Managing the Foreign Debt of a Developing Country

Introduction

Project Overview

For our project, we have chosen to deal with the management of the foreign debt of developing countries, an important issue for many countries nowadays. We will use Bulgaria as a basis model and try to build some king of a model showing Bulgaria’s interactions with the World Bank, IMF, and the London Club consequent of the fulfillment of the Brady plan. By linking the negotiation process and all its particular steps to specific results, we will try to create and solve a game model applicable for most counties in debt. We will also try applying the model to other developing countries in Europe and South America in order to test it and change and improve it if necessary. As a type of experiment, we can have a simplified game online, which could be plaid out by the class in order to see how evident each undergone step following the Brady plan is.

External Debt - Definition

The external debt of a country is the portion of the government debt that is owed to foreign creditors. A large external obligation constitutes a major issue for most developing countries and emerging market economies since it is an obstacle to continued capital acquisition and future economic growth. According to the debt overhang theory, “if debt will exceed the country’s repayment ability with some probability in the future, expected debt service is likely to be an increasing function of the country’s output level. Thus some of the returns from investment by the domestic economy are effectively ‘taxed’ away by existing foreign creditors and investment by domestic and new foreign investors is discouraged.”

Extenal Debt - Possible Resolutions

An administration facing the issue of a large foreign debt to GDP ratio has three options: 1) to decree a moratorium on debt payments (to discontinue the payments on the debt); 2) to reach an agreement with the creditors to defer the payments on the debt (in this case, an installation plan is created that might cancel some of the payments on the debt or employ that part of the debt as transferred to an equal amount of equity - an action knows as a swap); 3) to negotiate a loan with international financial institutions such as the IMF (International Monetary Fund) or the World Bank that will allow the continuation of payments on the debt.

Cases

Eastern Eaurope: Bulgaria

In the case of Bulgaria, a large external obligation was accumulated during the years of the Communist regime. With the fall of Communism in 1989, Bulgaria lost its protected markets in the sphere of agriculture, heavy industry, electronics and information technology. Due to strong international competition from the West and Bulgaria’s large external debt burden, the country was unable to fulfill the service of its debt and Bulgaria’s economy collapsed. As a result, Bulgaria declared a moratorium an all foreign debt payments in 1990. According to the Bulgarian National Bank (BNB), the foreign debt of Bulgaria at that time amounted to over $10 billion, which represented 74% of the country’s GDP. After three years of negotiations with the London Club, on July 28, 1994 Bulgaria signed a contract for the reduction and the restructuring of its foreign debt. This contract was signed under the Brady plan with the following general elements: 1) creditor banks would grant debt relief (cut in principle, or interest payable) in exchange for guarantees on the remaining portion of the debt; 2) loans from the World Bank and the IMF that would be used to finance the guarantees by providing collateral on the reduced value of the debt or by buying back a portion of the debt in ‘cash’ 3) debt relief would have to be linked to some assurance of economic reform that would stimulate investment and the return the flight capital. The logic that underlies the Brady plan is that the reduction of the debt service burden would play both an economic and political role in generating a “credibility shock”. Due to the increased credibility rating of the country in debt, the foreign direct investment increases, thus stabilizing the economy in crisis.

Under the Brady contract, Bulgaria negotiated the spread of the debt into four categories: repurchase, Discount Bonds (DISC) (secured with 30-year U.S. Treasury bonds), Front Loaded Interest Reduction Bonds (FLIRB) and Interest Arrears Bonds (IAB) (all three types of bonds fall into the general class known as Brady Bonds). Under the repurchase option, the IMF and the World Bank provided Bulgaria with funds to buy 20% of its debt back towards the London Club. The Brady bonds that were issued had a total value of $5.137 billion – 55% of the Bulgarian external debt. Upon the completion of the Brady deal, a country manages to gain the following positive outcomes: first, the national budget is free from the burden of interest payments on an outstanding debt; second, the government has the ability to decrease its foreign obligation through directly purchasing Brady bonds; third, the debtor country has the ability to use the Brady bonds as a form of payment in the privatization process. On the negative side, however, stands the growing interdependency between the government of the country in debt and the international financial organizations (IMF/World Bank). Many critics of the Brady plan believe that the IMF “reflects bargaining power rather than economic circumstances and that it is driven largely by the political self-interests of the Fund’s major shareholders” Furthermore, the IMF has been blamed for the conditions it poses on debtor countries; for example: in return for assistance, the IMF might ask for the elimination of trade barriers, monopolies, or tax distortions. The IMF advocates that such changes are mandatory and beneficial in the long run. However, Kenya’s experience illustrates the contrary. In 1993, Kenya received a small assistance package on the condition that it open-up its financial market system. As a result of the rapid liberalization of the market, there were fourteen banking failures in one year as a state of chaos emerged in the banking system.

In 2002, the Bulgarian government decided to trade its Brady bonds for global bonds as a natural continuation of the debt transformation process. Similar swaps had already been performed in some developing Latin American countries such as Argentina and Brazil. “The transformation of Brady bonds into normal credit bonds is the end of ten years of transition. Many developing countries are past the stage of restructuring their bad external debt, and now they are valuable participants in the global economy. That is definitely a sign of success,” Nicholas Brady, the designer of the plan, was quoted saying.

The positive results of the debt transformation for the country were immense. The Brady bond swap lead to the following results: the total volume of Brady bonds after the event was reduced to $2,486 million; collateral under the deal of $135 million was released; the debt maturity was extended in time; and probably the most significant impact of the debt transformation – the deal improved the Debt/GDP ratio (exhibit 1) which contributed to the establishment of a new and improved credit profile on the basis of the reconstructed external debt. Furthermore, it was the first time that US dollar denominated Brady bonds were traded for bonds denominated in Euros, differentiating the Bulgarian external debt swap from any other similar transaction made so far.

According to Milen Velchev, the Bulgarian Finance Minister at the time of the debt transformation, the fact that the external debt to GDP ratio of the country decreased substantially in the past years, contributed to Bulgaria’s solid international reputation: Bulgaria’s credit rating has been improved 14 different times by the four leading credit rating agencies. “This is unprecedented in the world - I have not heard of another country that has had its credit rating raised so many times in such a period,” said Velchev.

As one observes Bulgaria’s foreign debt management, one can see the difficult process through which a developing economy must go through to overcome the burden of a great external debt. Bulgaria’s external debt restructure, however, proves that even though an outstanding debt is a serious economic obstacle, it can be overcome through a well planed fiscal strategy, coordination with creditors, and assistance from foreign institutions. Thus, the country serves as an example to other developing market economies from the region such as Macedonia, Serbia, Montenegro and Romania.

Africa: Nigeria

“Macroeconomic management in Nigeria was the focus last week for legislators, government officials, representative of the media and the private sector, and experts from within Nigeria and abroad, including from the IMF. The conference made a valuable contribution the development of a home-grown economic strategy, particularly relevant after the recent ending of the informal monitoring arrangement between the Nigerian government and the IMF. Yet that announcement has raised many questions about the state of our relationship, so I would like to set the story straight. Nigeria and the IMF are partners, and we have a close and cooperative relationship. We do not always agree-few partners do-but we share a common vision for Nigeria, a vision expressed by President Obasanjo through his leadership in the New Partnership for Africa (NEPAD). To its great credit, the government has been increasingly transparent about its relations with the IMF. This can be seen, for example, in the government's decision to publish the details of its August 2000 request for IMF financial support. Last year, the Fund's annual consultation report, which contained the Fund staff's candid assessment of the government's policies, was also publicly disseminated. Indeed, it was very encouraging that this report provoked widespread debate within the country, enhancing the national dialogue on economic policies. The IMF has been criticized for focusing on macroeconomic and related structural policies rather than a broad development agenda. But the policies we propose are geared to-and, indeed, are prerequisites for-achieving developments goals. Financial stability and a vibrant private sector, supported by strong domestic institutions, provide the basis for durable long-term growth and poverty alleviation. The IMF has provided Nigeria with policy advice, technical assistance, and training in its areas of expertise, as well as financial support for policies that will help achieve the country's economic and social objectives. The government economic program that the IMF supported with a $1 billion pledge in August 2000 did achieve some early success. Most notably, inflation was reduced and transparency in the use of public resources was improved. But a big increase in spending in early 2001 fueled a sharp increase in inflation to over 20 percent and widened the differential between the official and parallel exchange rates to over 20 percent, distorting the allocation of resources in the economy. Although the objectives of the program were not met, the government still felt that it would be in the country's best interest to continue the close relationship and remain actively engaged with the IMF. So, in October 2001, the IMF and the government agreed on an informal framework that would monitor the country's economic policies over a six-month period. It was expected that the six-month framework would be the precursor of a broader three-year program to tackle Nigeria's economic problems, fostering growth and reducing poverty. Such a program could have been supported by IMF financing and, by showing consistency in dealing with Nigeria's economic problems, could have been used by the government to support its appeal for debt relief from foreign creditors. However, for the same reasons mentioned above, the objectives of this framework were not achieved. Our concern on excessive spending and distortions in the exchange system are shared by many participants in last week's conference and others throughout Nigeria, but are worth elaborating. First, when oil prices are high, the government-like any household that receives a windfall-should save for a rainy day. But Nigeria has pressing needs: to rehabilitate the infrastructure, strengthen education, improve delivery of medical services, and many others. So the legitimate question is, Why not spend now? But it is vital that spending be calibrated with the government's ability to spend well, and to provide the best value to the people for public resources. If not, the money is wasted: that has been the sad reality of Nigeria's past. That mistake should not be repeated. On the exchange rate, large differentials between the official and parallel exchange rate generate opportunities for corruption, as easy profits can be made "round-tripping" by those with the right to buy dollars at one rate and sell them at the other. This is why it is advisable to aim for a unified exchange system, one that responds to market conditions. Despite these differences, and the ending of the informal monitoring, the IMF and the Nigerian authorities will continue their close relationship. The IMF welcomes the government's invitation to provide its technical expertise, and it will continue to offer technical assistance to develop the skills of Nigerian officials to implement economic policy. The IMF supports the government's resolve to devise a home-grown program, and will also provide advice to aid in its formulation, as we did last week. The democratically elected government inherited deep-rooted economic, social and political problems. Decades of negligence and economic mismanagement led to a prolonged decline in real earnings, rising poverty, deteriorating health indicators, infrastructure decay, and widespread misuse of public resources. The IMF will continue to support efforts by President Obasanjo to provide a brighter future for all Nigerians-indeed, for all Africans, given his role in NEPAD. IMF Managing Director Horst Köhler, who has twice visited Africa during his two years in office and who will come twice more this year, has made clear the IMF's support for Africa and for Nigeria. As Nigeria undertakes the difficult task of building a bridge to the future, the IMF can be counted on for support, as a partner and as a friend”

http://www.imf.org/external/np/vc/2002/041502a.htm

Oil-rich Nigeria, long hobbled by political instability, corruption, inadequate infrastructure, and poor macroeconomic management, is undertaking some reforms under a new reform-minded administration. Nigeria's former military rulers failed to diversify the economy away from its overdependence on the capital-intensive oil sector, which provides 20% of GDP, 95% of foreign exchange earnings, and about 65% of budgetary revenues. The largely subsistence agricultural sector has failed to keep up with rapid population growth - Nigeria is Africa's most populous country - and the country, once a large net exporter of food, now must import food. Following the signing of an IMF stand-by agreement in August 2000, Nigeria received a debt-restructuring deal from the Paris Club and a $1 billion credit from the IMF, both contingent on economic reforms. Nigeria pulled out of its IMF program in April 2002, after failing to meet spending and exchange rate targets, making it ineligible for additional debt forgiveness from the Paris Club. In the last year the government has begun showing the political will to implement the market-oriented reforms urged by the IMF, such as to modernize the banking system, to curb inflation by blocking excessive wage demands, and to resolve regional disputes over the distribution of earnings from the oil industry. In 2003, the government began deregulating fuel prices, announced the privatization of the country's four oil refineries, and instituted the National Economic Empowerment Development Strategy, a domestically designed and run program modeled on the IMF's Poverty Reduction and Growth Facility for fiscal and monetary management. GDP rose strongly in 2005, based largely on increased oil exports and high global crude prices. In November 2005, Abuja won Paris Club approval for a historic debt-relief deal that by March 2006 should eliminate $30 billion worth of Nigeria's total $37 billion external debt. The deal first requires that Nigeria repay roughly $12 billion in arrears to its bilateral creditors. Nigeria would then be allowed to buy back its remaining debt stock at a discount. The deal also commits Nigeria to more intensified IMF reviews.

http://www.cia.gov/cia/publications/factbook/geos/ni.html

Aggregate Model

Here, we are going to develop an aggregate model based on the three area-specific interactions between each country discussed in the Game Theory Analysis section above. Based on what positive and negative outcomes we have found for each country, we are going to develop a model that captures as many strategies as we can witness in real life interaction conserning the managing of the foreing debt of a developing country.

Bibliography

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Foreign Debt Down. http://www.sofiaecho.com/article/foreign-debt-down/id_11294/catid_23.

BNB. Gross External Debt. http://www.bnb.bg/bnb/home.nsf/fsWebIndex?OpenFrameset

Pirian, Armenuhi. Bulgarian Brady Bonds and the External Debt Swap. http://unpan1.un.org/intradoc/groups/public/documents/NISPAcee/UNPAN009285.pdf>.

Sachs, Jeffrey. "Making the Brady Plan Work." Foreign Affairs (1989). <http://www.foreignaffairs.org/19890601faessay5962/jeffrey-sachs/making-the-brady-plan-work.html>.

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United States. U.S. Department of State. Bulgaria Economic Policy and Trade Practices. Feb. 1994. Dec. 2005 http://dosfan.lib.uic.edu/ERC/economics/trade_reports/1993/Bulgaria.html