The attached paper provides our conclusions on how our debt strategy should
be extended in the next phase. It parallels Rimmer de Vries’ paper in many
respects but argues, unlike Rimmer’s, that no government or IMF money is needed to deal with escalated
interest rates on floating rate debt—although regulatory changes may
be.2
We need your reactions before a version of this and Rimmer’s paper go to
Treasury. We recommend a discussion of both papers with you, Ken Dam, Allen
Wallis, Mike Armacost
and ourselves.
Attachment
Paper Prepared in the Department of State3
BUILDING ON THE DEBT STRATEGY: AN AUGMENTED ADJUSTMENT
FRAMEWORK
Overview
This paper recaps the debt strategy, reviews in detail the assumptions
which determine its viability and suggests areas where the basic
[Page 428]
approach could productively be
supplemented to strengthen the adjustment process in the medium term. In
particular, we recommend a strengthening and modification of the World
Bank role, closer coordination between the Bank and the IMF in a medium-term context and a
proposal on interest capitalization designed primarily to improve the
politics of debt management.
The Strategy
The debt strategy consists of the following main elements: (a) adjustment
by debtor countries; (b) Recovery, sustained expansion and open markets
in the industrialized countries; (c) Adequate amounts of commercial bank
financing; (d) Support of the IMF, the
key institution for encouraging and in lubricating the adjustment
process; (e) Readiness of creditor governments to provide emergency
liquidity when essential to give debtors time to implement adjustment
programs.
As pointed out in our earlier paper,4 many elements of the
strategy are not directly under the control of governments. The strategy
is therefore primarily a set of assumptions which define the conditions
under which the debt management process should be viable. We define
viability as a state in which debtor countries are able to achieve
current account positions consistent with available public/private
financing over the medium term and simultaneously maintain politically
acceptable rates of GDP growth, again
in a medium term time horizon.
A Strategic Checklist
Since the strategy rests on a set of assumptions, its viability can be
assessed by comparing the actual evolution of events with initial
expectations.
LDC Adjustment.
The aggregate current account deficit of the non-oil LDCs shrank from
$76 billion in 1981 to $43 billion last year. This was largely the
result of a sharp drop in imports in this period, reflecting the
implementation of austerity measures and the paucity of finance. Excess
demand was a critical part of the problem and its suppression must
figure importantly in the solution. Eighty-five IMF adjustment programs were implemented in this period.
Net IMF disbursements in 1981–83
totalled 9.5% of current account financing, compared with 2% in the
1978–1980 period. These programs included austerity, but also stressed
measures which stimulated production and redirected resources toward the
external sector.
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The politics of adjustment have been mixed. Implementation of IMF programs has occasionally sparked
violence (Morocco, Dominican Republic), but in most cases has met with
grudging acceptance (including tough cases such as Peru). Among the
major debtors: Mexico and Brazil are adjusting relatively smoothly;
Argentina and Venezuela and Nigeria are wild cards. Most of the rest of
the world is either struggling feebly against the weight of enormous
development problems of which debt is only one aspect (much of Africa),
or is managing well (most of South East Asia, East Asia, and yesterday’s
basket case, Turkey).
OECD Growth and Open
Markets. The USG debt strategy
assumed that the OECD countries would
grow at an average annual rate of 3–4% over the next five years. Other
analysts (IMF, Morgan Guaranty, the Institute for International Economic
Policy) set a 3% growth rate as an essential structural support for an
orderly debt work-out. The most recent OECD forecasts put OECD
real GNP growth at 4.1% in 1984,
following a 2.4% expansion last year. Growth should decelerate, on
OECD estimates, to about 2.8% in
early 1985. IMF forecasts are
consistent with the OECD’s.
The growth assumptions are critical—a 1% percentage point decline in real
GNP growth in the OECD would slash LDC exports by at least $4 billion annually. Thus,
uncertainties in the growth outlook are cause for concern. Moreover,
interest rates are rising as the strengthening US private credit demand presses against the budget deficit
and inflation expectations stir. Higher interest rates inject a new and
difficult factor into both the economics and the politics of debt
management. Each one percentage point increase in rates increases the
LDC debt service burden by $1.9
billion (net). Politically, the LDC
perception is that the hard won fruits of the adjustment effort may go
up in interest rate smoke. This could affect negatively their resolve to
stay the economic policy course and their willingness to play by the
rules.
Open markets among the industrialized countries are equally critical.
Increased protectionism reduces LDC
shares in our markets and is thus equivalent to a shortfall in OECD growth. Preserving relatively open
markets will continue to be difficult. The future course of events
depends on the balance between domestic political pressure and the
Administration’s resolve to fight it, which in turn depends on where our
policy priorities lie.
Commercial Bank Finance. The USG strategy, as originally formulated,
exhorted banks to hang in there, but did not specify “adequate” amounts.
A consensus has developed among analysts that $20–25 billion per year in
net new private financing is necessary to provide adequate financial
support for adjustment. The IMF and
OECD estimate that net new private
lending to [LDCs?] reached about $20 billion in 1983. While much of this
lending has been characterized as “involuntary” because it was
encouraged by governments and by the IMF, “voluntary” lending to protect existing bank exposure
was probably of equal importance.
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The IMF expects bank lending to continue
at just over $20 billion per year over the next few years. However,
commercial bank financing is likely to reflect a balance of
considerations (reluctant regionals, defensive lending, improved LDC creditworthiness, public pressure).
While the net result of such conflicting forces is uncertain, there is
little reason to expect an early return to market determined relations
between LDCs and their creditor banks.
Support of the IMF. Some say that this job was accomplished with the
quota increase and expansion of the GAB. Other are less sanguine and point out that the constraint
on IMF’s role is no longer the quota
limits, but the funds available to fill them. The issue of IMF financing is inseparable from that of
the role of the Fund in the adjustment process. This is discussed
below.
Official Bridge Financing. Bilaterally and with
other OECD countries through the
BIS, the US has reacted quickly to provide very short term liquidity
support to countries in dire need. Some targets were of systemic
importance (Mexico, Brazil); others were not, but mattered politically
(Yugoslavia, Jamaica, the Philippines where we have a commitment, but no
expenditure as yet). Judicious use of bridge financing, using primarily
the Treasury’s ESF, is just as
important politically (we are there in time of great need) as it is
economically. Accordingly, this aspect of the strategy is going well,
although there is a tendency to use the ESP facility more sparingly.
Augmenting the Basic Approach
While fundamentally sound, the debt strategy could be usefully augmented
through:
- —
- A moderate expansion of conditional finance to support the
adjustment process. Because we are operating at the low end of
the viable range, the LDCs have less flexibility than earlier
assumed. The tough cases will probably continue to experience
substantial strain. Thus, the probability of political
instability is higher than expected.
- —
- Giving more concrete institutional recognition to the fact
that the adjustment process must (1) unfold over several years
and (2) extend well beyond austerity in order to attack the
roots of deep-seated structural imbalances and to effect the
redirection of LDC productive
resources toward the external sector. Such a shift in productive
effort is necessary to support existing levels of debt as well
as expected future increases in indebtedness. (There is no
question of the LDCs “paying-off” their debt. The development
process requires a continuing net inflow of capital. This
implies that the LDCs should continue to run current account
deficits, which further implies an increase in net indebtedness
over time.)
- —
- Voicing official support for measures, such as certain forms
of interest capitalization, which could improve the politics of
debt management. A paper outlining a capitalization mechanism we
could support together with a brief sketch of the costs and
benefits of such a mechanism
[Page 431]
is attached at Tab A.5
(Such a limited proposal would capitalize the difference between
initial lending rates and higher rates resulting from
expectations of increased inflation.) We would only stress here
that floating interest rates are a private sector phenomenon and
should be managed without the direct involvement of the public
sector, including of the IMF
(the Venezuelans strongly support a Compensatory Financing
Facility for interest rate changes). The USG role should be confined to
supporting economically sound capitalization proposals.
The above conclusions concerning the sustainability of the debt strategy
and the desirability of strengthening its medium term aspects and
adjustment focus point toward an expanded role for the World Bank and
the IMF, and for closer coordination
between the Bank and the Fund in promoting economic adjustment over the
next several years. Concerning the World Bank per
se, its effectiveness in supporting adjustment
would require an increased emphasis on program (balance of payment
support through Structural Adjustment Loans or sector loans) as opposed
to project lending, more active use of IBRD/Commercial bank cofinancing
and an enhanced role in promoting. equity investment. Specific proposals
and a more detailed analytical rationale for them are at Tab B.6
More intensive coordination between the Bank and the Fund should underpin
medium term adjustment. The IMF has
neither the resources nor the mandate to support adjustment in a
multi-year frame. The IBRD has both,
but has a predominant focus on project lending and lacks expertise in
the stabilization area. Thus, there is a need for programs with a
multi-year time span to be designed jointly by the Fund and the Bank.
Such programs would emphasize a large stabilization component and a
heavy IMF role in the early phase of
the programs. In the latter phases the relative emphasis would shift
toward structural change and IBRD
finance as the program proceeded. Overall consistency would be provided
by an investment program agreed between the IBRD, IMF and financing
countries to help ensure that the Bank’s project lending would “fit”.
This approach should feature maximum IMF funding early in the program to support vigorous
adjustment—a cold bath with a commitment to medium term financial
support. This would require scrapping the present policy of “catalytic”
Fund programs (skimpy IMF financing—50%
of quota) in countries where the necessary profound changes are likely
to require several years. We doubt that such an attenuated process is
likely to succeed and strongly favor a relatively short but financially
important IMF role to be backed over
time by the IBRD. Again a larger, more
program-oriented, World Bank would be necessary to mesh with the Fund in
such an effort.
