THE RISE OF PRIVATE EXTERNAL DEBT: Why improving domestic creditor rights alone is not helpful for emerging market economies

The past three decades have seen private firms becoming increasingly important as independent participants in the global capital market. In a sample of 85 representative emerging market economies, the average share of total external debt borrowed by the private sector increased from under 5% in 1990 to about 17% in 2009. At the same time, the cross-country average stock of private publicly non-guaranteed debt per capita grew from $60 to $663 (in 2010 dollars).

This trend is inconsistent with the traditional view that public borrowing of foreign funds brings superior welfare to the debtor country. But research by Haichao Fan and Xiang Gao, published in the November 2017 issue of the Economic Journal, provides an explanation why a decentralised arrangement may be preferable to a centralised one in developing countries where both foreign and domestic creditors'' rights are imperfectly protected and there is residence-based creditor discrimination.

Under decentralisation, foreign lenders who are worried about potential defaults would impose credit ceilings on domestic borrowers. Given imperfect and inequitable institutions, it is intuitive that foreign lenders would tighten private debt ceilings for borrowers residing in countries with weaker foreign creditor protection – but the relationship between debt ceilings and the strength of domestic creditor protection remains unclear.

If this relationship is negative, then centralisation may decrease the amount of international lending, and hence reduce the national welfare of debtor countries. This is because the resulting perfection of the domestic institution under centralisation could be detrimental when foreign creditor rights protection is weak. To support the growth of private external debt, governments of emerging markets must carefully structure the pace and sequence of improvements for both foreign and domestic creditor protection institutions.

The new study finds a negative relationship in the developing world. To get a sense of the magnitude, consider two countries with foreign creditor rights rankings below the lower quartile. Moving from around the 25th percentile (Nigeria) to around the 75th percentile (Iran) in the distribution of domestic creditor rights, there is $170 less debt per capita during the period of 2004-2009 on average. This represents a 35% decrease in the sample mean, which is $487.

With a parallel pair of countries (Cameroon and Greece) that lie above the upper quartile in foreign creditor rights rankings, this negative effect turns positive ($937 more debt per capita moving from the 25th to the 75th percentile in domestic rights). This is because the supply-side story barely operates when foreign investments are fully guarded. Stronger domestic protection now indicates better governance and creditworthiness.

These observations suggest that when making efforts to attain the efficient amount of external borrowings, domestic rights institution-building should be combined with eliminating discrimination against foreigners. Otherwise, there is an incentive for the private sector to default internationally first, causing foreign creditors to tighten constraints.

This policy implication is evident in cross-border round-tripping in relation to financial transactions in Africa, India and China. The implication also underpins the ''revived Bretton Woods'' interpretation of the capital flow structure vis-à-vis emerging Asia.

''Domestic Creditor Rights and External Private Debt'' by Haichao Fan and Xiang Gao is published in the November 2017 issue of the Economic Journal. Haichao Fan is associate professor at the Institute of World Economy, School of Economics, Fudan University. Xiang Gao is associate professor and Head of Research Center of Finance at Shanghai Business School.