Sovereign Debt Crises and Maturity Structures

Barcelona GSE Focus

How does a country’s debt maturity structure affect the likelihood and resolution of a debt crisis? How do different restructuring policies affect welfare? In their Barcelona GSE working paper (No. 818) “The Long and Short of It: Sovereign Debt Crisis and Debt Maturity, Raquel Fernández and Alberto Martín explore the role of debt maturity on the frequency with which a country enters a debt crisis and on the severity of the latter. They then use their framework to evaluate the welfare effects of different debt restructuring policies, including the International Monetary Fund’s recent proposal to deal with certain debt crises through debt reprofiling.

The State of Affairs

Sovereign debt is an important budget-management tool for countries. It enables them, for instance, to finance large infrastructure projects or temporary shortfalls in public revenues. In general, countries are free to choose both the amount and type of debt instruments that they issue. One important choice in this regard is that of the maturity structure of debt, i.e., of the mix between short- and long-term debt.

Sovereign debt also entails risks, however. As the stock of debt rises or as the economic outlook worsens, creditors might become concerned about being repaid. In such instances, as the perceived likelihood of default increases, the country finds it harder to roll-over its short-term debt and a crisis may ensue. How such crises are handled, and whether or not they lead to outright defaults, have important welfare consequences for all involved.

There is currently a widespread perception, as the recent experience of Greece illustrates, that the international financial system does not handle debt crises very efficiently. This perception has generated a call for reforms. The International Monetary Fund, in particular, is considering amending its lending framework to make it easier for countries to deal with large stocks of outstanding debt, either by facilitating debt restructurings or – most notably – by providing alternatives such as debt “reprofilings”. The intuitive idea behind reprofilings is that, when a country is faced with a debt crisis, it may be helpful to extend the maturities of its private debts and postpone payments until there is greater certainty regarding the country’s prospects and the sustainability of its debt burden.

These proposals have generated a lively debate. Adherents stress their ex post benefits, i.e., they will help countries deal more efficiently with debt crises when these happen. Opponents emphasize instead their ex ante costs, i.e., they will raise the cost of funding, and ultimately lead to more frequent crises or prevent some countries from borrowing altogether. These criticisms have been especially voiced in the case of reprofiling, which is bound to raise the costs of short-term debt by making it more similar to long-term debt.

Restructuring and Reprofiling of Debt

Fernandez and Martin develop an analytical framework to assess the merits of these reforms. Their framework assumes that countries’ borrowing is subject to several standard contracting frictions:

  • Countries borrow through non-contingent bonds (that is, countries issue debt instruments that promise a fixed payment regardless of circumstances) that are hard to renegotiate.
  • Countries are unable to commit, either to keep their stock of debt on a certain path or to repay their debt.

Enter an International Financial Institution (IFI – such as the IMF). The authors assume that countries can request help from such an institution, which in turn decides whether or not to intervene. In the event of intervention, the IFI: stops all payments to creditors as well as new borrowing by the country, and; restructures or reprofiles outstanding debt. A debt restructuring involves a proportional haircut to all types of creditors (both short- and long-term) that seeks to decrease the risk of an outright default. A debt reprofiling instead postpones all due payments to a future date (i.e., lengthens the maturity of debt). Naturally, reprofilings can only be successful if they impose a haircut or a de facto write-down on short-term creditors, so that they are forced to roll over their debt at an interest rate that does not fully reflect the expected risk of default. Reprofilings can thus be considered akin to a light restructuring, the cost of which is fully borne by short-term creditors.

How does Debt Maturity Matter?

First the authors show how debt maturity shapes both the likelihood and costs of debt crises. Short-term debt is costly because creditors may be unwilling to roll it over in the face of bad economic prospects, triggering a debt crisis. If countries could commit to keeping their stocks of debt on a certain path, they could avoid these crises by issuing enough long-term debt. But, absent this ability to commit, long-term debt is also problematic because it can be diluted. In particular, once it has been issued, countries can issue more debt. This decreases the probability with which the original long-term debt holders are paid, i.e., it results in dilution. When choosing their debt maturity structure, countries optimally trade-off these costs and benefits of short and long-term debt.

Is There a Role for an IFI?

How can an IFI increase welfare through its intervention? One obvious role is its superior ability to coordinate private creditors ex post so as to prevent inefficient outcomes. In the absence of an IFI, each creditor finds it in its own self-interest to insist upon repayment rather than roll over its debt, even if the latter increases the ability of a country to repay. The IFI can, by coordinating creditors, avoid these inefficient payments.

But restructuring and reprofiling do not just enhance ex post efficiency, they also redistribute resources between the country and its creditors and also among creditors themselves. This ex post redistribution, which depends on the extent to which debt is written-down and on the haircuts imposed on short relative to long-term creditors, has important ex ante implications. To the extent that restructuring and reprofiling entail a write-down of debt during crises, they raise the country’s ex ante cost of borrowing. To the extent that reprofiling redistributes resources from short to long-term debt, it raises the relative cost of short-term borrowing. The welfare implications of restructuring and reprofiling depend on how these ex post and ex ante effects net out.

A central result of the paper is that how these interventions distribute haircuts between creditors of different types is irrelevant from an ex ante perspective. That is, it does not matter whether short or long-term bonds are more severely hit when the IFI intervenes: it suffices that such interventions not decrease total expected payments to creditors in order for them to be welfare enhancing. This result is intuitive yet surprising. It implies that, despite the central role played by short-term debt in the authors’ framework, the relative cost of this debt is irrelevant to ex ante welfare. What matters instead are total expected payments in times of crises to creditors as a whole. This suggests that the debate over the merits of restructuring regimes should not be centered on the distribution of payments among creditors, but rather on the distribution of payments between creditors and the debtor country.

An important assumption in the framework, which is implicit in the previous discussion, is that both restructuring and reprofiling halt issues of new debt by the country. This feature prevents the country from borrowing excessively in the aftermath of such interventions, which – given that they entail an average lengthening of the maturity structure – may create new incentives to dilute the restructured or reprofiled debt. The analysis thus also suggests that the ultimate welfare effects of these interventions may depend on the IFI’s ability to control the country’s market access for some time after they take place.

The authors highlight the need for further research in this area, especially regarding ability of the IFI to coordinate creditors efficiently and in preventing the country from taking on additional debt too soon. But showing how the country chooses its debt structure and how policy tools can affect these choices to reduce the chance of crises is an important evaluation given the increasing debt loads of many economies around the world.


 

Artwork credit: Based on original world map poster by Erik Penser Bankaktiebolag