INTRODUCTION

In this chapter we examine how increased uncertainty about an emerging market's debt overhang might affect the willingness of foreign investors to supply new international credit. We show that increased uncertainty about the debt overhang has a nonlinear and potentially large adverse effect on the supply of international credit. As a result, it can contribute to the liquidity shortage often experienced by emerging markets during a crisis. We also show that if international creditors have preferences characterized by first–order risk aversion, a moderate increase in uncertainty about debt overhang – or about other relevant factors affecting repayment prospects – can cause the supply of credit to dry up completely. We therefore offer one possible explanation for why emerging markets may find themselves suddenly cut off from international capital markets.

We begin by describing events that contributed to increased uncertainty about the debt overhang in two of the Asian economies hit hard by the financial crisis in 1997 – Thailand and South Korea. We then compare reported external debt levels before the crisis with higher figures uncovered once the crisis began. We suggest that external debt levels for these two countries turned out to be much higher than what was reasonably foreseen. Surprised by the size of the upward adjustments, investors likely attached greater uncertainty to the size of the debt as well.