How should sovereign debtors restructure their debts? Fixed interest rates, flexible interest rates, or inflation - indexed

Andrew Warner

No 1187, Policy Research Working Paper Series from The World Bank

Abstract: Can developing countries affect the variance of real imports solely by altering the way debt service is paid? The answer, says the author, is a qualified yes. The presumption that fixed rate debt is less risky than flexible rate debt is historically inaccurate as a general proposition. Using annual data for 1970-90, the author shows that for many developing countries, flexible rate borrowing actually reduced net risk - whether debt service payments were indexed to nominal interest rates or to inflation in industrial countries. The covariance terms are larger and more often positive with inflation than with nominal interest rates. The author presents a macro model of the industrial countries to organize thoughts about the comovements of these variables in response to shocks. The terms of trade of developing countries are linked to this model by the assumption that the level of demand in industrial countries positively affects the terms of trade in developing countries. The worst case scenarios for developing countries is flexible interest rate borrowing combined with monetary contraction in the industrial world, which raises nominal interest rates, reduces inflation, and worsens the terms of trade of developing countries. To the extent that developing countries want to avoid this scenario, borrowing at either fixed interest rates or inflation indexed rates would be preferable to borrowing at flexible nominal interest rate. To reduce risk, countries should seek debt contracts in which debt service payments vary positively with their terms of trade. Results indicate that inflation indexed debt is most desirable on this score. The author examines only extreme options, with all debt of one type. The optimal strategy would probably entail all three kinds of borrowing. And the paper does not examine options for efficient international risk sharing.

Keywords: Economic Theory&Research; Environmental Economics&Policies; Banks&Banking Reform; Insurance&Risk Mitigation; Financial Intermediation (search for similar items in EconPapers)
Date: 1993-09-30
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