CHAPTER 3
Box 3.5: The pros and cons of debt-relief interventions Macroeconomic
nominal exchange rate changes is needed).
decisions should not be taken in haste.
A debt overhang affects growth through multiple channels. If the debtor is the public sector, the overhang could require higher taxes to service these debts, which in turn would weaken economic incentives and undermine growth prospects (Sachs 1989). It might also turn funding markets more fragile. Specifically, if rollover risks increase, creditors might want to limit their exposure, concerned that liquidity problems may generate market disruptions.
Microeconomic
First, it is important to assess if a debt overhang actually exists and that, absent public financial support, social welfare will decline. In emerging Europe, the case for such debt relief does not appear to be compelling. Even in the countries most at risk, marketbased approaches appear adequate to address the borderline debt-overhang cases discussed in this chapter. Also, although the strength of banks’ balance sheets in emerging Europe is uncertain, these banks depend heavily on their Western European parent institutions’ strength. The provision of public money by emerging Europe’s governments is not easy to justify.
Evaluating whether there is a debt overhang requires balance sheets to be assessed. Myers (1977) argued that a link exists between debt levels and firms’ decisions: if profits from new investments are likely to be used to pay existing creditors, shareholders might choose to pass up what would otherwise be profitable investment opportunities. Similar arguments apply to household investment in home improvement (Melzer 2010), reduced Further, when the debts are external, the financial integration process that created these labor supply owing to the wedge imposed on incomes by debt-service obligations (Mulligan obligations might also alter the economic adjustment process. Large external obligations 2008), and limited consumption (Olney 1999). Equally, banks that have overleveraged require trade surpluses that are more easily balance sheets and are facing losses might achieved with exchange rate depreciations, limit new lending. In sum, balance sheet but while depreciations help to bring in the factors might become a drag on banks’ ability necessary foreign exchange, they also have to restore credit and support the recovery. valuation effects. Import compression might generate the necessary foreign exchange The extent to which the balance sheets of resources, but at the expense of limiting firms, households, and banks undermine domestic demand and deepening a recession. economic activity also relates to their Thus the resulting social and economic costs aggregate impact on the economy. Other might require either a debt restructuring or firms, households, and banks might pursue increased access to official financial assistance investment, consumption, and lending to mitigate the economic adjustment. opportunities that economic agents with overleveraged balance sheets cannot. But as The positive aspect of financial integration, seen, debt incidence in emerging Europe is not as in Europe, is that it allows countries to widespread and thus unlikely to become a drag spread the adjustment across borders. Foreign on economic activity. investors, for instance, see a decline in profits on their equity holdings. Another feature of Given that the public sector in emerging emerging Europe is that the foreign financing, Europe is not highly leveraged, it is often which enabled high credit growth, is also the argued that governments can share the burden imposed by existing debts on firms main source of external account adjustment and households. For several reasons, such (that is, no change in relative prices through
Second, the debtor and creditor moral hazard risks need to be gauged. From a borrower perspective, just talk of debt relief weakens payment discipline. From a lender perspective, bailouts might encourage excessive risktaking. Debt-relief interventions also risk creating opportunities for politicization and capture by special interest groups on a matter that, so far, remains a largely private affair in much of emerging Europe. Third, the premise that households should be compensated for an increase in debt-service burden due to external economic shocks is not easily justified given the distribution of debt across income quintiles. The analysis suggests that most households have room to tackle economic shocks. If, for political reasons, it is necessary to introduce such programs, it would seem sensible to target scarce public resources by loan size and household income.
concentrated in few firms and households, there is at least the potential for other actors (that is, new banks) to consider entering the financial sector. Given the challenges faced by Europe as a whole, however, there is no question that downside risks remain unusually high. Deleveraging has so far been limited and orderly, but in large measure because growth prospects in emerging Europe remained strong. The challenges within the eurozone are calling into question this assessment and could force parent banks to retrench in noncore markets.
Economies—solvent and liquid Several studies have recently analyzed the level of external indebtedness beyond which a country is likely to suffer slower growth and sustainability risks (Reinhardt and Rogoff 2010; Imbs and Rancière 2007). They point to a gross external debt-to-GDP ratio above 60 percent as a vulnerability threshold, although this varies with a country’s level of financial development and
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