, ties-does notintend eventhough ithas notsucceeded ofthis.The issueofasymmetric in convincing themarket expectations
6 There maybe a touchofperversity in theceilingeffect about bydebt brought relief.Whenevercapacityto pay improves exogenously-owing,forexample,to a termsof trade improvement-someof the gains inevitably go to the debtor even beforedebt relief(thatis, whenthe ceilingis high). Similarly, some of the losses from a deterioration wouldbe bornebythedebtor,and notwholly bythe
In that creditors. theceiling as a result ofdebtrelief increases the case,lowering

gains forthe debtorwhen events,such as the termsof trade,turnout well but does not help when eventsturnout badly.
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W. MAX CORDEN
below. Here it can be notedthat,ifthegovernwillbe discussedfurther has no intention at all of defaulting, ment of the debtor country the value of the debt brought whole of the fallin the contractual about by the operationof the facility or in some otherway debt reliefthrough in reducedproa clear-cut would represent gain to the debtorcountry spectiveresourcetransfers.7 different do notperceive The creditors, however, having expectations, in the contractual value-or all of it-as a loss to them. thisreduction the ceilingeffect but also see some They may expect to lose through of to in an explicit what believe be realities-that virtue recognition they has limited or to the country capacity willingness pay, thatthe emperor has fewerclothesthan the initialcontract specified. Moral Hazard For threeofthefourreasonsgivenhere (otherthanthethird, marking debtdownbelowcost), thedebtorcountry wouldwantthepriceat which thefacility thebanksto be as low as possible.The lower buysdebt from the price,the greateris the declinein the contractual value; hence, the is lowerthedefault the lower the wheneventsturn ratio, ceilingapplying and the lower are actual repayments if defaultis never out favorably, intended. If thispurchasepriceis equal to or closelyrelatedto themarket price, has an incentive the debtorcountry therefore to get the marketprice down. This can be done by making"defaultnoises"-just a hinthere, a threatthere-and the banks will be glad to sell at a low price,in the case at anypriceabove zero. This is thefamiliar extreme "moralhazard" problem. A possiblesolutionfrom thepointof viewof creditors seemsto be for not thefacility's to be determined the market by purchaseprice price,or at least by the market once of the likelihood such a price ruling facility being establishedhas become serious. Market prices at some earlier "cut-off" date might be taken. If the banks are to sell voluntarily, the will have to be no lower than the market current price. purchaseprice But it could be higher. 7Thereis an important Ifthedebtor to this country's argument. qualification relief thefacility takes thelong itwill realize that debt view, through government on thepart ofthecreditors andin orotherwise-even entirely voluntary though still havean adverse effect on its with default-could actual no wayassociated investors lookbackthey will future creditworthiness. After all,when country's loanfinally a $1,000 outto be worth whatever reason. see that turned less,for will never havetheopportunity toshow that itwould havepaid Thegovernment initial contractual value. thefull
413
The problem is to fixa pricethatdoes notgivea gain,or an undue to the there wouldbe a bail-out. But whatis a banks;otherwise gain, Given the created ofthedebtor gain? expectations bytheir anticipation to combined with the default noises madebythe country's capacity pay, debtor or others in thatcountry, a sale ofthedebtto the government at a very lowpricemay still seemto be a gaintothebanks. This facility is trueeventhough thepriceis likely to represent a lossrelative to the at the timethe loans wereoriginally made. Presumably expectations thefacility should aimto avoideither gainor lossto thebanksrelative to the situation at some "pre-discussion-of-facility" date-that is, an cut-off date. appropriately early Mostproposals fora facility do notpursue in detail thecritical questionof howthepriceat which debtis to be purchased is to be deterthat there is a moral hazard andthat there must mined, given problem a be for each It is at this presumably separate price(discount) country. that the arise. Sometimes elaborate point greatest practical problems which areessentially ofcapacity estimates to pay,areprocalculations, but the difficulties such estimates would involve cannot posed, political be ignored. Given thethinness ofexisting actual market markets, prices, or at someearlier whether current cut-off date,maynotbe adequate guides. VII. Two Assumptions Reconsidered Atthebeginning ofthis two crucial were made:that paper assumptions thedebtor's to was determined-for capacity pay exogenously example, oftrade-andthat aboutthecapacity to pay bytheterms expectations werethesameamong all therelevant Given these parties. assumptions, a fairly followed that showed that a facility would straightforward analysis a to the banks because of the market effect and a gain yield gain price to thedebtor becauseoftheceiling effect. Thesegains would be at the ofthefacility, which would be taking overa risk. It wasfurther expense assumed that debtowedto thefacility would notbe given over seniority debtretained Ifthelatter were a gaintothe subordinated, bythebanks. banksand lossto thefacility be avoided. might thetwoinitial havebeenremoved inparSubsequently, assumptions ticular wasexplored that thefacility V, thepossibility ways.In Section BankorFundacting onitsbehalf) couldactually affect the (ortheWorld debtor's so thatcapacity to paywouldbe improved to ensure policies ofrepayment ofthemarked-down valueofthedebt.In other certainty to nolonger be exogenous. In Section words, VI, one capacity paymight
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W. MAX CORDEN
wasnoted. Thedebtor caseofasymmetric government may expectations ofdefaulting, butthemarket notbe convinced of haveno intention may moral hazard wasintroduced. this.In addition, Prospective repayment andthreats ofreduced would affect the willingness (for capacity), given market price. to theinitial are really These complications approach specialcases, of issuessometimes butthere are further casesthat these have analysts is in mind. A moresystematic therefore needed. approach of expected to paydetermined First of all, theconcept capacity by be as totalrepayment" factors could redefined exogenous "expected bothbyexpected to payand byexpected determined capacity willingBothwould be influenced, orevendetermined, nesstopay.8 bypolicies. ofcapacity to payis broadened in this Whentheoriginal concept way, moreplausible. If theredefined to it becomes is concept applyto the inthis initial that analysis paper,ithasto be assumed expected policies in thesenseofnotbeing to change as a result are exogenous expected ofthefacility or itsactivities. oftheestablishment istoallow for Thenext and endogenous affecting step policies capacity ofpolicies is central to many to pay.The endogeneity debtwillingness As notedin Section V, the basic idea is thatthe strategy proposals. to thedebtor theintermediabenefit from debtrelief through provided wouldbe reciprocated inthedebttionofthefacility byimprovements andthat somekind ofassurance about these canbe or'spolicies, policies In with the of this obtained, help conditionality. waymore perhaps be of can ensured. certainty repayment to endogenous to pay,twopoints are usually With willingness regard is the moral hazard of as noted threats made.The first, above, problem: down. A second to can the market idea reduced willingness pay get price valueofthedebtis so faris that, whenthecontractual notmentioned a realistic the it is down to more so that level, brought forgiven partially to the remainhave a debtor may willingness repay government greater to paywas $600, debtwas $1,000and capacity der. If thecontractual It has then beenargued thata large wouldbe inevitable. somedefault a more modest deis as bad-and incurs similar default penalties-as fall to zero. But if in case the so that to that fault, might willingness pay downto $600,there wouldbe a good debtweremarked contractual to pay might could be avoided,and willingness chancethatdefault become100percent.
tion III.
to pay may depend not onlyon capacityto pay but also on willingness
4 in Secofin present-value See footnote be thought terms. 8Allthisshould
415
As regards aboutthecapacity and willingasymmetric expectations worth as already nesstopay,there areseveral First, possibilities noting. notintend, andhencenotexpect, thedebtor to default mentioned, may themarket that there is a positive while believes of contrarily probability In thatcase the debtor thusexplaining the market discount. default, itwouldgainfrom willbelieve whereas the anydebtrelief, government their debt on the market no (and creditors-selling voluntarily assuming not lose. If the to the banks a subordination)-will expect facility paid with a above the initial market discount-the banks price-still price ifthedebtor wouldactually maybelievethatthey gain,eventhough, were the banks would have expectations correct, actually government's lostbyselling. A scheme couldconceivably outwhereby thefacility be worked pays, for debt with a forexample, contractual value of $400 $500and marks themargin of $50 adequately thatdebtdownto only$450,with comfortheriskit incurs so thatit neither thefacility gainsnor pensating loses.In this casethecreditors believe that themarket they gainthrough thedebtor itgains believes that becausethere government priceeffect, inthecontractual andthefacility is somereduction neither price, gains norloses. This schemeleads intothe secondpossibility, the facility whereby or at leastis expected to do so byitsowners makesa profit or actually havean unduly Themarket viewofthedebtmay pessimistic managers. andhence there be a large market discount. or'sprospects, Butthe may down marks the debt a so that the contractual value little, only facility by of themarked-down debtit holdsstays wellabovethecostpriceand ofcertainty there is a high that willbe loworzerodefault. there degree All this on confidence in the to getthedebtor's depends ability policies to the market's sufficiently improved disprove pessimistic expectations. ithas beenargued in themainanalysis herethat themarket Finally, a effect benefit for the at least to the relative banks, represents price thedebtcrisis andthediscount situation after But there developed. may ofdebt whodo notselltothefacility be someholders because-contrary of marginal do notbelievethatthe to theexpectations holders-they of default is at value thedebtthey hold probability high all. Theymay atthecontractual havemade value,notnearthemarket may price. They a moreoptimistic assessment of capacity or willingness to pay.If they that there will be full in feelassured make repayment anycase,itwould tothem ifthetotal no difference contractual claims arereduced through ofthefacility. that theoperation Butifthey believed thedebtis really worth more than itsmarket the then arises did why they price, question and so bring notbuyup thedebtheldbyothers thepriceup to their
416
W. MAX CORDEN
The argument assumes thatthemarket is, in expectations. optimistic somesense,imperfect.
VIII. Would NewInvestment Increase as a Result oftheFacility?

totheanswer Therearethree tothis Ifthedebtofthe parts question. senior the answer is not it is is that new clear; rights facilitygiven possible be discouraged. wouldactually investment hasshown that for various reasons theanalysis there be an First, may inresource thedebtor reduction transfer from as a actual result country ofthefacility-that is,thedebtor country may actually gainsomething. intheviewofsomethis oftheexercise. is theprimary Indeed, objective ofsucha gainwould leadalsotoan expectation An expectation oflower thanotherwise-including ofprofits taxation taxation andcapital-and newinvestment. thismaywellencourage if the debt held doesnotacquire senior Second, bythefacility rights, inthemarket falls so that thediscount as described there should earlier, forinvestment inflows to resume or to increase. indeedbe a tendency will haveassumed someoftheburden ofpotential Thefacility default on willhavea lesserburden to bear theexisting debt,and newinvestors thanbefore. thematter is notso simple iftheexisting debtis subordinated Finally, is whether to thefacility's debt.The question then newdebtincurred in or whether it wouldacquire the market wouldalso be subordinated, debt.The reasonable is that overthefacility's the seniority assumption would As noted above,intheabsence facility enjoycomplete seniority. ofincreased subordination wouldactually reduce themarket certainty, tothe"ceiling hence newinvesteffect"; price (raisethediscount) owing wouldbe further If all old debthadbeensoldto the ment discouraged. in effect new debt would then be subordinated to old debt facility, completely.
IX. Is ThereReally Needforan International Facility?

A central remains. One might the desirability of a question grant in thecontractual reduction valueof thedebtbutstill wonder an why in the form of a the lines would be intermediary facility along proposed needed.
417
inthemarket banks cansellthedeveloping countries' debts Although to at a discount, bankmanagements not feel free may grant outright intheform ofreduction ofthecontractual relief because value, possibly In practice, oflegalobstacles. relief in the form of however, long-term andvarious debttransformations canbe andhasbeen debtrescheduling sucharrangements are different from congranted-although reducing is no incentive tractual value. One couldalso arguethatthere forany togrant relief oftheceiling holder because effect. There is always private thefull that contractual valuewill be repaid, so why thepossibility forgo forrelief thispossibility? be created Incentive may,however, by the ofmoresevere threat default. ofthree in favor One can think oftheestablishment ofa arguments from thepoints of viewof thebanksand thedebtor countries facility involved. A Channel forResource Transfer The most obvious from thepoint ofviewofboth is argument parties thatthefacility could act as a channel forthetransfer of current rethecountries sources thatunderwrite it,or forthe (thatis, aid) from of if transfer future some default risk resources is perceived. possible a is also an argument from of This,ofcourse, against facility thepoint owners ifthey in providing are notinterested aid viewof itspotential or specifically to thedebtor in general countries. Thispoint will either below. be taken up again one alternaIfforeign aid to thedebtor countries is indeed intended, to negotiate theparties debtrelief contracts tivecouldbe for bilaterally countries to guarantee and thenforsome or all of theindustrial the debtsin partor in full.This arrangement wouldgive marked-down an opportunity industrial countries to helpthose debtors that particular to familiar of interest them. The here is are special thatthe difficulty as theproblems oforganizing are nota single concerted banks "party," haveshown. lending the otheralternative is to receivedirect For the debtorcountries aid. The aid couldbe usedbythedebtor to buyback bilateral country forinduswouldbe an opportunity someofitsowndebt.Again,there todiscriminate infavor ofparticular debtor But trial countries countries. in thatcase: whether is highlighted funds the fundamental question in aid are bestspent in buying backdebt.Theycouldperhaps received extra be better usedto finance investment.
418
W. MAX CORDEN
A More OrderlyProcess ifworld conditions turned economic It couldbe argued that, adverse, wouldbe a decento the operation of sucha facility the alternative with relief. In that situation ofdebtrestructuring numertralized process thebanks ous bilateral bycommittees represented arrangements-with from sufficient banks-couldget in getting havedifficulty that support an that would could be The rather intermediary bring disorderly. facility ofautomaticity andconsisAn element totheprocess. orderliness more inthechoice ofpurchase ofdebt andkinds countries across prices, tency therestructuring anddebt andso on, couldsmooth ofrelief, theextent crises that couldlead thus avoiddefault Thefacility relief might process. oftrade flows. and disruption difficulties to political GreaterRealism and Certainty uncertain with ofsuch isthat A key feature obligations, very proposals on a to be paid is expected valueswellabovewhat contractual probabilvalued debt that be replaced would (inthe basis, bymore realistically ity tobe repaid certain would be more view ofitsproponents) and,ideally, risk. ofserious default wouldbe free in certainty thattheincrease be argued It might (ifit couldbe obitdoes,to an extent at least, eventhough desirable is ingeneral tained) intheterms of ofexogenous theburden shift uncertainty (for example, This is a countries. because the debtor toward back gain possibly trade) ofthelackof to be endogenous-aresult is believed someuncertainty rather than will debtor firm governments capacity-to-pay political by forthe is a roleforconditionality Thenthere and,hence, uncertainty. meanthat thetwo Bank.Thisdoes notnecessarily Fundor theWorld takeon the thefacility, or their owners, should, institutions, through
risks. remaining
It refers is also important. notto theactualoperOne negative point that itmight comeinto buttotheeffects ofexpectations ofa facility ation If the banks and the moral hazard It concerns a problem. operation. is somechancethatan institution countries believethatthere debtor to takeoversomeoftherisks, be established suchas thefacility might to arrive at debtrelief less incentive will have agreements directly they of trade The threat of or without disruption, particularly disruption. to theinternational couldbe an inducement flows, community leading werenever seen as But ifsuchan institution sucha facility. establish
419
the parties involved wouldhave an directly beingeven a possibility, to arrive at agreements. to avoidprolonged incentive Theywouldtry and disruption becauseit is damaging to them all. uncertainty X. Is AnyCompulsionInvolved? and then thecreditors. debtor country On the Debtor ifconditionality On theonehand, were notinvolved, a debtor country havenothing to loseintheshort would from run debtrelief the through medium of thefacility. But in thelongrunit might lose somecreditsince future creditors wellthink that what hashappened worthiness, may a debtor oncecan happen confident that again.Therefore government, thefull itwillbe ableto repay contractual valueofitsdebtandwanting to takea longview, from benefit outofthescheme. Thisis may staying there a true eventhough be discount market on its debt that may suggests so far,thedebtor has notbeen able to convey itsconfithat, country denceto themarket. ifconditionality ofthescheme, were then each On theother hand, part it could decide whether to the debtor burdens preferred accept country and getdebtrelief thefacility, or whether of conditionality it through to out. There would not need to be anycompulsion. preferred stay On the Creditor Each bankcouldbe free to sellor to keepas much as it likedofthe debt it holdsat present. Sales of debt need not be compulsory. As described the would in the eventhough here, facility market, operate this is nota feature ofallproposals. Butthis freedom ofthebanks tosell or notto sellcouldbe somewhat The willingness to sellwillbe illusory. influenced actions. A decision bythedebtors' bythedebtor government to subordinate debtthatis notsold wouldlower themarket price-as wouldthreats default. inbankregof,or actual, Furthermore, changes ulations increditor countries that reduced theattractiveness to banks of on to debt could also increase the willingness to sell to the holding facility.
I first To whatextent would sucha schemebe voluntary? considerthe
420
W. MAX CORDEN
XI. Concluding Remarks From the viewpoint, of a debtorcountry, the availability of an first, international debt facility cannotbe harmful to it because it cannotbe is associated with compelled to participateand, if use of the facility as is it choose not to. But, forthe conditionality, usuallyproposed, may reasonsgivenin SectionVI, a debtorcountry is quite likely to gainfrom participation. Fromtheviewpoint of creditors, the bankswould gain ifsales of debt to the facility were truly if therewere no subordination of voluntary, debt thatis not sold to the facility, and if the moral hazard problems discussedin SectionVI wereovercome.Otherwise thebankscould lose. It has been notedthatthe moralhazardproblemmight be overcomeby determining purchasepricesof debt on some objectivebasis or on the basis of marketpricesat an early"cut-off" point. But thiscan present some ofthemostdifficult involved withtheestablishpractical problems mentof a debt facility. Finally, and most crucial, there are the interestsof the potential ownersor underwriters of the facility to consider.If the facility would debt of all the developing purchasea significant partof the commercial countries thatcurrently have problems-as is suggested in manyof the of riskinternationally from proposals-a largetransfer privatebanks to the underwriting or multilateral institutions would take governments The extent of the transfers would on the detailed place. depend arrangementsthathave been discussedhere. Of course a facility could operate on a smallscale, butthenitwouldonlymake a smallimpacton theworld debt situation. The potentialownersmay see some benefitin increasing certainty be brought about bythedebtrelief (whichmight processcombinedwith and in avoiding a disorderly conditionality) process of debt restrucand so on discussed in Section the (as default, turing, IX). Furthermore, ownersmay wish to provide aid to particular debtorsor assistanceto is not the best way of banks, althougha generalizedfacility particular this. But it is inevitable theobligations that that,by underwriting doing thefacility the owner would assume some riskeven issues, governments whenthe debt not sold to thefacility is subordinated to thatheld bythe and even more so without subordination. facility, REFERENCES andMarket Valuation ofExternal P., "Buy-Backs Debt,"Staff Dooley,Michael
Vol. 35 (June 1988), Papers, International MonetaryFund (Washington), pp. 215-29.
421
and others, in the Debt-Laden Growth Third Feldstein, Martin, "Restoring World: A TaskForceReport to theTrilateral PaCommission," Triangle 33 (NewYork:The Trilateral Commission, pers,Report April1987). Paul R., "International Debt Strategies in an Uncertain in World," Krugman, International Debtandthe ed. byGordon Smith and Countries, Developing John World Bank,1985),pp. 79-100. Cuddington (Washington: andHarry "U.S. Commercial BanksandtheDevelopSachs, Jeffrey, Huizinga, on Economic 2 (1987),The Crisis," ing-Country Brookings Papers Activity: Institution Brookings (Washington), pp. 555-601.

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An International Debt Facility? Author(s): W. Max Corden Source: Staff Papers - International Monetary Fund, Vol. 35, No.

An International Debt Facility?

AN INTERNATIONAL DEBT FACILITY?

II. A Simple Scheme

III. HowDebtor and BanksMayGain

AN INTERNATIONAL DEBT FACILITY?

sum consistingof principaland interestcombined. Given the initial

AN INTERNATIONAL DEBT FACILITY?

AN INTERNATIONAL DEBT FACILITY?

Thefirst is rather similar totheonejustdiscussed. Conditionality may

oftheDebtor and MoralHazard VI. Interests Countries

AN INTERNATIONAL DEBT FACILITY?

In that creditors. theceiling as a result ofdebtrelief increases the case,lowering

AN INTERNATIONAL DEBT FACILITY?

4 in Secofin present-value See footnote be thought terms. 8Allthisshould

AN INTERNATIONAL DEBT FACILITY?

The argument assumes thatthemarket is, in expectations. optimistic somesense,imperfect.

VIII. Would NewInvestment Increase as a Result oftheFacility?

IX. Is ThereReally Needforan International Facility?

AN INTERNATIONAL DEBT FACILITY?

AN INTERNATIONAL DEBT FACILITY?

AN INTERNATIONAL DEBT FACILITY?

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