The Interpretation of Market Discounts in Assessing Buy-Back Benefits: Comment on Dooley

Abstract

IN TWO RECENT articles Michael Dooley (1988a,b) has provided important analyses of voluntary debt reduction techniques. His argument parallels the well-known Modigliani-Miller (M-M) proposition that the market valuation of a given probability distribution of returns will be unaffected by the composition of claims upon it. For country debt, this distribution is based on the assumption that the country only fails to maintain contractual loan service through inability to pay. This commitment, combined with the (realistic) assumption that full repayment on the contractual terms is highly improbable, effectively transforms the original loan contracts into equity claims on the country's net exports of goods and services (Dooley (1988a, p. 218)). If an efficiently operating secondary market in country debt instruments is assumed, this framework ensures that the country must be largely indifferent to debt buy-back schemes. If the buy-back is financed by a third-party benefactor, the benefit will accrue primarily to existing creditors through the enhanced market value of remaining claims to the (unchanged) payments stream (Dooley (1988a, p. 214)). Self-financed buy-backs, however, pre-empt resources from this stream and therefore leave market values substantially unaltered (Dooley (1988b, p. 717)). Although these results provide a valuable reference framework, they share with the M-M propositions the need for essential qualification before policy conclusions can be safely drawn. With other authors already referring to buy-backs as a creditors' "boondoggle," it is important that the limitations of the underlying analysis be emphasized (Bulow and Rogoff (1988)). The interpretation of market discounts is crucial in this connection.