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International debts: what's fact and what's fiction. Presidential address to the Western Economic Association, July 2, 1988.

SCHWARTZ: INTERNATIONAL DEBTS

The official strategy on the international debt problem was breached in May 1987 when Citicorp, acknowledging the likelihood of credit losses on its Latin American loans, announced that it was increasing its reserves by $3 billion. Nineteen banks between 26 May and 8 July also announced additions to their loan loss reserves, in aggregate amounting to over $12 billion, according to Musumeci and Sinkey [1988]. In May 1988, the General Accounting Office (GAO) estimated that reserves of U.S. banks against their troubled loans to LDCs totaled about $21 billion, whereas adequate provisioning would require reserves of $49 billion (see the Wall Street Journal, 19 May 1988).

The GAO used prices on secondary debt markets in determining the adequacy of loan reserves. The banks and regulators, however, dispute the GAO's report (see the Wall Street Journal, 13 May 1988). The secondary markets, they contend, are thin, and transactions of even moderate size cannot be executed at quoted prices. The price quotations may also misrepresent the prospect of repayment for the following reason. By holding a foreign country's debt, a creditor bank has been subject to the implied obligation to lend new money pro rata to that country. However, by selling the debt on the secondary market, a creditor bank is released from that obligation, and hence may accept a lower price than would otherwise be the case. On the other hand, as Sachs and Huizinga [1987,579-87] note, the decline in bank equity prices since 1982 closely matches the secondary market valuation of LDC exposure. The qualifications concerning the significance of the secondary market prices of foreign debt did not apply to prices of foreign bonds that in the past traded at a discount in the market. Those prices reflected solely the probability of repayment of the bond.

The additions to loan loss reserves in 1987 reduced the banks' reported income and their book capital. Equity was reduced by a transfer to reserves, and plans to issue equity were announced by many banks following their additions to reserves. The reserves, however, are not charged against current income for tax purposes. Should write-offs occur in the future or agreements be reached with the debtors to reduce outstanding debt, the losses will be charged to reserves with no effect on reported income. Latin American debt has not been written down because of the additions to reserves, and no forgiveness is involved for LDC debts.

The banks face difficulties in reducing their developing country debt by sales, swaps, and write-offs. Loan agreements may prohibit repurchase of the debt by the borrower, hence limiting the sales option. (14)Swaps for local currency or equity have had only small effects on debt reduction. J.P. Morgan and Company earlier this year devised a program with Mexico that had the blessing of the U.S. Treasury. Morgan swapped $400 million of its Mexican government debt for $263 million twenty-year Mexican government bonds. The Mexican issue was collateralized by twenty-year U.S. Treasury zerocoupon bonds (at time of sale, priced to pay 8.41 percent annually) that Mexico bought with $2.56 billion of its international reserves. Swaps by other banks participating in the program reduced Mexico's bank debt by about $1 billion, although a $10 billion reduction had been forecast. Morgan regarded the swap as advantageous because it also served to reduce its obligation to supply future loans to Mexico. For other banks the size of the discount on the swap made the deal unattractive. (15)The third way for the banks to reduce exposure to developing-country debt is write-offs. Write-offs have limited appeal. They risk inciting political pressure to force debt forgiveness.

The regulators, the U.S. government, and international-agency lenders continue to pressure the banks to provide additional loans to the Latin American debtors that are either in arrears on interest payments or pay a large percentage of their trade surplus to cover service charges. Some regional banks demand loan guarantees from the World Bank as a quid pro quo for their contribution to the loan package, since World Bank debt has seniority over commercial-bank debt. Provision of guarantees would offset that advantage.

Over the period that the debt situation has persisted, enormous and clearly wasteful use of bank resources has been required to negotiate new loan agreements that can win the adherence of a sufficient number of bank lenders. One anomaly that characterizes the position of the banks is that every dollar of additional lending that they have advanced has been immediately discounted by the market, whatever the margin of doubt surrounding the quoted price.

Continued lending was originally urged to preserve the financial solvency of U.S. banks. Solvency of the banks may no longer be in question, but they may not be in a position to contest the fiction that continued lending is in their self-interest. The regulators call the tune and the banks are obliged to dance to it.

Lindert [1988] concludes that before World War I, the record of two-party bargaining worked pretty well. Where a revolution occurred, however, as in the decade of the 1910s in Mexico and Russia, the creditors had no effective bargaining posture vis-a-vis the post-revolutionary governments. In the 1930s, debt repudiation and the end of lending were the result of the worldwide collapse.

In the post-World War II context, governments initially borrowed from other governments, leaving to the IMF responsibility for loans for balance of payments adjustment and to the World Bank responsibility for development loans. These two agencies subsequently played a role in debt refinancing arrangements between governments. By 1979, however, the creditors were private banks with a high level of exposure. U.S. banks, reluctant to write down nonperforming loans with interest arrears lest it encourage efforts to forgive debts, were eager for third-party help. The IMF grants concessionary loans to a debtor conditional on domestic austerity only when the country has settled on a financing package with the banks. Under this arrangement, the banks have an incentive to demand the maintenance of the original level of interest rates, and the debtors do not hold out for rescheduling agreements that offer debt relief. In Lindert's third-party intervention since 1982 has impeded bilateral bargains between the debtor governments and the creditor banks. The two parties directly involved could have resolved the debt repayment problem.

THE ROLE OF THE CREDITOR GOVERNMENTS AND THE MULTILATERAL INSTITUTIONS

In the past, when confronted with foreign debt delinquency, politically dominant creditor governments sometimes actively intervened on behalf of their distressed national who had invested abroad. At other times, creditor governments remained aloof. Foreign policy grounds generally determined the decision. In the 1980s international debt crisis, intervention undertaken by the U.S., the dominant creditor country, was a decision of the monetary authorities. They determined that, to preserve financial stability in the domestic banking system, it was essential to create the facade that the foreign borrowers were faced only with a liquidity problem.

The U.S. government took the lead in devising the strategy to cope with the problem. Other creditor governments backed the U.S. approach. The aim of the strategy was to enable the debtor countries to maintain current debt service by

providing them with additional loans from official and private bank sources. Income and capital accounts of the U.S. banks would reveal no loss.

In past episodes of foreign default that have recurred from century to century, international agencies did not exist. It was not until 1930 in the interwar period that the Bank for International Settlements was organized. The post-World War II multilateral agencies were essentially bystanders during the 1970s, when foreign bank borrowing by Third World countries swelled; they had no mandate when originally established to deal with international debt problems. However, they seized the opportunity afforded by the debt crisis in the 1980s to enlarge the scope of their involvement in the economies of the problem countries, becoming active participants in the strategy the U.S. had devised.

The IMF was established to finance temporary international payments imbalances for individual countries under pegged exchange rates. Once the Bretton Woods system collapsed, the initial functions of the IMF evaporated. A deficit in the current account would presumably lead to a decline in a country's floating exchange rate. No temporary IMF adjustment loan would be needed. The commercial banks in the event were prepared to lend to oil importers facing higher bills for energy.

To find a new function, the IMF expanded its activities, principally the Compensatory Financing Facility (introduced in February 1963) that provides financing in the event of export shortfalls. It also established a new upper tranche Extended Fund Facility, covering a three-year period. The rationalization for these innovations was that balance of payments adjustment involved not only aggregate demand conditions but also supply side conditions, such as the need for productivity increases, changes in production structure, and investment. Results on the supply side could not be expected in the short run, hence longer-term financing was needed. The IMF's expanded activities enabled it to extend loans with conditionality provisions to dozens of countries, when previously (under Bretton Woods) it made such loans to only one or two countries a year.

The World Bank followed the same course as the IMF. It introduced Structural Adjustment Loans to support structural changes in industry, agriculture, and energy. The object was to achieve long-term policy reforms that would accelerate development. The bank also introduced sector adjustment loans, as part of the bank's Special Action Program. More countries have been granted loans under the sector than under the structural adjustment program.(16)

The transformation of the IMF's role from a provider of temporary assistance to a source of medium-term financing of heavily indebted countries increased the agency's need for funds. To supplement the resources available to the Fund, Congress approved in 1983 a quota increase and an enlargement of the General Arrangements to Borrow after intense lobbying by the chairman of the Federal Reserve System and the Bankers' Association for Foreign Trade. Since then, the IMF has borrowed from Saudi Arabia and Japan, and recently indicated that by April 1989, it would need a 50 percent quota increase.

Similarly, the World Bank, which finances more than 85 percent of its loans by floating debt issues in world capital markets, sought an increase in its capital. Nations with more than 75 percent of the voting shares ratified in April 1988 an increase in its capital from $96.6 billion to $171.4 billion. The U.S. with slightly less than 20 percent of the voting shares has not. The bank has appealed to Congress to grant it $70.1 million as the U.S. share of the first year's increase in its capital (see the Wall Street Journal, 21 June and 23 September, 1988).

As I've noted, conditionality, which has always been a feature of an IMF loan, has since 1982 been coupled with a requirement that the debtors reach agreement with their creditor banks before the loan is granted. An IMF agreement is also a prerequisite for debt rescheduling by export credit agencies of the Paris Club creditor governments and for lending by the World Bank and the development banks.(17)

The key feature of lending by the international agencies is that the debtor countries obtain the credits at subsidized rates. Does the subsidy improve the productivity of the use of the borrowings? The loans may be repaid but, as the quotation from Krueger showed, official lenders have not been successful in enforcing the conditionality provisions the debtor countries have accepted to reform their internal economic policies. That is a fact that needs to be acknowledged.

The strategy devised by the U.S. treats not only the debtor countries but also the creditor banks as wards of the U.S. regulators. Neither the accumulation of foreign debt before 1982 nor the strategy to deal with it subsequently was market based. The regulators abetted the accumulation of the debt by U.S. banks, praising them for effectively recycling surplus current account funds of OPEC countries, and abstaining from cautionary injunctions as the portfolio of foreign debt grew.(18) The regulators permitted the banks to evade the provision that limits loans to a borrower to no more than 15 percent of a bank's capital. Loans to various state-operated firms and institutions in a foreign country--all guaranteed by the government--were regarded as individual loans. When the debt problems erupted, the banks were not urged to reduce dividends and build loan loss reserves. Instead public policy was based on the fiction that the Latin American debts on the books of the banks were assets that had full face value, despite their discounted value in secondary markets. No objection was made to the accounting treatment of accrued interest as current income. In conjunction with the IMF, the regulators orchestrated new lending by the creditor banks which far exceeded lending by the international agencies and official government transfers.

It is fair to ask whether the activism of the regulators and the international agencies has contributed to the solution of the debt problem. The three components of the solution proposed in 1982 were all achieved: interest rates on foreign loans were reduced; world economic recovery is still ongoing; and official and private lending has continued. The verdict of the BIS [1988, 132-33] is less than reassuring: "The persistent severe debt service problems, unsatisfactory domestic economic conditions and growing frustration in many developing countries have led to increasing doubts about the adequacy of the strategy used so far to cope with the international debt crisis."

CONCLUSIONS

Why is it that expert opinion on the international debt problem has persistently provided optimistic appraisals of the outcome, despite continued evidence to the contrary? One reason is that some experts have tended to be debtor country sympathizers.(19) Further assistance to the debtors in their view is the high-minded way to solve the problem.

Another reason for optimistic appraisals is that projections of the debtor countries' performance in the future extrapolate some variable that would permit them to manage their current debt burden over the long run. Thus Martin Feldstein [1987] conjectured that if Brazil were to obtain additional loans, devote 2 1/2 percent of its GNP to debt service, and grow at 3 1/2 percent a year, the ratio of its external debt to GNP would decline and the economy would grow faster than the interest on its external debt. On this calculation, Brazil would begin repaying its debt by 1997. There is one proviso: "Of course, this prognosis requires sensible economic policies in Brazil." Steven Webb [1987], who analyzes the ability of developing countries to outgrow their debt, projects their growth for forty years as the sum of labor productivity, assumed to grow as fast as it did from 1960 to 1985, and the growth of working-age population. Those countries with rapid productivity growth that paid 2 1/2 percent of GNP toward debt service would greatly reduce their debt burden by the beginning of the next century. Unfortunately, assuming that productivity will grow as fast as it did from 1960 to 1985 begs the key question: will the developing countries adopt "sensible" internal policies?

My conclusions follow.

(1) The troubled debtors did not use their borrowed resources well. They are largely responsible for their own plight. Their own domestic economic policies were and are flawed. Further borrowing by them will only add to the burden of their existing debt. The troubled debtors give little sign that they have improved their domestic economic policies in the six years since their problems surfaced: and even if they now undertake economic reform, improved allocation of resources would yield higher returns only in the long term.

(2) The banks made a mistake when they extended the loans. Retaining the loans at face value on their book has been a fiction, but one that financial markets see through. Inevitably, banks will take losses on Latin American loans; how much loss depends on their leverage in bargaining with the debtor countries.

(3) The interventions of regulators and the international agencies have been a failure. They have coerced the banks to continue lending and have required debtor countries to accept conditionality provisions as the price of an IMF loan. Yet the international agencies have been unable to enforce the conditionality provisions.

At the present juncture, the U.S. Treasury, more than the Federal Reserve System, is in the forefront of debt negotiations. The Treasury serves as a cheerleader for the debtor government and the international agencies. The Treasury appears to regard the banks as eleemosynary institutions that should be doing more for hard-pressed debtors: Since May 1987, when many creditor banks made large additions to their loan loss reserves, the Treasury has repeatedly expressed dissatisfaction with the conduct of the banks. In its view, the banks should have responded more positively to the Mexican debt swap plan, and been more cooperative in raising fresh loans for the countries now in line for new IMF agreements (Brazil and Argentina). The banks have also been charged with failing to reward with timely and adequate loans countries like Colombia, which recently avoided rescheduling, and Ecuador, which, according to the Treasury, left it up to the banks to restructure its loans.(20)

The issue is not whether the banks reject the Treasury's complaints. The issue is the ground for the Treasury's intervention in the negotiations between the debtor countries and the banks. It is time for the Treasury and the regulators to discard fiction and base their position on facts. One fact is that bad debts lead to losses. Accounting practices that regulators currently permit the banks to use attempt but fail to hide the fact that these are bad debts. Market value accounting would eliminate the fiction. The debtors will have to help themselves with sound, tough domestic economic actions if they are ever to emerge from their troubles. The losses that must be borne can be distributed in some fashion by voluntary bargains between the debtor countries and the creditor banks without intervention by third parties.

(14.) The agreement that Brazil appears to have concluded with its creditor banks in June 1988 for $5.2 billion fresh loans with a twelve-year maturity, including a five-year grace period at the start during which no principal payments would have to be made, permits Brazil to by back a portion of its debt on the secondary loan market (see the Wall Street Journal, 22 June 1988).

(15.) See the Wall Street Journal, 25 May 1988. According to the BIS [1988, 137], U.S. regulators ruled that banks that participated in the Mexican scheme would not have to show other claims on Mexico at a lower value.

(16.) The World Bank has also increased the share of "policy-based loans (loans extended for general budgetary support as compared with the project-based lending that the World Bank has traditionally pursued)" from 8 percent in 1980 to 23 percent in 1987, according to Rep. Walter E. Fauntroy (chairman of the House International Development Institutions and Finance Subcommittee), who interprets the purpose of the loans to be the provision of debt service payments to private banks. He is an advocate of third world debt relief. See his letters to the editor of the Wall Street Journal, 11 July 1988, and to the New York Times, 14 July 1988.

(17.) After three years of resistance, Brazil accepted as a precondition for an IMF loan that it reach an agreement with its creditor banks (see note 14). It formally requested a $1.44 billion loan on 1 July 1988, presenting its economic reform program to the fund (see the New York Times, 5 July 1988).

The prerequisite in one African case (countries not otherwise considered in this paper) has not been enforced. It has been reported that Nigeria rejected an IMF loan for $540 million that required reforms including privatization of ninety-six government-controlled enterprises and official devaluation of the naira. The country was nevertheless granted and accepted in place of the IMF loan a $450 million World Bank loan; Nigeria's foreign debt was rescheduled, some export credit was restored, and it obtained $4.3 billion from the World Bank for structural adjustment projects over three years (see the Wall Street Journal, 22 June 1988, 24).

(18.) See the statements by Chairman Burns, 10 March 1977; also the speech by Chairman Volcher, March 1980, quotation from p.13.

(19.) Rudiger Dornbusch, for example, exhorts the banks to "Build, Don't Bleed, Economics," New York Times, 13 May 1988. Presumably the banks before 1982 believed that they were building the economies of the debtors. Dornbusch does not explain why that belief was mistaken. He now advocates a temporary suspension of interest payments in dollars. Debtors instead would pay interest in local currency, which the creditors would invest in the debtor country, the investments to be managed by the outsiders. The debtor domestic budgets would have to provide for the interest payments, which could not be created by printing money.

(20.) Ecuador suspended talks with its foreign bank creditors on 8 July 1988, on its unsigned $5.1 billion rescheduling accord with the banks that was reached in October 1987. The country, which has a shortage of foreign exchange because of falling oil prices and an earthquake in March 1987 that halted oil exports for five months, has not paid interest to its creditor banks since January 1988 (see the New York Times, 9 July 1988).

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Author:Schwartz, Anna J.
Publication:Economic Inquiry
Date:Jan 1, 1989
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