External Debt Buyback: Scorned Too Much

Abstract

Heavily-indebted developing countries that had lost access to voluntary international financing in the 1980s have been granted various forms of debt relief while also considering, and sometimes executing, repurchases of their foreign debt at deep discounts. While it is true that debt forgiveness or grants for repurchasing foreign debt will reduce that discount, debt buyback need have no such effect. The reason is that the application of international reserves, which serve as a country’simplicit collateral against external debt, to debt buyback reduces the value of the assets, and of all possible outcomes, left for international creditors. Hence the market discount on their remaining claims may either rise or fall depending on the closeness of the collateral relationship between liquid official foreign assets and less liquid foreign debt. This finding, demonstrated with rigor, refutes the claim, made in Krugman and Obstfeld’s widely-used textbook, that a self-financed debt buyback hurts the debtor country and benefits its creditors generally. It would do so by driving up the price, i.e., lowering the discount from par, of the debt that remains outstanding. Since the opposite may occur under conditions defined in the paper, categorical policy advice, for debtor countries to avoid buybacks, is unfounded.