Debt Essay

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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.

Large Enterprises

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 Borrowing

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.

Islamic Finance

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.

Bibliography:    

  1. R. Appleyard,  A. J. Field, and  S. L. Cobb,  International  Economics (McGraw-Hill,  2006);
  2. F. Brigham and J. F. Houston, Fundamentals  of Financial Management  (Thomson, South-Western, 2004);
  3. Damodaran, Corporate  Finance:  Theory  and  Practice (John Wiley & Sons, 2001);
  4. Ayub Mehar, “Is Debt a Substitute of Equity? Relevancy of Financial Policy in Current Economic Scenarios,” Applied Financial Economics (v.15/5, 2005);
  5. Saunders and M. M. Cornett, Financial Markets and Institutions: An Introduction to the Risk Management Approach (McGraw-Hill Irwin, 2007);
  6. James D. Scurlock, Maxed Out: Hard Times, Easy Credit, and the Era of Predatory Lenders (Scribner, 2007);
  7. Solnik and D. Mcleavey, International Investments (Pearson Addison-Wesley, 2004).

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