Rescheduling of Sovereign Debt: Forgiveness, Precommitment, and New Money

Article excerpt

Many less developed countries in the past decade failed to meet contractual obligations on their external debt. Lenders generally responded by rescheduling these debts rather than declaring them to be in default, but further commercial lending to these sovereigns has virtually ceased. These borrowers now face an enormous debt overhang, while their lenders face substantial losses on their international loan portfolios.

Among the many proposals for addressing this crisis, the relative desirability of debt forgiveness and new lending has been the focus of considerable debate. The Baker plan of 1985 emphasized additional funding coupled with growth-oriented domestic policies rather than debt reduction. Lenders were encouraged to provide additional funds ("new money") to help the impaired and indebted economies grow their way back to creditworthiness. However, lenders were reluctant to offer new funds that would increase the sovereign's debt burden without some assurance that future repayment would be likely. With debt generally recognized as providing borrowers with a disincentive for investment,' the emphasis has now shifted to the need for debt forgiveness on the part of the lenders and a commitment to internal adjustment by the borrowers. Both parties are viewed as benefitting by a reduction of the inherited debt, and possibly the provision of additional funds, if the sovereign borrower can commit itself to adopting policies that reduce internal consumption and promote investment, thereby providing greater future resources for the repayment of the debt obligation.(2)

While the investment depressing effects of a debt overhang have been much analyzed [see, for example, Krugman (1988), Corden (1989), and Helpman (1989)], only little attention has been devoted to the effect of the debt overhang on the borrower's allocation of investment between the tradeable and nontradeable goods' sectors. We will argue that this issue may have important implications concerning the enforceability of sovereign debt contracts and the structure of debt relief programs. Related to this view is the observation of Cohen and Sachs (1986) and Diwan (1990) who argue that aggregate investment may not be as important for future debt repayment as the amount allocated to export production. This suggests that the export revenue-generating capacity of a sovereign may be positively linked to the degree of enforceability of its debt agreements. Diwan focuses on the allocation of resources to exports and import-substitutes and demonstrates that it may be optimal for lenders to offer partial debt forgiveness if it induces the sovereign to invest in export promotion (rather than in an import-competing sector) and thereby generate foreign currency for loan repayment. Our paper is related to that of Diwan in that we, too, emphasize the importance of recognizing the sovereign's incentives with respect to its choice of investment subsequent to loan rescheduling. However, our focus is on an integrated study of debt relief, new money, and contract enforcement, and their resulting incentives for the sovereign's promotion of tradeable goods production.(3) Thus, we study the interrelationship within an optimal loan "package" between debt relief, new money, and the ability of the sovereign to precommit to a particular investment decision, and its effect on the allocation of resources to the tradeable and nontradeable goods' sectors. Another point of difference is that we examine also the implications for debt renegotiation if the sovereign has an informational advantage vis-a-vis the lender.

Enforcement of the renegotiated agreement is of central importance in a study of sovereign debt. Since such debt is distinguished by the absence of the usual enforcement mechanisms, the debtor's cost of repudiation is not obvious, but nevertheless must exist since debtors attempt to avoid outright default. Such costs have been rationalized in the literature as being based on the ability of creditors to "punish" defaulters, for example, to impose trade sanctions, as well as on the desire of the sovereign to maintain a "reputation for repayment. …