The Net Benefit of Debt Relief

Both borrowers and lenders can benefit from debt relief when the borrower suffers from 'debt overhang'... understanding why the Brady Plan produced rising asset prices, increased investment, and accelerated growth is pivotal to understanding the circumstances under which debt restructuring can be expected to yield efficiency gains.

In order to determine whether the much-debated debt-relief programs have the intended effect of aiding the economies of less-developed countries, Serkan Arslanalp and Peter Blair Henry study the impact of such relief on stock markets. In Is Debt Relief Efficient (NBER Working Paper No. 10217), the two economists hold that stock markets are excellent indicators in this regard, because the markets bring together the entire expected future stream of debt relief costs and benefits into a single summary statistic: the expected net benefit (current and future) of debt relief.

The researchers acknowledge that the effects of debt relief on the stock market depend on one's model of lending. Models emphasizing costs suggest that debt relief may hurt the recipient country's stock market in three ways. First, if the relief program allows a government to continue wasteful policies, then economic growth and corporate profits may be held back. Second, countries that fail to honor their debts may incur trade sanctions that likewise will inhibit growth and profits. Third, debt relief may harm a debtor's reputation and increase its costs for future international borrowing

Nevertheless, both borrowers and lenders can benefit from debt relief when the borrower suffers from "debt overhang." Overhang occurs when the cost of a country's debt, taken with a decline in the economy, discourages new investment. In such a circumstance, if each creditor foregoes some of its claims, then the debtor is able to better service debts owed to every creditor. This means that the expected value of all creditors' claims would rise. Thus if all creditors agree - or are forced to agree - to cut some losses - the debtor nation may qualify for profitable new lending. An influx of new capital in turn may reduce the discount rate in the debtor country. To the extent that the country suffers from a "debt overhang" caused by the collective action problem, debt relief increases the incentive to undertake efficient investments. These investments will likely raise expected growth rates.

The United States offered debt relief agreements for less-developed countries (LDCs) in March 1989. Between 1989 and 1995, 16 LDCs -- mostly Latin American nations -- signed such agreements. Arslanalp and Henry note that in the 12 months prior to the announcement of the relief offers, the average country's stock market appreciated by 60 percent, for a total market capitalization growth of $42 billion. This they attribute to anticipation of the relief programs. At the same time, stock prices of the 11 major U.S. banks with large LDC loans increased by an average of 35 percent, for an increase in total market capitalization of $13.3 billion. The net benefit of the relief programs was therefore $55.3 billion.

The researchers note that such growth must not be considered in isolation from overall world markets. But their comparison with countries that did not sign on for debt relief and with banks that were not major LDC lenders is fairly conclusive. The stock market increase associated with debt relief quite clearly was economically large and statistically significant. No significant rises were found in the stock markets of the nations that opted out of debt relief.

Equally noteworthy, say Arslanalp and Henry, is that the 1989 debt relief offers were contingent on debtor countries enacting major economic reforms and restructuring. These reforms included stabilization, trade liberalization, privatization, and great openness to direct foreign investment. The reforms were originally proposed in 1985 by U.S. Treasury Secretary James A. Baker III and were endorsed by the World Bank and the International Monetary Fund to deal with the Third World debt crisis. However, debt relief was not on offer at that time. In 1989, however, U.S. Treasury Secretary Nicholas F. Brady proposed debt relief agreements coupled with the Baker reforms. The LDCs now had new motivation to enact such reforms. Thus as with the anticipation of the debt relief, say the researchers, the anticipation of the reforms may also have helped boost LDC stock markets.

Arslanalp and Henry conclude that understanding why the Brady Plan produced rising asset prices, increased investment, and accelerated growth is pivotal to understanding the circumstances under which debt restructuring can be expected to yield efficiency gains. The Brady plan worked, they say, because debt relief was the right course of action for middle-income LDCs where debt overhang stood in the way of profitable new lending and investment. But key questions remain. The first of these is how one determines if a country in fact is suffering from debt overhang. A second question is whether or not allowing a debtor country to unilaterally invoke a restructuring procedure will yield the same kinds of efficiency gains that were achieved under Brady's multilateral framework.

The evidence suggests there can be large efficiency gains to debt restructuring in middle-income LDCs. But it is not clear that the results can be used to evaluate the prospects for debt relief for the world's highly indebted poorest countries. Debt relief in fact may not yield efficiency gains for those countries because it is not obvious they suffer from debt overhang. Instead, the obstacles to investment and growth in the world's highly indebted poorest countries more likely are weak economic institutions and infrastructure.

-- Matt Nesvisky