Academic journal article Atlantic Economic Journal

The Determinants of the Secondary Market Price of Less Developed Countries' Debt

Academic journal article Atlantic Economic Journal

The Determinants of the Secondary Market Price of Less Developed Countries' Debt

Article excerpt

Introduction

The world debt crisis was brought about by excessive borrowing and large deficits on the part of developing countries, over-lending by banks and a deteriorating world economy. In August 1982, Mexico, unable to service its debt, declared a debt moratorium, soon followed by Brazil, Argentina, Bolivia, Venezuela and a number of other countries. Initially, Latin America's debt problem was attributed to short-term liquidity difficulties. Thus, the solutions proposed and put in place involved economic contraction and stabilization to insure full payment of interest due. In 1985, the Baker Plan was introduced. This plan was an alternative scheme to the earlier country-specific plans that were arranged individually between creditors and debtors. These arrangements often received additional financial support of international financial organizations, such as the International Monetary Fund and the World Bank. The Baker Plan emphasized renewed growth as well as full repayment of interest and was partly financed by the World Bank.

By the end of the 1980s, interest arrears were a very common problem among the largely indebted developing countries and commercial bank funds were no longer accessible. The response was the Brady Plan which was introduced in the early part of 1989. The goals of this scheme were to seek ways to achieve voluntary debt reduction agreements between commercial banks and the highly indebted countries. Mexico was the first country to reschedule its debt under the Brady plan and achieved a 35% reduction on the face value of debt in August 1990. However, the debt overhang continued to be a problem for most countries for a long time.

A secondary market for loans to less developed countries (LDC) emerged soon after the debt crisis of 1982. These loans are traded among creditor banks and other investors and a secondary market price is formed through these transactions. LDC loans trade at a discount in the secondary market, meaning that a dollar of debt at face value commands a price that is less than a dollar. For example, in May 1995, Mexican debt still traded at a 50% discount, the corresponding figures for Peru and Venezuela were roughly 45% and 70%. (1) These discounts correspond to secondary market prices of $0.50, $0.55 and $0.30 on every dollar of debt, respectively.

Secondary market prices for less developed countries' debt are a good proxy for perceived success of debt management. Due to the rapid expansion of the emerging markets (2) debt, it has become more essential for the policymakers to have a better understanding of the factors that affect investors' expectations of the probability of default on LDC debt. The discount in the secondary market will be higher for LDC debt for which the probability of default is higher. This paper develops a present-value model of LDC debt to understand the factors behind high discounts on the secondary market of countries that have undertaken significant reforms and have achieved a substantial reduction in their foreign debt.

In this paper, we show the global lending environment is a dominant determinant of secondary market prices of LDC debt. The only action by the debtor countries that seems to affect the discount in the secondary market is their foreign exchange reserves to imports ratios. This paper differs from the work of others in the literature in two ways. Firstly, we provide a theoretical basis for the empirical work that we do. In other words, we do not estimate an ad hoc regression model but rather estimate a regression that we derive from a model of debt default. Secondly, our empirical work includes factors related to the global lending environment that have been missing in previous empirical studies. Hence, our finding that global lending environment is the dominant factor in determining secondary market prices sheds a new light on the evidence from previous empirical studies.

The paper proceeds as follows. …

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