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.
- Why is short-term borrowing a source of financial fragility?
- Why is short-term debt so prevalent?
- Policy responses
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.
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.
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.
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.
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
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).
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