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

256. Paper Prepared in the Department of the Treasury¹

Washington, undated

CONTINUATION OF CURRENT APPROACH TO DEBT PROBLEMS: A REALISTIC ASSESSMENT

The current approach to debt problems focuses on the adoption of debtor reforms buttressed by external financial support. Its fundamental objective is to generate stronger growth in debtor nations as a basis for achieving a reduction of debt burdens over time and a restoration of access to financial markets. A complementary objective has been to improve the debt/equity mix of both new and existing external obligations and to boost domestic savings as an alternative to new foreign debt.

The debt strategy has successfully bought time during which commercial banks have strengthened both capital and reserve positions, reducing the risk of default to the financial system. It has encouraged a stronger focus on growth-oriented macroeconomic and structural reforms in debtor nations essential to sustained growth over the longer term. And it has maintained a cooperative international effort in support of debtor nations. The bright spots are real and have been summarized in previous papers. Nevertheless, there continues to be a political perception that the debtor nations are in as difficult a position now as they were a few years ago.

In assessing progress toward the strategy’s basic objectives, the following factors stand out:

(1) While debtor nations have been implementing more growth-oriented policies, policy implementation has been uneven and so far has generally failed to generate renewed investor confidence. Debtors have frequently failed to fully implement Fund programs, in some cases requiring waivers of performance requirements under consecutive programs. The reform process has been stop-go instead of a sustained effort. Tangible “results” from structural reforms have been especially difficult to measure.

(2) Growth has improved for most countries, but remains too slow in many to sustain the political will to continue economic reform efforts or to generate a substantial reduction in debt in a reasonable period of time. In the three largest debtors (Brazil, Argentina, Mexico) growth has fallen sharply for either external (oil price) or domestic policy reasons.

(3) Export earnings have recovered to pre-1982 levels (following a sharp decline in 1985–86), but for most countries have not generated any “excess” earnings for use in reducing debt. (The exceptions are the Mexican debt/bond exchange using Mexican reserves and the Chilean debt buyback from copper earnings.)

(4) For most countries, debt and debt service burdens continue to increase. Debt for the 15 major debtors has increased by $100 billion since 1982; debt/export and debt/GDP ratios remain well above the 1982 level. While interest payment/export ratios have improved, the recent increase in interest rates is eating away at these benefits. Six of the major debtors are currently in arrears on payments to commercial banks (a de facto means of temporarily reducing debt service payments).

(5) Investment has declined from an average of about 25% of GDP in 1980–81 to 17% in 1985–87; domestic savings as a share of domestic income also remains below pre-1982 levels. In many cases, healthy investment opportunities are not being exploited due to lack of access to funds. While some $10 billion in debt/equity swaps and $9 billion in other debt conversions since 1985 have helped to reduce debt and debt service burdens, conversions at this pace won’t produce manageable interest burdens over the near term for most countries. (Chile, again, may be the exception.)

Although the trends appear more positive during 1987–1988, they can only be sustained with strong growth in OECD export markets or commodity prices and a resumption of lower or declining interest rates. These are events which we cannot count on for sure.

Tactically, the debt strategy has relied since 1982 on the generation of large debtor trade surpluses and concerted international lending packages to assure continued payment of interest on commercial bank and official loans. Commercial banks, however, are increasingly reluctant to provide new financing as they seek to reduce their LDC exposure. Debtor nations, for their part, seek more direct and immediate relief to reduce their large net transfers abroad. At the same time, the pressure for increased IMF and World Bank loans, World Bank “enhancements” of commercial bank loans, and IMF or World Bank loans for debt reduction purposes is growing.

A cold and hard appraisal of a continuation of the current approach would suggest the following negative trends:

○ There will be a continuing gradual shifting of risk on LDC debt from the private to the public sector.

○ Debtors will continue to adopt partial reform measures in order to obtain financial support. Such reforms will become more difficult, however, in the absence of more rapid progress in reducing debt burdens—and debtor nations will demand a higher premium for their reform efforts (larger loans from the international financial institutions or specific, immediate relief).

○ Growth will remain anemic, and won’t be sustained if reform efforts falter. Incentives for debtor reform will decline unless cash flow can be improved. Any increase in export earnings will go primarily to service debt rather than being invested in future growth.

○ Commercial banks will continue to insist on being paid interest as they withdraw from new lending, while providing “relief” only at the margin.

○ The Fund and Bank will become increasingly enmeshed in new lending to debtor nations as the commercial banks pull back. Loans from both institutions will increasingly focus on servicing both their own and commercial bank debt. The potential for arrears, already increasing for both institutions, could threaten their own viability, or necessitate debt reschedulings and additional infusions of funds from shareholders. This problem may well need to be faced within the next two to three years.

○ Continued new lending by the international financial institutions (and stronger arm-twisting to obtain even marginal lending by commercial banks) will boost both debt and debt service burdens, further burdening debtor nations.

○ Adverse external developments (higher interest rates, slower OECD growth, lower oil prices) will continue to cause periodic financing “crises” for individual countries. Ad hoc responses will provide temporary bandaids, but not long-term solutions.

○ Democracies, particularly in Latin America, may be placed at risk.

Appraising these negative points involves matters of judgment on which there is obviously substantial disagreement. However, there is a clear need in the current debt strategy to place a stronger emphasis on reduction of debt and debt service burdens. The strategy is already moving in this direction, in encouraging the development of both new money and voluntary debt reduction techniques in commercial bank packages. However, progress in reducing debt burdens has been at the margin for most countries. The potential for further voluntary transactions is limited by:

○ commercial bank willingness to accept losses;

○ the debtors’ unwillingness to open their markets more widely to foreign investment; and

○ deep disagreement between debtors and banks about the terms to apply to debt/equity swaps and/or other techniques for reducing debt.

A more comprehensive approach to debt reduction would require solutions that depend more heavily on official resources or sanctions, or a large scale transfer of risk to the international financial institutions.²

1. Source: National Archives, RG 56, Records of the Office of the Secretary of the Treasury, Congressional Correspondence, 1988, UD–10, 56–10–1, Box 35, Group Letters S/, Current Approach to Debt Problem 88–72157. No classification marking. Sent under identical covering memoranda, dated December 12, from Brady to Shultz, Baker, Powell, and Greenspan. The memorandum to Baker included a handwritten note from Brady, which reads: “Jim, Also attached is the memo #1 which formed the basis for the first meeting. NFB.”
2. Also sent under the December 12 covering memoranda (see footnote 1, above), are two papers outlining potential new approaches to the international debt problem. The paper, “Back to Basics for the IMF and World Bank,” suggests that the United States could call for a major reassessment of the roles of the IMF and World Bank in the world economy. The paper, “A ‘Permanent’ Solution Through Debt Service Moratoria and Restructuring: A Fresh Start for LDCs,” examines the role debt moratoriums and negotiated debt restructurings could play in alleviating debt difficulties. Both papers are attached but not printed.