What Does Debt Relief Do for Development? Lessons from the ...pubdocs.worldbank.org/en/138471541446850108/Debt-Relief.pdfThe debt relief program I Partial or full bailout of overdue

What Does Debt Relief Do for Development?Lessons from the Largest Household Bailout in History

Martin KanzWorld Bank Research Department

Policy Research TalkNovember 5, 2018

Motivation Program and Timeline Impact on Credit Market Impact on Households Political Economy Policy Implications

Motivation

å Economists have long been concerned with high levels ofsovereign debt as source of macro instability, contributingfactor to financial crises, slower long-run growth

å Household debt as source of macroeconomic risk has onlycome into focus after 2007-2008 global financial crisis


Motivation

å Economists have long been concerned with high levels ofsovereign debt as source of macro instability, contributingfactor to financial crises, slower long-run growth

å Household debt as source of macroeconomic risk has onlycome into focus after 2007-2008 global financial crisis


Motivation

Today

¶ Household debt and the macroeconomy: what do we know?

· Debt relief programs as a potential solution

I Impact on credit market and economic activityI Impact on borrowersI Political economy implications

¸ How to design better debt forgiveness programs?


Motivation

Today






Motivation

Today






Motivation

Today






Household debt and the macroeconomy

å The 2007-2008 global financial crisis brought household debtas a source of macroeconomic risks into the spotlight

I Bubble in consumer lending, excessive subprime borrowingI Household debt is repackaged into intransparent mortgage

backed securities, which invite excessive risk-taking by banksI Small increase in defaults among highly leveraged households

are magnified by mortgage backed securities → banking crisis!

å Since then, much research on household debt and macro(in)stability showing that high debt-to-asset ratios lead to:

I More frequent and severe banking crisesI More severe and longer recessions (Mian and Sufi 2011, 2013)I Slower economic growth, higher longer-run unemployment

(Mian, Sufi, and Verner, 2017; Schularick and Taylor 2012)


Household debt and the macroeconomy

I In emerging market economies, household debt-to-GDP ratios havedoubled over the last ten years (IMF 2018)

I Parallels to subprime lending in the U.S., consumer lending booms,potential source of systemic risk


Debt forgiveness pros and cons

å Lowering household debt can reduce macroeconomic risks, butdebt forgiveness programs remain controversial

1. The case for interventions into debt contracts

I Stimulate investment and consumption directlyI Insurance against otherwise uninsurable aggregate shocks

(Bolton and Rosenthal, 2002)I Fixing debt overhang (are there productivity effects?)

(Guiso, Sapienza and Zingales, 2009; Breza 2013)

2. The case against interventions into debt contracts

I Distort incentives for banks (Diamond and Rajan 2000;Gianetti and Simonov, 2009; Phillipon and Schnabl 2013)

I Distort contracting environment and incentives for borrowersI May lead to ex-post credit rationing


Debt forgiveness pros and cons

Evidence from the world’s largest household debt relief program:

¶ Impact on credit market and real economy:“The Economic Effects of a Borrower Bailout” Xavier Gine and Martin Kanz,

Review of Financial Studies, 31(5): 1752-1783 (2018).

· Impact on beneficiary households:“What Does Debt Relief Do for Development?” Martin Kanz, AmericanEconomic Journal: Applied Economics, 8(4): 66-99 (2016)

¸ Political economy implications:“Electoral Effects of a Fiscal Transfer: Evidence from Indian Elections”

Thomas Fujiwara, Martin Kanz, and Priya Mukherjee (in progress)


Program and Timeline


The debt relief program

å In 2008, Govt of India enacted the Agricultural Debt Waiver andDebt Relief Scheme (ADWDRS) against backdrop of financial crisis

Why is this an interesting program to study?

I Economically significant

I Possibly the largest household level bailout program in historyI US$ 16 - 17 billion (1-1.5% of India’s GDP)I Benefit to approximately 40-60 million rural households

I Representative of many similar debt relief programs

I Thailand: US$ 2.9 billion bailout for rural householdsI Brazil: restructuring of more than US$ 10 billion farm debtl

I Identification: program eligibility rules allow for causal tests atmarket and borrower level


The debt relief program

I Partial or full bailout of overdue agricultural loans

I Covers all ag loans originated Dec 31, 1997–Dec 31, 2007I Loan must be 90+ DPD on February 28, 2008I Loans at private, public sector, and cooperative banksI Banks refinanced by the Reserve Bank of India

I Eligibility depends on land collateral:

Who gets bailed out?

Land ≤ 2 hectares −→ 100% unconditional bailout

Land > 2 hectares −→ 25% conditional bailout

I Eligibility criteria were unanticipated and applied retroactively

I Very little scope for manipulation of default status, land records


The debt relief programTimeline

¶ December 1997 to December 2007

1997

Loans originated

Dec 31, 2007 Feb 28, 2008 2010




I Households take up loansI Pledge land as collateral

1997

Loans originated

Dec 31, 2007 Feb 28, 2008 2010





· March 28, 2008

I Debt relief program is announced

1997

Program announcedProgram announced

Dec 31, 2007 Feb 28, 2008 2010





· March 28, 2008

I Debt relief program is announcedI Loan has to be in default as of

December 31, 2007, and untilFebruary 28, 2008

I Eligibility is based on collateral

1997

Loans originated

Dec 31, 2007 Feb 28, 2008

Eligibility

2010





· March 28, 2008

I Debt relief program is announcedI Loan has to be in default as of

December 31, 2007, and untilFebruary 28, 2008

I Eligibility is based on collateral

¸ June 2008: loans written off

1997

Loans waived

Dec 31, 2007 Feb 28, 2008

Eligibility

2010


Impact on Credit Market and Economic Activity


Effect on credit supply

I Persistently lower credit in high-bailout districts

I Consistent with “evergreening before the bailout [Peek and Rosengren, 2005]

I 1 StDev (20%) increase in bailout share 18-25% decrease in credit growth


Loan performance and moral hazard

I Decline in loan performance in districts with high program exposure

I Defaults come from borrowers that were previously in good standing

I 1 StDev (20%) increase in bailout leads to 50-64% increase in loan defaults

I Banks shift lending to less risky districts indicating borrower moral hazard


Effects on real economic activityProductivity, wages and consumption

I No positive effect of the bailout on agricultural productivity, rural wages, orconsumption → program did not have the intended stimulus effect

I Bailout may resolve debt overhang but at the same time credit dries up

I Consistent with micro-evidence: we see no change in investment behavior


Impact on credit market and real economy: summary

I No impact of the program on real economic activity

I Policymaker believed that debt forgiveness would remove investmentdisincentives due to debt overhang

I This did not happen → no effect on investment, productivityI Investment incentives improve, but credit dries upI Policymaker failed to anticipate credit supply responseI Bank response is privately and socially optimal: reallocate

credit to observably less risky and more productive districts

I Large and long-lasting moral hazard costs of the program

I Severe deterioration of credit discipline, borrower moral hazardI Every 1% of credit bailed out increases defaults by about 2.5%I Negative spillover effects: post-program defaults are

concentrated among borrowers previously in good standing!


Impact on Beneficiary Households


Effects on beneficiary households

The Indian bailout was targeted specifically at households in therural sector, which accounts for 60% of employment, 14% of GDP

The government’s case for debt forgiveness

I “Debt overhang” in the rural economy

I This creates disincentives for investment, households pass upprofitable investment opportunities

I Additionally, overindebted households are cut off from thecredit market

I Debt forgiveness holds the promise of resolving debt overhangand improving access to finance and rural productivity

How did the program affect the balance sheets, investments andproductivity of recipient households?


Effects on beneficiary householdsEvidence from a household survey

I Recall, eligibility depends on land pledged as collateral

I ≤ 2ha qualify for full bailout, > 2ha for 25% debt relief

I Survey with 2,897 households within ± 0.5 hectares of cutoff

I Extremely similar in demographics, income, debt levels etc.

I Only difference: 100% full or 25% partial debt relief


Effects on beneficiary householdsEvidence from a household survey

Household survey with 2,897 respondents in Gujarat

I Sampled from official bank lists: universe of recipients,verified debt relief amounts and land holdings

I Survey outcomes: total income, ag revenue, profits, savingsand consumption; investment and productivity

I Difference in debt levels at cutoff: US$ 924, approximatelyequal to India’s 2010 per capita income (US$1,031)


Effects on household debt

I Stated goal: reduce debt and restore access to formal creditI Clear pledged land collateral to enable new borrowing and

productive investmentI Debt is reduced (mechanically). But: households do not use

collateral to draw new bank loans!I Could be due to supply or demand. National level results

suggest it’s mostly due to lower credit supply


Effects on household sources of credit

I Lack of new formal borrowing changes composition of debt

I Households have proportionally more debt from family andinformal lenders after debt forgiveness

I ...and pay higher average interest rates on remaining debt

I Debt forgiveness was largely unsuccessful at restoringborrower’s access to formal credit, despite clearing collateral!


Effects on household savings and consumption

I Do households perceive debt relief as a windfall?

I There is no consumption nor savings response to the bailout

I This is not surprising as debt relief does not increase liquidity(would do so only if collateral were used to access new loans)


Effects on household investment and productivity

I Note that all households in the sample are producers, so debtoverhang argument more relevant than in other settings

I Debt overhang: households forgo profitable investmentsbecause they do not internalize returns

I No evidence that the bailout resolved debt overhang problems


Effects on borrower moral hazard

I Bailout changes terms of the credit contract, sets precedentthat default has no negative consequences → moral hazard?

I How does experiencing debt forgiveness affect borrowers’concerns about the reputational consequences of default?

I Beneficiaries less worried about reputational consequences,but more worried about future access to finance

I Bailout changes beliefs, gives rise to borrower moral hazard


Effects on beneficiary households: summary

I Debt relief does not improve access to bank credit

I But: strong and persistent shift in the composition of debt

I No evidence that debt forgiveness resolves debt overhang

I Strong negative effects on behavior and expectations:

I Debt relief beneficiaries more likely to default on formal loansin the future, consistent with moral hazard externality

I Less concerned about the reputational effects of defaultI more concerned about consequences of default on future

access to credit

I Bailout has high moral hazard cost, no offsetting positiveimpact on financial access or economic activity


Political Economy Effects and Moral Hazard


Political economy and moral hazard

I Strong macroeconomic stability rationale for addressing highlevels of household debt

I But: large-scale debt forgiveness programs can generatesignificant moral hazard on the part of banks and borrowers

I Why? Political intervention into the credit market, ex-postchange in the terms of credit contract

I Expectation of future politically motivated interventions intothe credit market does lasting damage to credit discipline

I What are the political returns of debt relief? What are thepolitical economy incentives?


The political returns of the bailoutEvidence from Indian elections

I Voters strongly reward candidates affiliated with ruling partyand coalition that enacted the bailout

I State elections staggered in time: effect lasts for 3-4 years


The political returns of the bailoutEvidence from Indian elections

I In areas with higher exposure to the debt relief program,voters are more satisfied with their economic situation, rategovt performance more highly, vote accordingly

I Voters reward candidates affiliated with ruling party andcoalition that enacted the bailout (as seen in electon results)

I Strong incentives for political interference in debt resolution


Policy Implications


Household debt and macroeconomic stability

å It’s now well established that high levels of household debtgenerate significant macroeconomic risks

I Economies with higher household-debt-to-GDP ratios aremore vulnerable to banking crises, have longer recessions,slower recovery and slower economic growth in the longer run

I Reducing household debt may be more useful as a stabilizingpolicy or direct stimulus than forgiving sovereign debt

I Tradeoff between short-term gains of deepening creditmarkets and long-term financial stability and growth

I How to resolve high levels of household debt without resortingto policies creating new distortions?


How to design better debt forgiveness programs

å Debt forgiveness programs may be useful to reducemacroeconomic risks, but can magnify other problems

I Bailout programs and fiscal deficits

I Moving risks from bank balance sheets to fiscal deficitsI Shifts macroeconomic risks without resolving them

I Incentive distortions and moral hazard

I Intervention in credit contracts damage the credit cultureI Change in incentives for banks and borrowersI Can generate bank and borrower moral hazardI Both contributing to financial instability in the longer-run

I Negative effects magnified by political economy factors

I Politicians reap electoral reward, do not internalize costsI No incentive to internalize moral hazard costsI Borrowers default in anticipation of future bailouts


How to design better debt forgiveness programs

å Designing debt relief to minimize moral hazard

I Bailouts should be designed to minimize impact on creditmarket incentives and repayment culture, avoid rewardingexcessive risk-taking (banks) or default (borrowers)

I Banks: Do not fully recapitalize banks to make theminternalize part of the cost of bad loans that are written off

I Borrowers: Make debt forgiveness contingent on factors thatborrowers cannot affect through their actions

I Idea similar to index insurance: grant blanket debt relief afterdroughts, drop in househo price index etc. instead of waivingdebts on the basis of default status or debt amounts!

I Provide incentives for prudent lending and timely repayment

I But: any debt forgiveness program is an ex-post change to thecontracting environment, generating an incentive distortion


What are alternatives to debt forgiveness programs

å Political interference in debt resolution generates moral hazardcosts that are far larger than the fiscal cost of the bailout

1. Ex-ante: addressing risksI Better credit information

I Limiting multiple borrowing and overindebtednessI Integrating bank, non-bank and microfinance information

I In agricultural economies: better insurance

I Mandating crop insurance, promoting index insurance

2. Ex-post: institutionalizing debt resolution

I Better debt resolution process: most developing countriescurrently lack personal bankruptcy code that would allow fororderly discharge of non-performing debts

I Institutionalizing the debt resolution process (e.g. throughpersonal bankruptcy) reduces scope for political interference


Summary: what do we learn?

å India’s debt relief program for rural households illustrates thepromise and pitfalls of debt forgiveness programs

I Improvements in credit allocation

I Large negative effects on moral hazard, credit culture

I Moral hazard costs are not offset by a stimulating effect onreal economic activity

I Political interference in debt resolution generates moral hazardcosts that are much larger than fiscal costs of the program

å Results can give guidance to design of debt forgivenessprograms more generally. Goal: institututionalize debtresolution process to reduce scope for political interference


Thank you!

Documents

What Does Debt Relief Do for Development? Lessons from the ...pubdocs.worldbank.org/en/138471541446850108/Debt-Relief.pdfThe debt relief program I Partial or full bailout of overdue