Estimating the efficiency gains of debt restructuring
Ning S. Zhu
One rationale for debt reduction operations under the Brady Plan has been, by alleviating the debt overhang, to improve investment efficiency. Brady-type debt and debt-service reduction (within a strong policy framework, where there is a track record of economic adjustment) has been shown to affect development significantly. The principle benefit of eliminating the debt overhang is to improve investment incentives for private investors - direct liquidity relief is secondary. So, evaluating a debt and debt-service reduction operation should involve estimating efficiency gains as well as direct financial savings. The authors present a method (requiring only weak assumptions) for establishing an upper bound on the efficiency impact of debt reductions. The key reference framework for evaluating much more complex Brady-type debt deals is open-market buybacks. Their approach to determining this upper bound hinges on the assumption that efficiency gains on a straight open-market repurchase of debt never exceed the gains to creditors. If an open-market buyback indeed reduces the debt overhang and moves a country toward more (and more efficient) investment, creditors will anticipate this in setting a price for remitting their claims. So, at least part of the efficiency gains are dissipated in additional capital gains to creditors. To give point estimates to efficiency gains, they develop a simple two-period model of debt overhang and investment and discuss assumptions under which it is possible to obtain a closed-form solution to the model. Their empirical estimates indicate that the general bounds derived in the first step tend to overstate substantially the efficiency gains of debt reduction operations. In Mexico's case, for example, the upper-bound estimate of efficiency gains is US $15 billion, but the point estimate is only about US $1 billion. What are the policy implications of their low point estimates? The debt-overhang disincentive may not be as important as the broader problem of debtors'credit constraints in international capital markets. How can new loan packages to developing countries be structured to maximize investment incentives? By using loans rather than outright grants, donors can give a country more funds for current investment at lower present dicounted expense. But grants, unlike loans, do not distort investment incentives. In short, if a credit-constrained country starts with no debt overhang, the first tranche of aid should probably be in hard loans. As total transfers increase, if the borrowing country has not gained access to private capital markets, marginal transfers should be grants. The optimal strategy for new flows can involve both increasing grants and decreasing loans. When transfers are expected to be heavy, a case can be made for using grants exclusively.
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