National Debt Crisis in Developing Countries: an Overview

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euro-debt-crisis-mediumThe debt crisis in developing countries was partly responsible for the deterioration in welfare levels in many countries in the eighties. It also resulted in the development of different models to analyse a situation whose starting point is a high debt. In this article, diverse aspects of this theory are presented.

In the mid-eighties, the idea that a debt of many developing countries with private creditors would have lethal magnitude if not paid in full is widespread. For that reason a secondary market emerged. This usually occurred when the market believed that some countries cannot afford to pay off the debt. The existence of the secondary market seemed to provide a direct method for debtors to avail themselves of the belief that the debt will not be recovered, namely the purchase of its own debt. Many troubled borrowers bought part of this foreign debt at a lower price. Also, many have made debt-equity swaps availing the prices as the basis for contributions. The positive aspect of such solutions is not as clear as it might seem at first sight; not all the solutions proved to be favorable to the debtor country and to be taken into account for evaluation.

Both buybacks and debt swaps modify the risks assumed by the debtor and the creditor. Under the assumption of an exogenous income stream, experts examined if it is possible to improve the way in which the debtor and creditor share the uncertain variables that affect their relationship.

The assumption that the amount of debt does not affect the distributed income is useful to clearly distinguish some important phenomena. However, there is some reason to doubt their validity. Precisely, the theory was based on the hypothesis that high debt inhibits growth. In an unexpected circumstance, when the situation of the debtor improves, it usually results in higher revenues for creditors. This means that the debtor has at its disposal different tools that could increase the current income, but usually they are very unpopular. Such is the case of economic reforms that promote growth, but require sacrifices and are politically costly.

Although all the creditors are looking to reduce the debt of a country, there are forces acting in the opposite direction.

The first is the problem of setting a “bad” precedent. When the creditors examine the case of a debtor, they have to be concerned not only by this debtor but also by the fact that other debtors will later require granted concessions. This acts as a brake on making concessions. This brake acts more sharply against small debtors. To their misfortune, creditors have less to lose in front of such debtors, consolidating their status as trustable negotiators.

The second force comes from the existence of private information related to the debtor. Once the possibility of forgiveness is put on the table, it is obvious that any debtor will exaggerate their need for relief, and if the creditor knows the debtor’s real need for relief, it can lead to a deadlock. Usually, the bank does not know if the debtor really needs debt relief. Any debtor would declare the need of debt relief. Such phenomenon and possible mechanisms to overcome it have recently been analysed based on modern theories of economics.

Published by Kidal Delonix (764 Posts)

Kidal Delonix is a contributor to Mr. Hoffman's blog. The views and opinions are entirely his/her own and may not reflect Mr Hoffman's views.

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