theories of indebtedness

International Indebtedness&

Theories of Sovereign Risk

International Finance-II, 2014Department of CommerceNorth Bengal University

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Few Historical Events of Late Eighties of the last century which led Fukuyama to conclude ‘the end of history’:a)Crumbling of Berlin Wall, 1989 (Germany)b)Dissolution of the Soviet Union, 1989 c)Confrontations in China (captured best in Tiananmen Square), 1989

“A wave of optimism engulfed the Western democratic States. This contagious optimism was best exemplified by the confidence and popularity of Francis Fukuyama's claim that the end of history was at hand, that the future - if that word could still be said to have the same meaning - was to become the global triumph of free market economies.”

Bernd Magnus And Stephen Cullenberg in the Introduction to a Jacques Derrida’s book “Specters of Marx: The State of the Debt, the Work of Mourning and the New International”.

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“The twentieth century saw the developed world descend into a paroxysm of ideological violence, as liberalism contended first with the remnants of absolutism, then bolshevism and fascism, and finally an updated Marxism that threatened to lead to the ultimate apocalypse of nuclear war. “

But the century that began full of self-confidence in the ultimate triumph of Western liberal democracy seems at its close to be returning full circle to where it started: no to an "end of ideology" or a convergence between capitalism and socialism, as earlier predicted, but to an unabashed victory of economic and political liberalism.” (page-1)

“What we may be witnessing in not just the end of the Cold War, or the passing of a particular period of post-war history, but the end of history as such: that is, the end point of mankind's ideological evolution and the universalization of Western liberal democracy as the final form of human government.” (Page-2)

Francis Fukuyama said in his article ‘The End of History”

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“The ruins of the Reich chancellory as well as the atomic bombs dropped on Hiroshima and Nagasaki killed this ideology on the level of consciousness as well as materially, and all of the proto-fascist movements spawned by the German and Japanese examples like the Peronist movement in Argentina or Subhas Chandra Bose's Indian National Army withered after the war.” (page-10)

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Francis Fukuyama said in his article ‘The End of History”

But the situation of liberal democracy and also free market economy since early eighties of the last century has not been free from economic crisis, social injustice, inequality, starvation and other perennially persisting ills which are causes of human tragedy. Though, according to Fukuyama, those are because of incomplete implementation of basic principles of liberal democracy, we feel, however, that there exist some inherent fundamental contradictions even in liberal democracy and free market economy for which we have to wait to declare final triumph of free market economy and the ‘end of history’.

Loan pushing by developed countries to LICs leads to Indebtedness and that compounds to sovereign risk which may be fatal for the existence of present international financial system.


If one agents lends money to another within same country and the borrower refuses to repay, the lender can in principle resort to the nation’s laws. Such recourse to the law, so goes the standard argument, is not usually possible when the government of country-A (or some agent in A) lends to country-B (or some agent in B).This phenomenon gives rise to a kind of risk which is called sovereign risk different from business risk or financial risk.

Why then Country-A would lend to Country-B?

It seems widely agreed that country-A will lend to B only when A has the ability to hurt B.First: the lender can threaten to refuse loans to defaulting borrower. This Contingent

Renewal is effective only if the borrower has a cyclical need for credit.Second: the lender can embargo trade with the borrower.Third: a lender can intervene militarily.

Two aspects distinguish international from domestic credit markets.

First: sovereign risk can be different from the risk of lending within a country,Second: repayment can not always be made in the debtor’s currency.

SOVEREIGN RISK

An incident on August 13, 1982“a bombshell that shook an entire universe”-Kraft Joseph, ‘The Mexican Rescue’, 1984What was that incident?

Finance Minister of Mexico announced on August 13, 1982 that Mexico could no longer service its enormous external debt.

This date is considered by the academicians and other concerned people as the start of current international debt crisis.

What are the consequences (or fall out) of this announcement?

i)Lenders cut back their lending to other Latin American countries who in turn became incapable of continuing with their repayment schedule

ii) Imports fell by 42 percent in mexico

iii) Wage bill dropped by 32 percent


A Theoretical Frame Work:

Discussion is based on the following three papers:

(i)Eaton, Gersovitz, Stiglitz (1986), “The Pure Theory Of Country Risk”, EER

(ii) Krugman (1985), “International Debt Strategies In An Uncertain World” in Smith & Cuddington (Ed.) “International Debt and the Developing Countries”

(iii) Basu (1991), ‘The International Debt Problem, Credit Rationing and Loan Pushing: Theory and Experience’, Princeton Studies In International Finance No- 70


World Bank data revealed that in 1970s developing country debt grew at an alarming annual rate of 21 percent and the Debt-to-GNP ratio rose from 18 to 28 percent. This explains the extent of sovereign risk in international finance market existed at that time and the incident of Mexico was not an unexpected one.


However, here we are considering a two-period model following Eaton et el (1986):

Lender lends L units in period-1 and charges an interest rate i.Repayment in period-2 is R= Loan amount (L) + interest (at the rate i) on L = L+ iL = (1+i)LNon-repayment cost or penalty = b (the amount of cost that can be inflicted on borrower is positively related to the amount L). Thus we have,

(1) ),( Lbb

We postulate Monotonicity here, hence

Disadvantage of Finite-horizon Model:

(2) 000 )(,)( bLb

above bounded and concave is (.)b

But, penalty can not be made infinitely large and hence the slope of penalty function must be downwards after a certain point. Therefore, the function

Finite-horizon or Infinite-horizon?The Monopolistic Lender Model


Borrower’s Problem:

Borrower country’s utility is if consumption in period i is Ci

Utility function is continuous, convex and strictly increasing in each of its argument.

),( 21 CCU

Let )ˆ,ˆ( 21 CC be consumption streams if it does not borrow from abroad and use the loan package ),( iL

])(ˆ,ˆ[ LiCLCUU R 121

Then utility under three situations may be considered:

i.Loan borrowed in period-1 and repaid in period-2

ii.Loan borrowed in period-1 but caused default in period-2 and paid penalty

iii.Loan is not borrowed

)](ˆ,ˆ[ LbCLCUU D 21

)ˆ,ˆ( 21 CCUU O

LiLb )()( 1Borrower will, therefore, repay if


Lender’s Problem:

Supposing Lender’s opportunity cost of lending to the borrower is r, then the lender’s problem is to maximize the profit π as follows:

and (2) i)L(1b(L)

subject to

(1)

Maximize

,)(),(

),(

LriiL

iL

(3) 121OULiCLCUU ])(ˆ,ˆ[

It is quite rational to suppose that the utility of borrowing is greater than the utility of not borrowing, otherwise there is no incentive to borrow. Hence the second constraint (equation-3).

It is quite rational to suppose that the utility of borrowing is greater than the utility of not borrowing, otherwise there is no incentive to borrow. Hence the second constraint (equation-3).

Slope = 1+i*

b(L)

(1+r)L

B

A

L* L

The Monopolistic Lender Model



Competition and Credit RationingCompetition and Credit Rationing

The standard model of the International Credit Market is one in which lenders compete with one another and push their monopolistic profits to zero.

Following Eaten et el (1986) we have that profit is zero when i=r in the profit function π= (i-r)L in our model. Then from (2), we can compute the maximum loan amount without causing default:

LrLb ˆ)()ˆ( 1

)(

)ˆ(ˆr

LbL

1

Default Frontier

L̂

rE

L

i

C

O



Demand Curve under the assumption of no default:

))(ˆ,ˆ()( LiCLCUiD 1argmax 21L

Demand curve is the locus of the peak points of all iso-utility curve drawn in (L,i)-space

kLiCLCU ))(ˆ,ˆ( 121

Demand Curve for LoanDefault Frontier

Iso-utility Curve

L̂

rE

L

i

C

O


Excess Demand

D

Demand Curve for LoanDefault Frontier

Iso-utility Curve

rE

L

i

C

O L̂


Competitive Lender: Demand Equals Supply

Next STRATEGY

OFLOAN PUSHING