Debt is the state of owing something to another party. It is generally assumed to involve the transfer of financial assets, but in the barter economy the payment is executed in kind. It is important for both lender and borrower to reach an agreement about a deferred payment, and the lender is rewarded with an appropriate interest payment for forgoing current consumption. In the contemporary Islamic world, which has strong similarities with the stance of the medieval Catholic Church that condemned usury, debt repayment is replaced by profit sharing of co-investing parties. The orthodox religious thinking in certain parts of the world thus indicates that interest payment associated with debt leads to profit making without commensurate work effort and simultaneously causes the exploitation of those expected to pay it.
Nevertheless, debt has been an important market phenomenon throughout history. Expensive and prolonged wars had to be financed by extensive borrowing and this could eventually lead to bankruptcy. Private investors, such as the Rothschilds, supported the British government in war against Napoleon I, and one of the major roles of early central banks in the world was to provide public financing for the state. In contemporary economic flows it is evident that leverage, i.e., increased debt levels, lead to higher risk, but also to higher returns because of the difference between the (higher) investment return and (lower) cost of debt. The cost of debt financing is even lower because it is paid before tax, which implies lower after-tax cost of financing.
The notion of debt is not only essential at the microeconomic level. Governments issue so-called sovereign debt instruments (bonds) or accumulate various sorts of international loans for investment and consumption-related purposes and like companies are prone to default on debt if overexposed to the same. The best examples are Mexico and Brazil in 1982, the Russian Federation in 1998, and Argentina in 2001.
Small and Medium-Scale Enterprises
At the micro level, companies borrow funds directly from financial markets or indirectly from financial intermediaries, such as commercial banks, savings institutions, credit unions, and finance companies. The scale and scope of lending instruments is different among lending institutions and are suited for particular market niches that occasionally include individual consumers (car financing provided by finance companies or personal loans from commercial banks). The involvement of a financial intermediary increases borrowing costs by a charged fee, which is potentially more disadvantageous with comparison to direct financing. However, small and medium-scale enterprises (SMEs) would pay a significant premium to obtain funding from non-bank investors who do not have full insight in its business/credit rating. Accordingly, bank lending can be more attractive for SMEs, due to financial intermediaries’ customer knowledge base and especially if debt is collateralized, i.e., supported by tangible assets that can be resold in the case of bankruptcy to retrieve extended funds.
Two-thirds of bank loans have maturities shorter than one year, and the modes of loan extension are diverse. Banks ask companies to sign promissory notes that may be secured with tangible assets. A series of promissory notes are issued as part of an informal line of credit indicating the maximum credit a bank will provide for the borrower during the year. When formalized, the line of credit becomes “revolving,” the committed sums are larger, lending periods turn generally longer than a year and loans are provided by a single bank or a syndicate of banks.
By contrast, “blue chip” companies with high credit rating receive comparatively low-cost funding by issuing debt instruments directly to public or even private placements. Securities issued in debt markets are called bonds, denoting certificates issued by the borrower, which promise regular annual/semi-annual interest payments and on maturity date, the return of the principal amount stated on them. Zero-coupon bonds are issued at a heavy discount, do not provide interest payments (no interest coupons to be cashed in), and the principal is returned at the end of the contracted period.
From the maturity point-of-view, short and medium-term debt instruments are called notes, while issues with longer maturities are called bonds or debentures. For periods shorter than one year, companies brandishing high credit standing issue unsecured commercial papers, i.e., promissory notes assuring that the principal payment will be made after the expiration of the prescribed period, which can be anything from one day to nine months. Funds raised are used to finance daily operations and as a bridge until long-term funds have been received. If a company does not have a good credit rating, banks provide acceptances to increase the quality of the issue called the bill of exchange. Alternatively, the sale of a security accompanied by a promise to repurchase the same at a future point in time is an additional vehicle for secured near-cash investments and is called a repurchase agreement.
Debentures are long-term bonds that are not collateralized by any property (tangible asset) as a reassurance that the debt will be paid. Not surprisingly, blue-chip companies routinely issue debentures. If called “subordinated,” debentures are inferior to all senior debt positions on the liabilities side of the balance sheet. This indicates that no payments will be made until after all senior obligations have been honored, which is an important rule in liquidating the company.
A company can accrue liabilities due to the nature of its business or taxation policies. Salaries are paid on fortnightly or monthly basis and some of these liabilities will accrue in the balance sheet. In addition, sales taxes are paid on a weekly, monthly, and quarterly basis, which leads to further accruals. These liabilities are interest free, but the creation of this type of debt is not controlled by the company. Another type of debt financing is provided by trading partners. If a firm purchases goods with a payment expected after an extended period of time (30 or 60 days), there will be a significant amount of accounts payable (trade credit) on the liabilities side of the balance sheet. If the market player acts as a monopsonist, i.e., a business entity with overwhelming purchasing power in the market, it is possible to extract longer payment periods from suppliers.
On the other side, an aggressive market growth policy would most likely include an increase in the amount of trade credits extended to new customers in order to drive them away from competitors. Nevertheless, in order to improve cash flow positions, companies offer discounts for early payments. For instance, if a payment been made by a purchaser after 10 instead of 30 days, a 2 percent discount is offered. The debtor will make early payments if this 2 percent return is sufficient to offset any other profitable short-term investments over the 20-day period (from the 10th until the 30th day).
In a more complex multinational corporation, the parent provides loans to subsidiaries in which case notes and interest payable appear as additional balance sheet positions of a subsidiary. The parent company combines intercompany debt issues with other types of financing such as equity infusion or loans extended by local banks in the country where the subsidiary is located.
The last source of financing is politically desirable, because it strengthens ties with the local banking community and reduces the incidence of expropriation by rogue regimes. It is essential that the capital structure reflect an appropriate level of the subsidiary’s (debt) leverage and that it acts as an independent entity from the parent, which leads to an increase in efficiency in the face of potential default not guaranteed by the parent company.
Sovereign countries borrow from domestic and international markets and like companies are expected to provide good record in repaying debts. Financial institutions request collateral in order to secure placements, but this feature is sometimes unfeasible in extending sovereign loans. Therefore, lenders must conduct the meticulous analysis of trade policy, government intervention, political stability, fiscal and monetary austerity, foreign direct investment flows, inflation, and financial system structure in order to obtain adequate risk assessment. Thereafter, risk levels are converted into premiums for each country above or below U.S. Treasury bond rates, which is a good estimate of debt costs associated with the foreign project. Even though U.S. Treasury issues are assumed to be risk-free in financial evaluations, the incidence of sovereign countries’ defaulting on international debt is not unheard of.
Moratoriums, i.e., unilateral decisions to postpone repayments of sovereign debt, can lead to significant financial losses. In 1982, Mexico and Brazil announced their inability to service debt, which prompted many U.S. banks to increase reserves in the expectation of an increase in unserviceable loan positions. Citicorp in 1987 boosted reserves by US$3 billion to cover losses. In 1998 the Russian Federation defaulted on a US$40 billion short-term debt, and the subsequent year some banks accepted 5 cents for each dollar owed to creditors. The abandonment of the Argentine peso peg to the dollar in 2001 caused financial turmoil and the default on a US$130 billion in sovereign debt. However, a settlement with international creditors was not reached until 2005, when 30 cents was offered on the dollar of debt defaulted in 2001. In this manner, Argentina has topped the list with the most unfavorable, nonnegotiable dollar-denominated debt settlement ever reached.
Commercial lenders and creditor countries have always tried to create countervailing forces against irresponsible debtors. The Paris Club of creditor countries in 1956 and the ad hoc London Club of commercial lenders were created as a result of this tendency. The Paris Club comprises 19 creditor countries from North America and Western Europe along with the Commonwealth of Australia, Japan, and Russian Federation. Another 13, mainly newly industrialized or resource-rich countries, have been invited to attend meetings on a case-by-case basis, but any final agreement is made between permanent members and debtor countries. It was created in 1956 as a result of negotiations between Argentina and various creditor nations; over the period of 50 years, the Club negotiated 402 debt restructurings worth US$532 billion across 81 countries.
Since 1996, significant concessions have been granted to the Highly Indebted Poor Countries (HIPC), following the joint recommendation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) to reduce debt burdens for most disadvantaged countries. This action should allow them to service debt through trade, financial aid, and capital inflows. To become eligible for this scheme, a country must (a) be the exclusive recipient of international development assistance from the IMF and World Bank; (b) reach unsustainable debt levels where extant debt-relief mechanisms such as Naples terms are insufficient (a potential reduction of eligible external debt of 67 percent in net present value (NPV) terms); and (c) demonstrate a track record of reforms advocated by IMF and World Bank. By 2008, 21 countries had reached the completion point at which Paris Club members reduced their debt burden by 90 percent or more in net present value terms. An additional 18 countries are still at various stages of negotiation leading to the final completion point.
The major criticism of the Club’s policy is directed toward decisions that are allegedly politically tainted, such as the 80 percent write-off of Iraq’s debt in 2004. In addition, the growing concern voiced by Club officials is related to the aggressive lending of nonmember countries such as Brazil and China. The extending of loans under less strict terms prompts borrowing countries to request the Paris Club to renegotiate previous debt agreements under more acceptable conditions.
The London Club is an informal group of commercial investors temporarily created for negotiations with the sovereign debtor. Following the acceptance of the debtor’s request, the Advisory Committee of the London Club is created, which is usually chaired by a leading financial institution. When the restructuring agreement is signed, the Advisory Committee is dissolved.
In the contemporary financial markets, investors purchase developed and emerging countries’ bond issues by visiting local debt markets. While in developed countries most of the bond issues have investment grade, in developing economies potential borrowers can seldom demonstrate high investment grade, which is Baa or above if rated by Moody’s or BBB or above if rated by Standard & Poor’s. In addition to political risk, impediments to this type of cross-border investments are the exchange risk and occasional inability to transfer funds outside the country. By contrast, governments rarely default on bonds denominated in domestic currency, because they can always print money to fully repay debt.
Alternatively, foreign bonds can be issued on major national bond markets and are denominated in the currency of the trading place. Dollar-denominated foreign bonds traded in the United States are called Yankee bonds, while foreign bonds denominated in yen and traded in Tokyo are called Samurai bonds. Third, investors buy Eurobonds, which are bonds placed by a syndicate of international banks in countries that are different from the one in which currency the issue is denominated. Among emerging economies, major Eurobond issuers are the representatives of largest Central and South American countries.
Finally, as part of the Brady plan in 1990, heavily indebted emerging countries decided to issue Brady bonds that are traded in the international capital market and mainly supported by various principal and interest payment guarantees. In addition, Mexico and Venezuela issued securities linked to the price of oil, which means that extra payments are made to investors if the value of oil exports increases over time.
If someone is using someone’s money, he or she is expected to pay interest, and depending on the maturity of the obligation, the interest rate will be fixed. In other words the price of using money is interest that one party has to pay to another. However, in early Christian times, as now in Islamic finance, usury or charging interest was forbidden and haram. Therefore, Islamic finance offers a series of instruments which have interesting complexity in order to offer free-interest banking for those who observe religious rules closely. In Islamic finance, the modalities are such that a person lends money via a financial intermediary and becomes an indirect business partner, and shares to some extent the (business) risk to which the borrower may be exposed when utilizing borrowed money. The non-interest (or not-for-profit) options offer a richer variety of instruments and give a different perspective on debt and borrowing and how the risk may be pooled or shared, depending on a situation.
- R. Appleyard, A. J. Field, and S. L. Cobb, International Economics (McGraw-Hill, 2006);
- F. Brigham and J. F. Houston, Fundamentals of Financial Management (Thomson, South-Western, 2004);
- Damodaran, Corporate Finance: Theory and Practice (John Wiley & Sons, 2001);
- Ayub Mehar, “Is Debt a Substitute of Equity? Relevancy of Financial Policy in Current Economic Scenarios,” Applied Financial Economics (v.15/5, 2005);
- Saunders and M. M. Cornett, Financial Markets and Institutions: An Introduction to the Risk Management Approach (McGraw-Hill Irwin, 2007);
- James D. Scurlock, Maxed Out: Hard Times, Easy Credit, and the Era of Predatory Lenders (Scribner, 2007);
- Solnik and D. Mcleavey, International Investments (Pearson Addison-Wesley, 2004).
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