INTRODUCTION

In this chapter we examine how increased uncertainty about an emerging market's debt overhang might affect the willingness of foreign investors to supply new international credit. We show that increased uncertainty about the debt overhang has a nonlinear and potentially large adverse effect on the supply of international credit. As a result, it can contribute to the liquidity shortage often experienced by emerging markets during a crisis. We also show that if international creditors have preferences characterized by first–order risk aversion, a moderate increase in uncertainty about debt overhang – or about other relevant factors affecting repayment prospects – can cause the supply of credit to dry up completely. We therefore offer one possible explanation for why emerging markets may find themselves suddenly cut off from international capital markets.

We begin by describing events that contributed to increased uncertainty about the debt overhang in two of the Asian economies hit hard by the financial crisis in 1997 – Thailand and South Korea. We then compare reported external debt levels before the crisis with higher figures uncovered once the crisis began. We suggest that external debt levels for these two countries turned out to be much higher than what was reasonably foreseen. Surprised by the size of the upward adjustments, investors likely attached greater uncertainty to the size of the debt as well.

Introduction

The view that international financial market integration brings significant long-term benefits is hardly a controversial one among mainstream economists. Financial openness, for instance, increases opportunities for portfolio risk diversification and consumption smoothing through borrowing and lending; and producers who are able to diversify risks on world capital markets may invest in more risky (and higher-yield) projects, thereby raising the country's rate of economic growth (Obstfeld, 1994, 1998). Increased access to the domestic financial system by foreign banks is often viewed as raising the efficiency of the intermediation process between savers and borrowers, thereby lowering the cost of investment. Higher foreign direct investment flows (FDI) often have a direct, positive effect on productivity and the efficiency of domestic resource utilisation (through transfers of technology and other intangible assets), thereby raising the rate of economic growth.

But it is increasingly recognised that a high degree of financial openness may entail significant short-term costs as well. The magnitude of the capital flows recorded by some developing countries in recent years, and the abrupt reversals that such flows have displayed at times, have raised serious concerns among policy makers. The Mexican peso crisis of December 1994 led to financial instability throughout Latin America, particularly in Argentina. The collapse of the pegged exchange rate regime in Thailand on 2 July 1997 led to currency turmoil throughout Asia, particularly in Indonesia, Korea, Malaysia and the Philippines.