Sovereign Debt: A Primer

The troublesome debts of a number of developing Countries have spawned a large literature on why countries borrow, on what debt contributes to growth, on why countries repay, and on how existing debt should be dealt with. This paper provides a basic introduction to some issues in sovereign debt. First. it presents the basic accounting concepts associated with debt and some data, focusing in particular on the net resource transfers associated with external borrowing. Second, it reviews the mechanics of debt and growth implied by the Harrod-Domar and two-gap growth models, and points out how this analysis can yield misleading conclusions about the sustainability of debt and the determinants of solvency. Third, it treats debt as a component of the intertemparal maximization of a borrower in a competitive loan market facing an intertemporal budget constraint. Fourth, it introduces debt into recent models of endogenous growth, and with the conclusion that what debt contributes to growth depends sensitively upon the source of growth. Fifth, it discusses issues arising from sovereign risk, including problems of liquidity, at enforcement, and of raising revenue to finance repayment (and the attendant problem of capital flight). Sixth, the paper examines incentives to repay, showing chat maintaining access to credit markets by itself can be a reason to repay sufficient to sustain substantial debt levels. Seventh, it reviews the various options available to a creditor facing a debcor unwilling to meet currenc debt-service obligations. A conclusion is chat declaring a debcor in default and seeking a legal remedy is relatively less attractive in the context of sovereign debt, compared with domestic lending, relative to the alternative of lending "new money" to meec debt-service obligations. Eighth, the paper examines debt buybacks. One conclusion is that, in the absence of any efficiency cost imposed by outstanding debt (so that the only implications of the form and extent of repayment are for the distribution of surplus between borrower and lender) how much a buyback benefits the borrower depends on how much buying back debt reduces what is available for repayment later. Another is that, if there are efficiency losses associated with debt (a "debt overhang") then debt forgiveness can benefit both a debtor and its creditors. Contrary to claims in the literature, this outcome does not require that a reduction in the face value of debt raise its market value (a "debt Laffer Curve"), and the debtor benefits even though the buyback raises the market price of tile debt. The efficiency argument for buybacks is inconsistent with the case for lengthening the maturity of the debt.