Foreign Relations of the United States, 1981–1988, Volume X, Eastern Europe

201. Action Memorandum From the Acting Assistant Secretary of State for Economic and Business Affairs (Morris) and the Assistant Secretary of State-Designate for European Affairs (Burt) to Secretary of State Shultz¹

Washington, November 3, 1982

SUBJECT

• Yugoslavia in its Hour of Financial Need; U.S. Options

ISSUE

Whether the US should take the lead in arranging a “modest” financial assistance package for Yugoslavia.

ESSENTIAL FACTORS

Yugoslavia is in deep financial trouble. A debt rescheduling is inevitable absent official financial support, a resurgence of confidence among private lenders and further significant actions by the GOY. Thus, we have three options: (1) take the lead in marshalling official assistance at a level sufficient to insure Yugoslavia against the need to reschedule its debts, (2) arrange a more modest support package, counting on the possibility that a concrete demonstration of Western governments’ commitment to Yugoslavia would induce a change in private sector lending behavior; or (3) candidly inform the GOY that their financial problems appear to have reached the point where a “more permanent” solution is necessary, stating that the US would accede quickly to a GOY request for an official rescheduling. These options are evaluated below. While recognizing the important gaps in our information, we seek your approval to proceed with developing the “modest” package, option (2).

ECONOMIC SETTING

External borrowing to finance burgeoning current account deficits in the late 1970’s pushed Yugoslavia’s convertible (hard) currency debt to nearly $20 billion. The GOY has acted decisively to correct internal and external imbalances, signing on to a $1.8 billion, 3-year IMF standby in 1980. Moreover, the Yugoslav debt service ratio, at 25%, is not excessive. However, the ripple effects of the Polish crisis and sloppy GOY foreign exchange management (failure to deal effectively with commercial bank arrears) has sparked an abrupt decline in private lending, including the withdrawal of short-term deposits/lines of credit, and resulted in a swift depletion of official foreign exchange reserves.

Western European and Kuwaiti banks continue to provide to Yugoslavia modest amounts of medium term funds—about $500 million in CY 1982. The UK and Canadian banks are standing back. The GOY may soon regain access to US and Japanese markets. A $200 million Citibank-led syndicated loan should be concluded soon, subject to the elimination of small remaining arrears of a major Croatian commercial bank, Privredna Banka Zagreb (PBZ). However, the difficulty experienced in scraping the package loan together, and the fact that the participation of the New York agency of a Yugoslav bank was necessary to put the loan over the top, will dilute the hoped-for image of improved market receptivity and the positive catalytic effect on other private lenders.

The financial strain will not abate in 1983. Even if the full year current account is in balance, as expected, Yugoslav financing needs will exceed $4.0 billion. Due to the seasonal pattern of the Yugoslav balance of payments, the entire financing requirement for the year appears in the first half. The IMF estimates first half needs of $4.25 billion—a current account deficit of $1.25 billion; and principal payments of $3.0 billion, of which $1.8 billion is on short-term debt. The IMF figures are consistent with BIS and CIA projections.

The only readily identifiable source of financing for 1983 is the expected IMF/IBRD disbursement of about $1.0 billion. Continued private lending at 1982 levels (about $700 million) and a rollover of all short-term debt would be necessary to reduce the Yugoslav financing gap to $750 million. The risk is that Yugoslavia could rapidly accumulate arrearages in the first half of 1983, scuttling the IMF program, and shattering what is left of private market confidence. The immediate next step would be a general debt rescheduling.

THE POLITICAL CONTEXT

As Mojsov stressed when he met with you October 4,² the GOY believes that rescheduling would be an economic and political catastrophe—an admission of national bankruptcy, a failure of the post-Tito leadership. The GOY has also suggested that the USG would be implicated in the defeat, with adverse consequences for the US/Yugoslav bilateral relationship. While we should not let ourselves be driven by Yugoslav perceptions—especially of the relationship between the US public and private sectors—we should keep these factors in mind as we evaluate our options.

Severe regional and ethnic animosities have complicated and delayed the process of economic adjustment. Centrifugal political forces and provincial jealousies have impeded the efficient allocation of scarce foreign exchange and have created financial confusion. The GOY, to the banks’ dismay, has had only limited success in forging a coherent approach to financial management.

YUGOSLAV ADJUSTMENT EFFORTS

The GOY has acted firmly to compress the domestic economy and to reduce the current account deficit. In the past two years, it has adhered to the conditions of its three-year IMF stand-by agreement and is in the process of negotiating the terms of the third and final leg. Setting the stage for the third year of the IMF program, the GOY has devalued the dinar by a further 20%, raised interest rates and taken further steps to control the growth of credit and nominal incomes.

However, private markets remain unconvinced of the GOY’s capacity to manage this situation, and with good reason. Frequent payments delinquencies and uncoordinated requests for mini-reschedulings by some regional commercial banks (especially PBZ), together with the GOY’s failure to provide timely and accurate economic information, have turned off private lenders. The primary constraint on improved Yugoslav performance in this area is, as noted above, the Yugoslav domestic political situation and structure.

Moreover, GOY requests for official financial assistance, at least in their initial form, lack realism. The Yugoslavs recently approached the BIS informally concerning their interest in obtaining $500 million in four-year money. Central bankers, stressing the short-term nature of BIS arrangements (Mexico and Hungary obtained maturities of only three and six months, respectively), reacted negatively and suggested that, when a formal request is made, it be more realistic. The GOY has not yet come back, awaiting first the completion of the current IMF review assessment.

U.S. OPTIONS

(1) Provide financing, in coordination with other Western governments, sufficient to insure against a rescheduling. IMF sources estimate that Yugoslavia will require, at a minimum, $750 million from the BIS and a $1.0 billion consortium loan from governments to “avoid default” in the first half of 1983. Our assessment is that official financing at this level would be overkill if the banks continue to lend at last year’s level and hold constant their short-term exposure; it would be inadequate if private credit dries up. Increasing the amounts to cover the worst-case scenario would constitute a “bail-out” of the banks. Moreover, any package with a US share such above $150 million would require a supplemental appropriation.³

(2) Arrange a more modest package—$750 million—through the BIS. The US portion would be $150–200 million, roughly consistent with our share of Yugoslavia’s external debt. The sources of funds would be the Treasury’s Exchange Stabilization Fund (ESF) and the Federal Reserve swap line with the BIS. This would decrease, but still not eliminate, the probability of rescheduling. On the assumption that such a concrete demonstration of Western governments’ political and economic support for Yugoslavia would induce a substantial change in private lending behavior, rescheduling might not be necessary. Some US banks have suggested to us that they would welcome such a signal from Western governments. In addition, the BIS loan to Hungary was apparently a factor in inducing banks to reverse their withdrawal of funds.

In return, we should require much more extensive financial information than we are now receiving, before proceeding with an official assistance effort. We will be compiling a list of specific types of information which we should require the Yugoslavs to provide and look at other measures in such areas as foreign exchange management—which could have a beneficial effect.

The Treasury and the FRB reacted skeptically to the use of ESF/FRB money at the time of the initial GOY approach to the BIS, but did not flatly reject the idea. They will expect significant action on economic reform from the GOY (so should we) and may also insist on collateral—the BIS has indicated that most of the GOY’s $800 million in gold is unpledged (which will need to be verified). GOY actions would also be essential to spark a positive catalytic effect in the private sector, and thus would be critical to the success of the exercise.

The costs of US participation in a loan package for Yugoslavia are reduced flexibility to respond to similar crises in other countries and the risk of non-repayment. (Collateral would insure us against non-repayment.) Rescheduling would reduce the non-repayment risk as it would release substantial amounts of foreign exchange. The BIS funds would not be rescheduled.

(3) Candidly inform the GOY that their financial difficulties have reached the point where a “more permanent” solution is necessary, noting that the U.S. would accede quickly to a GOY request for an official rescheduling. We should select this alternative only “by default,” i.e. only after having reached the conclusion that rescheduling is an unavoidable foregone conclusion. Our present projections indicate that, given some outside assistance, rescheduling is not inevitable because Yugoslavia’s debt service ratio is only 25%, the maturity structure of the debt is favorable, with the short term component only 10% of total outstanding obligations and economic policy is moving in the right direction. We are currently updating the balance of payments forecasts, and seeking a detailed maturity schedule. We are also seeking from the GOY detailed information on the size and location of gold and foreign exchange reserves.

Obviously Option 2 may fail, either because of a shortfall in private lending or on the current account. Rescheduling may still be necessary. If so, we should encourage the GOY to face reality, stressing that a buildup of arrears would lead to a broken IMF program and thus to an extended period of financial uncertainty.

CONCLUSION

We conclude that the U.S. should take the lead in arranging a modest assistance effort of about $750 million through the BIS (U.S. share would be about $150 million). Such a package would (1) reduce the probability that the GOY will have to reschedule; (2) provide another concrete example (along with Mexico) that Western governments are prepared to act forcefully to provide liquidity to countries caught in the present “liquidity trap” as private banks try to reduce foreign exposure willy-nilly; (3) avoid a “bail-out” of the banks—as success would hinge on the private banks’ maintaining at least their present exposure in Yugoslavia, implying that they wish to avoid a rescheduling; and (4) would minimize the negative bilateral political fallout should a rescheduling prove necessary.

An IG/SIG process will begin with an IG meeting November 9,⁴ to examine in detail the Yugoslav economic/political situation and the appropriate U.S. response thereto. We will be initiating discussion of the Yugoslav crisis with our key allies next week at the Quad, and would hope to proceed to a SIG this month, leading to a National Security Decision.

RECOMMENDATION

That you authorize us to develop with other agencies agreement on a “modest” official assistance package for Yugoslavia. We may at some point need your assistance to sell the idea to Regan and/or Volcker.⁵

1. Source: Reagan Library, Secretary George Shultz Papers, Official Memoranda (11/06/1982) (2). Secret; Nodis. Drafted on November 1 by McGonagle; cleared by Milam, Davis, Azrael, Sestanovich, Palmer, and Constable. Sent through Eagleburger and Wallis. A stamped notation indicates that it was received on November 3 at 6:18 p.m.
2. A memorandum of conversation of this meeting was not found.
3. Shultz highlighted this sentence by drawing a line in the right-hand margin.
4. See Document 202.
5. Shultz initialed the “Approve” option. A stamped date below the “Approve” line reads, “Nov 6 1982.”