IMF WORKING PAPER i 1990 International Monetary Fund. This is a working paper and the author would welcome an> commenis on the present text. Citations ...
IMF WORKING PAPER i 1990 International Monetary Fund
WP/90/77
This is a working paper and the author would welcome an> commenis on the present text. Citations should refer to an unpublished manuscript, mentioning ihe author ami the dale of issuance by the International Monetary Fund The views expressed arc those of the author and do not necessarily represent those of the Fund
INTERNATIONAL MONETARY FUND Research Department Debt Overhang, Debt Reduction and Investment: The Case of the Philippines Prepared by Eduardo Borensztein* Authorized for D i s t r i b u t i o n by Mohsin S. Khan September 1990
Abstract While there i s a substantial body of l i t e r a t u r e on the effects of "debt overhang" on investment i n heavily-indebted countries, there i s surprisingly l i t t l e empirical work available on this subject. This paper tests the hypothesis that the stock of foreign debt acts as a disincentive to private investment i n the s p e c i f i c case of the Philippines. The empirical estimates provide support for this hypothesis, p a r t i c u l a r l y after 1982. The estimates indicate that a $1.3 b i l l i o n debt reduction (such as the one completed through the buyback operation i n early 1990) would increase investment demand by something between one half and two percentage points of GNP,
JEL C l a s s i f i c a t i o n Numbers: 121, 433
*I would l i k e to thank U l r i c h Baumgartner, Mohsin S. Khan, Peter Montiel and the participants in a Research Department Seminar for many useful discussions and comments.
- ii Contents I. II. III.
Introduction
V.
1
An Application to the Philippines: Private Investment and Debt: 1. 2. 3.
IV.
Page
Some Background
Empirical Estimates
3 5
Investment function Measuring the effect of foreign debt Debt reduction and macroeconomic variables
5 9 12
a. b. c.
13 13 15
Production function Private consumption The effects of debt reduction
Interest Parity and the Secondary Market Price of Debt
16
Conclusions
19
Chart 1 Chart 2
Philippines Philippines:
Effect of Debt Reduction
Table 1 Table 2 Table 3
Philippines: Philippines: Philippines:
Investment Ratios and Growth Rates Estimated Debt Overhang Effect Simulation of Debt Reduction
References
4a-4b 16a 4 11 17 21
I.
Introduction
The poor investment and growth performance of the highly indebted countries i n the past few years i s frequently attributed, at least to some extent, to the burden of their foreign debt, a phenomenon which has been termed the "debt overhang." Basically, the debt overhang hypothesis states that the accumulated debt act as a tax on future output, discouraging productive investment plans of the private sector and adjustment e f f o r t s on the part of governments. In a sense, foreign debt acts l i k e a tax when the debt s i t u a t i o n i s such that an improvement i n the economic performance of the indebted country has the side product of higher debt repayments; that i s , creditors receive part of the f r u i t s of increased production or exports by the debtor country. 1/ Despite the many persuasive theoretical arguments put forward for the debt overhang hypothesis, there has been remarkably l i t t l e empirical e f f o r t to test i t . 2/ Most empirical evidence at present consists of either the observation that i n debtor countries there has been a decline of investment coincidentally with the onset of the debt c r i s i s , or of investigations of the cross-country r e l a t i o n between levels of debt and the market price of debt i n secondary markets, as i n Cohen (1988), and Froot and Krugman (1990). 3/ A shortcoming of this type of empirical analysis i s that i t does not control for the effect of other factors affecting both economic developments and external debt, or for the endogeneity of foreign debt. For example, adverse shocks could cause a drop i n domestic investment, a deterioration i n economic performance, and an increase i n foreign debt.
1/ There i s by now an extensive l i t e r a t u r e on the debt overhang hypothesis, Important theoretical contributions in this area have been made by Dooley (1986), Krugman (1988), Sachs (1989), Froot (1989), and Calvo (1989). A" review with empirical applications can be found i n Froot and Krugman (1990) 2/ There are also theoretical counter-arguments against the debt overhang hypothesis, and models i n which debt may have an at least ambiguous effect on e f f o r t , as in Helpman (1989), where the ambiguity comes from income and substitution effects, and Aizenman and Borensztein (1989) where the ambiguity arises from strategic consideration i n a game - theoretic framework. 3/ An exception i s the recent paper by Cohen (1990), where the author estimates the extent to which the trade balance turnaround of 1982-87 was obtained through the crowding out of productive investment. Contrary to this paper, the estimates obtained by Cohen (1990) are based on cross-sectional reduced-form regressions.
- 2Attributing the negative economic developments to the debt overhang would obviously not be a correct inference. 1/ This paper attempts to test the existence of a debt overhang effect directly for one heavily-indebted country--the Philippines. The strategy is to estimate a standard neoclassical investment demand function, and then add a term representing the extent of debt overhang and test i t s significance. In this way i t i s possible to obtain a measure of the impact of the debt overhang that i s not tainted by other influences. For example, policy actions and/or economic conditions may cause increases i n real interest rates which may be responsible for the drop i n investment. Although such increases in interest rates may be in some way related to the debt overhang situation, this approach attempts to isolate the reduction in investment stemming directly from the potential taxation due to foreign debt rather than from interest rate effects. Therefore, the estimation provides a differentiation between general macroeconomic conditions and the direct debt overhang effect. This differentiation is of c r i t i c a l importance in guiding policy measures to reactivate investment. Complementing the estimation of the investment function with estimates of production and consumption functions, i t i s possible to simulate the general equilibrium-- direct and indirect--effects of debt reduction policies. This i s done with the aid of a Solow-type growth model, extended to the case of an open economy. In addition to ameliorating the disincentive to Investment created by the debt overhang, debt reduction makes more foreign savings available to augment the domestic resources available for investment. Both the direct and indirect effects of debt reduction are incorporated i n the model simulations. There might be, however, a more subtle way i n which foreign debt discourages domestic investment. This would be the case in which there Is perfect capital mobility, and the claims on the country held by commercial banks are close substitutes of domestic claims in the debtor country. One would then observe that the required contractual yield on foreign debt (that which results from considering the prevailing discounts on secondary markets for international debt) would equal the required contractual yield on domestic debt contracts. While i t would not be possible to detect a debt overhang effect with the above methodology, i t i s clear that debt reduction, by changing the market discount, would have a definite and immediate effect on domestic investment. The paper also tests empirically this framework for the sample period for which data on prices for debt in secondary markets are available. While the estimates obtained in the paper are only for the Philippines, the model i t s e l f has general applicability to other indebted countries as well. Also, as the results provide one of the few direct tests of the adverse effects of debt overhang on private investment, they
1/ See Sachs (1990) and Bulow and Rogoff (1990) for contrasting Interpretations of the causality between debt and economic performance in highly-indebted countries.
- 3have a bearing on the overall v a l i d i t y of the hypothesis, and thus on the s o c i a l p r o f i t a b i l i t y of debt-reduction schemes that have been put forward in both academic and policy making c i r c l e s . The plan of the remainder of the paper i s as follows. Section II provides some factual background on the foreign debt problem of the Philippines. Section I I I introduces the investment function and outlines the estimation results which are then used to simulate a macroeconomic model that i l l u s t r a t e s the impact of debt reduction. Section IV tests interest parity conditions with and without the inclusion of secondary market prices of debt. Some conclusions are offered in Section V.
II.
An Application to the Philippines:
Some Background
In terms of casual empiricism at least, the debt overhang story appears to have a good a p r i o r i case in the Philippines. The Philippine economy had shown steady growth and high investment rates i n the Post-War period, comparable to several of i t s successful Asian neighbors. Foreign debt accumulated rapidly, however, and i n 1982-83, as the country ran into economic d i f f i c u l t i e s and suspended payments on foreign debt, private and public investment collapsed, with t o t a l investment to GNP f a l l i n g by as much as 10 percentage points. Although GNP growth rates have returned to h i s t o r i c a l levels since 1986, investment remained very depressed and only recovered b r i s k l y i n 1989, Coincidentally, i n 1989 the debt situation appeared to look brighter, as the Philippines was on the verge of completing a buyback of part of i t s outstanding private bank foreign debt in the context of the Brady i n i t i a t i v e . Moreover, private investment growth accelerated i n 1989 after some more modest gains i n 1987-88. The long-run trends on growth and investment i n the Philippines are summarized i n Table 1 and Charts l a to Id. The overall investment: to GNP ratio had been moving steadily up from 15 percent i n the f i f t i e s to over 25 percent, before collapsing to an average of 13.5 percent i n 1985-87. Even discounting the increase i n investment of the late seventies, which derived mainly from a sharp increase i n public investments whose economic efficiency has been widely questioned (see, for example, D'Aquila (1987) and Dohner and Intal (1989)), the level of investment as of 1988 was s t i l l pretty low relative to the more normal periods of the s i x t i e s and early seventies. The recovery of investment i n 1989 brings I t to a level similar to h i s t o r i c a l values. The growth rate remained r e l a t i v e l y steady at about 5-6 percent per annum before the c r i s i s years of 1983-86. Population growth was on a declining trend from 3,0 to 2.5 percent during this sample period. Technological progress may be responsible for another 1-1 1/2 percentage points of annual growth on average, with the remainder being attributable to the growth of fixed c a p i t a l . 1/ As the data show, the Philippine
1/
See Section IV.
- 4Table 1 Philippines:
Period
Investment Ratios and Growth Rates
Investment/GDP
GDP growth rate
1951-60
13.9
6.5
1961-70
16.8
5.2
1971-80
20.5
6.2
1981-89
18.3
1.6
1951-55 1956-60 1961-65 1966-70 1971-75 1976-80 1981-85 1986-89
12.6 15.2 16.0 17.6 17.6 23.5 20.2 14.0
8.2 4.8 5.2 5.1 6.1 6.2 -0.5 4.5
Source:
National Income Accounts of the Philippines.
Chart 1 Philippines 12.0
12.0
a. LOG(GDP) 11.5
11.5
11.0
11.0
10.5 '-
- 20.5
10.0
10.0
9.C
9.0 50
1 1 i \ I \ I 1 1 .1 f 1 t I f 1 I [ I ! 1 1 I I I ' i 9.0 5 2 54 5 6 5 8 6 0 6 2 64 6 6 6 8 7 0 7 2 7 4 7 6 7 8 8 0 8 2 84 8 6 8 8 0.2G
0.26
b.
Investment/GDP
0.22 y
-i 0.22
0.18 y
0.18
1 50
52
1 ) I 1 I I 1 1 J I I I 1 I I I 1 t 1 1 1! 54
56
58
60
62
64
66
68
70
72
1 1 I 1 1 ! I I I 1 I 1 1 1 74
76
78
80
B2
84
86
88
0.10
Chart l(contd.)
Philippines 0.20
0.2U
c. Private Investment/CDP 0.18
- 0 18
r
0.16
- 0.U1.
0.14 -
i 0 14
0.12 L
L
50
52
54
56
58
GO G2
64
66
68
70
72
74
1 1 !
76
78
! ]
80
62
84
86
cL Azbtic Investment/GDP
0.0 1 :
0.00 50
0 01
0.00 52
54
50
58
60
62 64
66
68 70 72 74
76 78
BO
82
84 86
- 5economy has proven f a i r l y resilient to downturns since the Post-War years to the debt-crisis years. This casual empiricism, however, i s not sufficient to establish causality between debt problems and economic performance. Early in 1990, the Philippines concluded a buyback operation with i t s commercial creditors, under the auspices of the Brady i n i t i a t i v e . This was the f i r s t stage of a proposed two-stage operation, and included both the cash buyback and new money offers from commercial banks, A second round of debt reduction operations w i l l take place at a later stage. The total resources made available by multilateral and bilateral agencies for cash buyback and "enhancements" of new debt securities are estimated at $1.5 b i l l i o n of which $650 million were used i n the f i r s t stage buyback. The amount of commercial bank medium- and long-term debt eligible for the debt reduction operations was about $ 7.0 b i l l i o n . Market reaction to the debt reduction plan was very positive. Philippine debt was trading at about 36 cents per dollar in early March 1989, prior to the announcement of the Brady i n i t i a t i v e • By mid-April the price had climbed to 46 cents and by mid-May to around 50 cents, where i t stabilized. The buyback was carried out at a price of 50 cents. This positive reaction is not surprising, since the value of claims on the Philippines should be favorably affected by the debt reduction i n i t i a t i v e on two accounts: f i r s t , the $ 1.5 b i l l i o n provided by third parties should increase, to some extent, total expected payments to Philippines commercial creditors; and second, the expected improvement in investment and growth resulting from the reduction in total contractual obligations should also improve repayment prospects. III.
Private Investment and Debt:
Empirical Estimates
This section presents the specification and estimation of an investment function used to test the debt overhang hypothesis for the Philippines. This investment function i s then incorporated in a general equilibrium framework to simulate the effects of debt reduction schemes. 1.
Investment function
The investment function i s formulated along the lines of the neoclassical "q" model, which derives the investment decision of a representative firm from profit maximization over an infinite time horizon. This implies that investment is a function of the increase in profits that: i t may bring about and of i t s cost, which comprises the direct purchasing cost of the capital goods and associated adjustment costs such as resources spent by the firm in planning and putting into operation the new capital units, disruptions of the productive process, etc. Since capital is long-lived--it depreciates only partially every period--the present value of the increase in profits must be computed. In this present value computation, the firm uses the cost of capital that is determined in
- 6financial markets; this expected discount rate w i l l be taken as exogenous in the formulation. 1/ Thus, the investment function can be derived from the maximization of the following function:
P(K (1) V(Kt') = max
/ *• i=0
s.t. where P(K
,1
K
t+i
, R t+i
= (l-S)K
t
+ I
t
) is the level of profits obtained by the firm in period
til
b'l
t+i, 2/ K is the capital stock, I is investment spending, R i s the appropriate discount factor, and S is the depreciation rate of capital. V(K ) represents the market value of the firm in period t, The discount t
factor R
discounts flows from period t+i back to period t using the
expected cost of c a p i t a l corresponding to such periods, that i s , i
R
t+i
j = 1
i+T
where the r's are the one-period expected rates of return demanded by financial markets from this firm. The above maximization problem yields an investment function of the following form 3/ ma
(2)
i rm
a
ipI
+
a
2 E Y ^~o ^t+j)
M
t+i
i=0
where p is the (relative) price of investment goods, E is the mathematical expectation operator, fi is the relevant discount factor, and M is the marginal product of capital. The discount factor f} is given by: t+i
1+r t+i
1/ This formulation and estimation generally follows that of Abel and Blanchard (1986). 2/ This s p e c i f i c a t i o n excludes the effects of other productive factors that may be used. However, this s i m p l i f i c a t i o n does not a l t e r the derivation of the investment function, 1/
For more detailed derivations see Abel (1988) and Shapiro (1986.)
with 5 and R as defined above. To f a c i l i t a t e estimation, a linear approximation to the right hand side of (2) i s taken, which yields the following
where M and /? are the values of M and /? around which the approximation i s taken. Two problems must be solved to obtain an estimable form of equation (3). The f i r s t i s to obtain measures of the marginal product of capital and of the expected real interest rate, and the second i s to compute the value of the i n f i n i t e sums of future marginal products of capital and discount factors. The marginal product of capital was taken to be equal to the average product of capital, which is measurable. 1/ The expected real Interest rate series was constructed by obtaining a prediction of the Inflation rate using lagged i n f l a t i o n and the current nominal interest rate. The i n f i n i t e sums were computed applying the Hansen and Sargent (1981) methodology, making use of a prediction formula for future values of the marginal product of capital and of the expected real interest rate inferred from the application of standard Box-Jenkins (1976) time-series techniques to those two variables. The marginal product of capital i s thus measured as;
where a i s the share of labor i n GNP and Y is GNP. obtain expected i n f l a t i o n i s the following 2/
The regression used to
1/ This equality is an implication of profit maximization under constant returns to scale. 2J
In a l l regressions, the values reported in parenthesis below the
estimated coefficients are their respective standard errors; R i s the adjusted coefficient of determination; DW i s the value of the Durbin-Vatson s t a t i s t i c ; Rho i s the coefficient of first-order autocorrelation of the error term; and the Durbin-h i s the value of the test s t a t i s t i c for autocorrelation in models with lagged endogenous variable.
(5)
- 0.042 (0.043)
n
Sample: 1956-1988; Rho - 0.69 (0.16)
0.440 n( (0.143)
0.018 1 (0.003)
R 2 - 0.52
where Jl is the rate of inflation (GNP deflator) and i i s the interest rate (one-year Treasury B i l l s . ) From an examination of the time series properties of the marginal product of capital and the expected real interest rate, the following time-series processes were identified;
(6) M Sample:
(7) Sample:
-
0.016 + 0.80 M ( - l ) (0.005) (0.062)
1951-1988;
r
Durbin-h
= 0.03;
R 2 - 0,82
0.031 + 0,229 r (-1) (0.009) (0.181)
1958-1988;
Durbin-h
0.14
R 2 - 0.02
Notice that, i n contrast ot the process followed by the.marginal product of capital, the expected real interest rate process i s very nearly a constant plus a white noise residual. This lack of variance in the real interest rate creates, as w i l l be seen, considerable d i f f i c u l t y i n estimating accurately i t s effect in an investment function. The identification of the above processes implies that one term in the marginal product of capital and one term in the expected real interest race is a l l that i s necessary to forecast any future value of those two variables conditional on information currently available. 1/ This means that a reduced form of equation (3) requires the inclusion of one lagged term in the marginal product of capital and the current term in the expected real interest rate. This specification produces the following estimates
1/ The timing convention is that information available as of time t-1 includes the value of the marginal product of capital at t-1 and the value of the expected real interest rate at time t. The expected real interest rate at time t requires knowledge of the nominal interest rate for time t (which i s known at the end of period t-1) and the forecast of inflation for period t, which i s conditional on variables that are a l l known as of period t-1.
- i
(0.046) !
195?-1981;
(0.034) DW - O.?9
(0.331)
(0.106)
R 2 « 0.52
regression results art r e l a t i v e l y good, A i l the coefficients havi* the right a l p i , although th« c&»f£ici«iTit oa the r « t l interest r«t« is HOG •Ignifleant, ftowrar, the low value of the Durbin-Wntften t c a t i e c i c sows m L n p e c i f i t ^ t t e n problem, There «r« a number of reasons »ay eani# an #qu^t£«ri &uch as (fl) to be fGlsspticifiBd* hue tins presumption here is that an omitted variable, T^fxesenling the debt blem! Is th* malm ptason, In addition, a global test of Lht cat) bs ftlstairaed by exploiting the Inttf*" atn4 cfa^s-^qvattom r e s t r i c t i o n s on the values of tihe parameters that arise from the overlap between the co«ffleiaTitB i n ©qpaticin (6), (7) * and ( S ) . Tha result is m f a i l u r e to Reject dhe^e parameter t e s t r i e t i o n s , The value of thfl c h i s t a t i s t i c C2 decrees of freedom) is 2.72, 1/ Measuring the »ffee: of foreign debr ©eenemlc literature has t4*ntlfi*4 senjiral dir«ct and Indirect channels through which a large foreign deb: affects productive investment nogactvply: che ""debt p^'echstig11 eiffBEt^ whl.cli c^fors to the radncciJ incentives to invest; th* high domestic r#al interest rates &UB to the to international credit; the Ifiw p r o f i t a b i l i t y du^ to a activity; the aecrtmie in public inveatoeTit th»t Is to prLvac* lm^stmenfc, ate, Host of th«&fe efftpeca tx* c^^tvred bj ch» expi&nstory varinbiipii in the regress ton, such m real iRt#r#&fe rat* and tht «sp#ettd nsrglntl p r o f i t a b i l i t y M investment. However, the pr«suraflbly string incentiv* problem associated vlch the d*bt ov^irhAn^ #ft#ct ffl#y l a r i t l y etcapt the msttnate^ e^nnti«", because It Is in larg* measure' associated with expectations aljout future events. A iimpl# appr#ieli to Inc^rporace the debt, overhang effect: i n tht t^natlon ^^s followed, From the potrjt D£ wimw of a chf dtht overhang cao bft erAOsLatid into the poteftt In fch* present value of) r.5>;;iMon which w i l l fcu^ainc :'^:essify to foreign dtbt. Thtrefort^ the dofct to CKP m t l o csuid be an uppr^ i:k;isure of the magnitude, of (the pras^nt value of) taxation that would b# !:ecoss:ii'V to n]>::iin L.he L"equir*d resources. Ber.:Lis^ by equation iuvnutiKint Is a funcclon fi»f c i ^ pfpstitt valiift dt il*C p r o f i t s , ti» of a d#bc \*aviablt In the regression i s a l l that is necessary. This
