Academic journal article Contemporary Economic Policy

Commercial Banks and LDC Debt Reduction

Academic journal article Contemporary Economic Policy

Commercial Banks and LDC Debt Reduction

Article excerpt


Much empirical literature examines the foreign debt servicing capacity of lesser developed countries (LDCs) before and after the onset of the LDC debt crisis in 1982 (Abassi and Taffler, 1982; Avramovic et al., 1968; Cline, 1984; Edwards, 1984; Dhonte, 1975; Feder and Just, 1977; Feder, Just, and Ross, 1981; Frank and Cline, 1971; Grinols, 1976; Kharas, 1984; Mayo and Barrett, 1978; Saini and Bates, 1978; Sargen, 1977; Schmidt, 1984.) Of particular concern to most of these studies are the factors that may influence the probability that a country will default on, or be forced to reschedule, its foreign debts. Using a variety of statistical methodologies, the studies identify several macroeconomic variables that are statistically linked to higher default probabilities in indebted LDCs. (For a review of the empirical literature on LDC default probabilities, see McDonald, 1982; Saini and Bates, 1984; and Eaton, Gersovitz, and Stiglitz, 1986.)

The LDC debt literature, however, has failed to address the question of how international creditor banks have responded to those macroeconomic factors found to be systematically related to the probability of default (defined here as the probability that a bank is repaid less than the face value of debt). This question has taken on even greater importance since the onset of the LDC debt crisis in which a succession of indebted LDCs, beginning with Mexico in August of 1982, found that they no longer could service their external debts at existing levels and terms. Faced with the very real prospect that widespread LDC default could shake the world financial and trading systems and the economic and political stability of debtor countries, the international financial community struggled for years to find an appropriate policy response to the crisis.

The cooperation of the creditor banks was key to the success of any LDC debt policy. Thus, some theory of how banks responded to high expected LDC default probabilities was needed. Toward the latter part of the 1980s, a theory that gained prominence offered an intuitive, albeit controversial, framework within which to explain bank behavior in response to high expected LDC default probabilities. This theory posited that banks' optimal strategy in certain situations may be to reduce their claims on indebted LDCs (see, for example, Krugman, 1989; Sachs, 1986). This theory was perhaps best represented by Krugman's (1989) debt-relief Laffer curve, which demonstrated that when high default probabilities existed, reducing a country's debt burden actually could increase the expected value of the debt (see section II for a more on-depth discussion of the debt-relief Laffer curve). Implicit in this theory was the assertion that a bank's incentive to reduce its claims on a country is positively related to the prospect that the country will default.

The rapidly growing volume of voluntary market-based debt reduction beginning around 1985 seemed to bear out the theory that a bank's optimal strategy may be to reduce its outstanding LDC claims. From 1985 through 1488, the yearly total of market-based debt reduction--as measured by instruments such as debt-equity swaps, debt buybacks, local currency payments, or local currency conversions--increased from $742 million to $18.2 billion. Then in March of 1989, U.S. Treasury Secretary Nicholas Brady made debt reduction the new cornerstone of the official LDC debt policy. (The Brady Plan replaced the failed Baker Plan, which in 1987 called for the banks to increase net lending flows to troubled LDC debtors by $20 billion over three years.) The so-called Brady Plan was targeted to a relatively small group of highly indebted middle-income countries, that owed nearly 85 percent of all LDC commercial bank debt in 1989.

The Brady Plan was based on at least three key assumptions. First, debtor countries would be willing to undertake appropriate economic reforms in exchange for significant debt reduction. …

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