Important Concepts

Brady Plan:                                   A method devisedby the U.S. Treasury for resolving the 1980s debt crises. Bank borrowing of 18debtor countries was restructured with some debt reduction and some repackagingof loans as Brady bonds.

Conditionality:                               The “strings” attached by the International Monetary Fund to loans itmakes to a country in financial crisis; these are intended to address andcorrect the fundamental problems that caused the crisis.  Such strings include fiscal and monetaryrestraint and liberalization of the country’s domestic and internationalmarkets.

Debt overhang:                              The amount bywhich a borrower’s debt exceeds the present value of future transfers that willbe made for debt service. For example, if a loan is made for currentconsumption or for low‑quality investment, today’s value of the future incomestreams from those uses will be much less than the amount the borrower owes.

Debtrestructuring:                        A general term for changing the details of an existing loan.  “Debt rescheduling” modifies the due date (or“maturity”) of the loan; “debt reduction” modifies the amount (or “principal”)of the loan.

Debt service:                                  Repayments ofprincipal and interest. The debt service ratio is a measure of a country’s debtburden and expresses debt service as a percentage of total export revenues orGDP.

Internationalcapital flows:            Financial flowsof credit and ownership claims between countries. Flows of physical capitalgoods are typically treated as ordinary trade flows, not capital flows, in thebalance of payments accounts.

Moral hazard:                               A situation inwhich someone insured against risks will purposely engage in risky behavior,knowing that any costs incurred will be compensated by the insurer. A financialsystem that offers “rescue packages” may encourage borrowers and lenders toundertake low‑quality or high‑risk investments, thus increasing the likelihoodof a crisis.

Nationallyoptimal tax on              As with anoptimal tariff, a large country may be able to exert
fund flows:                                     marketpower and turn the terms of trade in its favor. For example, if
                                                     alending country taxes the outflow of funds, it will raise the price
                                                     thatborrowers have to pay. The country’s lenders earn a higher rate
                                                     ofreturn and the government collects the tax revenues. Although
                                                     thismay increase welfare in the lending country, it always reduces
                                                     worldwelfare.

Sovereign:                                      Someone orsomething that has legal independence. This usually refers to nationalgovernments because (as in the case of debts they owe) they cannot be forced torepay, be sued, or have their domestic assets seized.

Tequila effect:                               When investorsrecall loans from all developing countries rather than only from the particularcountry facing the debt crisis.