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How factors in creditor countries affect secondary market prices for developing country debt

  • Ozler, Sule
  • Huizinga, Harry

Bank loans to many developing countries trade at a discount on the secondary market. These discounts are typically assumed to reflect only the repayment prospects of the borrower country. But the authors demonstrate that factors in the creditor countries have a major impact on secondary market prices. Their empirical investigation suggests a systematic relationship between secondary market prices and the size distribution of banks'portfolios. There is a strong negative correlation between discounts in the secondary market and U.S. banks'heavy exposure to developing country debt. It is estimated that every US$4 billion increase in a large bank's exposure to a country reduces the discount 10 to 15 cents on the dollar. The authors find that discounts and total bank capital are positively correlated over time : a US$8 billion increase in the capital of the largest U.S. banks increases discounts by nearly 25 cents on the dollar. They explain their results with a simulation model of a representative bank with minimum capital requirements, flat-rate deposit insurance, and limited liability. The bank's portfolio adjustment decision involves trading risky foreign loans in the secondary market or making short-term domestic loans. The model yields a negative relationship between the banks'exposure to developing countries and discounts in the secondary market.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 622.

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Date of creation: 31 Mar 1991
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Handle: RePEc:wbk:wbrwps:622
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  1. Brickley, James A. & James, Christopher M., 1986. "Access to deposit insurance, insolvency rules and the stock returns of financial institutions," Journal of Financial Economics, Elsevier, vol. 16(3), pages 345-371, July.
  2. Vassilis A. Hajivassiliou, 1989. "Do the Secondary Markets Believe in Life After Debt?," Cowles Foundation Discussion Papers 911, Cowles Foundation for Research in Economics, Yale University.
  3. Cohen, Daniel, 1988. "Is the discount on the secondary market a case for LDC debt relief?," Policy Research Working Paper Series 132, The World Bank.
  4. Sachs, J. & Huizinga, H.P., 1987. "U.S. commercial banks and the developing-country debt crisis," Other publications TiSEM ada14007-7229-4f6d-a016-f, Tilburg University, School of Economics and Management.
  5. Berg, Andrew & Sachs, Jeffrey, 1988. "The debt crisis structural explanations of country performance," Journal of Development Economics, Elsevier, vol. 29(3), pages 271-306, November.
  6. James Tobin, 1956. "Estimation of Relationships for Limited Dependent Variables," Cowles Foundation Discussion Papers 3R, Cowles Foundation for Research in Economics, Yale University.
  7. Ozler, Sule, 1989. "On the Relation between Reschedulings and Bank Value," American Economic Review, American Economic Association, vol. 79(5), pages 1117-31, December.
  8. Froot, Kenneth A, 1989. "Buybacks, Exit Bonds, and the Optimality of Debt and Liquidity Relief," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(1), pages 49-70, February.
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