The Debt Crisis
Deja Vu?

Observers familiar with the history of international lending approach the 'debt crisis' of the 1980s with a sense of deja vu. Recent debt-servicing difficulties in Latin America, Eastern Europe and elsewhere represent only the latest in a series of similar episodes stretching back over centuries. Sovereign borrowers have often resorted to default, the defaults of the 1930s being merely the most dramatic instance of a recurrent phenomenon. Quite often, defaulting debtors were able to re- enter the international capital market only to default again; creditors were then criticized for reckless lending, ascribed to myopia or excessive competition.

The widespread defaults of the 1930s do offer the most suggestive parallels to recent difficulties. In Discussion Paper No. 75, Research Fellow Barry Eichengreen and CEPR Director Richard Portes therefore undertake a systematic analysis of the interwar experience in order to assess the relevance of the 1930s to recent difficulties in international capital markets. They analyse the nature of borrowing, the incidence of default and the returns ultimately realized by foreign lenders. They first describe the nature of international lending in the 1920s and 1930s, employing regression analysis to summarize variations across countries and over time in the pattern and magnitude of sovereign indebtedness. They find that levels of debt during 1930-38 were closely related to GDP (with an elasticity near unity) and positively associated with the degree of 'openness' of the economy, as measured by the ratio of imports to GDP, as well as with population size. The latter two variables are significant in explaining debt per unit GDP over the full pooled sample of observations.

Eichengreen and Portes then explore the association between interruptions to debt service and conventional measures of economic structure. They find, using pooled time-series and cross-section data, that the proportion of a country's debt in default during 1934-38 was positively related to its debt/GDP ratio, the extent of deterioration of its terms of trade from 1929 onwards, and the percentage increase in its government budget deficit during 1929-31. This relationship gives a straightforward economic explanation of default. Being in the Latin American area, for example, did not predispose a debtor to default, given its economic characteristics (a 'dummy variable' for this region was insignificant).

The authors also examine the longer-run implications of default and the remedies available to creditors. They present new estimates of the rate of return on foreign loans floated in the 1920s, distinguishing between loans in default and loans in good standing in order to construct a measure of the costs of default ultimately incurred by lenders. They also compare realized rates of return on loans made in different years, to different countries and to different classes of borrowers. The internal rate of return on default-free loans was 6.7% for dollar bonds and 5.8% for sterling bonds, but default hit dollar bondholders much harder than those holding sterling bonds. The average realized internal rates of return (weighted by issue value) on the full samples of government-backed loans are 3.25% for dollar issues and 5.41% for sterling issues. It is notable that despite the preoccupation with sovereign default, investors who lent directly to national governments ultimately received respectable rates of return; settlements appear to have been relatively favourable.

Eichengreen and Portes conclude by outlining promising directions for further research. Most important is the impact of default on the subsequent economic performance of the defaulting debtor - did it disrupt trade and capital flows and thereby hurt the growth of capital-importers? This should have significant implications for assessment of how current debt-service problems are being managed.

Richard Portes discussed this and other related work at a lunchtime meeting on 21 October, a full account of which appears in this Bulletin.


Debt and Default in the 1930s: Causes and Consequences
Barry Eichengreen and Richard Portes

Discussion Paper No. 75, October 1985 (IM)