Developing countries expected to use the excess world savings recycled to them following the 1970s oil shocks to augment their productive capacities, which they would then use to repay the debt. The sharp rise in world interest rates in the 1980s, however, forced them to transfer net resources to the rich countries. In Discussion Paper No. 778, Programme Director Daniel Cohen surveys the corresponding development of the academic literature on external debt. This first switched its focus from the intertemporal nature of the balance of payments to develop a theory of debt repudiation based on the imposition of optimal credit ceilings on sovereign debtors. Once the stock of debt clearly exceeded the present value of the transfers debtors were willing to pay, however, attention turned to the implications of this `debt overhang' for investment and growth. The key issue in the 1990s became how best to write down the face value of the accumulated debt.

The ensuing debate over the `right' price at which to undertake such deals focused on the distinction between the average price at which an individual investor would sell debt and the marginal price at which lenders as a whole would sell when internalizing their decisions' effects on its aggregate value. Cohen reviews models developed to determine real and nominal costs to bankers of unilaterally writing down debt. He shows that a 50% write-off at face value may involve the loss of no more than 11% of the debt's market value in real terms or as little as 3.5% in nominal terms.

Cohen proposes that research must now focus on whether developing countries should restrict their borrowing on world financial markets to smoothing terms-of-trade fluctuations or scope remains for mobile capital to help them grow faster. The literature on `new growth' theory pioneered by Romer and Lucas offers a starting-point. This already challenges the view that capital will move from rich to poor countries, even if free of sovereign risk.

Growth and External Debt
Daniel Cohen

Discussion Paper No. 778, May 1993 (IM)