FRBSF Economic Letter
2000-26; September 8, 2000
 Economic
Letter Index
Short-term International Borrowing and Financial Fragility
In the wake of the large number of international financial crises that
occurred in the 1990s, several proposals have been put forth to reform
the "international financial architecture," that is, the institutional
features that characterize the international monetary system. These proposals
aim to make the system less prone to financial crises in the future. In
this Economic Letter, I look at the issues surrounding one of the
reform proposals, specifically, policies to discourage short-term international
borrowing.
Why is short-term borrowing a source
of financial fragility?
When private investors borrow short-term, they may fall into "maturity
mismatch" difficulties. Maturity mismatch difficulties arise when
the assets backing short-term debt obligations are longer-term, and therefore
less liquid, than their liabilities. Illiquid assets cannot be sold quickly
at fair value. One common example of an illiquid asset is real estate,
where it takes some time to locate a buyer willing to purchase the asset
at its fair value. Another example is an ongoing business concern, whose
intrinsic value far exceeds its immediate liquidation value.
These disparities imply that when debts are not rolled over, assets must
be liquidated at a discount to cover short-term obligations. For example,
suppose that a corporation borrows short-term overseas to finance a long-term
investment. In the event that its short-term loans are not rolled over,
the firm would need to liquidate its investment prior to its maturity.
The scrap value of this investment may be insufficient to meet its short-term
obligations, even though the firm would have been able to meet its long-term
obligations if the investment had been rolled over.
Chang and Velasco (1999) adapt the well-developed literature on banking
to show that these maturity mismatches among private investors can leave
nations prone to multiple equilibria problems that are dependent on the
beliefs of foreign investors. For example, consider the possibility of
two equilibria: The first is a "good" equilibrium, an outcome
under which foreign investors expect that a country will be able to service
its outstanding debt obligations; in that case, most short-term investments
will be rolled over. This allows the invested assets to reach maturity,
yielding adequate resources for the debtor to service its outstanding
obligations. In other words, the country will have the ability to service
its debt obligations if investors believe it will service its debt obligations.
The second is a "bad" equilibrium, an outcome under which investors
lose confidence in a nation's ability to service its outstanding debt
obligations. As in the banking literature, it is commonly assumed that
short-term debt obligations exhibit "sequential service"--that
is, the first person to withdraw funds is paid in full, and so on, until
available funds for debt service are exhausted. The analogy to international
lending is that those who withdraw funds from a nation before a crisis
are paid in full, but those who stay in until a crisis arises lose their
claims. Under these circumstances, investors who believe that a nation
will not service its debts will attempt to withdraw their funds early.
Of course, if everyone attempts to withdraw their funds at the same time,
the debtor's illiquid assets will have to be sold at reduced values. In
this manner, the pessimism held by investors becomes self-reinforcing.
Short-term borrowing plays a central role in the "bad" equilibrium.
To illustrate, consider the case when debtors borrow through longer-term
obligations, whose maturities roughly match those of their assets. With
long-term borrowing, there would be no risk of a "run" that
forces a nation to liquidate its assets at a discount. Creditors would
not be entitled to demand repayment until the assets backing the debtor's
debt obligations had matured. As a result, heavy reliance on short-term
borrowing has been widely cited as a source of financial fragility. Rodrik
and Velasco (1999) demonstrate that the ratios of short-term debt to reserves
are robust predictors of financial crises.
Why is short-term debt so prevalent?
One argument for the prevalence of short-term debt rather than long-term
debt may be that short-term debt is the only debt available to a borrowing
country. Short-term lenders may be the only creditors left whole after
a financial crisis under sequential service. Consequently, if a financial
crisis is perceived to be imminent, long-term debt may only be available
at prohibitively high interest rate premia, or it may not be available
at all. In the years immediately preceding Mexico's 1982 debt crisis,
its share of short-term debt increased sharply.
Another argument concerns moral hazard issues. The availability
of long-term and short-term debt reflects the market's anticipation that
government and international financial institutions will intervene to
mitigate the severity of financial difficulties. For example, during the
Mexican peso crisis of 1994, the United States and the International Monetary
Fund provided funds to allow the Mexican government to retire its maturing
debt obligations. At the time, the Mexican government had $28 billion
in outstanding short-term instruments and only $6 billion in foreign reserves.
It is widely considered doubtful that default could have been avoided
without this outside assistance (see, for example, Eichengreen 1999).
There are a number of reasons why government officials are tempted to
intervene after difficulties arise. Financial crises can induce significant
hardships on both international creditors and the debtor nations which
are forced into default. Both economic and political considerations leave
it difficult to resist coming to the aid of a distressed nation or region.
In addition, there is some belief that international financial markets
exhibit "contagion," where financial difficulties in one country
can spread to others, even those in remote regions with no apparent relationship
to the original problem nation.
Nevertheless, to the extent that such official bailouts of private obligations
are anticipated, they can increase moral hazard problems in international
lending. Moral hazard arises when international bailouts are expected,
because investors anticipate with positive probability that some portion
of the downside risk in their investments will be covered by a public
entity. This encourages private creditors to accept greater risks and
lower contractual interest rates on foreign loans than they would in the
absence of such government guarantees. In particular, a borrowing nation
will be able to sustain a larger share of short-term lending in its overall
borrowing portfolio the higher is the probability that its creditors place
on the potential for an external bailout if that country finds itself
in a financial crisis.
A third argument for the prevalence of short-term debt is that short-term
borrowing may be privately, if not socially, desirable. Rodrik and Velasco
(1999) demonstrate that short-term debt is likely to be cheaper for individual
borrowers within a developing country. In their model, the possibility
of a liquidity crisis coupled with the sequential service assumption implies
that short-term debt has a higher probability of being serviced than long-term
debt. Interestingly, the probability of long-term debt service, and hence
the interest rate premium paid on long-term debt, is dependent upon the
stock of outstanding short-term debt; that is, the more short-term debt
outstanding, the higher the interest rate premium on long-term debt. As
a result, their model implies that short-term borrowers inflict a negative
externality on long-term borrowers by reducing the probability that long-term
debt will be serviced.
Finally, short-term debt may have a positive influence on debtor behavior.
Jeanne (2000) develops a model in which a greater share of short-term
debt in a nation's borrowing portfolio increases its government's incentive
to pursue fiscal reforms, which make a run on its country's debts less
likely. This improves the terms at which the debtor nation can borrow.
Jeanne's argument can be applied more generally to a number of "agency"
issues, where conflicts of interest may arise between a debtor and her
creditors. These conflicts may arise in both external government or private
borrowing, as long as the debtor can take actions that influence her ultimate
debt service.
Policy responses
In the absence of any social gains from short-term borrowing, the negative
externalities imposed by short-term borrowers on potential long-term borrowers
in their nation call for developing countries' officials to discourage
short-term borrowing, either through tax policies or through quantitative
restrictions on short-term capital inflows. For example, Chile's tax structure
on foreign borrowing places the highest taxes on borrowing of the shortest
maturities (Eichengreen 1999).
Eichengreen (1999) points out that short-term lending to debtor-country
banks is particularly undesirable. In addition to increasing a nation's
susceptibility to a liquidity crisis, moral hazard issues are particularly
severe in loans to debtor-country banks. Failures by debtor-country banks
directly threaten a nation's financial stability, implying that it may
be difficult to resist bailing out debtor banks (and their creditors)
after the fact. Eichengreen argues that debtor country regulators should
implement price-based incentives for banks to limit their short-term borrowing,
by tying capital requirements to the maturities of bank funding.
He further points out that the developed nations also can play a role
in discouraging their creditors from short-term lending. Developed nations
could raise the Basle risk weights on short-term claims and differentiate
lending to banks located in countries that meet "internationally
recognized accounting, regulation, and disclosure standards" from
lending to banks in countries that do not meet those standards.
Two problems stand out in these proposals for policies to discourage
short-term borrowing. First, as stressed by Jeanne, short-term borrowing
could play a socially beneficial role in limiting agency problems, in
which case short-term contracts should not be discouraged; however, such
circumstances may be difficult to identify in practice. Second, the feasibility
of discouraging short-term borrowing in a desirable way is not guaranteed.
Eichengreen notes that policies specifically targeted at reducing short-term
borrowing by debtor-nation banks from creditor-country banks will, to
some extent, merely increase short-term nonbank borrowing from creditor-country
nonbank institutions. Because these non-bank institutions are less regulated
than banks on both sides of the lending transaction, it is unclear what
the overall impact on the riskiness of the financial system will be.
Conclusion
While the positive correlation between a debtor nation's short-term borrowing
and its probability of falling into a financial crisis is well established,
the merits of policies targeted at discouraging short-term borrowing are
still in question. Proper analyses of the merits of short-term borrowing
require a framework that explains the motivation for both borrowers and
creditors to prefer a short-term contract. If the short-term borrowing
is motivated by some distortion, such as private debtor-nation citizens
who are imposing a negative externality on the rest of their nation, or
the anticipation of an external bailout in the event of difficulties,
then intervention to address this distortion is warranted. If, on the
other hand, the short-term borrowing has beneficial implications, such
as increasing the credibility of a debtor nation's reform program, interventions
to discourage such borrowing may actually do harm.
Mark M. Spiegel
Research Officer
References
Chang, Roberto, and Andres Velasco. 1999. "Illiquidity and Crises
in Emerging Markets: Theory and Policy." N.B.E.R. Macroeconomics
Annual. Cambridge, MA: MIT Press.
Eichengreen, Barry. 1999. Towards a New International Financial Architecture:
A Post-Asia Agenda. Washington, DC: Institute for International
Economics.
Jeanne, Olivier. 2000. "Debt Maturity and the Global Financial Architecture."
Mimeo. International Monetary Fund (May).
Rodrik, Dani, and Andres Velasco. 1999. "Short-Term Capital Flows."
N.B.E.R. Working Paper No. 7364 (September).
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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