Can debt-reduction policies restore investment and economic growth in highly indebted countries? A macroeconomic framework applied to Argentina

A }~ /A Policy, Resarch, and Extlrnal Affairs WORKING PAPERS Debt and international Finance International Economics Department The World Bank May 1991 WPS 691 Can Debt-Reduction Policies Restore Investment and Economic Growth ^in Highly Indebted Countries? A Macroeconomic. Framework Applied to Argentina 0~~~~~~~~~~~~~~~~~~~ Jacques Morisset Since 1982, public and private investment rates have declined dramatically in mostdebtorcountries. What would be the effects of debt-reduction operations for heavily indebted countries like Argentina? The Policy.Roacarch, and External Affairs Complex dispibua s PRE Wording Papes todisscsminatthefding of woi progress and to encouragc the exchange of ideas among Bank suff and all others intested in development issucs. Thlea papers carry the names of the authors, eflect only their views, and should be uscd and cited accordingly. The findings, interprtations, and conclusions are the authors own. They should not be attributed to the World Bank. its Board of Directs, its snanagenent, orany of its member countries.  Polley, Rosearh, and Etornal Aftirs Debt aad Intweronalh Flnamc WPS 691 This' paper - a product of the Debt and Intemational Finance Division, Inteinational Economics Department - is part of a larger effort in PRE to investigate the bene$ts and costs to debtor countries and their creditors of voluntary, market-based debt and debt service reduction arrangements. Copies are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Sheilah King-Watson, room S8-040, extension 31047 (33 pages, with tables). Morisset devised an analytical framework to relatively w2ak, the indirect effects through examine the implications of debt-reduction domestic assets are strong. operations for the economy of a typical middle- income, heavily indebted country. The prospect of greater stability in the domestic economy increases the demand for A major finding is thar debt-reduction domestic assets, particularly bank deposits. This policies can succeed io restoring investment and, reduces domestic interest rates and increases the consequently, growthfin debtor countries. Such supply of credit extended by the domestic policies combine a liquidity effect resulting from financial sector. Both effects have a positive the reduction in debt service payments and an influence on productive invesunent. incentive effect resulting from the debt relief. ,The analysis includes a calculaton of the A simulation designed to analyze the effects debt-reduction and liquidity combination that of debt-reduction policies in Argentina showed maximizes Argentina's GDP. The putpose was that a 30 percent reduction in debt had a 2.4 to determine the best use of a potential loan to percent positive effect on the level of (DP in the the country from intemnational financial institu-- first year and a 5.4 percent effect in the fifth 'tions. year. The empirical results suggest the tentative The model identifies various channels conclusion that a Brady Initiative debt and debt through which a reduction in foreign debt service reduction operation could establish the influences investment. Although the direct basis for sustainable growth in ArgenIna, if effect of debt relief on private investment is combined with appropri?te domesticpoliciea. 'Me PRE Workiang Paper Series disserninates the findings of work under way in the Banis Policy, Research, and Extemal Affairs Complex. Anobjective of the series is to getthesefindings out quickly, evenifpresentations are less than fuly polished. The findings,,interpretations, and conclusions in these papers do not necessarily represent official Bank policy. Produced by the PRE Dissemination Center,<  Table of Contents Introduction 2 1. Specification of the Model 3 1.1 The private Sector 4 1.2 The Banking and the External Sectors 7 1.3 The public Sector 9 1.4 Remaining Equations 11 1.5 An Overview of the Model 12 2. An Empirical Test : Argentina (1962-86) 14 2.1 Data and Fj.timation Results 14 2.2 Goodness-of-Fit 17 2.3 Total Effects of Debt-Reduction and Capital Inflows Policies on Domestic Variables 17 3. A Policy Implication : The Efficient Use of International Resources in a Debt-Reduction Program 19 4. Conclusion 22 Tables 24 Appendix 1 27 Appendix 2 30 Bibliography 30 *I am grateful to S. Claessens for his helpful comments. I also wish to thank J-C. Berthelemy and the participants of seminars at the World Bank and the Instituto di Tella.  3 Introduction Since 1982, public and private investment rates have declined dramatically in moss debtor countries. For the group of 15 heavily indebted countries, the investment to GDP ratio dropped on average by 6% between 1971- 81 and 1982-88 when, for non-crisis countries, this ratio increased in average by 15%2. On the basis of this empirical evidence, the poor investment and, consequently, growth performance in highly indebted countries is frequently attributed, at least to some extent, to the burden of their foreign debt. Basically, the decline in public investment is explained through the cutoff in external financing. The public debt-service payments could not be financed by any new foreign borrowing so that adjustment efforts were concentrated on public investment. Easterly (1989) emphasizes "the adjustment burden in the crisis countries was on the public expenditure side. Capital spending was the most severely cut, falling sharply in Argentina, Brazil, Mexico, Morocco, and the Philippines". Furthermore, the public sector situation worsened, since the governments of debtor countries often felt compelled to assume external liabilities of the private sector. In order to explain the sharp reduction in private investment, the recent economic literature has identified several direct and indirect channels. If the private sector has been also credit rationed, most authors argued that a large foreign debt affects productive investment through a disincentive effect3. Since the government in most debtor countries appeared unable (or unwilling) to meet its increasing debt-service payments, private investors anticipated higher rates of taxation on real and financial assets as well as more instability in the economic environment. These changes affected private investment negatively through the debt-overhang effect, which refers to the reduced incentives to invest. In addition, as foreign assets became more attractive relative to domestic assets, this often led to an increase in domestic interest rates, reducing private investment further. An impressive number of theoretical papers has been carried out during recent years in order to challenge or to assess the validity of the debt overhang hypothesis'. There has been, however, relatively few attempts to rest empirically this hypothesis. The purpose of this paper is to confront the actual strategy - debt-reduction - with a macroeconomic and dynamic framework that integrates the liquidity and incentive effects. The use of a simultaneous equations model allows to take into account various direct and indirect 2Source : IMF World Economic Outlook, supplementary note 1, 1989. 3A disincentive effect may also influence public investment. For instance, a large external debt might discourage the government adjustment efforts, since much or the benefit of adjustment will go to the creditors. We consider, however, that the credit rationing effect is stronger than the disincentive effect on public investment. 4see for example Sachs (1989), Krugman (1988), Corden (1989) or Diwan '1990).  4 relationships between external debt, investment and economic growth. Our assumption ib that the impact of a redrction in external debt on growth results from the interactions of a number of mechanisms which are likely to remain unexplained if single-equation approaches are used5. More broadly, the paper can be viewed as an attempt to examine if the instruments proposed in the Bzady Plan are able to restore growth in debtor countries. While the resilting model is estimated and simulated for Argentina, it might be applied to other indebted countries as well. Simulation results indicate that investment and, consequently, growth are quite responsive to debt-reduction programs. As a matter of fact, debt-reduction operations produce not only a liquidity effect on public investment through the debt- service reduction but also an incentive effect on private investment through the reduction in the stock of external debt. It appears that this result is not due to the direct impact of debt reductio;. -n private investment, but rather to the portfolio incentive shift from foreign assets into domestic assets which reduces domestic interest rates. The presence of strong potential incentive effects is encouraging because the liquidity effect will be limited in countries like Argentina which are running arrears and are unlikely to obtain any new foreign lending in the short-run. The paper proceed as follows. The model to be estimated is described in section 1. Section 2 presents the estimation procedure and the estimation results for the case of Argentina. Also, some simulation results are presented and discussed. In section 3, assuming that the International Financial Institutions make available some loans to Argentina for debt-reduction, we attempt to determine empirically the debt reduction-new liquidity combin-ition which fits the best with the preferences of the debtor country. Finally, section 4 contains our conclusions. 1. SPECIFICATION OF THE MODEL The notation and the complete list of variables and equations constituting the model are shown in Appendix 1. The main features of the model can be summarized as following. First, it represents a stylized three sectors model (private, public and financial (banking) sectors) for a small open economy. Second, it attempts to include the most important characteristics of highly indebted countries : high inflation, large fiscal deficits, massive capital flight, huge external debt, high debt service and a relatively developed banking sector. Third, as a clear consensus has emerged in recent years that domestic credit is rationed in LDCs (see Van Wijnbergen (1983), 5For some single-equation estimations of the private investment equation, see for example Cohen (1989), Serven and Solimano (1990), de Melo and Faini (1989) or Hofman and Reisen (1989). To our knowledge, only Borenzstein (1990), Dooley et al. (1990) and Schmidt-Hebbel (1989,1990) used a simultaneous equations framework.  5 Blejer and Khan (1984) or Fry (1988))6 and that unrestricted access to international markets is hardly a relevant case for most LDC borrowers, it assumes that the principal constraint on private agent's decisions is the quantity rather than the -ost of external and internal resources7. Finally, it attem?ts to reconcile -he Tobin-Sidrauski approach with the McKinnon-Shaw argumente in the sense that the contribution of money to economic growth can be positive or negative according to its relationship with productive capital. 1.1 the private sector As a starting point, we consider the following real budget constraint for the private sector : (1) yd + (OLp + eOD$p)/P - cp + ip + (LM1 + OV + OB + eOJ$)/P The private sector can accumulate assets into five cowpo:ients : national liquidities (OMl), bank deposits (OV), capital goods (ip), public bonds (OB) and foreign assets (eOJ$). Equation (1) states that private expenditure for net accumulation of assets is constrained by the amount of private savings (Yd - cr), the changes in net domestic credit to the private sector extended by the banking system (OLp) and the changes in gross private external debt (eOD$p). The real private disposable income (Yd) is defined to be GDP plus the earnings on domestic and foreign assets, minus interest paid on external and internal debt and net taxes. (2) Yd Y - t + (i, - W)(V 1/P) + (ib - ir)(B-1/P) + (if - X - e^)(eJ-i/P) - (i, - r)(L.rI/P) - fdsp where fdsp is, on a cash flow basis, the foreign debt service paid by the private sector. The desired real demands for money, bank deposits, capital, and public bonds and the consumption function can be specified by a standard integrated portfolio model : (.) C*p = a10 + allYd + a12ir '4 Ol3im + al1ib + ac5eD$/P 6Note that the rationing in LDCs is justified as a disequilibrium phenomenon caused by legal ceilings on interest rates. By contrast, for developed countries, the argument is based on modern theories of imperfect information (see Blinder (1987) or Stiglitz (1988). 7Under rationing, the shadow price of the capital is higher than interest rates and the quantity constraints faced by an agent become therefore arguments in its behavior.  6 (4) Ml* ' 20 + a2lYd + C221r + 023im + 024ib + a25eD$/P (S) V - 030 + *31Yd + @32a + 033im + 034ib + C35eD8/P (6) u *40 +