LDCs might find it against their interests to repay their foreign debt, if its servicing cost exceeds the potential benefits of default. Some argue that they should always adjust: increase domestic taxes, curtail aggregate demand and attain a sustainable foreign debt/export ratio. The incentive to default depends upon the real foreign interest rate, the debt/income ratio, access to international capital markets, donor countries' macroeconomic policies, the nature and impact of demand and supply shocks, and domestic budget solvency constraints in the borrowing country.

In Discussion Paper No. 647, Subrata Ghatak and Research Fellow Paul Levine examine the welfare implications and incentive compatibility of debt repayment with reference to a national solvency condition that current external debt as a proportion of GDP must be proportional to the present value of future primary surpluses, discounted at the `growth adjusted' real foreign interest rate. Where GDP growth exceeds the real interest rate, and the growth-adjusted real foreign interest rate is negative, stabilizing the trade balance/GDP ratio will suffice to stabilize the debt/GDP ratio.

Applying these principles to a small macroeconomic model for India, Ghatak and Levine calibrate the ratios of exports and imports to GDP and find that a 1% real devaluation leads to a 3% increase in export volumes. They add the national and public sector solvency conditions and calibrated aggregate demand and supply sides, and they assume that taxes, government spending and the real exchange rate are available policy instruments. The government and the private sector have two options: debt repayment, and hence fiscal and exchange rate adjustment to satisfy both solvency conditions; or debt repudiation, leading to a loss of foreign capital inflows and the inability to run a trade deficit. The authors find that debt repayment is incentive compatible if functioning within the national solvency condition is preferable in terms of some welfare criterion to the consequences of immediately eliminating the trade deficit. They also consider the possibility that financial autarky leads to lower long-run growth rates; the final outcome depends on the initial size of the debt/GDP ratio, the initial trade balance ratio, and the form of the required adjustment to solvency.

The numerical solutions suggest that a small drop in trend growth resulting from a loss of foreign investment and lending is enough to deter reneging on debt but only with a government discount rate of 5% or less per annum. With a discount rate for India of 10% per annum, a drop in trend growth of as much as 4% is insufficient to deter repudiation. Debt relief improves the relative appeal of debt repayment, but even writing off 75% of the external debt will not make it incentive compatible.

The Adjustment Towards National Solvency in Developing Countries: An Application to IndiaSubrata Ghatak and Paul Levine

Discussion Paper No. 647, May 1992 (IM)