Over my professional lifetime, debt has played a contradictory role in global economies—glorious to ignominious. I find this puzzle fascinating, and it prompted me several decades ago to put debt at the top of my research agenda.
In the 1980s, sovereign debt defaults in Asia, Latin America and eastern Europe precipitated the biggest sovereign debt crisis the world had ever seen. In the 1990s, we saw debt and currency crises in Mexico, Brazil, Turkey and Russia. In 2008, US household mortgage debt triggered a global financial crisis, which spilled over into sovereign debt crises in half-a-dozen western European countries.
US sovereign debt also played a central role in creating the infamous “global imbalances” of the 1980s and 90s, whereby China, the oil-rich countries of the Middle East, and, to a lesser extent Germany and Japan, lent massive sums to the US.
Now, in 2016, we live in a dangerous aftermath. Global imbalances compounded by the 2008-2010 global financial crisis and stagnation in western Europe led to persistent very low interest rates in the US, Japan and western Europe. These, in turn, led to low rates in the developing world. All that will change as the US gradually raises interest rates.
Moreover the sources of a global savings glut are drying up: from the Middle East as the oil price plummets, from China as its growth rate grinds down, from Europe as Germany struggles fiscally to accommodate two million refugees, and even from Japan as it struggles to maintain an export surplus.
A range of developing countries are in peril from the shrinking savings glut, compounded by the likelihood of capital outflows to the US. Brazil and Turkey top the list.
India, on the other hand, is relatively un-indebted, is beginning to deal responsibly with bad bank debt, still has lots of room to lower interest rates, runs a very small current account deficit and a reasonably small fiscal account deficit, enjoys a freely floating exchange rate, and, most importantly, can expect the world’s highest growth rate among large economies in 2016. Thus, India can avert some of the problems that developing countries like China and Thailand may face, and even developed economies like South Korea and Singapore: countries not in danger of financial crises but that will be tempted to ignore or subsidize bad bank debt because of fears that that unprofitable firms will shut down and shed jobs. China’s bank balances and debt accumulation are spiralling towards trouble; India’s are not. This is perhaps testimony to how India’s democracy and rule of law are paying off economically.
In short, India tops the list of emerging economies least in peril. Some quick further comments on India’s monetary and financial policies. Particularly since the appointment of Raghuram Rajan in the fall of 2013 as governor of the Reserve Bank of India, India’s monetary policy has been enlightened. The double-digit inflation of 2013 has been brought down below 5%. The Reserve Bank has implemented inflation-targets, but nevertheless has had room for interest rate reductions because relatively high inflation targets —above 5%—are reasonable for an economy growing rapidly in the face of structural rigidities.
Crucially, the bank and the Modi government are seriously engaging with the on-going problem of non-performing loans at India’s banks. The strategic debt restructuring scheme—a procedure whereby banks can swap debt for equity—has been implemented. A bankruptcy code has been drafted, and recently presented for comment. We can hope that India’s banks neither fail nor stagnate as did Japan’s in the 1990s, and Europe’s in the 2000s.
Over three decades of working on bad debt and its resolution, I have come up with three rules of thumb, known as Dean’s Paradoxes of Debt.
- The best way that creditors of bad debt can maximize their expected re-payments is to forgive a optimal portion of the bad debt.
- Debt burdens are best relieved by fiscal profligacy, not austerity.
- High debt loads are not necessarily disastrous: Britain’s debt load was nearly 200% of its GDP for fifty years after the Napoleonic Wars, yet it prospered as never before or since. And in modern times, Japan’s debt load exceeds 200% yet it continues to prosper – not grow very much, but not shrink either. What debt in Japan does, via continuous fiscal deficits, is effectively re-distribute income from domestic savers toward the world’s best infrastructure and the rich world’s most equitable distribution of income.
Let’s start with the first paradox: in short, it says that if you’re carrying bad debt, you’re better off to forget and forgive than you would be if you bore down and squeezed out the last penny.
In August 1982, Mexico shocked the world’s biggest banks by defaulting on its debts. Like now, oil prices had collapsed and oil exporters like Mexico were in trouble. Unlike now, interest rates were sky-high: LIBOR had hit 20%. Like now, the US dollar was rising and of course, like now, most foreign debt was denominated in US dollars. Mexico had been living high off the hog by borrowing, and now its foreign debt service payments were unsustainable, compounded by its shrinking export income. President Portillo appeared in tears on TV and resigned. Within one month most of Latin America was in default and the so-called international debt crisis had begun.
The remedies proposed by the creditor banks and creditor countries were eerily reminiscent of what Northern Europe has been trying to impose on Southern Europe since 2009: demands for full repayment, but financed by more and more lending—souring an already sour pot by putting more and more money into it, with that Greece’s debt to GDP ratio is now higher than it was in 2010.
Back to the debt crisis of the 1980s. After seven years of throwing good money after bad, and raising Latin America’s debt load from $300 billion to more than double that, the First Paradox of Debt was finally implemented. Two academic economists (Jeff Sachs and Paul Krugman) convinced a government economist (Paul Volcker) that debt write-offs—the opposite of more lending—would be win-win for both debtors and creditors. In short if bankers could agree to coordinate debt write-offs, they would be better off than if they postponed the inevitable by lending more money.
But coordination between bankers was key, because otherwise, if, for example, Chase Manhattan wrote off debt claims on Brazil but Citibank didn’t, Citibank could effectively free ride on Brazil’s improved ability to pay due to Chase’s write offs. So the key to success was for the public banker (Paul Volcker) to persuade a powerful private banker to persuade the world’s biggest banks to coordinate their write-offs.
So Paul approached Bill Rhodes, a senior vice president at Citibank. Bill mobilized the 15 biggest banks in the world into a “Core Bank Committee”: the culmination was that they engineered massive write-offs of bank claims on sovereign debt, starting with Mexico in 1989 and continuing through 1995 with 24 other countries world-wide, not least the Philippines and Poland and other ex-communist countries. After seven “lost years”, Latin America boomed.
When India almost ran out of reserves in 1991, then-finance minister, Manmohan Singh, triggered reforms that saved the day.
When Mexico hit the wall again in early 1995, a swift and slightly illegal short-term loan engineered by president Bill Clinton quickly turned the country around.
When much of East Asia was in debt crisis in 1998, Thailand, Malaysia, and South Korea rebounded with renewed growth.
None of this has happened in Western Europe since 2009. Unlike 1988, Europe had no Paul Volcker at the head of the European Central Bank. Nor did Europe produce a Bill Rhodes to coordinate private banks to provide write-offs. Had the Eurozone and Europe’s big banks simply written off Greece’s debt in 2010 and walked away from further lending, contagion to the rest of Southern Europe could have been avoided, and Europe’s banks could have comfortably re-capitalized.
And had the EU encouraged fiscal stimulus rather than fearful austerity, Europe’s largest indebted economies—Italy, Spain and, yes, France—would not be dragging down the Eurozone the way they are now. That then leads to Dean’s Second Paradox: Debt burdens are best relieved by fiscal profligacy, not austerity.
Before moving back to India, it is important to take a moment to abstract from the last decade of sovereign debt crises, and reiterate the three Paradoxes.
- When debt turns sour, it is better to forgive and forget. More precisely, with optimal write-offs, both creditors and debtors can be made better off. This paradox holds for private debtors as well as sovereign debtors (that is, for company and country debtors), as long as they are simply illiquid rather than insolvent. Sovereign debtors are never insolvent in the long run because they have the power to tax.
- When sovereign debt turns sour, belt-tightening (“austerity”) is generally a bad idea not a good one. Because countries can never be insolvent in the long run, it make sense to keep them alive rather than starve them. This could be called “The Principle of the Golden Goose”: when it is ill and stops laying golden eggs, the farmer is wise to feed it well and wait for it to recover rather than slaughter it for supper.
In the language of macroeconomics, deficit or even money-funded growth is usually wiser than forcing repayment of bad debt on schedule. The debt-to-GDP ratio is better brought down by increasing GDP than by repaying debt.
- High ratios of debt-to-GDP may not be crippling. Classic examples are Britain’s huge foreign debt burden in the first half of the 19th century, after the Napoleonic Wars, and Japan’s currently huge domestic debt ratio right now.
Of course there are many counter-examples: India’s foreign debt became unsustainable in 1991 because export revenues were not sufficient to finance outflows for imports and debt service. The rule of thumb for whether a country should or should not take on more sovereign debt is whether the expected returns on domestic debt exceed the rate of interest paid to the lender, hedged against currency risk if the debt is denominated in foreign currency.
Paradox 1 suggests that a new bankruptcy code is crucial. Indeed, the draft code looks sound, emphasising as it does three principles:
a)Ranking of borrowers according to “seniority”, with the ex ante understanding that junior creditors may never be repaid.
b)Relegation of decisions about attachment of collateral and/or write-offs to bankruptcy courts rather than reliance on very slow and ad hoc passage through regular courts.
c)Broadening of sources of credit beyond the banks to debt markets. The latter is crucial. It has already begun with the introduction of tradability to government debt, but the domestic market for commercial debt is still in its infancy.
Paradoxes 2 and 3 also contain lessons for India. The current debate about a sound upper limit for the fiscal deficit is premised on a fear that deficits will be either inflationary or will accumulate to an unsustainable debt load. The Reserve Bank under Rajan is unlikely to bow to pressure to print money in order to fund government debt. Moreover the new tradability of such debt will lower borrowing costs. In any case, India’s deficit is under 4%, modest by international standards, as is its debt-to-GDP ratio.
On balance, I would argue in the upcoming budget for upper-limit fiscal stimulus, given potential contagion from slow growth in China, Europe and even the US, and also because India’s GDP growth is still well below inflationary capacity. I would argue further for financing it via a de-regulated domestic government bond market rather than government-owned banks. This would likely inject stimulus more quickly than waiting for the banks to cleanse their balance sheets of bad debt. The government’s plans to speed up approval of infrastructure projects are wise and welcome.
Perhaps controversially, I would suggest edging away from India’s legacy Public Private Partnership toward traditional government-owned infrastructure such as roads, railroads and clean power, subsidized if necessary on the grounds that the long term externalities could be huge. And of course projects like these would underpin the Modi government’s “Make in India” program to foster labor-intensive enterprise.
This briefing paper is based upon a seminar given at IDFC Institute in January 2016.