Commercial debt reduction is no panacea. It requires payment of a price up front, and the direct financial gains are often small. For payoffs, one must look at debt reduction's effects on development, which come about mainly through reducing uncertainty about how the growth of investment and efficiency will be shared.
In a recent review of the analytic aspects of debt reduction operations, researchers from the World Bank's Debt and International Finance Division look at how to evaluate the costs and benefits of debt reduction and the influence of the process on investment and growth.
Debt and debt service reduction (hereafter, simply debt reduction) has a significant development impact when done in the context of a strong policy framework and a solid track record of economic reform. Debt reduction has important fiscal implications, not only through the reduction in scheduled external debt service, but through the reduction in the interest rates on domestic debt. Debt reduction also contributes to public policy by improving growth incentives and reducing fiscal pressures. It increases the availability of external resources through improved country creditworthiness and more attractive investment opportunities---not through the insignificant liquidity relief realized from the agreements with commercial banks.
The main purpose of debt reduction is to establish more efficient arrangements between debtor countries and commercial banks, thus improving the conditions for development. Both parties can share the efficiency gains. The commercial banks benefit, since without such operations their claims are worth less than face value. With the cash payment they receive in exchange for the debt reduction, the banks are better-off financially. And for debtor countries, the positive development impacts can more than offset the financial costs.
Seven countries have carried out comprehensive debt reduction deals with their commercial creditors---the Philippines (in two phases in 1990 and 1992), Mexico (1990), Costa Rica (1990), Venezuela (1990), Uruguay (1991), Nigeria (1992), and Argentina (1993). The operations included the participation of almost all of the eligible commercial banks.
These agreements used a wide variety of instruments, ranging from debt buybacks, where debt is retired against an up-front payment, to new money bonds, where additional money is provided by banks, increasing rather than reducing debt. Discount bonds and par bonds (including front-loaded interest reduction bonds) provide debt reduction in exchange for safe collateral.
The common feature of the par and discount bonds is that they reduce the scheduled interest service from predebt exchange levels---through reduction in princi- pal for discount bonds and reduction in interest rates for par bonds. These bonds are also similar in that they are partially collateralized.
The use of a variety of instruments reflects the different preferences of creditor banks. In this context, new money from some of the participating banks is an integral part of these operations and has often been important in financing the enhancements required for the other instruments. The net result of each operation has been the reduction of commercial bank debt or debt service in exchange for the up-front provision of cash or safe collateral.
The new instruments have three notable features. First, the debt exchanges have entailed the conversion of almost all outstanding commercial bank loans to securities. Second, fixed nominal interest rates have been used in par bonds, as opposed to floating rates indexed to LIBOR. Roughly half the outstanding commercial bank debt was converted from floating to fixed interest rate debt. Third, there are recapture clauses for creditors based on changes in export prices (Mexico and Venezuela), terms of trade (Uruguay), or GDP (Costa Rica), where additional debt service is contingent on positive movements.
These changes in debt service can be summarized in the debt reduction equivalent (see the box). The debt reduction equivalent ranged from 26 percent of the original face value of eligible debt for Venezuela to 80 percent for Nigeria (see the table on page 4).
For the seven countries combined, commercial bank debt was reduced by more than 40 percent. But additional official lending to help finance buybacks or the purchase of associated collateral amounted to about a sixth of the commercial debt reduction equivalent. Taking this increase in official debt into account, the seven countries' total external debt was effectively reduced by about 15 percent, ranging from about 10 percent for the Philippines to about 20 percent for Costa Rica.
Debt reduction operations affect development through three channels: through the fiscal balance and public policy, through domestic savings, and through the balance of payments. By agreeing to a debt reduction operation, a debtor country government can credibly signal that it has the willingness and capability to achieve its policy goals.
Since debt reduction operations restructure public debt, they have a direct financial impact on fiscal accounts. Public indebtedness may impose severe restrictions on public policy through its effect on public expenditures, particularly if fiscal deficits are inflexible and if inefficient deficit financing mechanisms need to be used. The actual liquidity relief provided by the debt reduction operations is generally small in terms of total public revenue. But the overall fiscal impact of debt reduction operations can be more significant if such operations reduce the real interest rate on public domestic debt.
Interest payments on public domestic debt are often a significant proportion of public revenues. For example, for five countries interest payments on domestic debt were one fourth of total fiscal revenue, or about twice as much as on external debt. The reduction in real interest rates on public domestic debt following the operations had a major impact on the burden of domestic debt and, consequently, on public sector liquidity and the fiscal deficit. For Mexico, for example, this impact was several times larger than the liquidity impact achieved through the restructuring of external debt.
High levels of debt can tax future output because an improvement in future economic performance improves a debtor country's ability to pay and benefits creditors through higher debt service payments. High levels of debt also heighten uncertainty, since repayments under these circumstances result from protracted debt renegotiations. This uncertain "tax rate" is a disincentive to investment and growth through its drastic effects on public policy and, more indirectly, on private investment. The reduction in scheduled debt service through a debt reduction operation removes part of this distortion.
High debt levels are, however, preferable to having no access to foreign credit. Indeed, for capital-constrained countries, improved access to foreign savings results in efficiency gains, since additional financing can be used for high-return investments. But the front-loaded agreements with commercial banks lead to an inherently small or negative short-run cash-flow impact and thus cannot be the basis for significant investment effects. In the wake of debt reduction, most of the efficiency gains in external financing come from the improved relationship between the country and foreign investors that results from the improved country risk. A significant improvement in country credit ratings and debt prices is a clear measure of debt reduction's success.
Regardless of the exact channel, the key to the reduction in country risk is a solid policy framework inspiring investor confidence. Increased investor confidence encourages new capital inflows, such as the repatriation of accumulated capital flight and international portfolio investment.
Financial variables may provide more useful evidence of the economic impact of debt reduction operations than real variables, because they adjust faster and are easier to measure. We look therefore at the development impact of debt reduction through four quick-adjusting indicators: real interest rates, domestic stock prices, market-based country credit rat-ings (supplemented by secondary market prices and traditional creditworthiness indicators), and external resource transfers for some of these countries. The most revealing time period is around the date of the agreement in principle, during which most of the new information about the operation is incorporated.
Nominal interest rates abruptly fell by 20 percentage points in Mexico during the negotiation period, and real interest rates fell by almost 60 percentage points in a six-month period as negotiations evolved. To a large extent this improvement has been maintained. The real burden of domestic debt fell by more than 15 percent of public revenue, several times the actual liquidity relief on external debt.
The real interest rate response was less dramatic in the other countries. In Venezuela, the pattern was similar to that in Mexico, but the magnitudes were smaller. Changes in monetary policy beyond the debt reduction contributed to this difference. In Costa Rica, real interest rates fell originally, but nominal rates have not come down, and the gains were reversed in 1991.
Stock market prices in Mexico and Venezuela rose in the negotiation period, suggesting that the market expected positive effects. After the operations, prices stagnated in Mexico and continued to climb in Venezuela, suggesting that other factors were also at work in Venezuela. In the Philippines, stock prices rose dramatically during the negotiations but then dropped sharply.
Credit ratings by private market participants rose for all countries and continued to rise strongly for several countries after the operations were concluded.
The evolution of external capital inflows is also generally consistent with improved creditworthiness. One useful measure of the ability of a country to attract foreign financing is the adjusted resource transfer from abroad, defined as capital inflows (including errors and omissions) net of factor payments. In Mexico, this net transfer in 1991 was up by about 4 percent of GDP, mostly in direct and portfolio investment. In Venezuela, the net transfer in 1991 increased by about 11 percent of GDP over 1990, including an increase of almost $1 billion in direct investment.
But the benefits of the development impact of debt reduction are shared by the debtor and its creditors. A priori, it is not clear who gets to keep the major share of the gains. Countries need to scrutinize the means by which they reduce debt, since this determines the gains to creditors.
Commercial creditors. The compensation to banks required to reduce debt, and therefore the financial cost to the country, depends on the negotiation mechanism in voluntary debt reduction operations. In an open-market operation, banks can free-ride by holding on to their old debt claims in the expectation that other banks will provide debt relief. But if a minimum degree of participation among banks is a condition for the restructuring, financial costs can be reduced.
The menu approach requires each commercial bank creditor to choose one of the menu options. This imposes coordination among banks and reduces the net payments to banks by minimizing free-riding. Furthermore, the diversity of the menu options has made the negotiations more efficient, allowing countries to respond in cost-effective ways to banks' preferences and to capital, regulatory, and tax constraints.
If the seven countries had purchased the same amount of debt in the open market, rather than in a coordinated way using the menu approach, free-riding and inefficiency would have led to additional financial costs to the countries of more than $13 billion. The countries' net financial cost (the banks' financial gain) in these operations is estimated to have been about the same, so the use of the menu approach may have reduced the debtor countries' net financial cost by about half.
Official creditors. In aggregate, official creditors may have experienced a positive financial impact, but concerns remain about the change in credit risk if countries experience debt service difficulties.
Most of the seven countries' eligible commercial bank debt was repurchased or converted into bonds. Having a larger share of private debt in the form of bonds might reduce the flexibility that a debtor country will have to handle future debt servicing difficulties, increasing the burden on the country and its other creditors, mainly official.
Official creditors thus experienced a rise in absolute and relative exposure. Nevertheless, the restoration of some access to international capital markets and the return of flight capital can be expected to reduce dependence on future official support.
Debtor countries. The medium-term liquidity implications of debt reduction arrangements are important for debtor countries, but the relief provided tends to be small, so its development impact is not significant.
The immediate liquidity impact of a debt reduction arrangement is negative unless additional new money is an important element. Debt reduction operations generally imposed an up-front liquidity cost on all countries, since cash outflows associated with collateral purchases and cash for buybacks (net of new money) have been large. Official financing helped alleviate this initial liquidity problem, partly financing the initial outflow.
The estimated subsequent cash-flow savings based on the extrapolation of historical payments records (rather than unrealistic contractual terms) are generally modest and sometimes negative. In their balance of payments impact, they do not exceed 5 percent of exports, within the observed range of variation of equivalent terms of trade changes. In their fiscal impact, they amount to similarly small fractions of public revenues.
In sum, the main benefit to the debtor country is not that it buys back its debt at "bargain prices" or that liquidity improves dramatically through lower debt servicing. Instead, a country incurs some up-front financial costs (minimized through a comprehensive menu approach) because it expects the operation to generate larger offsetting benefits for long-run development.
The main fiscal effects of debt reduction operations are likely to come from greater certainty about future public policy and from potential liquidity benefits, particularly through the reduction of the burden of domestic debt as a result of lower interest rates. In sum, while the remarkable surge in private capital inflows to many of these countries is the result of a combination of favorable circumstances---both domestic and external---the debt reduction operations have made a decisive contribution.
See Stijn Claessens, Ishac Diwan, and Eduardo Fernandez-Arias, 1992, "Recent Experience with Commercial Bank Debt Reduction," World Bank Policy Research Working Paper 995.
These findings also draw on more recent internal data and analysis by the Debt and International Finance Division, International Economics Department.