1. 1 Chapter 14 The Debt Crisis of the 1980s © Pierre-Richard Agénor and Peter J. Montiel

2. 2 l Figure 14.1.

3. 3

4. 4 l Origins of the Debt Crisis. l Policy Response and Macroeconomic Implications. l Resolution of the Crisis: The Brady Plan.

5. Origins of the Debt Crisis

6. 6 l Public Sector Solvency. l Application to the Debt Crisis.

7. 7 Public Sector Solvency

8. 8 Application to the Debt Crisis l Figure 14.2. l Figure 14.3.

9. 9

10. 10

11. Policy Response and Macroeconomic Implications

12. Resolution of the Crisis: The Brady Plan

13. 13 l Outline of the plan. l Macroeconomic Effects: Conceptual Issues. l An Overview of Some Early Brady Plan Deals.

14. 14 Outline of the Plan

15. 15 Macroeconomic Effects: Conceptual Issues

16. 16 An Overview of Some Early Brady Plan Deals

17. Appendix Incentive Effects of a Debt Overhang

18. 18 l Existence of a debt overhang creates disincentives for domestic investment in the debtor country. l Debt forgiveness can è stimulate domestic investment; è increase the actual payments received by creditors. l Sachs (1989b): two-period model. l Debtor government maximizes the discounted utility U(  ) derived from domestic consumption in each period: U(c 1, c 2 ) = u(c 1 ) +  u(c 2 ), u(  ): standard concave utility function; c t : domestic consumption in period t, 0 <  < 1: discount factor.

19. 19 l Country enters the first period with an existing stock of debt, which gives rise to a contractual payment obligation of D 0 during the second period. l No debt service payments are due in the first period. l Actual payments to the original creditors in the second period are given by R, where R < D 0. l Actual amount to be paid emerges from negotiations that take place between the government and its original creditors. l In the second period the government pays R to its original creditors, plus it services any additional debt it incurs from new creditors in the first period. l However, the government cannot agree to pay more than a fraction 0 <  < 1 of the country's second-period income in total debt service.

20. 20 l If this constraint becomes binding, all creditors are paid in proportion to their exposure, the implication being that no creditor class has seniority. l Government has to decide how much to invest and borrow during the first period, subject to the constraints: c 1 = f(k 0 ) + D 1 - I 1, c 2 = f(k 0 + I 1 ) - (1+r*)D 1 - R, k 0 : initial capital stock at the beginning of period 1, I 1 : investment during period 1, D 1 : new borrowing during period 1, r*: world risk-free interest rate, f(  ): standard neoclassical production function.

21. 21 l Credit supply constraint also needs to be satisfied by the government, because new loans will be available only if new creditors expect to be fully repaid. l Given the existing obligations to the original creditors, this requires (1+r*)D 1 < f(k 0 + I 1 ) - R. l As long as condition (A4) holds, new borrowing D 1 is a choice variable for the government, because funds are available in infinitely elastic supply at the interest rate r*. l If it does not hold, country is unable to borrow at all because new creditors would be unable to receive the market rate of return from lending to this country. (A4)

22. 22 l If (A4) holds, first-order conditions for a maximum -u (c 1 ) +  u (c 2 )f (k 0 + I 1 ) = 0, u (c 1 ) -  (1+r*)u (c 2 ) = 0. l To solve for I 1, substitute (A5) in (A6) and simplify. l Domestic investment is given implicitly by f (k 0 + I 1 ) = 1+r*. l Substituting (A7) in (A6) defines first-period borrowing implicitly as a function of R. l Increase in R reduces c 2, because it reduces the resources available for consumption in that period. (A5) (A6) (A7)

23. 23 l This raises the marginal utility of c 2 and thus increases the incentive to postpone consumption. l This can be done by reducing D 1. l Formally, D 1 = d(R), < 0. -  f u  (c 2 ) u  (c 1 ) +  (1+r*)f u  (c 2 ) -1 < d =

24. 24 l Note that -1 < (1+r*)D 1 < 0. l Thus, while (A4) may hold for low values of R, an increase in R reduces the right-hand side of (A4) more than the left-hand side. l There will thus be some critical value of R, say R*, at which (A4) will hold as an equality. l For R > R*, (A4) will be violated. l Suppose that R = D 0 > R*. l Since all creditors would experience a shortfall, new creditors will not enter.

25. 25 l Constraints (A2) and (A3) become c 1 = f(k 0 ) - I 1, c 2 = (1-  )f(k 0 + I 1 ). l In this credit-rationed regime, the government's only choice is over the level of first-period investment. l First-order condition in this case is given by -u[f(k 0 +I 1 )] +  (1-  )u[(1-  ) f(k 0 +I 1 )]f (k 0 +I 1 ) = 0. l To show that debt forgiveness can increase investment and make both parties better off, let I 1 denote the solution to (A10). (A10) ~

26. 26 l Total debt service to the original creditors in this case is R =  f(k 0 +I 1 ), which is less than D 0 by assumption. l If the original creditors had written down the country's debt obligation to this amount initially, (A10) would become c 2 = f(k 0 +I 1 ) - R, with the first-order condition: -u[f(k 0 +I 1 )] +  (1-  )u[f(k 0 +I 1 ) - R]f (k 0 +I 1 ) = 0. ~~ ~ ~ (A12) (A13)

27. 27 l By substituting R=  f(k 0 +I 1 ) in (A13) and calculating dI 1 /d  < 0, it is easy to show that investment increases when the contractual debt obligation is reduced from D 0 to R. Reason: l When contractual debt is not fully serviced, external creditors claim a share of any additional output forthcoming from new investment. l This is like imposing a distortionary tax in the form of the fraction in (A10), which reduces the incentive for the government to invest. l Additional investment increases domestic welfare since, by (A11), -u(c 1 ) +  u(c 2 )f (  ) > 0 when this expression is evaluated at I and R, implying that additional investment is welfare enhancing. ~~ ~ ~ ~

28. 28 l Result: debt forgiveness increases domestic welfare without harming the original creditors; that is, debt forgiveness is Pareto-improving. l With an increase in R to above R (but below D 0 ), debtor country could remain better off than in the no- forgiveness condition. l Value of debt service to original creditors increases over what they would have received without debt forgiveness. l Result: removing distortionary effect of the debt overhang can make both parties better off. ~