**Policy, Research, and External Affairs|**

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- This paper a product of the Debt and Intemational Finance Division,<sup>Intemational Economics</sup> Department- is part of a larger effort in PRE to understand the costs<sup>and beneflts of various mechanisms</sup> of debt settlement in the context of the intcmational debt crisis. Copies are<sup>available free from the World</sup> Bank, 1818 H Street NW, Washington, DC 20433. Please contact<sup>Sheila King-Watson, room S8-025,</sup> extension 31047 (33 pages).

When sovereign debt trades at a discount on secondary markets, a market buyback increases the secondary market price. The wealth of private creditors increases because part of the funds used in the repurchase is a transfer payment to them.

This transfer of resources can be mitigated by imposing a capital gains tax on the remaining debt. Diwan and Kletzer show how this can be achieved by including exit and new-money options in a menu of options from which creditors can frecly choose. The menu approach imposes an implicit tax on the capital gains on the remaining debt by requiring lenders that do not exit to extend ncw loans in proportion to the debt they retain.

It is enough to make the buyback price equal to the earlier predeal price. Any new-money call will do the job. In equilibrium, creditors will provide enough new money to stabilizc the postdeal price at a level that Ieaves them indifferent to the exit option. Increasing the new money call increascs the cost of the menu as wcll as the cxtent of the debt reduction achieved.

The menu approach Diwan and Kletzcr describe does not require that particular choices from the menu be assigned to each lender. Instead, it implemcnts debt reduction through a price system, allowing different creditors to select diffcrent portfolios in equilibrium from a common set of options.

With heterogeneous banks, some resources will be transferred when participation in the debt - reduction plan is voluntary and the buyback price will generally need to be higher than the prebuyback price.

Diwan and Kletzer illustrate some of their rcsults by analyzing the reccnt Mexican debt agreement. They show how to read through the complex financial acrobatics to estimate the net debt reduction. Funds provided by intemational financial institutions beneflted both Mexico and its creditors. Mexico directly retained about 62 percent of these resources and the banks 34 percent.

When creditors are heterogeneous and possess private information about the value of debt reductio.. .o them, a mechanism is needed to elicit that information. Researchers should analyze how a menu can be combined with an auction of new money or exit instruments to elicit that inforrnation.

The PRE **Working** Paper Series disseminates the findings of work<sup>under way in the Bank's Policy, Research, and Extcmal</sup> AffairsComplex. An objcctive of the scries is to get thesc findings out quickly,<sup>evcn if prcscntations arc less than fullypolished.</sup> The findings, interpretations, and conclusions in these papers do not necessarily<sup>represent official Bank policy.</sup> Produced by the l'RE Dissemination Ccnter