Managing Market-based Debt

8/3/2019 Managing Market-based Debt

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Michel CAMES

Postgraduate Diploma in Development Studies

International Processes of Change and Development

University of Leeds

Essay

1995/96

The alternatives of managing market-based debt and their

prospects

This essay aims to illustrate the alternatives offered to debtors and

creditors alike, limiting its scope on commercial debt, to find an outlet of

the present situation in which the Northern banks and developing countries

are equally locked: the debt crisis which has been on the agenda for more

than 10 years. It attempts this by presenting a general overview of the

policies applied since its outbreak in 1982 and proceeds to introduce themarket-based debt-reduction schemes a la Brady with their particularities.

Then, it presents one less common but the more interesting and forward-

looking scheme: debt-for-nature swaps and the way they are presently

being implemented. The essay continues to shed light on the different

schools of thought when it comes to managing the debt crisis and finally

concludes with a personal statement about the appropriate handling of this

crisis.

The main contention of this essay is that in order to understand and settle

the debt crisis, we ought not only to grasp the ultimate facts leading to the

inability of the developing world to pay back their debt but to view it from a

wider angle and to include the self-interest of Northern banks to contract

debts, the monetarist policies pursued by their governments and the world

wide pattern of trade with decreasing terms of trade for many southern


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countries. From this point of view, the debt crisis ceases to be a crisis solely

of the South, but it is looked upon as a burden which ought to be shared by

all instigators, including the North.

Since the debt crisis emerged by the inability of the Mexican government to

repay loans due to the private banking system and sovereign lenders, there

have been many attempts to design schemes to solve or at least alleviate

the crisis to the mutual benefit of both the debtor countries and the

creditors.

The main response to the debt crisis in the beginning was the attempt to

reschedule the debts by stretching their maturities in order to give

developing countries more breathing space to grow out of their debt

problems. This containment strategy with a decline in new bank lending set

in soon after the magnitude of the crisis was recognized and lasted until

1985. As Corbridge states, the effects of this strategy on development were

not hard to guess at: most African and Latin American countries began to

underdevelop. In Latin America, development had been sacrificed to

secure the stability of the international banking system (Corbridge, 1993, p

60).

In 1985 then a new debt initiative was announced with the Baker Plan. Its

Adjustment with Growth policy made provision of additional lending from

mainly commercial banks to a handful of severely indebted countries

contingent on market friendly, growth-oriented structural adjustment

programmes being adopted. Debt reduction was not taken into

consideration yet and the limited amount of money and countries involved

made the whole scheme turn out rather deceptive. Only four years later,

the Brady Plan was introduced. It has generally been looked upon as being

more successful. As Oxfam states, it marked a watershed in the

international debt strategy for middle-income countries, belatedly

acknowledging what had long been evident: that a large proportion of


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commercial debt was unpayable, even with the financial squeeze applied

under adjustment programmes (Oxfam, 1995, p 176).

For commercial debt, concerted debt-reduction schemes have beenintroduced. As the African Centre for Monetary Studies points out, a

concerted debt-reduction scheme is a programme worked out by the debtor

country in collaboration with its creditors with a view to restructuring and

reducing its debt. Most important, it overcomes collective-action problems

such as the equal-sharing clauses and free rider problems whereby a bank

not participating in a debt-reduction transaction can benefit at the

participants cost. The equal sharing clause demands that if a deal is made

with one lender, the same deal must be offered to other lenders in the

consortium. The free-rider problem arises when non-participating creditors

gain as against participating creditors by reaping the benefit of the rise in

the secondary market debt value, which has only be triggered off by the

reduction scheme. According to the debt relief Laffer curve, the value of

expected repayments increases in the same degree than the face-value

debts as long as full repayment is expected. At higher levels of debt,

however, the possibility of non-payment arises and grows, so that the

expected payment line traces out a curve that falls increasingly off the full

repayment line. Beyond some point, the disincentive effects begin to

outweigh the face-value of the debt and the value of expected repayment

actually decreases with increasing debt.

Analogically, with debt reduction the Laffer curve comes closer again to the

full repayment-curve which simply means that the remaining debt will

increase in its secondary-market value to a degree which can even be

higher than before the reduction. This mechanism effectively annuls the

benefits of voluntary debt reduction and prevents it from being launched.

Or, as Jeffrey Sachs puts it: The failure to make real headway with debt

reduction is not an accident. Even when a reduction of the debt burden

would be beneficial to the broad class of creditors and debtors alike, it is


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unlikely to emerge from the current structure of debt negotiations.

Meaningful debt reduction requires an appropriate institutional setting to

overcome important collective action problems. Instead of voluntary debt

reduction, we need concerted debt reduction (Jeffrey Sachs in AfricanCentre for Monetary Studies, 1992, p 106). The free-rider problem can

also be overcome by building into the schemes a process that turns the

potential cost to the holding-out creditor into a benefit to the debtor. By

requiring creditors who exchange less than a given amount of their debt

through standard options to provide new money, this turns out to a benefit

to the debtor. The creditor speculating to obtain the capital gain of the

secondary market will have his new provided money discounted back to the

new secondary-market price.

According to the African Centre for Monetary Studies, the Brady Initiative

aims at reducing the debt of middle-income countries owed to commercial

banks by using a menu approach, the main elements of which are: 1) the

swapping of old debt for new paper at significant discounts, or with the

same face-value but lower interest rates, 2) buy-backs of the debt at deep

discounts, 3) encouragement of the swapping of debt paper for equity

shares in private or privatised enterprises in the debtor country.

The menu provides the flexibility, whereby the creditor can exercise its

choice on reduction techniques depending upon its own assessment. Thus a

creditor that has a strong presence in the debtor country may find it most

rational to exchange a large proportion of its debt through a debt-equity

swap. A small bank, however, with limited exposure would prefer a

combination of some buy-back and some exchange into lower-interest

bonds or even simply to exit totally through the cash buy-back option.

The debt buy-back operation is the simple buy-back, for cash and at

secondary-market prices, of its own debt by the debtor. Besides the open

buy-back, secret buy back operations are carried out by an agent who


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buys the debt anonymously on behalf of the debtor. This opens up not only

the possibility of holding the secondary-market price before the purchase

when news of the impending deal would increase the price of the debt, but

also for the debtor to take actions to depress the price artificially on thesecondary market prior to the deal by sending the appropriate signals

such as current budget deficits to the market. This might however

adversely affect future debt-reconstitution negotiations with the creditors if

it becomes public.

With a debt-equity swap, which is a transaction converting the debtor

countrys external debt into equity in a domestic firm, generally a foreign

investor acquires a participation of an enterprise by buying it at a discount

on the secondary market. This participation can be in the private sector or

in the para-public sector that is being privatized as part of the debtor

governments overall privatization programme. Also, a private companys

debt can be exchanged for equity investment in the same company.

Compared to simple buy-back operations, debt-equity conversions have

several additional benefits from the point of view of the debtor, namely the

encouragement of foreign capital flows, risk reduction by replacing debt

with equity, support of privatization programmes and the boost to the

transfer of technology. Also, the repatriation of flight capital can be

encouraged if nationals are allowed to buy into domestic enterprises by this

means.

However, there are some major drawbacks of debt-equity concessions

towards buy-back operations. First, the degree of foreign penetration of the

domestic economy has to be accepted. Second, debt-equity swaps might

only replace investment that would have been made anyway. Then there is

the serious drawback of the misallocation of resources resulting from

distortions caused by subsidies paid to investors through debt-equity

transactions when the foreign investor is allowed to undertake investment

expenditures at a lower cost than his domestic counterparts (African Centre


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for Monetary Studies, 1992). Apart from debt-equity swaps, there are

numerous other possible combinations of swaps. Among them are debt-for-

nature, debt-for-development, debt-for-trade and debt-for-health swaps.

According to Mahony, 19 debt-for-nature swaps had been completed in tencountries by mid-1991. They implied northern environmentalists buy up

some of the loans which developing countries owed to southern banks and

which were offered at discounted prices and cancel these foreign debt

obligations in return for good behaviour by these countries, which actually

meant making payments in local currency up to the face value of the debt

to a local NGO.

However, there have been two major setbacks in their application. The first

concerns the generally voluntary or isolated action of such swaps. Not

being integrated into a concerted debt reduction scheme, these swaps just

let the remaining debt rise in its secondary-market price and consequently

the debtor countries are often left with an about equal amount of expected

repayments after having reduced the actual face-value debt.

The actual benefit from these swaps goes then integrally to the creditor

banks. Consequently, First World environmental groups have just given

money to First World commercial banks. No transfer has thus taken place

from North to South.

Also is there no guarantee that eventually the local NGOs will be founded

by the government and even if they are, other environmental spending

might be cut to make up the cost.

But even in the case when environmentalists pry out the money of their

governments, they mostly create, enlarge or administer national parks by

merely drawing a line around it on a map and issuing uniforms to a few

rangers. Thus, the natural areas will not be more protected than before as


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this will not stop poachers, illegal loggers and landless farmers to invade

these areas (Mahony, 1992).

As Miller points out, the critical obstacle is simply that there is no way thatdebt can be reinstated on grounds of non-compliance. Non-compliance may

not be due to a lack of goodwill or of ignorance of the part of any party

involved in the recipient country, but they may be unable to take the

appropriate actions if strong political, economic or social pressures militate

against the desired corrective action. Frontiers are exceptionally tempting.

It is a rare politician that can resist or be strong-armed enough in the face

of pressure from the energy-hungry industrial-urban interests, the hungry

landless, the covetous powerful landlords allied with the mining and timber

barons. Also, pressure for non-compliance is increased when the debt

servicing obligation continue to leave little room for meeting immediate

needs (Miller, 1991).

From a southern point of view, the debt-for-nature swaps do not lead to a

democratic management of natural resources and a better quality of life for

the local population. Instead, it reaffirms the creditors political and

economic domination over the debtors and propagates a development

model which commercializes life in all its aspects. Also do they legitimize

the debt at a time when many indebted countries are putting forward the

idea that the debts were incurred illegally (Mahony, 1992). The Debt Crisis

Network points at one major call of the South: the elimination of trade

barriers in industrial countries, along with the efforts to stabilize commodity

prices (The Debt Crisis Network, 1986, p 44).

This stance is also taken by a strand of purists (Cartwright, 1992) or

advocates of what Corbridge terms the system-instability perspective.

Corbridge quotes Susan George who claims that debt was accrued mainly

because the West and some local elites were able to define the process of

development in initiative terms. This mal-development would mimic


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without understanding and copy without controlling. She advocates a

strategy for Debt, Development and Democracy (3-D). This proposal

would recognize that debt is not an economic, but a political problem. She

suggests that countries are allowed to pay back their debt over a longerperiod of time in local currency. These payments would then be credited to

national development funds whose uses are determined by authentic

representatives of the people working with those of the state. For the

creditors, this solution would amount to cancellation since the local

currency would be used internally. Towards critics who argue that her

proposals would be utopian, she replies that the international financial

system could now bear the costs of cancellation and in the North ethical-

based movements and export-oriented lobbyists would encourage such a

scheme (Corbridge, 1993). She points out the boomerang effects to the

North in case of a further containment policy: deteriorating environment,

more drugs, lost markets, increasing immigration and rising potential of

conflicts (George, 1992).

Among this school of thought are also the proponents of the radical

repudiation strategy. It is commended as necessary and put forward as a

strategy which refuses to admit the legality of many of the debts

contracted, often by military regimes and which refuses to pay monetary

debts in human lives. This policy found some sort of expression in Peru

when under President Garcia in 1985 a 10 % ceiling on debt-service

payments as a proportion of export earnings was imposed unilaterally.

According to George, this strategy of debt repudiation will not work unless

all debtor countries agree on a total and collective repudiation of debts

(Corbridge, 1993). Indeed, Peru still suffers these days under its former

presidents policy in having to meet a particularly high degree of

conditionality when it wishes to attract foreign capital.

Following Corbridge, a more moderate stance is taken by the proponents of

the system-corrective perspective. They are attached to Keynesianism and


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consequently aim at limiting the laissez-faire-policy and give priority to

pragmatic and aggregate conceptions instead of individual management.

They are in favour of structural adjustment policies of one sort or another,

but they are wary of the suggestion that from the ashes a new phoenix willarise. They locate a persistent weakness of the containment strategy in its

willingness to assume that an economy in debt servicing difficulties can

grow quickly on the basis of a severe pruning of its assets. Thus a

premature transfer of real resources to the creditor puts the long-run

development of the economy in jeopardy. The alternative is to act

pragmatically and to seek an equitable sharing of the burdens of

adjustment. They also point out that such a sharing has a historical

precedent in past debt crises which have usually ended in some

forgiveness. Consequently, a partial write-down of the debt is the norm,

not the exception (Corbridge, 1993, p 156 quoting Sachs, 1989, p 23). The

neo-classical counterpart of this more pragmatic stance is found in the

system-stability perspective, which suggests, according to Corbridge, that

the international economic and financial system is inherently stable and

that the responsibility for particular debt crises should be shouldered by

those who acted against the norms of economic prudence. As a major

proponent, Bauer argues that the problems of the indebted countries have

arisen from policies that have wasted resources and damaged living

standard and development. He suggests that it should be made clear that

there will be no further funds for countries in default on their debts. A ban

on debt rescheduling will encourage a proper moral fibre in such countries

.... (Corbridge, 1993). Toye refers to this strand as the new vision of

growth and concedes it would contain much common sense which in the

past has often been neglected by policy-makers. He adds however, that it

is but a short step from common sense to uncommon nonsense and

Bauers vision provides an opportunity to study how this short step has

been taken (Toye, 1989, p 88).


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This perspective of neo-liberalism which attacks the key elements of

Keynesianism and rejects the right of the state to engage in macro-

economic planning had re-emerged into prominence among Northern

governments by the end of the 1970s and was thus to dominate thepolicies of these countries when the debt crisis broke out in 1982. It can

also be asserted that the rise of monetarist policies after 1979, when

money became scarce and interest rates began to rise, was contributing to

the ultimate outbreak of the debt crisis. The main response to the crisis in

the early years was containment, adjustment and austerity, which can be

found in the system-stability perspective.

It was only the inability of this approach which led to more pragmatic

approaches when in 1985 the Baker Plan and then in 1989, the Brady Plan

were adopted. This gradual shift to a corrective stance has been recognized

as a more appropriate approach to dealing with the debt burden even if the

magnitude of the debt relief schemes has been far too modest to cope with

more than a trillion US-$ of international debt. However, as can be

observed in Latin America, the debt crisis is far from over even if the

response of some Brady-style debt write-offs was a boom in private capital

flows to some countries previously at the centre of the debt crisis were now

figuring prominently among the newly favoured emerging markets.

According to Oxfam, a large proportion of this foreign capital is speculative

in nature and entirely disconnected from the real economy. Much of the

explosion in private capital flows represents high-risk and short-term

speculative activity. Such flows have less to do with opportunities for

productive investment and employment creation than with the pursuit of

the fast-buck in money markets (Oxfam, 1995).

All the more it has become clear how necessary initiatives a la Brady have

become. From my point of view, Brady-style menu-based concerted debt

reduction schemes are on the right track to a final settlement of the debt

crisis when it comes to commercial debt as they allow a flexible approach


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and the free-rider problem is adequately solved. It is this system-

corrective stance which seems the most sensitive and reliable lever to deal

with the debt burden. Nevertheless, it has only been the first step to a

more honest behaviour and still has deficiencies. The future will showwhether the corrective stance, which varies widely in design, will not have

to move further into direction of the instability perspective for the mutual

benefit of all partners. Even if this latter perspective does not seem

acceptable regarding equal treatment as imprudent countries will be

rewarded for their behaviour, we somehow must admit that we do not live

in an all over equal world and to strive for settlement of any existing and

conceived injustices will only lead to turbulence, conflict and war. It is also

in this context that debt-for-nature swaps might eventually become an

opportunity window (Cartwright, 1992). As Cartwright points out, the

value of biological reserves - particularly tropical rainforests - can only

increase as our need for, and our ability to use, genetic materials grows.

Since the wealthier and more technologically advanced countries of the

North would be the first to benefit from the genetic pool, they should be

prepared to pay for its survival.

The main value however of refraining from further tropical deforestation is

the benefit in reducing or bringing to a halt a possible change in global

weather patterns. Since the countries of the North have already largely

devastated their own natural ecosystems and on top of that are by far the

largest consumers of fossil fuels thus producing the lions share of carbon

dioxide which is responsible for the greenhouse effect, they should have a

strong self-interest in supporting effective conservation measures

(Cartwright, 1992). Briefly, it comes down to a right to consume/pollute-

conservation-swap and is currently being implemented in parts of the

globe, however under a differing objective: in order to achieve the

aggregate goal of national carbon dioxide reduction agreed upon at the UN

Conference on Environment and Development in Rio de Janeiro, Northern

countries invest into conservation, reforestation and pollution control


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measures in developing countries instead of at home because in developing

countries these measures can be implemented at much lower costs for a

given amount of biomass creation or protection regarding none or only

crude pollution control facilities in developing countries compared toNorthern countries industries with already sophisticated devices. This

questionable trick to achieve the highest productivity of capital could

however be combined with the debt burden of the developing world.

Northern countries would invest into the southern environment by merely

freeing developing countries to pay back part or all of their debt. The

reduction or cancellation of debt could thus be able to protect biomass by

the simple means of developing countries not having to finance debt

repayment by once-off environmental degradation activities such as

logging virgin rainforests, let alone the temptation to achieve debt relief by

using their territory as poison-garbage depots. It could allow the

developing world to save their face and the advanced countries to concede

that certain commodities such as water, air, the genetic pool and a

human climate cannot be consumed free of charge only by the more

wealthy part of humans. It would further the commercialization of all

assets, but would help to bend the market system to pay the full cost

(Miller, 1991, p 137). This possible outlook into the future of a further

capitalization of our common natural heritage does not appear like a

heavenly prospect, but yet it could be one possible outlet of growing

environmental conflict potential and the settlement of one of our worlds

crises - the debt crisis.


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Bibliography

African Centre for Monetary Studies (1992), Debt-Conversion Schemes inAfrica, London, James Currey

Cartwright, John, Conserving Nature, Decreasing Debtin Wilber, CharlesK. and Jameson, Kenneth P. (1973), The Political Economy of Developmentand Underdevelopment, Fifth Edition 1992, p 618 - 630, New York, McGraw-Hill, Inc.

Corbridge, Stewart (1993), Debt and Development, Oxford, BlackwellPublishers

George, Susan (1992), The Debt Boomerang, London, Pluto Press

Mahony, Rhona (1992),Debt-for-Nature Swaps - Who Really Benefits?,The Ecologist 22/3, 1992, Dorset, Ecosystems Ltd.

Miller, Morris (1991), Debt and the Environment, New York, United NationsPublications

Oxfam (UK and Ireland) (1995), The Oxfam Poverty Report, Oxford, Oxfam

Sachs, Jeffrey D. (1989), Developing Country Debt and EconomicPerformance, Chicago, The University of Chicago Press

The Debt Crisis Network (1986), From Debt to Development, Washington,D.C., The Institute for Policy Studies

Toye, John (1987), Dilemmas of Development, Second Edition 1993,Oxford, Blackwell Publishers

Williamson, John (1989), 25 Voluntary Approaches to Debt Relief,Washington D.C., Institute for International Economics

Managing Market-based Debt

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