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

230. Information Memorandum From the Director of the Policy Planning Staff (Solomon) to Secretary of State Shultz¹

Washington, November 13, 1987

SUBJECT

• Facing Reality In Our Debt Strategy

Summary. Our debt strategy still has a long way to go in enabling the problem debtors to become both prosperous and creditworthy. Experience so far suggests that the conditions necessary for its success—domestic adjustment, export expansion, and fresh capital flows—cannot be achieved in a politically realistic timeframe. The markets, limited though they are, recognize this. They are facing up to the consequences that some of the loans will not be serviced in full. The reluctance of creditor country governments to do so is putting our interests in the debtor countries under strain.

Many assessments that reach this conclusion end with the recommendation that creditor country governments should step in and do more. On the contrary, under present circumstances it would be better if they did less. Government intervention has done just about as much as it can to squeeze additional lending from commercial banks and budget pressures virtually rule out publicly financed mechanisms for debt relief. A process is already underway that could lead through direct bargaining between the banks and the debtor countries to a market-determined settlement of the debt overhang. Creditor country governments can help by pursuing supportive macroeconomic and trade policies. Otherwise, the best thing they can do is get out of the way. End Summary.

Since 1982, our debt management policies have successfully bought time to strengthen the international financial system. But the problems of the debtors remain. As shown in the charts for the sample of 15 countries singled out in the Baker Plan, the record overall is disappointing. While it would be preferable to use base years starting before the period of unsustainable borrowing peaked, the readily available IMF figures for the years since 1980 present a stark picture of the trends in per capita incomes, financial flows, and the ability to service debt. (See charts 1–3)²

What Went Wrong?

For debtor countries to service their loans and attract new ones without sacrificing growth, they need larger export capacity, demand for their exports in overseas markets, and new foreign capital. It has not worked out that way.

— Constraints on Adjustment. The debtor countries have been either unwilling or unable to restructure their economies at the pace and on the scale required.

○ Even the most reform-minded regimes have seen their efforts thwarted by resistance from powerful unions, business lobbies, and bureaucracies. Their failure to implement better policies reflects at least as much their political vulnerability as their misjudgments.

○ Building up export industries requires investment in new factories, infrastructure, and farms. Instead, the countries cited in the Baker Plan have responded to their debt burdens by cutting investment to levels barely sufficient to maintain existing capital stock. (See chart 4)³

○ The record of the industrial countries on trade liberalization and macroeconomic coordination has not inspired confidence that they will be able to adjust their own economies enough to accommodate both an increase in debtor country exports and a reduction in the U.S. trade deficit.

— Commodity Price Disinflation. Despite boosting the volume of their exports, the 15 major debtor countries have not increased their export earnings. The reason lies in the shakeout in prices for oil and non-oil commodities, the principal source of export earnings for all but Yugoslavia. (See charts 5–6)⁴

— Capital Flows. Despite the upsurge in international lending and in international bond and equity issues, developing countries with debt problems have been almost entirely left out. Claims by commercial banks on the 15 problem debtors actually fell in 1986. While commitments under new refinancing packages could exceed $18 billion over 1986 and 1987, banks are reducing their exposure to private sector borrowers. Their total net disbursements through 1988 are thus unlikely to increase by much. Foreign direct investment is providing little help to offset these trends. (See charts 7–9)⁵

Coming to Terms with the Judgment of the Marketplace

The markets are typically well ahead of governments in facing up to the fact that many debtor country loans are not worth their face value and are unlikely to become so. Six of the fifteen countries cited in the Baker Plan are confirming the market’s judgment by no longer paying interest on their loans. In fact, the process has already begun that will lead to writedowns, interest deferments or capitalization, and eventually selective forgiveness. Should creditor country governments try to resist? If not, what should their role be, if any?

There was a strong case for government intervention to protect the banking system when the debt crisis first broke. That task having been accomplished, other issues have come to the fore. We have fundamental interests in fostering stable, Western-oriented democracies and more vigorous markets for U.S. exports in the debtor countries. While it would be desirable if these countries serviced their loans in full, trying to deny the reality that some of them will not may only serve to undermine these other interests.

There are effectively two ways in which creditor country governments can deal with a process of interest deferment and partial debt cancellation:

— Debt Discount Facility. A facility with support from the IMF or World Bank would buy or guarantee the discounted loans of commercial banks. This arrangement would shift liability for any additional losses from the banks to the creditor country governments. Whatever its merits, today’s budget environment all but rules out such an approach.

— Direct Bargaining. Creditor country governments would stay out of the negotiations between the debtor countries and their lenders. Whatever the outcome, countries undertaking reforms could still be allowed access to IMF support. While taxpayers would not be directly liable for any writedowns, they would share the costs with banks through reductions in tax revenues.

Toward a Market Solution

In the end, direct bargaining between the banks and the debtor countries offers the most realistic alternative. At least initially, it could contribute to more contentious debtor-creditor relations. Writedowns would strain banks with weaker capital positions. But this approach would also discourage both the banks and the debtor countries from prolonging their disputes in hope that creditor country governments would intervene on either’s behalf. It would instead reinforce incentives to work out their own settlements involving more sustainable levels of financial transfers.

This approach should not be billed as a “solution” to the debt problem. Whether countries continue paying interest and try to borrow more or they opt for moratoriums on interest payments, without basic economic reform, they would be no closer to correcting their underlying problems. And whichever decision they make, a vigorous world trading system is a prerequisite for their future growth.

In many respects, more hands-off policies would leave essential elements of our debt strategy unchanged. For the debtor countries, the hard work of implementing domestic reforms with backing from the IMF and the multilateral banks would continue. For the creditor country governments, the challenge of assuring open and growing markets for exports from debtor countries and effective support for the official lenders would remain.

But this approach would also require that creditor country governments be strict in resisting the temptation to intervene in debtor-creditor negotiations. The recognition of the damage caused by trying to set prices in foreign exchange markets may make it easier to incorporate this lesson in our debt policy.

In practice, this means:

— Changing the practice of making IMF programs contingent on the commitment of commercial banks to lend more.

— Avoiding putting pressure on either the banks or debtor countries in their negotiations over new financing programs.

— Exploring ways to cushion the impact on banks of recognizing losses on bad loans.

— Examining the possible role of the IMF or World Bank in monitoring reform commitments made as part of agreements involving partial forgiveness or interest deferments.

If you believe this approach is worth pursuing, we can work with EB and ARA to assess in more detail its risks and benefits and to develop specific policy actions. You would also need to take up with Jim Baker Treasury’s practice of intervening in negotiations between the banks and the debtor countries.⁶

1. Source: Department of State, Executive Secretariat, S/P Records, Memoranda/Correspondence From the Director of the Policy Planning Staff to the Secretary and Other Seventh Floor Principals, Lot 89D149: S/P Chron—November 1987. Limited Official Use. Drafted by Marc Wall (S/P) on November 12; reviewed by Paul Balabanis (E), Nicholas Burakow (EB/IFD/OMA), Steven Webb (EB/PAS), Jane Harrington (ARA/ECP), and David Konkel (INR/EC); cleared by Kauzlarich. Kauzlarich also initialed for Wall and Solomon. The initials “AMH” are written on the memorandum and crossed out. “BJ 11/13” is written on the memorandum.
2. Chart 1, “Domestic Absorption—In Real Terms: 1980–87,” Chart 2, “Financial Flows: 1979–87,” and Chart 3, “Debt Ratios: 1979–87,” are attached but not printed.
3. Chart 4, “Investment: 1979–87,” is attached but not printed.
4. Chart 5, “Export Trends: 1980–87,” and Chart 6, “Real Prices—Oil and Non-Oil Commodities: 1980–87,” are attached but not printed.
5. Chart 7, “External Financing: 1979–87,” Chart 8, “Banking Lending: 1981–87,” and Chart 9, “Gross Bond Issues: 1981–87,” are attached but not printed.
6. See Document 235.