Are buybacks an efficient way to reduce sovereign debt?

Stijn Claessens, Giovanni Dell'Ariccia 05 March 2011

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The arguments in favour of debt reduction are well known. A debt overhang reduces the incentives for investment, both foreign and domestic, because of the threat of future taxes. In theory, the efficiency gains resulting from a reduction in debt overhang can be divided between the debtor and the creditors through a bargaining process. An agreement would then involve some “payment” by the debtor (cash or a more secure new debt obligation) in exchange for some debt relief. In practice, however, coordination problems make these arrangements difficult when the creditor body is fragmented. The benefits from debt reduction accrue to all creditors, whether they participate or not in the scheme. As a result, free riding may hold up the entire process.

Against this background, debt buybacks and (voluntary) debt swaps appear appealing as they are market-friendly avenues to reduce a country’s debt, especially when debt is trading at a deep discount and/or the country is paying high costs to attract new external financing. Yet despite this, a large literature from the late 1980s and early 1990s (see also Manasse 2011) argues convincingly that, when market prices reflect correctly the probability of repayment, these schemes typically result in a waste of valuable resources. The problem (as we discuss in detail the next section) is that a buyback raises the market value of the debt left outstanding, and consequently it may worsen – rather than improve – the net asset position of the sovereign.

The prospects for debt buybacks look better when informational asymmetries drive a wedge between the expectation of future repayment of creditors and debtor. For instance, for a government committed to honour its country’s obligations and invested in the policies needed to guarantee repayment the “true” value of the debt is close to its face value. However, the same debt can trade at a discount if the government is not be able to credibly convey its commitment and financial markets are sceptical that it will be able or willing to carry out its policy plans. Under these conditions, a buyback would achieve substantial savings. Further, it could act a signalling device and improve the country’s access to new external financing.

Buybacks may also appeal to governments that want to support their domestic creditors. Unlike for most Latin American countries in the late 1980s, in the current cases a significant share of sovereign debt is often held by residents (both banks and the non-financial private sector). Then, how the benefits from debt reduction are split between creditor and debtors becomes less relevant. In particular, for debt held by (possibly troubled) domestic banks, any transfer from the government may help reduce future recapitalisation expenses linked to public guarantees.

What is the problem with buybacks? A hypothetical, but realistic, example

While caveats in the previous section may result relevant for future cases of debt buybacks, from an empirical standpoint, past buyback schemes have proven costly to debtors and typically resulted in large transfers of resources to the creditors, with little reduction in the net asset position of the sovereign. Indeed, after some such deals in the 1980s, the last decade has been dominated by more concerted/negotiated debt restructurings.

The main issue with debt buybacks is that the price of debt can be expected to rise following a debt reduction. With less debt around, what remains is more likely to be serviced. Figure 1 depicts the market value of debt as a function of its face value consistent with this.1 This relation is logical and well established empirically (Krugman et al. 1991). This price rise leads to two related, but separate, problems (Krugman 1988; Dooley 1989; Krugman et al. 1991).

Figure 1.

  • First, to the extent that the secondary market for debt is efficient and forward-looking, it is impossible for the debtor to purchase debt at the initial debt price. Instead, (barred secret buybacks) the debtor will have to pay the higher post-buyback price to be able to retire debt. To see this, let 80cts represent the price of a unit of debt prior to the announcement of repurchase, the green line in Figure 1, and 90cts the price of the same claim after debt reduction is achieved, the red line in Figure 1. Clearly, no creditor would elect to sell its claim at less than the post-deal price 90cts. So, if debt is repurchased, it will have to be at 90cts and all creditors ‒ those that sell and those that retain their exposure ‒ end up with a capital gain of 10cts per unit of debt compared to the pre-buyback situation. The problem here is that it is impossible for the debtor to bargain and negotiate with an atomistic market. The post debt reduction price, 90ct, is the only possible market outcome. (In Figure 1, this overpayment in dollar terms is depicted as the intersection of the red line with the vertical line intersecting the horizontal axis at D0).
  • Second, this increase in price implies that the reduction in marked-to-market debt is far smaller than the resources spent to achieve it. Put differently, the net asset position of the sovereign may worsen rather than improve. To see this, assume the initial face value of the debt is 100, D0, which makes the initial value of the debt at the initial price, 80cts, now $80. Let’s also assume that debt is reduced to $80, D', making the post debt reduction value (after the increase in price) $72. The resources used to buy the $20 of face value back are then equal to the actual price paid, 90cts, times the debt bought, or $18. The debtor will only be better off if the total it spends on the debt buyback, $18, and the value of the remaining debt, $72, is less than the pre-debt buyback value. This is clearly not the case: 18+72 = $90 > $80. Only if the debt is bought back at less than (80-72)/20, or 40cts, will the cash used for the debt buyback be less than the change in the market value of debt. (Essentially, this condition states that the buyback price has to be less than the marginal market value of the debt to benefit the debtor. In the Figure this is the difference between V’ and V0). In other words, even if, through a concerted agreement, the country could retire some of the debt at the initial price of 80cts, it would still find itself worse off than before the buyback. (In Figure 1, this overpayment is depicted as the intersection of the green dotted line with the vertical line intersecting the horizontal axis at D0). 

In contrast, for a government fully committed to repay its debt (but unable to signal this commitment) what matters is the face value of the debt. The value of a debt reduction would then be D0-D’, which is obviously greater than 0.9*( D0-D’). In this case, the buyback can be a good deal.

The analysis remains the same if the country finances the debt buyback with new senior debt instead of cash. Assuming the senior debt is relatively small, so it does not affect the value of the other debt claims, and always gets repaid, it amounts to the same as the debtor using its own resources. In sum, market based buybacks are likely to see such a rise in the market value of the residual debt that the gains largely go to the creditors, and there is a net loss to the country in that the net overall debt burden has risen.

What does the historical record with buyback tell us?

The Bolivia cash buyback.The best example of the pitfalls of debt buybacks is the Bolivia case (Bulow and Rogoff, 1988). In 1988, Bolivia received $34 million in cash from donors to buy back its commercial debt. The face value of all debt with commercial banks was $670 million. But it was trading on the secondary market at just 6 cents on the dollar, for a total market value of $40.2 million. Bolivia bought back $308 million in debt, pushing the price up to 11 cents on the dollar, for a total expenditure of $34 million. As a result, the market value of the remaining debt (with a face value of $362 million) rose to $39.8 million. In other words, the market value of the debt fell by only $400,000. Essentially, the marginal reduction in expected debt payments to commercial banks was miniscule, $400,000, for a payment of $34 million. From a purely altruistic donor’s standpoint, this was an inefficient use of the cash donated. Bolivia would have been better off investing it. Had Bolivia used its own funds, the country would have lost money on the scheme, as the cash/borrowing exceeded the reduction in the expected value of the payments. 

The Brady debt reductions.The Brady plan differed from simple buybacks in that the debt reduction combined some concerted (all creditors of a certain class were required to participate in the exchange) with voluntary features (each creditor could choose to exchange its old claims for various new claims from a restricted set of options). This led to lower cost as the debt reduction happened at closer to the ex-ante than the ex-post prices. For six agreements (Mexico, the Philippines, Costa Rica, Venezuela, Uruguay, and Argentina), the savings relative to a pure market approach were on average some 22.4%, or, in dollar terms, some $11.9 billion (Claessens and Diwan 1994). While creditors still gained, debt reduction was achieved at better terms than using simple market buybacks. 

Debt restructuring since the Brady deals.Debt buybacks, at least as reported, have been rare since the mid-1990s and almost all recent sovereign debt restructuring have been debt exchanges (Panizza et al. 2009). The average discount among major restructurings was 39%, varying from 75% for Argentina to 2% for the Dominican Republic. About half of the deals happened when the debtor country was in actual default and about half before default occurred, with discounts similar between the two cases. They all involved a degree of coercion, although not necessarily more than in earlier periods (Sturzenegger and Zettelmeyer 2008).Again, the experiences suggest that debt exchanges are preferred over buybacks. 

What other considerations can come into play? 

The analysis and experiences laid out likely remain important considerations for the current cases of over-indebted sovereigns. That said, several other factors need to be evaluated as well. 

First, as mentioned at the onset, the analysis in this note is based on the secondary market price being a good indicator of the final (present value) of the payments made by the debtor. Consistent with that notion, the empirical record shows that countries with low secondary market prices typically end up having debt servicing problems. As noted, however, it could that there are differences of views and information between the market and the country. Then it could be that buybacks are an effective means to signal a country’s commitment. For this to work, however, two conditions have to be satisfied.

  • One, there need to be information asymmetries between the government and the markets, i.e., there are “good” governments that cannot convince the market of their true ability and intentions.
  • Two, buybacks have to be a tool that can reveal to the financial markets in credibly way those good governments from other governments.

The first is possible, although less likely than in the case of a corporation that say wants to signal the quality of its management (there are likely few informational asymmetries when it comes to the sovereign’s ability and willingness to repay). The second will depend on a number of factors, and is hard to assess a priori, and there appears to be very few cases of countries that engaged in partial buybacks and subsequently quickly regained markets access at very favourable terms.

Second, when a significant share of sovereign debt is held by residents, from a country’s “consolidated” standpoint how the benefits from debt reduction are split between debtor and creditors may appear less relevant. Also “donors” may want to support their financial institutions that hold the country’s debt. However, even when these considerations are present, a buyback of sovereign debt (or any other asset support) has been shown conceptually not to be the most efficient way to support or recapitalise financial institutions (Landier and Ueda 2009). Also, the experiences at the height of the financial crisis show that asset purchases were regarded as costly instruments that were not well targeted given the problems at hand. Furthermore, if secondary market purchases are combined with preferred-creditor status of “donor” loans, financial instability may occur as the remaining claim-holders would face greater risk, heightening the pressure to sell.

Finally, debt buybacks or voluntary debt swaps could be used strategically. Donors may not trust the debtor country’s authorities to use non-conditional funds in a productive fashion. Donor countries could buy debt at a discount and then offer to pass the haircut on to the debtor conditional on certain structural benchmarks being achieved. Obviously, however, this strategy has to be time-consistent in that the creditor is able to leverage its conditionality this way.

This note represents the views of the authors and does not necessarily represent IMF views or IMF policy. The view expressed herein should be attributed to the authors and not to the IMF, its Executive Board, or its management.

References

Bulow, Jeremy, and Kenneth Rogoff (1988), "The Buyback Boondoggle", Brookings Papers on Economic Activity, 2:675-699.

Claessens, Stijn, and Ishac Diwan (1994), “Recent Experience with Commercial Debt Reduction: Has the "Menu" Outdone the Market?”, World Development, February, 22(2):201-213. 

Dooley, Michael (1989), "Buybacks, Debt-Equity Swaps, Asset Exchanges and Market Prices of External Debt", in Jacob Frenkel and others (eds.), Analytical Issues in Debt, International Monetary Fund. 

Krugman, Paul (1988), "Financing versus Forgiving a Debt Overhang: Some Analytical Notes", Journal of Development Economics, 94:287-307. 

Krugman, Paul, Kenneth Froot, Stijn Claessens, and Ishac Diwan (1991), “Market-Based Debt Reduction: Principles and Prospects”, World Bank Policy Research Paper 16.

Landier, Augustin and Kenichi Ueda (2009), “The Economics of Bank Restructuring: Understanding the Options”, IMF Staff Position Note SPN/09/12. 

Manasse, Paolo (2011), “Unilateral restructuring, buybacks and euro swaps: An example”, VoxEU.org, 5 February. 

Panizza, Ugo, Federico Sturzenegger and Jeromin Zettelmeier (2009), “The Economics and Law of Sovereign Debt and Default”, Journal of Economic Literature, XLVII(3):651-698. 

Sturzenegger, Federico and Jeromin Zettelmeier (2008), “Haircuts: Estimating Investor Losses in Sovereign Debt Restructurings, 1998-2005”, Journal of International Money and Finance, 27(5):780-805.


 

1 Note that this curve differs from the corporate case, where the prince (the slope of the curve) remains one. This is because in case of a sovereign debt default, creditors cannot (fully) seize a country’s assets or otherwise force the country to pay (willingness to pay being the constraint). Because of this friction, the marginal value to the creditors of resources (cash) held by the country is less than one.

 

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Topics:  EU policies Europe's nations and regions Global governance

Tags:  debt, Eurozone crisis, debt buybacks

Head of Financial Stability Policy and Deputy Head of Monetary and Economic Department, Bank for International Settlements, and CEPR Research Fellow.

Deputy Director, IMF Research Department

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