Debt Overhang - HEC Lausanne sovereign debt problems and growth slowdowns are often associated....

Debt Overhang

Macro-Economic Policy

University of Lausanne

Fall 2013

Macro-Economic Policy Debt Overhang 1 / 20

Empirically, sovereign debt problems and growth slowdowns are oftenassociated.Causality can go in both directions.

I Growth slowdowns make debt-servicing more difficult for thegovernment.

I High inherited debt can contribute to the growth slowdowns: debt

overhang

FDebt = resources that have to be transferred to creditors = tax on the

economy

When a country has a debt overhang problem:I Debt forgiveness can actually increase the value of debtI In this case, it is optimal for creditors to allow partial default.I Is Greece in a debt overhang?


Europe’s Debt Crisis - Greece

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2003 2004 2005 2006 2007 2008 2009 2010

Real government debt

Real investment


Debt Problems in the Past

Source: Reinhart Reinhart Rogoff (2012): Public Debt Overhangs,Advanced-Economy Episodes since 1800.


Model of a borrowing economy

There are 2 periods.At date 1, the government has an inherited debt of face value D thatwill come due on date 2. The world interest rate is set to 1, so thecountry has to repay D in period 2.The country is risk-neutral with expected utility function:

U = C

1

+ E (C2

)

Date 1 budget constraint:

Y

1

= C

1

+ K

2



Date 2 budget constraint:if the country does not default:

AF (K2

) = C

2

+ D

If the country defaults, foreign creditors seize a fraction of output⌘AF (K

2

), 0 < ⌘ < 1:

(1 � ⌘)AF (K2

) = C

2

I F is increasing, concave, with F 0(k)k!0 ! +1.I A is a random variable with mean E (A) = 1 and distributed over [A,A]

with probability density function ⇡(A).



Debt market value V : payments creditors expect to receive at date 2:

V (D,K2

) = ⌘F (K2

)EA

��A <D

⌘F (K2

)

�PA <

D

⌘F (K2

)

�

| {z }Payments in default states

+ D · PA � D

⌘F (K2

)

�

| {z }Payments in non-default states

since the country will default for all values of A such that⌘AF (K

2

) < D.Debt market value V is lower than the debt face value D as long asthere is a positive probability of default.


Debt Overhang Effect

Country’s utility:

maxK2

U(K2

) = Y

1

� K

2

+ F (K2

)� V (D,K2

)

Denote the productivity threshold

A

⇤ ⌘ D

⌘F (K2

)

Country’s utility (after substitution)

maxK2

Y

1

� K

2

+ F (K2

) (1 � ⌘E [A |A < A

⇤ ]P [A < A

⇤])� DP [A � A

⇤]


How does an increase in inherited debt D affect the country’s optimalinvestment choice?FOC with respect to K

2

:

F

0(K2

)

2

641 � ⌘E [A |A < A

⇤ ]P [A < A

⇤]| {z }Effective creditor tax on capital

3

75 = 1

Implicitly defines K (D)

What happens to capital accumulation when debt increases?I K 0(D) < 0: Debt overhang effect


Debt Laffer Curve

Krugman (1989) and Sachs (1989) have argued that a severe enoughdebt overhang may enable creditors as a group to raise expected debtrepayments V (D,K

2

) by forgiving a portion of what they are owed

@V (D,K (D))

@D

= ⌘F 0(K )K 0 (D)E [A |A < A

⇤ ]P [A < A

⇤]| {z }Debt overhang effect<0

+ P [A � A

⇤]| {z }Prob. of full repayment>0


If the country is on the wrong side of the Laffer curve, creditors canmake themselves better off as a group by unilaterally writing down thedebt face value.But debt forgiveness rarely observed in practiceWhy?

I coordination problem between borrowers


Solutions?

Large buyer - public or privateWhat about debt buybacks?


Greece’s Case

April 2010: Downgrading of Greek debt by rating agencies to “junkstatus” (BB)May 2010: EU/IMF rescue plan: bilateral loans at discounted interestrates (110 billion euros)Followed by the creation of the European Financial Stability Facility:institution that can issue guaranteed bonds to provide loans totroubled eurozone countries.Since May 2010 ECB had to buy huge amounts of sovereign debt toease market pressure (very controversial)


Secondary Price of Greek Public Debt (1-year maturity)

0

20

40

60

80

100

120

31.12.08

28.02.09

30.04.09

30.06.09

31.08.09

31.10.09

31.12.09

28.02.10

30.04.10

30.06.10

31.08.10

31.10.10

31.12.10

28.02.11

30.04.11

30.06.11

31.08.11

BB rating 1st EU/IMF plan

CCC rating

2nd EU/IMF plan


Greece’s Case

Since then: austerity measures, political crisis, recession...June 2011: further downgrading of Greek debt to CCCJuly 2011-present: second rescue plan involving the private sector(new 110 billion euros loans by EU + private sector rolls over 135billion + loan of 20 billion to buyback part of the debt)


Empirical Evidence

Is there a debt overhang effect?Is the far side of the Laffer curve relevant?


Is there a Debt Overhang Effect?

Cohen (1993): Low Investment and Large LDC Debt in the 1980’s

I 1982: debt crisis in Latin America / 1980’s: low investmentI Debt overhang? Not so clear since 1980’s coincide with a rise in

world’s interest ratesI Purpose of the paper: disentangle the debt overhang effect from the

effect of high interest ratesI Results: it is not the level of debt per se but the level of debt

repayments that decreases investmentI A debt service of 3% of GDP decreases investment by 1%


Is the far side of the Laffer curve relevant?

Claessens (1990): The debt laffer curve: Some estimates

I Only a few indebted countries in the 80’s are on the wrong side of theirDebt Laffer curve.

FBolivia, Peru, Sudan, Zambia, and Nicaragua

What about troubled European countries today?


Last Thoughts

There is more evidence for debt overhang effects than for the far sideof the Laffer curveEven when the far side of the Laffer curve is not relevant, the costs ofdebt forgiveness for creditors might be lower than the gains forborrowers

I Rationale for the intervention of a public entity such as a multilaterallending agency

I In the model, compare the country welfare gain with the costs tocreditors.


Debt Overhang - HEC Lausanne sovereign debt problems and growth slowdowns are often associated....

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