12 exist"<sup>4</sup> ; which could create a risk premium between local assets and foreign assets. Moreover, domestic interest rates quoted in "world" currency may differ from "world" rates in "world" currency by a risk premium, to reflect the possibility of conversion into domestic currency at unfavorable terms, as occurred for example, with Mex-Dollars in August 1982 (Ortiz, p.90).<sup>15</sup> In developing countries, the risk premium might be positively related to the volume of foreign investment or liabilities (Dooley, Hanson, 1979), as well as to macroeconomic policy variables.

The post-debt crisis overhang of debt may represent a new and potentially important factor in raising the risk premium facing some developing countries. First, there is a risk that a country with a debt overhang may impose new taxes, including the inflation tax, to service the old debt, as Krugman and others have pointed out. Potential investors include the risk of such taxes in the risk premium that they would require before investing. Second, one alternative to investing in some countries - is the secondary market in the country's debt alternative liabilities of these countries do not obviously carry less risk of repayment than the instruments trading in the secondary market."<sup>6</sup> Since the mid1980s, this secondary market has increased in size and sophistication. Moreover, the "securitization" of countries' bank debts has allowed smaller investors to participate and mutual funds to develop.'<sup>7</sup> The effective interest rate in the secondary market reflects both the investor's expectation of debt service payments and the secondary market price. The secondary market price typically is below par, reflecting many factors including the market's expectation of the probability of future repayments on contractual terms and the likely buyback price under Brady deals, "world" rates, and other factors (See, World Bank, World Deb Tables 199019L, Chapter 3.). Hence, the comparable rate could be a multiple of the original terms on the debt traded in the secondary market, depending on the difference between the investor's and the market's expectation of repayment. Whether or not such a rate is the appropriate one for equation (1), it nonetheless must be recognized that the availability of high, albeit risky, returns in the secondary market may well raise the rate of return that must be offered to sophisticated investors in order to induce them to hold financial assets in the country, i.e. the debt overhang and the growing depth and sophistication of the secondary market could have led to a rise in the premium in Equation 1, compared to earlier years.<sup>18</sup>

> 14 For example, in 1982 the Argentine Government imposed a rcduction in domestic interest paymens under existing contracts; in 19S9, Argentine and Brazilian bank deposits were converted into long term bonds with reduced interest rates.

Ottiz (p. 81) sggesu such a differential wa common in Mexico in the 1970s. However, the government controlled the domestic interest rates and adjused them only from timeto-time, so the differential did not represent solely market forces. (A similar policy regime existed in Inda during the ltter half of the 1980e for non-resident depoits). Ihe Mexican government eventually pegged the Mex-dollar rates to the corresponding Eurodollar rates.

1t h1is applies not only to official liabilities, but to domestic bank depceits, that also may not be paid as originally agreed - as noted, the governmenu of Aina and Brazil both unilralUy conveted a large volume of bank deposis into long term bonds.

" Morcover securitized debt is beginninr to trade outside of developod country markets and the market of the issuing country, e.g. Umguay, has a market in Mexican debt.

" Notice that **this** argument is somewhat different than the rebted expanation that new investors would have to share propoxtionately in the fixed, capacity of the country to pay, nd thus, at the margin, can only expect to get the same fraction of the contractual terms on exising debt **as** existing credito. The poit here is that not only foreign but domestic investors view the condary market as aa option, particulady as capital mnrkets are opened. Another related expanation linking a rise in the risk premium and the debt overhang is that taxes of one kind or another will have to be raised to pay existing creditors - hence the below-par secondary market price even for countries that have fully erviced interest obligations - and these taxes will fai equally hard on any now' investors.