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Forgive or Buy Back: An Experimental Study of Debt Relief

Forgive or Buy Back: An Experimental Study of Debt Relief. Vivian Lei, Steven Tucker, and Filip Vesely. Motivation. Bono, Brad Pitt, the Dalai Lama, the late Pope John Paul II, …, and the Jubilee Debt Campaign

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Forgive or Buy Back: An Experimental Study of Debt Relief

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  1. Forgive or Buy Back: An Experimental Study of Debt Relief Vivian Lei, Steven Tucker, and Filip Vesely

  2. Motivation • Bono, Brad Pitt, the Dalai Lama, the late Pope John Paul II, …, and the Jubilee Debt Campaign • Call for 100%cancellation of the massive external debt owed by the world’s poorest countries. • Demand an end to “the scandal of poor countries paying money to the rich world”. • “I encourage you in your advocacy for total debt cancellation for poor countries because, frankly, it is a scandal that we are forced to choose between basic health and education for our people and repaying historical debt.” (President Mkapa of Tanzania, 2005)

  3. Motivation

  4. Motivation

  5. Motivation • HIPCs has received significantly more capital inflow in the form of new lending and foreign aid than their debt service. • Capital outflow in the form of debt service: 3% of the GDP • Capital inflow in the forms of new lending and aid: 15% of the GDP • Reducing poor countries’ heavy debt burden has always been on developed countries’ agenda since 1970s. • The Paris Club • Rescheduled payment deadlines for 81 countries between 1976 and 1988 • The Brady Plan • Reduced US$60 billion of debt for 16 middle-income countries during the early 1990s. • The HIPC (Highly Indebted Poor Countries) Initiative • Reduced US$37 billion of debt for 30 HIPC countries by the end of 2005.

  6. Motivation • Question 1: Will debt relief really help poor countries and also benefit their creditors? • Krugman (1988): Yes, as long as a debt overhang is present. • Debt overhang: • The expected present value of a country’s future resource transfers is less than its debt. • Impede investment and growth and thus increase the probability of a default in the future. • Decrease the expected value of repayments.

  7. Motivation • Question 2: Which debt relief scheme is best to relieve debt burden? • Krugman (1989): • Compare debt forgiveness vs. more market-based schemes such as debt buybacks • Forgiveness: a once-and-for-all reduction in the future obligations of a debtor country • Buyback: allows a debtor country to buy back its own debt at a discount • As long as the debtor country is initially on the downward-sloping side of the debt Laffer curve, both creditors (acting collectively) and debtors should be indifferent, in expected terms, between the two schemes.

  8. Motivation • Question 3: What does the empirical literature say about the efficiency or effectiveness of different relief schemes to solve for the problem of debt overhang? • Not much. • Most empirical studies aim to investigate if debt overhang really exists. • Regress growth rate of GDP/investment on debt stock/flow, using linear/nonlinear specifications and various techniques to control for endogeneity. • Results are far from conclusive. • No study has compared the relative effectiveness of different relief schemes because developed countries use the case-by-case approach to deal with poor countries’ debt problems.

  9. Objective • To investigate the effectiveness of debt forgiveness and debt buybacks in the presence of debt overhang in the lab. • Study the impact of different relief schemes on • creditors’ behavior • How much debt are creditors willing to reduce? • debtors’ behavior • How much effort are debtors willing to exert to improve their economic conditions? • expected payoffs of both sides

  10. Design • 2x2 design: treatment variables are • Relief scheme • Debt forgiveness • Debt buybacks • Number of creditors • One creditor • Two creditors

  11. Design • 4 Treatments: • Forgiveness/1 creditor • Buyback/1 creditor • Forgiveness/2 creditors • Buyback/2 creditors Due to project overhang!

  12. Numerical Example • Consider a risk-neutral debtor country • Inherits a nominal debt of $120, which is greater than its current resources, $40. • Has a chance to invest and, with some uncertainty, generate more income in the future. • With probability p, the investment succeeds and the debtor receives extra $80. • With probability 1-p, the investment fails and the debtor receives nothing. debt overhang

  13. Numerical Example • Consider a risk-neutral debtor country (cont’d) • Incur cost to strive for the extra income. • The cost function, e(p), is a convex function of p. • Decision needs to be made: • How much effort it is willing to exert (how much cost it is willing to incur) in order to generate extra $80? • Decision variable: p (or equivalently effort cost e)

  14. Numerical Example • Suppose there is no debt relief. • How much is the expected value of debt repayment (EV)? • EV ＝ p (40＋80)＋(1－p) 40 ＝ 40＋80p • How much is the debtor’s expected payoff (EU)? • EU ＝ 40＋80p－EV－e(p) ＝－e(p)≦0 • There is no incentive for the debtor country to undertake any investment (political or economic reform) when they have to repay a full amount.

  15. Numerical Example • Consider a two-stage game in which creditor countries, acting collectively, are willing to reduce some debt. • Stage 1: The representative creditor decides how much debt, if any, will be relieved. • Debt forgiveness: decide the amount to be forgiven (F＜80) • Debt buyback: decide the price (P＜1) at which the creditor is willing to sell for each dollar of the debt claims • Stage 2: The debtor chooses the effort level, represented by p, that would generate the extra income.

  16. Numerical Example • Debt forgiveness • How much is the expected value of debt repayment (EV)? • EV ＝ p [40＋(80－F)]＋(1－p) 40 ＝ 40＋p (80－F) • How much is the debtor’s expected payoff (EU)? • EU ＝ 40＋80p－EV－e(p) ＝pF－e(p)＞＝＜0 • e(p):

  17. Numerical Example • Debt forgiveness (cont’d) • Expected payoffs unique Pareto-dominant subgame-perfect equilibrium

  18. Numerical Example • Prediction for debt forgiveness: • F ＝ 40 (the amount of relief) • p＝ 30% • EV ＝ 52 • EU＝ 5

  19. Numerical Example • Debt buybacks • The debtor country benefits by buying back as much debt as possible. • If P is relatively high, then the debtor would spend all $40 of its current resources to buy back 40/P amount of debt. • Example: If P＝0.5, then the debtor would be able to buy back 40/0.5＝$80 at a total price of $40. • Remaining debt ＝ $120－$80 ＝ $40 • Amount of relief ＝ $80－$40 ＝ $40 • If P is relatively low, then the debtor would spend 120P to buy back all $120 of the debt. • Example: If P＝0.2, then the debtor would be able to buy back all $120 of debt at a total price of $24. • Remaining debt ＝ $0 • Amount of relief ＝ $120－$24 ＝ $96

  20. Numerical Example • Debt buybacks (cont’d) • How much is the expected value of debt repayment (EV)? • EV ＝ 40＋ p(120－40/P) • How much is the debtor’s expected payoff (EU)? • EU ＝ p[80－(120－40/P)]－e(p) ＝ p(40/P－40) －e(p)＞＝＜0

  21. Numerical Example • Debt buybacks (cont’d) • Expected payoffs unique subgame-perfect equilibrium

  22. Numerical Example • Prediction for debt buybacks: • P ＝ 0.5 • Amount of relief ＝ 40 (the same as F under the forgiveness scheme) • p＝ 30% • EV ＝ 52 • EU＝ 5

  23. Some Experimental Features • Each session consisted of 16 subjects. • Randomly assigned 8 subjects to be debtors and 8 to be creditors. • Subjects interacted with each other via the computer for 20 periods. • Random matching protocol: • Subjects were re-matched every period. • Zero probability of being matched with the same counterpart for two consecutive periods.

  24. Available Data • 6 sessions (3 for each treatment) which lasted about two hours • 96 subjects • 960 observations • Average earnings: NZ$25.41 (roughly US$17.64) • Creditors: NZ$40.90 • Debtors: NZ$ 9.93

  25. Result 1: Amount of Debt Relief Forgive: 45.54 Buyback: 37.11

  26. Result 1: Amount of Debt Relief Panel Data Approach: GLS with Random Effects • There is significantly more debt being relieved under the Forgive treatment.

  27. Result 2: Project Success Rate (p) Buyback: 35.73% Forgive: 36.92%

  28. Result 2: Project Success Rate (p) Panel Data Approach: GLS with Random Effects • Debtor’s effort in terms of the project success rate is significantly smaller under the Forgive treatment once the amount of debt relief is controlled for. • The more the creditor relieves the debt, the more the debtor reciprocates.

  29. Result 2: Project Success Rate (p) Panel Data Approach: GLS with Random Effects • Debtor’s effort exhibits greater volatility from one period to the next under the Forgive treatment.

  30. Result 3: Expected Payoffs Buyback: 52.64 Forgive: 50.53

  31. Result 3: Expected Payoffs Forgive: 3.89 Buyback: 2.68

  32. Result 3: Expected Payoffs Panel Data Approach: GLS with Random Effects • Given the amount of debt relief, debt forgiveness has a significantly negative impact on creditor’s expected payoff but not on debtor’s.

  33. Conclusion • Creditors tend to relieve more debt under the Forgive treatment. • Debtors do reciprocate, but they don’t reciprocate significantly more under the Forgive than under the Buyback treatment. • That is, creditors pay more for the same outcome under the Forgive treatment. • Debt forgiveness is a less efficient scheme for creditors to relieve the debt.

  34. One Creditor Two Creditors

  35. One Creditor Two Creditors

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