At a lunchtime meeting held in London on 23 March, CEPR Director Richard Portes and Daniel Cohen, a Research Fellow in the Centre's International Macroeconomics programme, reported preliminary results of a recent research project on `The Secondary Market for LDC Debt'. Funding for the meeting was provided by the Overseas Development Administration as part of its support for the project, which was also supported by the Bank of England and the ESRC.

The total LDC debt to commercial banks rose to more than $500 billion by the end of 1989. Turnover in the secondary market was $50 billion in 1988, $70 billion in 1989; the debt retired as a result of these transactions was $15-20 billion in 1988, but probably less in 1989.

The notion of a `debt Laffer curve' suggests that the total present value of expected repayments on debt initially rises with the nominal value from zero to some maximum and then falls <196> ultimately returning to zero. If the secondary market prices debt efficiently, then its actual price will correspond to the value on the debt Laffer curve. If the elasticity of the market price with respect to the face value of the debt exceeds unity, lenders will be able to increase the market value of their claims by writing off some of the debt. On the other hand, if this elasticity is less than unity, then debtors will be able to reduce the market value of their debt by means of buy-backs.

Portes explained that estimating this elasticity will therefore help to determine whether buy-backs of the type endorsed by the Brady initiative represent an effective means of reducing the aggregate market value of the outstanding debt, or merely a means of transferring resources from the World Bank or the IMF (or from debtor country reserves) to the banks selling the debt. A better understanding of the information conveyed by the secondary market price may also be useful in setting appropriate benchmark prices at which banks should concede debt reduction or the debtor (or an international agency) should be willing to purchase the debt.

Such estimates will also throw light on the relationship between the economic performance of individual countries and the price of their debt. If the market expects rolling rescheduling rather than default, then the secondary market price will reflect the proportion of debt that is expected to be serviced in the long run, and will vary with the performance of the individual debtor country. Alternatively, if the discount in the secondary market is indicative of a positive probability of default, pricing behaviour is likely to be dominated by overall market conditions and contagion effects.

Portes explained further that the influences on the demand and supply sides of the market were too complex for structural econometric modelling to be feasible. The diverse regulatory environments and tax and accounting methods of the various countries are difficult to interpret econometrically, and other major influences on the supply side include banks' price expectations and levels of provisioning and the anticipated effects on their share prices. On the demand side, the players include the corporate sector, LDC governments, LDC residents and the banks themselves, and the players in each category have different motivations. In particular, the relative growth of interbank trading has been accompanied by increased position- taking by dealers in the market, whose motives are essentially speculative.

Portes reported the results of some initial econometric work they had undertaken for the 24 countries for which monthly data were available. They had focused on the seven countries for which the secondary debt markets were reasonably liquid (Argentina, Brazil, Chile, Mexico, Poland, Venezuela and Yugoslavia), and the results of inspection and simple regressions indicated a strong negative time trend and revealed the effects of certain specific events, such as the moratorium on Brazilian debt in February 1987, the stock market crash of October 1987 and the Brady initiative of March 1989.

They investigated whether debt can be treated as an asset like stocks and shares by calculating pairwise coefficients of the risk on holding the debt of each country considered vis-à- vis that of holding the Standard & Poor's index. There was no overall pattern to suggest that some countries' debts are riskier than others nor any clear relation of risk to yield across countries. Calculating the specific risk for the debt of each country relative to a portfolio of the entire market yielded similarly negative results. Since the returns to a holder of debt are not significantly correlated to any measure of risk, these results suggest that the market does not price efficiently.

Cohen reported the preliminary results of time series analysis for the seven countries for which there were `liquid' secondary markets, considered in detail. These indicated that the price of debt responded very significantly to movements in the market rate of interest, with an elasticity close to unity, which suggests that the debt is viewed by the market as the present value of future payments. The price of debt for each country also responded very significantly to the prices of debt for all the other countries, when allowance was made for the common impact of the interest rate, which indicates that systemic risk is likely to be a dominant factor. In contrast, the role of country- specific factors such as fluctuations in the terms of trade was weak or statistically insignificant. Indeed, the results for Mexico and Venezuela showed no correlation between the prices of their debt and the price of oil, which seems to indicate that lenders do not regard the relationship between the payments due to them and the wealth of the relevant debtor country as a close one.

These and further results of the project will appear soon in the CEPR Discussion Paper series.