metadata: authors: 0: author: Hajivassiliou,Vassilis A.
count: World
docna: 0: docna: Do the secondary markets believe in life
            after debt?
docty: Policy Research Working Paper
subtopic: Debt Relief and HIPC,Banks & Banking Reform,External Debt,Inflation,Macroeconomic Management,Debt Markets,Crime and Society
teratopic: Environment,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: Using panel data econometric techniques
            to examine the case for external debt relief, this report
            explores the relations between measures of creditworthiness
            and debt discounts on the secondary markets. It finds,
            however, that secondary market values tend to reflect past
            difficulties, not anticipate future ones - so they
            can't be used to build a case for debt relief. The
            secondary markets, still in an early evolutionary stage, are
            quite "thin" and thus unable to exploit
            efficiently and quickly all available information on creditworthiness.
repnme: repnme: Do the secondary markets believe in life
            after debt?
display_title: Do the secondary markets believe in
            life after debt
listing_relative_url: /research/1989/08/700464/secondary-markets-believe-life-after-debt
topicv3: Commercial Banking m1326069 1236,Current Account m1326278 1135,Debt Relief m1326505 452,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Black Market m1439229 BLA-3388
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment,Macroeconomics and Economic Growth,Finance and Financial Sector Development
origu: Policy Plan & Prog Review Dept (PPR)
no_of_pages: 41
author_keys: 0: author_key: 876693
model_extractions: **Plc,Planning, and Research |**

# **Debt and Internatlonal Finance]**

Using panel-data econometric techniques to examine the case for external debt relief, Hajivassiliou explores the relations between measures of creditworthiness and debt discounts on the secondary market, Do the discounts on the secondary market reflect a history of past repayment problems - or do they anticipate future debt crises? Different answers to this question imply different things about the desirability of debt relief.

If the secondary mar-ket discount is a good predictor of future debt problems - and not merely a reflector of past problems - then debt relief, in averting anticipated problems, will reduce the secondary market discounts and increase the value of debt held by intemational lenders.

Hajivassiliou found, however, that secondary market values tend to reflect past difficul- ties, not anticipate future ones so they can't be used to build a case for debt relief. The - secondary markets still in an early evolution- ary stage are quite "thin" and thus unable to exploit efficiently and quickly all available information on creditworthiness.

Hajivassiliou also uses the model estimates to analyze other issues, including whether large surpluses by the oil-exporting natio, s significantly affected international lending markets after the first major oil shock; the question of liquidity vs. solvency; the degree to which discrepancies between official and black market exchange rates can predict future financing problems (little evidence was found to support the proposition that overvaluation is a precursor of debt crisis); and the degree to which factors exogenous to a country (such as imports by industrialized countries, inflation in OECD nations, and world interest rates) contribute to a country's debt crisis.

World economic factors were generally found to be statistically insignificant as predictors of repayment problems in developing countries - except that inflation in the industrialized countries in some versions of the models is found to marginally reduce the likelihood of future debt problems in developing countries.

This paper, prepared for the conference "Dealing with the Debt Crisis," is a product of the Debt and International Finance Division, Intemational Economics Department Copics are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Sheilah King-Watson, room S8-029. extension 33730 (40 pages with charts and tables).

The PPR Working Paper Scries disseminates the findings of work under way in the Bank's Policv, Plinning, and Research Complex. An objective of the scrics is to get thcse findings out quickly, even if presentations are less than fully polished. The findings, intcrpretations, and conclusions in thesc papers do not necessarily represent official policy of the Bank.

Produced at the PPR Dissemination Center
# Do the Secondary Markets Believe in Life After Debt?

# by Vassilis A. Hajivassiliou

# Table of Contents

|1. Introduction|1|
|---|---|
|2. Econometric Models of Credctworthiness|4|
|3. Empirical Results|9|
|4. Adjustment Efforts vs. Exogenous Causes of Debt Crises|11|
|**_5._**Stability of Creditworthiness Models over Time|12|
|6. The Secondary Market for LDC Debt|13|
|7. Conclusion|17|
|Appendices|20|
|Reierences|27|
|Tables|29|
|Figures|37|

I would like to dedicate this paper to a special friend whose support has been very important to me. I am indebted to Anne Royalty for superb research assistance. Special thanks also go to Plutarchos Sakellaris who helped with the data collection efforts. Steve O'Connell, John Cuddington, Ishac Diwan, Mark Stone, and the discussant provided very constructive comments and suggestions.
# 1. Introduction

The recent literature ^n external debt repayments problems of LDC's places primary emphasis on the issue of "debt overhang" (see in6ep-*k Krugman (1987), Sachs (1986)). This term refers to outstanding external debt amassed in the past that exceeds a country's expected ability to repay it. These authors build theoretical models that highlight the importance of debt overhang and derive policy implications about the desirability of forgiving or refinancing such debt. Figures 1 to 3 illustrate that the external financing problems of the developing nations have indeed been worsening steadily since the first major oil shock of 1973 and have also been affected adversely oy the second major cil shock in 1978. Moreover, the figures sugges **t** hat we may now be experiencing a substantial world debt crisis, since the problems have been accelerating.

Figure 1 contrasts the rapidly mounting outstanding external debt of the countries under investigation with the only mildly rising quantity of debt actually serviced. The gap between obligations and repayments is widening alarmingly. Figure 2 makes the same point by showing the fraction of debt-servicing obligations that are in arrears in each year. Figure 3 presents a similarly bleak picture, by showing that the proportion of countries under analysis that are experiencing a repayments problem of some type (for example, obligations in arrears, or a need to request IMF assistance or a rescheduling of repayments) exhibits the same deteriorating pattern.

There remains, however, a clear need for an empirical investigation of the mounting external financing problems of the LDC's and of the theoretical propositions of the debt overhang literature regarding such problems, in order to shed some light on the relative merits of the various arguments and policy implications concerning the desirability of debt forgiveness or refinancing. This paper attempts to meet such a need by employing panel-data econometric techniques. One specific issue it examines is whether a case<sup>4</sup> or external debt relief can be made by exploring the relations betweer. measures ef creditworthiness and the debt discounts on the secondary
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market. It investigates empirically whether the discounts on the secondary market reflect a history of past repayments problems or whether they anticipate future debt crises. The answer to this question has implications about the desirability of debt relief. For example, a situation of debt overhang is commonly referred to as being "on the wrong side of the Laffer curve." This implies that forgiving part of the outstanding debt will eventually lead to a higher value of debt being repaid by a country. The precise way this may happen is typically left unspecified. One possible mechanism that may make partial forgiveness appealing to the international lenders is the followiiig. Ifthe secondary market discount is a good predictor of future debt problems and not merely a reflector of such problems of the past, then debt relief, in possibly averting anticipated problems, may reduce the secondary market discounts and thus increase the value of the debt held by the international lenders. **1/** The fact that the secondary markets have been in operation for less than three years constrain **s** everely the type of econometric analysis that is feasible in attempting empirically to investigate these questions.2/ The approach we develop here is to employ the econometri **c** reditworthiness methodology in Feder and Just (1977), McFadden et al. (1985), and Hajivassiliou (1987). The constructed indicators of creditworthiness are then used to investigate whether the secondary market discounts anticipate or follow economic performance measures.

Section 2 presents descriptive econometric models of creditworthiness that serve as the basic framework for the empirical analysis of the paper, and it summarizes the key empirical results of these models. Several issues in I The issue of whether a case for debt relief can be made through the secondary market discounts is also investigated by Cohen (+98 **)4'A -WA 2** It is not possible, for example, **LO** use direct "reduced form" econometric models and try to explain statistically the discounts as a function of economic performance variables.
-3 -

international finance are investigated, such as the question of "liquidity vs. solvency," the degree to which discrepancies between official and black market exchange rates can predict future financing problems, and the importance of world factors exogenous to a country in causing debt crises. Ve also investigate whether large surpluses run by the oil-exporting nations significantly affect the international credit markets. These models are then tested for structural breaks following major external events, like the 1973 oil shock and institutional changes in meeting the debt crisis in the early 1980's. In the same section, we construct indices of exchange rate over-valuation, based on discrepancies between black market and official exchange rates, and examine whether overvaluation acts as one of the precursors of debt crises. Econometric methodological issues are discussed in Appendix 1.

Section 3 discusses the estimation results and some of their implications for policy. Ye show that, as expected a _p7iori,_ reliable econometr **i** nferences c on these issues requires explicit accounting for unobservable persistent heterogeneity among nations as well as for the impact on bankers' perceptions ofa history of bad debt performance. Section 4 attempts to evaluate the significance of world economic factors, exogenous to developing countries, in precipitating crises. Examples of such factors include measures of imports by industrialized countries, inflation in the OECD nations, and world interest rates. The findings are important for policy-related questions that address the "adjustment efforts" by LDC's and the distinction between economic mismanagement and adverse world developmen **t** s hat are beyond the control of country administrators. Section 5 examines the econometric stability of the models after the major oil shocks of the 1970's and after 1981, the last year of observation of most past studies of creditworthiness in the literature. Section 6 discusses the iss zs related to debt overhang and describes some of the characteristics of the recently developed secondary market for outstanding
-4-

LDC debt. I attemp **t** o answer the question of whether the discounts observed on this market are routinely reflecting past debt problema or anticipating future crises. The implications of our findings are explored.

Section 7 offers some concluding remarks. Data sources, constructi **o** n f variables, and descriptive statistics are presented in Appendix 2.

# 2. Econometric **Nodels of Creditworthiness**

Reduced-form descriptive econometric models were estimated in Feder and Just (1977) to quantify the determinants of LDC's external financing problems. In particular, binary logit models (KcFadden (1973)) were employed to explain the dichotomous variable Yit Yit = 1 if a debt problem occurs in country i in yea- t = 0 otherwise, as a (linear) stochastic function of k exogenous explanatory variables xit, with the index i...,I denoting country and t=.,... ,Ti year of observation. McFadden et al. (1985) and Rajivassiliou (1987) present more structural credit-rationing models that incorporate refined measures of the degree of severity of debt crises. Moreover, these studies address important methodological issues arising from the ract that differing country characteristics, such as colonial histories and political, financial, and religious institutions, imply the presence of unobserved persistent country heterogeneity. Appendix 1 discusses these issues from an econometric perspective and presents econometric methodologies appropriate to address them (see also Rajivassiliou and McFadden (1988)).

Let us begin with an empirical motivation for the econometric models to be presented. Information on three primary indicators of debt repayments problems was compiled: (1) confidential data on external debt obligations in arrears; (2) the occurrence of a rescheduling agreement between the debtor nation and the international bankers; and (3) programs of IMF involvement, such as stand-by
-5-

agreements of a high tranche level. Table 1 presents the empirical evidence on transitions between these types of difficulties. Each transition from the state in the previous year to the one in the current year is given in three different ways. The actual number of country-years vitfl such a transition is presented first; then in parentheses the column percentage appears, the percentage of transitions into a given current problem; lastly, in square brackets we give the row percentage, the percentage of all types of ensuing states that emanate from a specific type of problem in the previous year.

As can be seen from the table, arrears can be viewed as the mildest form of problem and seem to act as a reliable predictor of more severe crises. For example, we see that of the 952 country-years without a repayments problem in one period, Aearly 5% had their obligations go into arrears in the following period, as opposed to a _combined_ total of 7% that approached the bankers or the IMF for assistance. Moreover, more than 90% of countries with significant arrears in their obligations either maintain this situation the following year or experience a more severe multitude of repayments problems (a combination of arrears, IMF or reschedulings). In contrast, only 70% (60%) of countries currently having only an IMF agreement (rescheduling) in effect either maintain their status or have more than one type of repayments problems in the following year. These latter two types of problems thus seem to indicate a rather more severe type of debt crisis, as they are typically accompanied by more than one other type of repayments difficulty. Another way of highlighting these stylized facts is to note that of the 51 country-years exhibiting a severe crisis with all three types of difficulty present, 20% had only significant arrears in the previous period, 14% had significant arrears accompanied by an IMF agreement in effect, and 45% had a severe crisis in the previous period as well. In only 9 cases was a severe crisis preceded by a rescheduling or IMF involvement wvthout any arrears present. These features of repayments difficulties will guide our econometric modelling below.
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To explain the basic models we will use in this paper to quantify creditworthiness, denote by yi the latent (unobserved) propensity of country ito have a debt problem in period t. We model this as a linear, stochastic function of observable country characteristics, past history, world conditions, and other relevant factors, measured by a vector xit:

# (2.1) Yt = X +

In the credit rationing models of Eaton and Gersovitz (1981), WcFadden et al. (1985), and Iajivassiliou (1987), Yt is directly related to the gap between notional demand for and supply of new funds to the economy. Vhen the debt-crisis propensity exceed **s** ome threshold, normalized to 0, we observe the realizati **o** fn an external financing problem, whicb I indicate by (2.2) Yit =1 iffYt > = 0 otherwise.

# This is the threshold crossing model.

Denoting the cumulative distribution function of the error term it bv F(.), we can calculate the probability ofa financing crisis as

## (2.3) P(Yit=l) = F (X!tp)-

Under the specific distributional assumption of normality for the error term fit' we have what is known as the _probit_ binary response model. Expression (2.3) will serve as a simple indicator of lack of creditworthiness of country i in period t. In the sequel, we will define our binary variable indicating the presence of repayments problem, yit, by a combinati **o** fone or more of the following n types of
-7-

difficulties: "significant" arrears in the debt repayments obligations, anIMF stand-by agreement of a high tranche level or an extended-fund-facility agreement, or procedures to implement an agreement of a rescheduling of debt obligation initiated by a country ani its international creditors. 3/ An alternative measure of creditworthiness that relies on a 3-regime rationing model developed in XcFadden et al. (1985) and in Hajivassiliou (1987) is defined as follows: Two distinct thresholds, 0<sup>and</sup> 1<sup>, on the range</sup> of the debt crisis propensity, ytt, determine -he regime for economy i in year t. Define an indicator variable yit by: This model, known as a model of ordered resDonse, will be estimated by imposing necessary assumptions about the distribution of the error term. Assuming normality as above, we will have the _ordered probit_ model. This model is used to capture some of the features identified in the transition matrix of Table 1, by defining yit=O to indicate a "no crisis" situation, yit=l to stand for a "mild" crisis, and yit=2 to represent a "severe crisis". For example, recognizing the importance of significant arrears as a precursor of more severe repayment crises, we define a "mild crisis" as the presence of only significant arrears in a county's obligations, and characterize a severe crisis as one with IMF involvement or rescheduling. 4/

# 3 See the data appendix for precise definitions ofthese variables.

4 Another generalization we also investigated was a four-regime model, where the severity of a repayment crisis is. described by the number of different types of external financing difficulty a country experiences. The results are qualitatively similar to the ones of the 3-regime models and are not reported separately.
-8 -

A third measure of creditworthiness based on even moxe information can also be obtained by using censored regression models. Again suppose that (2.1) measures the propensity of a country to experience a debt-repayments problem with Yt measuring the excess demand gap for external funds. Suppose further that a strictly positiv **e** xcess demand gap will manifest itself in the country's letting repayments obligations gointo arrears, whereas no arrears will be observed for a country that is experiencing no repayments problem.5/ In this vein, if yit denotes observed arrears, we have the censored regression model (2.5) Yt =ytt if y%. > 0 = 0 otherwise.

Since in this model the full extent of the crisis is observed in the form of the level of arrears when these are strictly pcsitive, more information is utilized here than in the threshold crossing model (2.2). As a result, the creditworthiness indicator based on (2.5) will be more accurate than the analogous indicator based on (2.3). Ve will impose normality assumptions onthe censored regression model, and hence we will be estimating a _Tobit_ model.

Versions of all three types of models are estimated for a panel set of data of 109 developing countries observed through the years 1970-1986. The preferred specifications are then used to construct creditworthiness indicators. The final step is to investigate whether such creditworthiness ir 'icators exhibit any links to secondary market discounts as discussed in Section 6below. f/ 5 Some qualifications to this modelling are set out in Haj ivassiliou (1987).

6 Note that the more structural credit-rationing econometric model developed in Hajivassiliou (1987) will not be employed in this paper, because our main objective will be to examine anv predictive links between creditworthiness indicators and secondary market discounts, for which the "reduced form" approach taken here will suffice. Identifying the specific parameters of demand and supply functions is not of primary interest in this study.
-9 -

In the econometr **i** c mplementation of these models, it is important to allow explicitly for unobservable, persisteAt heterogevetty among nations, as Nell as for the impact on bankers' percept.ons ofa history of bad debt performance. This is done by using the so-called "random-effects" panel-data methodology. See Appendix 1 for details. As we will see below, our expectation that such heterogeneity is important isstrongly confirmed by our findings.

# 3. EmDirical Results

The main results of the basic creditworthiness analysis appear in Tables 2 and 3 and can be summarized as follows. In all versions of the 3 models estimated, binary probit, 3-regime ordered probit, and tobit, the signs of the coefficients of the ecplanatory variables exhibit considerable stabilty and are mostly as expected, when the estimated coefficients are statistically significant. 7/ Our results are uniformly strong with respect to the importance of information on past repayments problems. All types of variables that signal past problems (presence of significant arrears in interest, presence of significant arrears in principa], presence of either rescheduling agreement or IMF involvement 8/) are positive and significant ineach of the models in predicting future repayments problems. This importance of history of past bad debt performance, though somewhat weakened, is still preserved by the introducti **o** fn persistent unobserved heterogeneity among countries.

Our prior expectations of the importance of both unobservablp **e** rsistent 7Some versions of the 3-regime ordered probit model were also attempted, with the "mild crisis" case defined by the sole presence of an IMF involvement. The results of these trials were uniformly less strong compared to the specifications we report here in which arrears characterize the middle regime.

> 8 One may find the positive effect of past IMF involvement tobe rather surprising since one would expect the financial discipline imposed on a country through a conditionality-related IMF arrangement tobe considered valuable by international lenders. The puzzle may be resulved, howev-r, once one recognizes that our reduced-form specifications cannot separately identify banker from country behaviour.
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heterogeneity among nations, and the impact on bankers' perceptions ofa history of bad debt performance, are strongly confirmed. This can be seen throughout Tables 2 and 3. These tables show that allowing for heterogeneity does not elininate the effect ofhistory, though it predictably reduces history's significance somewhat. This also corroborates previous findings by NcFadden et al. (1985), Rajivassiliou (1987), and Rajivassiliou and McFadden (1988). One other interesting related finding is that once we condition on informatior about repayments problems in the immediately preceding period, the cumulated number of past problems is not statistically very important.

The coefficient of the ratio of reserves to imports is generally small, negative as expected, and statistically significant. The coefficient on the debt-to-exports ratio is small but has the expected positive sign. The ratio of interest service due to exports has a significant and positiv **e** ffect on the propensity to encounter debt repayments problems, while the ratio of principal service due to exports, even though generally less significant, has a negative sign. This evidence mildly favours the "solvency" hypothesis. Since the ratio of total ou standing debt relative to exports appears strongly significan **t** , he liquidity hypothesis would predict positive coefficients for both interest and principal due, because of the implie **d** eleterious effect of shortening average maturities. That we typically find a _negative_ effect of principal due lends weak support to the "solvency" view by rejecting the liquidity view. It is interesting to note that attempting topool interest and principal repayments due into a single debt-service-due variable is statistically very strongly rejected; debt service due appears to be insignificant.

The estimated models in Table 2 can shed some light on another important policy issue: Is an overvalued exchange rateg/ one of the fundamental causes of 3 possibly leading to a capital flight in anticipation of an imminent devaluation
- 11 -

external financing problems, or is overvaluation a very costly distortion that _arises_ fiom very high levels of external indebtedness? One way to investiga **t** e his issue is to construct a measure of over aluation and test whether it exhibits any predictive power in our models of (lack of) creditworthiness. Our over-valuation measure is based on a discrepancy between official and black market exchange rates. Simple econometric causality tests are carried out to test statistically whether overvaluation precedes or follows external debt problems. Such tests are not conclusive and hence are not able reliably to distinguish between the competing claims. Vith these caveats, note that we were never able to obtain any statistically significant predictive power of the overvaluation index in anticipating future crises nor did we find any effect in the reverse direction. The level of the overvaluatioi **n** dex neither Granger-causes debt crises, nor is it caused by them. Since these findings may be a direct result of inadequacies inthe constructed overvaluation measure, the issue is still open.

# 4. Adjustment Efforts vs. Exogenous Causes of Debt Crises

Another issue I analyze using the estimated models is the importance of world economic factors, which are exogenous to a developing country, in explaining the occurrence of external debt repayments problems. Such factors include the volume of import demand by industrialized countries, inflation in the OECD nations, and world interest rates. The findings have important policy implications on LDC "adjustment efforts" to stave off external financing crises. It is important to distinguish between economic mismanagement and unwillingness to implement policies that would ease the external financing requirements and adverse world developmen **t** s hat are beyond the control of country administrators and for which it is deemed unfair to penalize the country.

After controlling for a cour ry's flow of exports and the aipount ofinterest repayments, we find that "t*-world factors do not have any significant additional
- 12 -

explanatory power. To be more specific, neither the 3-month nor the 6-month LIBOR is statistically significant in the estimations. The Fame holds true in general for the oil-exporting countries' current account surplus and their level of international reserves, as well as for the current account surplus of industrialized countries. The only notable exception is inflation in the industrialized countries, which in some estimated versions of the models marginally _reduces_ the likelihood of future problems. This finding, albeit statistically weak, may be explained if /x$a inflation is associated with a loosened monetary policy by the authorities in the industrialized countries, which leads to an easing of the credit conditions in inte-national markets. Similarly, one might expect a higher LIBOR to increase financing problems for LDC's even after controlling for the implied higher interest repayments obligations, if higher LIBOR signifies restricted world liquidity. The presence of such an effect was not confirmed by our estimations.

# 5. Stability of Creditworthiness Models over-Time

Table 4 presents the results of investigating whether structural breaks occurred in the processes determining repayment problems over time. One popular view attributes part of the blame for the LDC repayments problems to the glut of "petrodollars" after the first 1973 major oil-shock. We find only weak evidence that such a structural break occurred in the estimated relationships. Similar tests were carried out to examine the importance of the second major oil shock of the late 1970's in causing structural instability of the econometric models. The evidence strongly rejects this hypothesis.

Another possibility we investigate is that a structural break occurred after the much greater institutional involvemen **t** hat followed the onset of defaults beginning in 1982. Ye find that t: probabilities of repayments problems seem to have worsened after 1981. See the significantly positive POST1981 dummy variable
- 13 -

in Table 4 and the marginally significant likelihood ratio, which suggests a structural break after 1981. This year also coincides with the last period of observation of most previous studies of creditworthiness. Hence, it may be misleading to attempt to extrapolate the findings of such studies to cover recent developments without incorporating recent data in the estimations.

# 6. The Secondary larket for **LDC** Debt

Several authors have recently explored the theoretical and policy implications of debt overhang, a situation in which external debt amassed in the past exceeds the normal abilities of a country to repay.IO/ Krugman (1987) builds models showing that it may be in the interest of international lenders to keep refinancing such loans balc xnderly4ng 4 F **ivrne.** The creditor's hope is that the debtor's fortunes may unexpectedly turn dramatically for the better, in which case the loans will be repaid. This is a formalization of Keynes' famous dictum that "if you owe your banker one hundred pounds you are at his mercy; if you owe him a million, _he_ is at your mercy. " A conflicting consideration, however, is that the interest rate on the refinanced loans should not rise to discouragingly high levels. Amassed external debt that exceeds by far the ability of a country to repay has been blamed by several authors for introducing possibly severe distortions in the operation of a country's domestic economy. For example, according to Sachs (1986), a very serious consequence of debt overhang is that it discourages domestic investment. Public investment declines because of the bad state of governmental finances, and private investment is then caught in a vicious circle with dwindling public investment causing a deterioration oI infrastructure necessary for private 10 See primarily Krugman (1987) and Sacns (19b6).
- - 14

enterprise. For these reasons a debt overhang situation is commonly referred to as a country lying on the "wrong side of the Laffer curve." Partial debt relief may be a sensible option for creditors in such a case, because the total value of the debt they will eventually recover may be higher than in the absence of relief. To investigate this issue, we can employ the econometric framework developed in the preceding sections and relate it to information on discounts at which external debt trades on the secondary markets. Part of our maintained hypothesis will be that the econometric indicators of creditworthiness we have constructed reflect the relevant actual repayments profiles of countries and therefore can be used to predict future repayments problems. If the secondary markets are backward looking and only reflect past performance, then their economic efficiency is rejected. Today's conditions would then not feed into secondary market discounts right away, even though such events clearly may have implications about future creditworthiness. Insuch a case, an incentive would exist for a debt facility to buy back debt and forgive part of it, because the operator of the facility might believe that investment will respond izvourably to forgiveness and alleviate the overhang. Alternatively, if the secondary market discounts can successfully anticipate future repayments problems, the bankers might find partial debt relief to be an attractive option. Then partial relief may reduce the likelihood of a future debt crisis and hence possibly raise the value of the debt held by the bankers, if it leads to sufficiently lower discounts.

To complete the argument, suppose now that we change our maintained hypothesis and take for granted that the markets are efficient; they are able to incorporate quickly new information. Given this maintained hypothesis, i.e., that they price the assets to reflect rapidly the relevant economic information, one should expect the secondary market discount also to be able to anticipate future repayment performance. Then irrelating creditworthiness indicators and discounts would be implicitly testing whether the indicators we constructed are good
-15-

proxies, and just how well they do in anticipating future debt-servicing capacity. The structural stability and high predictive ability of our models, reported in the previous sections, give some hope that the power in being able to separate the two hypotheses is relatively high. Therefore finding that the secondary market discounts are only weakly correlated with measures of the probability of future repayments crises would suggest significant inefficiencies in these markets in absorbing information. This might then suggest, of course, that countries would have an incentive to buy back their own debt because they can realize that debt is undervalued and that the markets do not appropriately value their true creditworthiness.

A problem we want to acknowledge directly is that our reduced form indicators may reflect an incipient liquidity problem or a more fundamental long-term insolvency problem. It/ Since the secondary market is pricing an asset, it ideally will reflect the anticipated lifetime stream of income of the asset and not necessarily short-term adverse income effects. Given the large information set used in constructing the indicators, however, I am confident that they are able to reflect long-term problems as well.

The recent burgeoning of unilateral debt actions by major LDC borrowers helps to explain much of the significant discounts at which LDC debt is valued on the secondary markets. 1<sup>2</sup> / Some descriptive statistics on secondary market discounting of the outstanding debt of 35 nations appear in Figure 4 for 1986 and 1987. The range is quite dramatic, with the debt of "bad risks" like Nicaragua and Sudan commanding less than 5 cents for each dollar, while the debt of financially

**11** Recall that our findings were not able to resolve this issue unambiguously.

> 12 Although the secondary market price of LDC debt held by international banks is not a perfect guide to more generpl market sentiments concerning LDC debt, Sachs (1987) finds that stock market prices of the commercial banks closely reflect the secondary market valuation of their LDC exposure. As a result, a careful analysis of the secondary market valuations seems important.
-16 -

more sound economies like Turkey suffers only a small discount. Note that in some cases the discounts vary quite substantially over the two years of observation. The discounted price for Nigerian debt, for example, fals from 55% in 1986 to 29% in 1987, while in the case of Colombia the discounted price _rises_ from 64% to 84% over the same period.

What relation, if any, exists between the discounts observed for outstanding LDC debt on the secondary market, and the measures of country creditworthiness and propensity to encounter a debt problem constructed using our econometric estimates? Table 6 presents the main evidence on the central question of whether the discounts reflect a history of past repayments problems or instead primarily anticipate future debt crises. Our findings suppor **t** he conclusion that the secondary market discounts are correlated in the expecte **d** irectionts/ with the econometric measures of creditworthiness we construct as well as with direct indicators of past repayments problems. But these correlations are not very strong. Their weakness is confirmed by the low explanatory power of the estimated regressions in the last part of Table 6, which try to explain the discounts by past, future, and current creditworthiness indicators. Moreo-er, these regressions suggest that the secondary market evaluations anticipate only rather imperfectly future external financing difficulties. 14/ Hence, the evidence casts doubt on a case for debt relief that is built on the argument that such relief would cause secondary market discounts to fall and hence possibly the value of outstanding debt to rise. Our findings suggest that the secondary markets, being still in an early stage of development, may be relatively "thin" and hence not able to exploit efficiently and rapidly all the available creditworthiness information. The large information set used in estimating the 13 There is, however, one statistically insignificant exception. 14 Indicators of current and _anticipated_ creditworthiness correlate less strongly with secondary market discounted prices, than do such indicators of current and past creditworthiness.
-17-

econometric models in this paper makes it unlikely that this finding can be explained by the inability of the constructed indicators of creditworthiness to capture both upcoming short-term liquidity as well as longer term solvency problems. Nor can this finding be explained by predictive inadequacies of the estimated models on which the creditworthiness indicators were based, since as can be seen from Tables 4 and 5, only mild structural breaks occur in the models and moreover the models exhibit a relatively high ability of predicting future repayments problems. Instead, this result seems due to the fact that the secondary markets are dominated by exogenous institutional factors. An interesting question that remains is whether these markets will eventually become more efficient. 15/

# 7. Conclusion

In this paper, I employed panel-data econometric techniques to draw some inferences about a possible case for external debt relief by exploring whether secondary market discounts for external debt efficiently reflect important economic performance information and underlying creditworthiness. I investigated empirically whether the discounts on the secondary market reflect a history of past repayments problems or whether they anticipate future debt crises. The answer to this question carries with it implications for the desirability of debt relief. If the secondary market discount is a good predictor of future debt problems and not merely a reflector of such past problems, then debt relief, by poss.bly averting anticipated problems, may reduce the secondary market discounts and therefore increase the value of the debt held by the international lenders. The main finding here that the secondary markets do not seem to absorb rapidly

**15** Another interesting question that arises here is an elasticity issue: in assessing the desirability of debt relief international bankers clearly care about the value of the debt and not just its price. See Cohen (1989) for an analysis of this question. By concentrating on price only, I have attempted to focus on the question of the efficiency of the secondary markets.
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economic information, suggests that they are still in an early evolutionary stage and not yet very efficient.

Descriptive econometric models of creditworthiness served as the basic framework for the empirical analysis of the paper. Our results strongly confirm prior expectations of the importance of both unobservable persistent heterogeneity among nations, and the impact on bankers' perceptions of a history of bad debt performance. Ve discussed issues related to debt overhang and formulated in an empirically testable way several propositions from the theoretical literature pertaining to policy questions. The estimated models were also used to analyze several other issues in the international finance literature. For example, indices of exchange rate over-valuation were construct-d, based on discrepancies between black market and official exchange rates, and were used to examine whether overvaluation is a precursor of debt crises. Little evidence was found for this proposition, nor did we find evidence for causality in the reverse direction.

Next, the possibility of structural breaks in the processes determining repayments problems over time was also explored, after the major oil shocks of the 1970's and after 1981, when a much greater institutional involvement in the international financial markets took place. No strong evidence for structural breaks after the two major oil shocks was detected. It does appear, however, that analyses using only information prior to 1981 cannot be safely extrapolated to the 1980's. The considerably greater amount of information available to us in this study, covering 6 more years of observation, seems to offer significant statistical efficiency gains in estimation, which result in more robust models.

Finally, attempts were made to evaluate the significance ofworld economic factors, exogenous to developing countries, in precipitating crises. Examples of such factors include measures of imports by industrialized countries, inflation in the OECD nations, the OPEC balar e3 of payments, and world interest rates. The findings are important for policy-related questiops that address the "adjustment
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that retain their consistency even when the distribution **a** l ssumption of normality is violated. The findings are quite similar to the ones obtained under the parametric distributional assumption of normality, and are thus not reported in detail. Moreover, the distribution free maximum score binary-response estimator only achieved a predictive accuracy of 73% , compared to about 857. for the normal binary probit model. Sirce ability to predict ensuing external financing problems is at the heart of our argument, our preferred specifications impose the parametric normality assumptions.