Enrica Detragiache

Sensible buybacks of sovereign debt

Abstract Sovereign debt is not prioritized, and creditors share the costs of a default in proportion to their exposure. Equal-sharing insures that all creditors cooperate in imposing default sanctions, but it leads to excessive borrowing. Countries that borrowed too much because of equal-sharing can gain from debt buybacks, even if there is no debt overhang. Sensible buybacks should be accompanied by either an interest rate reduction or a new money provision, they should grant unsold debt seniority over new loans, and they should assign future debt renegotiation to a third party.

Adverse selection and the costs of financial distress

Abstract Previous work suggests that, when the debtor has private information on the future profitability of the firm, financial distress is costly even if debt can be renegotiated. This paper shows that adverse selection problems can be completely avoided by offering creditors a mix of cash and equity in the renegotiation. Empirical evidence indicates that this is common practice in corporate debt workouts. However, asymmetric information leads to inefficiencies if equity is not treated as the residual claim in bankruptcy. In this case, equilibria exist in which distressed firms go to court too often.

Interest rates, official lending, and the debt crisis: a reassessment

The authors document and try to explain the sizable cross-country differences in interest rates on external debt paid by a group of highly indebted developing countries in 1973-89. They find that Indonesia and Turkey, which are often praised for not rescheduling in the 1980s, paid interest rates substantially below LIBOR - and avoided the interest rate shock of the early 1980s. Differences in the default-risk premium explain some of the variation among countries, but different degrees of access to official loans carrying highly subsidized interest rates played the major role. In the sample they studied, they found no evidence that debt at floating interest rates was more expensive than debt at fixed rates. For the period 1981-89, it is possible to control for differences in the currency composition of debt, and the results are essentially unchanged. These results suggest that studies of economic performance among the highly indebted countries during the debt crisis should control for cross-country differences in the burden of interest payments.

Financial Liberalization: Financial Liberalization and Financial Fragility

The authors study the empirical relationship between banking crises and financial liberalization using a panel of data for 53 countries for 1980-95. They find that banking crises are more likely to occur in liberalized financial systems. But financial liberalizations impact on a fragile banking sector is weaker where the institutional environment is strong--especially where there is respect for the rule of law, a low level of corruption, and good contract enforcement. They examine evidence on the behavior of bank franchise values after liberalization. They also examine evidence on the relationship between financial liberalization, banking crises, financial development, and growth. the results support the view that, even in the presence of macroeconomic stabilization, financial liberalization should be approached cautiously in countries where institutions to ensure legal behavior, contract enforcement, and effective prudential regulation and supervision are not fully developed.

The simple dynamics of a debt crisis

Abstract Optimal growth path of an ‘impatient’, neoclassical economy is studied, when creditors impose a credit ceiling to prevent debt repudiation. The ceiling becomes binding in finite time. When the credit-constrained regime begins, foreign capital inflows and domestic investment fall abruptly. Output per-capita, consumption, and real wages gradually decline, while the real interest rate rises. These results show that debt crises, in which high external debt is associated to low growth, can occur even in the absence of unanticipated shocks, policy mistakes, or ‘debt overhang’ effects. If distortionary policies cause ‘impatient’ behavior, the model is consistent with chronic capital flight in the debtor country. (JEL F34, F32)

Optimal loan contracts and floating-rate debt in international lending to LDCs

Abstract Most LDC debt is at floating interest rate, and the wisdom of this choice is analyzed here. For a prototype LDC, complete insurance requires repayment to increase with export revenues and import prices. Since the latter variables are positively correlated with LIBOR, floating-rate debt yields better risk-sharing than fixed-rate debt, and induces more investment in the LDC. When default is possible, repayment becomes contingent on the cost of sanctions is renegotiation states, and some renegotiation costs are likely to be incurred. Fixed-rate debt would have reduced the occurrence of default in the 80s, but only marginally.