The Macroeconomics of External Debt

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1 The Macroeconomics of External Debt Prof. Ester Faia, Ph.D. Goethe University Frankfurt June 2010 rof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 1 / 15

2 Debt Crisis De nition: A country is not able to meet its nancial obligations. Events leading to Debt Crisis. The case of Latin America (1980s). 1 External factors - Commercial banks lent large amounts to Latin American countries at low, but oating interest rates 2 Domestic factors (gov t policies that encouraged borrowing) - Domestic banks borrowed at high rates and invested in risky projects - Domestic currency was pegged to the dollar ) "real ex. rate ) "CA de cit 3 Sudden change of the economic environment - "world interest rate (anti-in ation policy by Paul Volker, late 1970s) - #prices of raw materials (exported goods) Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 2 / 15

- Domestic banks borrowed at high rates and invested in risky projects - Domestic currency was pegged to the dollar ) "real ex.

3 The beginning of the Debt Crisis "world interest rate ) "debt services (65% of the foreign debt at oating rate) "interest rate and #export prices ) "interest payments relative to export earnings Lending and investment in ows ceased in 1982 Gov ts failed to implement the scal reforms ) capital ight Large CA surpluses were required for countries to meet external obligations Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 3 / 15

ceased in 1982 Gov ts failed to implement the scal reforms ) capital ight Large CA surpluses were required for

4 Floating interest rates and CA adjustment Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 4 / 15

5 Floating interest rates and CA adjustment "int. rate requires larger amounts to service newly assumed obligations + existing debt The B.C. pivots clockwise around A; in period 2 households have to pay more than expected Households cannot re-optimize; the position of the economy is at C instead of B 0 TB = Q 2 C2 00 (under oating rates) is much higher compared to if the country was able to re-optimize its borrowing in period 1 (Q 2 C2 0) Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 5 / 15

pivots clockwise around A; in period 2 households have to pay more than expected Households cannot re-optimize; the position of the

6 The resurgence of capital to developing countries (1990s) In the early 1990s capital in ows increased again, from $133bn (late 1980s) to $670bn (early 1990s) Similar factors led to capital in ows to the region during both periods, early 1990s and late 19970s The capital in ows of 1990s produced the similar macroeconomic consequences as those of 1970s that led to the Debt Crisis Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 6 / 15

early 1990s and late 19970s The capital in ows of 1990s produced the similar macroeconomic consequences as those of

7 The debt burden Debt Burden = D, where D = external debt and GDP = gross GDP domestic product Surprisingly, the debt burden rose during the Debt Crisis Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 7 / 15

burden rose during the Debt Crisis Prof.

8 The debt burden (con t) What caused the " Debt burden? A decline in GDP, rather than an increase in debt (recall: capital in ow declined!) To understand why, consider the e ect of real depreciation on the value of GDP in terms of tradeables (GDP T ): GDP T = Q T + P N P T Q N As #real ex. rate ) " Q T (supply of tradeables), # Q N (supply of non-tradeables) and # P N P T ) # P N P T Q N (the value of domestic output of non-tradeables declines) Since " Q T and # P N P T Q N, what is the net e ect? AGDP 0 T > BGDP 0 T (see the graph below) Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 8 / 15

rate ) " Q T (supply of tradeables), # Q N (supply of non-tradeables) and # P N P T ) # P N P T Q N (the value of domestic output of non-tradeables declines)

9 The e ect of real depreciation on the value of GDP Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 9 / 15

10 Debt reduction schemes Full debt repayment was unrealistic goal after the Debt Crisis of 1982 "Adjusting" a country s foreign debt to what it would be able to repay was an option Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 10 / 15

to what it would be able to repay was an option Prof.

11 Unilateral debt forgiveness:creditors forgive certain amount of the debt - Example Up state Down state 1 2 Prob. of state 3 3 Receipts of creditors 100, Face value = 100, D = 100, D = 50 no debt forgiveness debt forgiveness - Expected repayment to creditors = π D U + (1 π) D D = 50 or Expected repayment - Secondary market price = Face value of the debt = 0.5 or Creditors loss: di erence between expected payments without and with the debt forgiveness scheme - Debtors capacity to repay does not improve in the bad state rof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 11 / 15

+ (1 π) D D = 50 or 33.33 Expected repayment - Secondary market price = Face value of the debt = 0.5 or 0.

12 Debt reduction schemes: Debt overhang Debt overhang - The probability of the debtor to repay the nancial obligation is contingent (not independent as assumed before) on the size of the debt, π = π (D), and depends negatively on D, d π(d ) dd < 0 - Debt La er curve: magnitude of debt outstanding vs. expected receipts by creditors Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 12 / 15

depends negatively on D, d π(d ) dd < 0 - Debt La er curve: magnitude of debt outstanding vs.

13 Debt reduction schemes: Debt overhang: Debt La er curve Debt forgiveness bene ts the creditors as long as expected payments increase. In this case: - when D D 0 of debt is forgiven - D D is forgiven (creditor gets maximum level of expected payments) Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 13 / 15

In this case: - when D D 0 of debt is forgiven - D D is forgiven (creditor gets

14 Debt reduction schemes: Free rider problem and third-party buy-back The free rider problem - Some of the creditors forgive some of the debt, but others choose not to participate - Debt forgiveness should be a concerted e ort Third-party debt buy-backs - Multinational organizations (e.g. World Bank, IMF, IDB) purchase developing country s debt at a secondary market price - Consider the example from before ) now, IMF buys 75 units of the debt (face value) ) D = Expected payments = 25 ) debtors can repay in both state - Creditors are the main bene ciaries Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 14 / 15

veness should be a concerted e ort Third-party debt buy-backs - Multinational orga

15 Debt reduction schemes: Free rider problem and third-party buy-back (con t) Debt swaps - Issuance of new debt with seniority over the old debt (the new debt is served rst) - Consider the example from before ) now, gov t issues 25 units of new debt (default free, the price is unity) ) in the down state the gov t defaults on the totality of the old debt - Expected payments and secondary market price decline - Gov t can use the newly acquired debt to swap (retire) some of the old debt - The debtor country is the main bene ciary Prof. Ester Faia (Goethe University Frankfurt) The Macroeconomics of External Debt 06/10 15 / 15

defaults on the totality of the old debt - Expected payments and secondary market price decline - Gov t can use the newly acquired debt to swap (retire)

Debt and Default. Costas Arkolakis teaching fellow: Federico Esposito. February 2014. Economics 407, Yale

Debt and Default. Costas Arkolakis teaching fellow: Federico Esposito. February 2014. Economics 407, Yale Debt and Default Costas Arkolakis teaching fellow: Federico Esposito Economics 407, Yale February 2014 Outline Sovereign debt and default A brief history of default episodes A Simple Model of Default Managing