Odious debt and original sin

Question 1

Is debt intrinsically bad?

Answer 1

No

• more about consumption choices, not how they’re financed
• debt can be important for monetary policy
• – Increase money supply by buying government bonds
• – Manage exchange rate volatility by buying foreign reserves (and then selling bonds to combat resultant inflation)
• important as a safe asset (Gordon)
• – asset with no adverse selection: stores value reliably
• – government debt is fairly safe
• – without government debt, private steps in, which is much riskier and needs to be collateralized
• – negative yields on German and Japanese bonds suggest unmet demand for safe assets

Question 2

What is original sin, and why is it dangerous for developing countries?

Answer 2

Eichengreen et al state that original sin is holding a large proportion of debts in a foreign currency, $5.6/$5.8bn of debt held in five currencies ($, £, ¥, SFr, €). 85% of debt denominated in a foreign currency.

Brings volatility (30% of the diff in volatility between developed and developing countries)

• ability to pay back debt
• capital flows

Particular problem if assets are domestic but liabilities are foreign. In this case:
- currency depreciation > lower net wealth (moderated by openness) >

Expansionary monetary policy less effective
- increase supply of local currency > currency depreciation > lower net wealth > less investment (opposite of what you want from expansionary policy)

Also greater potential for a sudden stops/capital flight

Question 3

Is original sin definitely the source of volatility problems?

Answer 3

No (Reinhart et al), debt intolerance is the issue

• Volatility plagues serial defaulters even at “safe” levels of foreign debt
• – note that Asian Tigers are not serial defaulters, as far back as 1820
• Serial defaulters have inflation exceeding 40%, 25% of the time, while other emerging markets have NO period of inflation above 40%
• – important because inflation is a measure of internal default
• Liberalisation harmed this even more, as it took away revenues from seignorage and trade taxes

Question 4

What do Alfaro et al find about composition of international flows and growth?

Answer 4

• international capital flows net of debt are positively correlated with growth
• international capital flows net of aid are positively correlated with growth
• government debt flows are negatively correlated with growth only if funded by another sovereign

Two facts explain these findings

• net of aid, there has been capital flight from low productivity countries
• capital outflows from productive developing countries have been reserve accumulation

Neoclassical model does well because private capital is positively correlated with growth, as expected

Question 5

What evidence is there to suggest that debt levels are healthier in modern developing economies?

Answer 5

Prasad

• 61% of liabilities in developing countries are FDI/equity
• 70% of developing country debt in domestic currency
• with foreign assets and domestic liabilities: currency depreciation > increase in net wealth

Question 6

What evidence is there to suggest that there ought to be some level of concern regarding debt in modern economies?

Answer 6

Considerable increase in debt owed to Non-Paris Club creditors in the last three or so years

• China has lent $300bn in the last decade, account for 15% of developing country debt
• China has less transparency regarding flows
• increased foreign debt

Question 7

What are the implications of increases in debt to Non-Paris Club creditors?

Answer 7

The good:

• finances development, social benefits and economic externalities
• commodity prices may be persistent which allleviates repayment concern, especially as India increases consumption (but concern about this too)

The concerning:

• some debt is collateralized, which can result in seizures (eg. Hanbantota port in Sri Lanka). Although this could also reduce borrowing costs
• almost all Chinese flows are official, no push/pull private flow factors

Interaction with Paris Club debt (Alfaro and Kanczuk):

• can default on NPC debts to smooth consumption if not collateralized
• NPC debts are non-transparent, so incorrect probabilities of default assigned by Paris Club
• thus more defaults, but more development possibilities
• if collateralized, not possible

Question 8

Explain the debt overhang hypothesis

Answer 8

Explains how debt relief can be profitable for all parties and encourage investment

Example

• owe $150, can only pay $100
• potential project: $10 investment, $20 return
• without relief, will no invest
• with relief of $45, creditor gets $105, investment happens, debtor gets $15

Krugman’s debt-relief Laffer curve

• too much debt supply reduces the value of debt, so beyond a turning point it makes sense to relieve debt
• one bank will not undergo debt relief on its own, due to free riding issues

Question 9

Why does debt relief take so long?

Answer 9

Pitchford and Wright

• strategic holdout: creditors wait until the last minute to try to extract the highest possible surplus
• coordination problems, as unsharable transaction costs of negotiation lead to free riding
• potential solution is collective action mechanism, eg. bondholder councils, which legally enforce equal payments
• but certain creditors can even free-ride on negotiation of collective action mechanism

Question 10

What is odious debt?

Answer 10

Despots took on the debt - public shouldn’t suffer

Question 11

What are the assumptions of debt relief for developing countries?

Answer 11

A) creates additional resources

B) resources will be spent on developmental projects

Question 12

What evidence is there to suggest that debt relief may not create additional resources?

Answer 12

Bird and Milne

• debt repayments may not have been being services anyway
• given that the most in-debt countries receive the most aid, it may reduce aid funds and thus remove resources

Question 13

What evidence is there to suggest that resources created by debt relief may not be spent productively?

Answer 13

Easterly

Debt relief hasn’t led to growth because of either:

• preference for high debts
• – high discount rate (prefers current consumption)
• – implicitly taxes private sector
• – debt relief won’t change this
• perverse incentives
• – borrowing with the expectation of relief
• – incremental debt relief can lead to delays, “selling” good policies for higher prices
• – bad policies > more room for improvement > more aid

Empirics

• high debt countries have high discount rates
• debt relief > new borrowing
• more in-debt > worse policies
• debt not explained by external shocks