Foreign Relations of the United States, 1981–1988, Volume XXXVIII, International Economic Development; International Debt; Foreign Assistance

185. Paper Prepared in the Department of the Treasury¹

Washington, August 30, 1985

THE INTERNATIONAL DEBT STRATEGY: APPRAISAL, KEY PROBLEMS, AND POSSIBLE MEASURES TO STRENGTHEN THE STRATEGY²

Introduction

The international debt strategy adopted in 1982 has provided a flexible framework for dealing with LDC debt problems on a case by case basis. The strategy has generally been successful in coping with the initial strains and providing a basis for the resumption of growth. In spite of the progress, however, the strategy is under increasing pressure:

— A growing resistance in debtor countries to the short-run economic and social hardships of adjustment has led to increased attention to “political” solutions, either generalized or unilaterally determined;

— Industrial country growth is slowing and there is a danger that interest rates may increase; and

— The deterioration in the U.S. trade position has fueled protectionist pressures which threaten LDC access to export markets.

Unless these pressures are reduced, the potential exists for a serious political and financial confrontation that would have a major impact on U.S. economic and security interests. The key to dealing successfully with these pressures is restoration and maintenance of a growing world economy in which all nations participate in greater global prosperity.

This paper provides an appraisal of the major elements of the debt strategy, outlines key problems which exist, and suggests possible steps to strengthen the strategy and provide a basis for increased world economic growth.

Appraisal of the Debt Strategy

The basic debt strategy involves a mixture of adjustment and financing, determined on a case by case basis, designed to strengthen debtor countries’ ability to service their debt and to provide for the resumption of growth and sustainable balance of payments positions. Progress under each element of the strategy is outlined below:

LDC Adjustment

○ A number of large debtor countries have successfully adjusted in the past four years and are no longer considered troubled debtor countries for the purpose of this paper (e.g., Korea, Turkey, Hungary, Indonesia).

○ Virtually all currently troubled major debtors are implementing adjustment efforts, usually supported by the IMF. Of eleven major debtors, seven have IMF programs, and two are participating in IMF enhanced surveillance arrangements.

○ Aggregate LDC current account deficits have fallen sharply, from $100 billion in 1982 to $44 billion in 1985.

○ The initial decline in LDC economic growth (to 1.9 percent in 1983), including negative growth of 3.1 percent in Latin America, has largely been halted and, in some cases, reversed. LDCs are expected to grow at an annual rate of 4.2 percent in 1985, with Latin America growing at 3.2 percent.

○ But adjustment appears to be approaching its politically acceptable limits in some countries, and pressures are mounting for more expansionary policies. This reflects political fatigue after three years of adjustment effort, an effort which has produced dramatic improvements in balance of payments but not in resolving domestic economic problems, particularly inflation. This has led to a lack of confidence that current growth rates can be improved, or even sustained.

Industrial Country Growth/Open Markets

○ From the 1982 recession low of –0.8 percent growth, OECD countries grew at an annual rate of 4.9 percent in 1984.

○ OECD import growth in 1984 was 12 percent, up from 4.1 percent in 1983.

○ Inflation has fallen to an average of 5 percent in 1984, while interest rates have fallen from 16.7 percent in 1981 to 8.5 percent currently (6 mos. LIBOR).

○ However, the stimulus from the U.S. expansion is declining, with no indication that growth in other industrial countries will pick up the slack. Germany, for example, is only expected to grow 2.5–3.0 percent this year.

○ Protectionist steps have limited the rate of increase in LDC exports. Rising protectionist pressures could reduce access further and curb the ability of LDCs to realize their full export and growth potential.

○ U.S. trade losses due to LDC adjustment efforts, especially in Latin America, have contributed importantly to our trade deficit and protectionist problems.

Commercial Bank Lending

○ The banks have agreed to reschedule and rollover $210 billion in debt and increased their exposure by about $35 billion in 1983 and 1984.

○ The private banks have not, however, resumed voluntary lending to many countries that are adjusting, and in some cases are retrenching. The annual increase in bank claims in LDCs is declining (e.g., from $31 billion in 1982 to an estimated $5–10 billion in 1985).

○ It is becoming increasingly difficult to obtain even this amount of increased exposure, with growing resistance by banks to participation in new money and debt rescheduling packages for adjusting countries (Chile and Colombia are two recent cases in point).

IMF

○ The 1983 increase in resources of $40 billion contributed to a sharp expansion in IMF lending, with outstanding Fund credit totalling about $35 billion at end-1984 compared to $19 billion at end-1982.

○ The IMF-supported programs have generally succeeded in promoting balance of payments adjustment and reducing financing needs, but in a number of countries have not led to comparable improvements domestically.

○ Moreover, the World Bank has not been adequately integrated into the debt strategy in a manner that would facilitate structural adjustment.

○ Consequently, many LDCs are making “prolonged use” of IMF resources, and some are falling into arrears on their IMF obligations.

○ Unless corrected, this situation threatens to damage severely the IMF’s financial integrity and credibility, undermining the IMF’s ability to deal with the Latin debt problem and play a central role in the international monetary system.

Bridge Financing in Selected Cases

○ The major industrial countries responded flexibly to immediate liquidity crises by providing short term bridge financing until IMF or other financing arrangements were put in place.

○ Bridge financing has been provided to 6 countries totalling about $7 billion.

○ However, requests for bridge financing are growing from countries which do not have assured means of repayment and/or do not pose a threat to the system. It is also becoming more difficult to get other industrial countries to participate in bridge financing arrangements.

The Policy Dilemma

The appraisal of the debt strategy indicates that we are faced with a pressing policy dilemma:

Given commercial banks’ unwillingness to increase exposure and our budget constraints, how to ease the current economic pressures on developing countries and thereby enable greater growth to be realized in their economies, while still encouraging adjustment, protecting the soundness of our commercial banking system and the IMF, and preserving broad U.S. political and strategic interests.

The successful resolution of this dilemma will be critical to achieving the increased economic growth needed to restore LDC creditworthiness and preserve a stable world financial system.

The magnitude of the problem is illustrated by the difficulty in reconciling projected lending with politically acceptable growth rates (i.e., 5 percent). Our analysis indicates that even under an optimistic scenario, it will be very difficult for several major Latin American debtors (Mexico, Venezuela) to raise the necessary financing in the period 1986–1988. Under a pessimistic scenario, financing requirements rise so sharply that under current financing techniques the available financing would fall far short of what is required.

○ The optimistic scenario assumes:

— a 3% average OECD growth,

— LIBOR declining gradually to 7.5% in 1988,

— good external adjustment by the debtors, and

— a decline in nominal oil prices to the level of approximately $26 per barrel by the end of 1986, and stable thereafter.

○ Under this scenario, the increase in bank exposure required for the period 1986–1988 for the major Latin debtors would be about $12 billion. This would represent a 1.6% rise in bank exposure each year to these countries. While this may appear to be financeable in the aggregate, Mexico and Venezuela would find it extremely difficult to raise sufficient capital from banks.

○ The pessimistic scenario assumes:

— average OECD growth of 2%,

— an increase in LIBOR to 13% in 1986, declining to 9% in 1988,

— mediocre adjustment by debtors,

— a decline in nominal oil prices to $22 per barrel by the end of 1986, and stable thereafter.

○ Under this scenario, politically acceptable growth is unattainable. It would require financing on the order of $46 billion, an approximate 6% increase per year. This is clearly impossible for banks to accept under current policies and practices. We estimate that in the case of Mexico, banks will be unwilling to provide more than $3 billion per annum even with comprehensive economic adjustment. The market for new Venezuelan exposure is probably no more than $1 billion per year in this time frame.

Measures Aimed at Promoting Growth in the Major Debtors

Below are two areas of possible measures which we believe warrant consideration.

○ We focus initially, and primarily, on ways to increase commercial bank lending, for we believe it is that element of the debt strategy that has fallen shortest of fulfilling its part.

○ Many of the measures are interrelated, suggesting the need for a “package approach.” A more active role for the MDBs could, along with regulatory changes, help induce greater commercial bank lending.

I. Increasing Commercial Bank Lending to Latin America

Claims of BIS area banks to Latin America increased by 10 percent ($16.3 billion) in 1982, by only 2.7 percent ($5.7 billion) in 1984; claims of U.S. banks to Latin America increased 12 percent ($7.3 billion) in 1982, by 4 percent ($2.5 billion) in 1984. In 1984, the increase was to Brazil and Mexico; claims on the rest of Latin America actually declined. Most of the recent lending is involuntary and “lumpy,” made in connection with IMF programs.

Some decline in bank lending was to be expected with falls in inflation and interest rates and adoption of adjustment programs. Current lending levels, however, are clearly inadequate to meet the needs of the major debtors and inappropriate given the banks’ financial stake in Latin America. The decline in their lending to LDCs has enabled them (in keeping with legislative and regulatory guidance) to strengthen their financial condition, thus possibly putting them in a better (although far from optimal) position to increase LDC exposure at this time.

Tailoring Regulatory Criteria to Reflect More Accurately Potential Economic Performance and Risk

There are several possible measures that might be used in some form or combination to promote increased commercial bank lending (additionality) and/or ease the immediate LDC debt service burden. Apart from moral suasion, these measures include:

A) Capitalization of Interest Payments

○ Banks would be permitted to add a certain amount of uncollected interest to unpaid principal in selected cases and to include in income the interest that is capitalized.

○ Regulators would expand existing guidelines, add new ones as necessary, permitting limited capitalization where additional lending strengthened existing assets.

○ Regulators would also adopt/seek changes in 90/180 day rules governing non-accrual of interest and “bad debt” if necessary to facilitate agreements.

○ Used only for major debtors with demonstrated adjustment records.

○ Need to overcome objections that measure would weaken prudential standards or violate accounting/disclosure requirements, and to forestall demands from domestic sectors for similar treatment.

B) Banks to Make New Loans to Improve the Quality of Outstanding Credit or Be Required to Write-off Some Exposure

○ Banks which failed to achieve specified lending targets under new money packages for major debtors would have existing loans classified as value impaired and be required to take write-offs and/or increase reserves.

○ Targets (in terms of percentage increase of outstanding claims as of, say, end-1984) determined in conjunction with IMF and other major creditor countries.

○ Need to persuade other creditor countries to impose similar targets and sanctions in order to avoid risk that U.S. bank lending enables others to get out.

○ Might need to adapt regulatory, accounting and disclosure rules. Also deal with demands from other LDCs and domestic sectors for similar treatment.

C) Lower fees and charges

○ Banks required to reduce fees and interest rate spreads in conjunction with IBRD guarantee schemes (see below).

D) Encouragement of Debt-Equity Swaps to Reduce Debt Service

○ Banks and debtor countries would be encouraged to negotiate swap of bank claims for equity in either nationalized or private firms that might be attractive to foreign investors.

○ Scheme need not involve sales of major firms in sensitive sectors; could be designed so that equity sold in small and medium sized companies which could benefit from injection of foreign capital, management, technology.

○ Difficult to induce significant volumes, but could encourage by introducing concept in IBRD Structural Adjustment Loans and by adapting present accounting/regulatory practices and legal provisions of loan contracts that might discourage such swaps. (Recent Mexican rescheduling agreement explicitly provides for such swaps.)

II. The Multilateral Development Banks

As indicated above, we believe the primary focus of our overall strategy should be on techniques to increase commercial bank lending to debtor countries in order to support higher growth and a restoration of creditworthiness. We seek a strengthened MDB role in the strategy which would:

○ maximize flows to major Latin debtors,

○ support policy changes that would promote long-term growth and development, and

○ (in the case of the World Bank) catalyze commercial bank lending.

The World Bank

Is well positioned to accomplish these objectives; measures would also benefit other IBRD members.

For each option, we would:

○ seek to increase Latin America’s share of overall IBRD lending from 30.4 percent to 37.5 percent; about 50 percent of Latin lending would go to Brazil, Mexico and Argentina. (Venezuela is not an IBRD borrower.)

○ increase share of fast disbursing structural/sector lending in Latin American program from 20 to 30 percent,

○ relax the individual country portfolio guideline from 10 percent to 12–12.5 percent to remove constraint on lending to Brazil, and

○ encourage greater use of IBRD guarantees of commercial bank financing.

LOW OPTION:

○ IBRD commitments rise from $11.5 billion (FY 83–85 average) to $16.5 billion in FY 90.

○ annual commitments to Latin America would rise from $3.4 billion to $6.2 billion in FY 90.

○ fast disbursing structural/sector lending to Latin America would rise from $560 million to $1.6 billion in FY 88.

○ require a GCI of $31 billion.

— U.S. share $6.2 billion. Four annual U.S. subscriptions of $1,550 million requiring annual budget authority of $38.8 million assuming 2.5 percent paid-in capital.

HIGH OPTION:

○ IBRD commitments rise from $11.5 billion (FY 83–85) to $20 billion in FY 90.

○ annual commitments to Latin America would rise from $3.4 billion to $7.5 billion in FY 90.

○ fast disbursing structural/sector lending to Latin America would rise from $560 million to $1.9 billion in FY 88.

○ require a GCI of $53 billion.

— U.S. share $10.6 billion. Four annual U.S. subscriptions of $2,650 million requiring annual budget authority of $66.3 million assuming 2.5 percent paid-in capital.

APPRAISAL:

○ U.S. objectives regarding Latin America would be easiest to achieve (vis-a-vis other donors and the LDCs) within the framework of a $53 billion GCI.

○ While there will be significant Congressional opposition to any GCI, a $53 billion GCI is “doable” with a concerted Administration effort. The fact that we are extending the timeframe of a GCI to cover IBRD lending through FY 91, and thus reducing annual U.S. budgetary costs, will be a plus.

○ A $53 billion GCI would provide the flexibility for a major increase in lending to Latin America, as well as in the region’s lending share, while also allowing for meaningful increases in lending to other borrowers.

○ In a $31 billion GCI, it would not be realistic to expect the desirable increase in Latin America’s share of total lending.

The Inter-American Development Bank

The next replenishment of the Inter-American Development Bank (IDB) will cover lending for the four calendar years of 1987–1990. Negotiations are to begin in early 1986. Our objectives are to achieve fundamental changes in IDB operations and policies, including:

— strengthening policy conditionality;

— increasing control over project quality;

— developing policy coordination with other donors; and

— encouraging private sector development.

At the same time, the IDB is well situated to aid in increasing resource flows to major Latin debtors through well-targeted non-project loans. The dilemma is that the dual objectives of achieving significant reform and maximizing flows to major Latin debtors may well be contradictory and cause significant difficulties in negotiations.

LOW OPTION:

○ IDB combined annual lending to Argentina, Brazil, Mexico, and Venezuela of $1.25 billion for CY 87–90 (a 25% increase). Lending to other IDB members would increase a total of 15%.

○ Requires a capital increase of $26.4 billion and FSO (soft window) replenishment of $350 million. FSO lending would be focused on Central America and the Caribbean.

○ U.S. share of $9.2 billion in the capital increase and $144.5 million in the FSO. Assuming 2.5% paid-in capital, combined capital and FSO replenishments require total budget authority of $93.5 million per year as compared to $130.5 million under current replenishment.

HIGH OPTION:

○ IDB combined annual lending to Argentina, Brazil, Mexico, and Venezuela of $2.0 billion for CY 87–90 (a 100% increase). Lending to other IDB members would increase a total of 25%.

○ Requires a capital increase of $34.3 billion and FSO (soft window) replenishment of $500 million.

○ U.S. share of $11.9 billion in the capital increase and $206 million in the FSO. Assuming 2.5% paid-in capital, combined capital and FSO replenishments require total budget authority of $126.1 million per year as compared to $130.5 million under current replenishment.

APPRAISAL:

○ Range of options is realistic, outcome would depend on final weighting of objectives to be sought.

○ High option would require concerted effort to gain Congressional approval and funding given substantial increases in total U.S. contributions.

○ There will be substantial international political pressure on us to agree to a high IDB replenishment level, given Latin America’s current economic problems.

Purchases of Discounted Commercial Bank Loans

○ The World Bank or a new affiliate would purchase at a discount commercial bank claims on a particular debtor country. The discount could reflect in part existing secondary market valuation of the debt.

○ The World Bank would then restructure the purchased loans to debtor countries to lower the interest rate and lengthen the terms.

○ The commercial banks would have to agree to make new loans (after allowing for the discounted portion) to restore previous exposure levels and possibly to increase them to the same debtor; as a quid pro quo, the commercial bank would be given access to the World Bank’s guarantee program.

○ Proposal would stretch out LDC debts and cause banks to take a “hit” but costs to governments in terms of capital would be very large.

○ In order to avoid a need for banks to revalue downward other claims on the debtor, revisions in current accounting treatment might be necessary.

1. Source: National Archives, RG 56, Records of the Office of the Secretary of the Treasury, Official Files of the Executive Secretariat, 1985, UD–11W, 56–88–79, Box 66, Memo to the Secretary, August ’85. Confidential. Sent under an August 30 covering memorandum to Baker, in which Conrow explained that the paper would be for distribution at a September 3 meeting on international debt strategy. No record of the September 3 meeting has been found.
2. A draft of this paper, which was sent under an August 13 covering memorandum from Mulford to Baker and includes Baker’s handwritten comments, is ibid.