PRINCETON STUDIES IN INTERNATIONAL FINANCE No. 70, October 1991 THE INTERNATIONAL DEBT PROBLEM, CREDIT RATIONING AND LOAN PUSHING: THEORY AND EXPERIENCE KAUSHIK BASU INTERNATIONAL FINANCE SECTION DEPARTMENT OF ECONOMICS PRINCETON UNIVERSITY PRINCETON, NEW JERSEY PRINCETON STUDIES IN INTERNATIONAL FINANCE PRINCETON STUDIES IN INTERNATIONAL FINANCE are published by the International Finance Section of the Department of Economics of Princeton University. Al- though the Section sponsors the Studies, the authors are free to develop their topics as they wish. The Section welcomes the submission of manuscripts for publication in this and its other series. Please see the Notice to Con- tributors at the back of this Study. The author of this Study, Kaushik Basu, is Professor of Economics at the Delhi School of Economics and a Council Member of the Econometric Society. He has also been a Member of the Institute for Advanced Study in Princeton and a Visiting Professor of Economics at Princeton University. Basu serves as editor of Social Choice and Welfare and on the editorial boards of several other journals. His most recent research has been in the fields of industrial organization theory and development economics. PETER B. KENEN, Director International Finance Section PRINCETON STUDIES IN INTERNATIONAL FINANCE No. 70, October 1991 THE INTERNATIONAL DEBT PROBLEM, CREDIT RATIONING AND LOAN PUSHING: THEORY AND EXPERIENCE KAUSHIK BASU INTERNATIONAL FINANCE SECTION DEPARTMENT OF ECONOMICS PRINCETON UNIVERSITY PRINCETON, NEW JERSEY INTERNATIONAL FINANCE SECTION EDITORIAL STAFF Peter B. Kenen, Director Margaret B. Riccardi, Editor Lillian Spais, Editorial Aide Lalitha H. Chandra, Subscriptions and Orders Library of Congress Cataloging-in-Publication Data Basu, Kaushik. The international debt problem, credit rationing and loan pushing: theory and experience / Kaushik Basu. p. cm.—(Princeton studies in international finance, ISSN 0081-8070 ; no. 70 Includes bibliographical references. ISBN 0-88165-242-3 (pbk.) : $9.00 1. Debts, External—Econometric models. 2. Loans, Foreign—Econometric models. 3. Debts, External—Latin America—Econometric models. 4. Loans, Foreign—Latin America—Econometric models. I. Title. II. Series. HJ8015.B37 1991 336.3′435—dc20 91-39784 CIP Copyright © 1991 by International Finance Section, Department of Economics, Princeton University. All rights reserved. Except for brief quotations embodied in critical articles and reviews, no part of this publication may be reproduced in any form or by any means, including photocopy, without written permission from the publisher. Printed in the United States of America by Princeton University Press at Princeton, New Jersey International Standard Serial Number: 0081-8070 International Standard Book Number: 0-88165-242-3 Library of Congress Catalog Card Number: 91-39784 CONTENTS 1 INTRODUCTION 1 The Plan 1 Some Background Notes 2 2 SOVEREIGN RISK AND RATIONALITY 6 A Problem 6 Norms 8 Nicaragua, an Illustration 11 3 THE STANDARD APPROACH 15 Borrower Behavior and the Monotonicity Postulate 15 Competition and Credit Rationing 20 4 TWO MODELS OF LOAN PUSHING 24 The Conceptual Background 24 The Extortionate Lender 26 Lender Interdependence and Excess Supply 28 5 CONCLUSION 35 REFERENCES 36 LIST OF FIGURES 1 The Monopolistic Lender 17 2 The Competitive Lender: Excess-Demand Equilibrium 21 3 The Competitive Lender: Demand Equals Supply 22 4 Excess-Supply Equilibrium 27 5 Lender Interdependence and the Supply of Credit 32 1 INTRODUCTION The Plan This study has three purposes. It highlights and scrutinizes some implicit assumptions in the newly emerging “theory of international debt.” It draws attention to several of the political (and, more generally, noneconomic) issues that are neglected in formal models but that arise in analyzing relations between international debtors and creditors. And it proposes a new theory that formalizes the concept of “loan pushing” and demonstrates the possibility of equilibria under conditions of excess supply of credit. The assumptions at issue are concerned with questions of rationality and market structure. It is argued that formal models of behavior by debtors and creditors must make allowance for international norms and customary law and that, in fact, most models do, though often only implicitly. Certainly, some of the larger questions of politics and political economy must be put aside in constructing formal models, but it is easy to develop a “trained incapacity” even to acknowledge their relevance. Because some of these questions are very important for an analysis of international debt, they should receive more attention than they have in the past. With the rise of game theory and strategic analysis, economists can now take account of some of them. Chapter 2 encourages research in this direction by using illustrations from the Latin American experience. Although this study is largely a critical survey, it also analyzes “loan pushing,” a phenomenon discussed anecdotally in the literature but not rigorously modeled. The theoretical literature has been largely con- cerned with the postcrisis (i.e., post-1982) period, in which credit has been scarce and third-world countries have demanded more than the My interest in this subject developed over several years. Discussions with Tariq Banuri, Peter Bauer, Sudipto Bhattacharya, Jim Boyce, Gerald Epstein, Carol Heim, Allen Kelley, Anne Krueger, Badal Muherji, Siddiq Osmani, Robert Pringle, Debraj Ray, Jaime Ros, and Hans-Bernd Schafer played an important role in this, as did the lectures Lance Taylor gave to my development economics class at the Delhi School of Economics in 1987. I have also benefited from seminars at Duke and Vanderbilt Universities and at the University of Massachusetts at Amherst. In addition, I am grateful to an anonymous referee for helpful comments. An early version of this paper was written at the World Institute for Development Economics Research in Helsinki. 1 banks have been willing to extend. Not surprisingly, therefore, the literature has modeled equilibria with excess demand for credit. In this, it has been quite successful, but it has ignored the credit glut before 1982, during which “multinational banks...practically forced money on the less-developed countries” (Kindleberger, 1989). There seems to be a case, therefore, for providing a model in which an excess supply of credit occurs in equilibrium. Chapter 4 shows that this is quite natural, given the sort of supplier interdependence peculiar to credit markets. Some Background Notes On August 13, 1982, Mexico’s finance minister announced that Mexico could no longer service its enormous external debt. The announcement was described as “a bombshell that shook an entire universe” (Kraft, 1984), and the date is conventionally treated as the start of the current international debt crisis. Subsequently, Mexico’s declaration turned out to be, not a debt repudiation, but a ninety-day moratorium on repay- ments. In fact, right from the time it took office in December 1982, Mexico’s new government made very clear its willingness to negotiate repayments (Ros and Lustig, 1987). Nevertheless, its announcement triggered a chain reaction. It caused banks to become cautious and cut back their lending to other Latin American countries,1 rendering those countries, in turn, incapable of continuing with their repayments and thus forcing them to reschedule their obligations. The effects on the Latin American economies were quite dramatic. Imports fell by 42 percent in Mexico in 1983, and the wage bill dropped by 32 percent between 1982 and 1984, a result of both a contraction in employment and a fall in wages. In some ways, the crisis was inevitable, and its roots are apparent in the changing structure of international lending in the 1950s and 1960s (see Streeten, 1972, chap. 10). In the 1970s, moreover, developing-country debt grew at the alarming annual rate of 21 percent, and the debt-to-GNP ratio rose from 18 to 28 percent (World Bank, 1988). Add to this the oil crunch and climbing interest rates in the industrialized countries, and the brew was ready. 1 In September 1982, lending to Brazil dropped to half the earlier rate, and cutbacks in credit availability soon spread to Argentina, Peru, Chile, and other Latin American nations (Cline, 1984). For further discussion of these secondary repercussions, see Kuczynski (1983). General developments in international credit since 1982 are described well in Lever and Huhne (1985), Koht Norbye (1988), and International Monetary Fund (1989). The basic conceptual issues are summed up usefully in Stewart (1985) and Taylor (1985). 2 That third-world debt was beyond what could be easily serviced was quite evident well before August 1982. Why then was a mere admission of this fact the cause of such severe repercussions? 2 Consider a situation in which borrowers use up loans without creating the ability to repay or service them. With the loans being treated by the lenders as assets and the borrowers knowing they cannot repay them, the amount of wealth people in the world think they own will exceed actuality. Eventually, some of them will have to adjust estimates of their wealth downward. If this happens slowly, through inflation, for instance, a crisis is avoided. If, on the contrary, the realization comes suddenly, there will be a debt crisis, a crisis potentially made worse by bank runs and economic stagnation. A sudden announcement by a heavily indebted country of repudiation or a suspension of debt-service