U.S. policy on the problems of international debt.

U.S. Policy on the Problems of International Debt The international debt problems of developing countries in the 1980s have been serious and complex. It is tempting, nevertheless, to seek simple, universal solutions to those problems. I believe that we must resist that temptation, for several reasons.

First, international debt problems are sufficiently complex, and the developing countries are sufficiently different, that it is inappropriate to speak of a single policy.

Second, U.S. policy in this area has been evolutionary. Even for an individual borrowing country, tomorrow's policy approach may well differ from today's, just as today's approach differs from yesterday's--or from the one last year or in 1982.

Third, U.S. policy on international debt is a responsibility that is shared within the U.S. government: the Treasury Department, the State Department, the White House, the Congress, and the Federal Reserve are all involved in the formulation of various aspects of that policy, and its implementation involves an even longer list of institutions. Moreover, the United States cannot dictate policies in this area because the problems of international debt are global in scope, affecting the interests of many developed countries around the world as well as many developing countries.

For all these reasons, this article does not attempt to present the definitive statement about U.S. policy on these problems. Rather, I offer some perspective on where we have been, where we are, and where we might be going. I make three basic points.

First, developing countries, the governments of creditor countries, the international commercial banks, and the international financial institutions have a substantial common interest in seeking cooperative, constructive, and innovative approaches to handling the debt problems of the developing countries. The benefits associated with cooperative approaches are overwhelming; they extend beyond the direct benefits for the countries and their lenders to benefits that can only be shared--a prosperous world economy and a stable financial system. Government has the responsibility to emphasize that common interest and to nurture cooperative approaches.

Second, though it has been uneven and disappointing, significant progress has been made over the past seven years in dealing with international debt problems and the associated economic and financial problems of the developing countries. In my view, insufficient attention has been paid to, and insufficient credit has been given for, this progress.

Third, U.S. policy in this area will continue to be evolutionary. Secretary of the Treasury Nicholas F. Brady put forward some "ideas and suggestions" on March 10, 1989; these ideas were refined during the international meetings at the beginning of April and were embodied in guidelines approved by the Executive Boards of the International Monetary Fund and World Bank in May and June; they are in the process of being exploited by Mexico and the Philippines; and they will continue to be refined. Moreover, even if Secretary Brady's initiative galvanizes progress beyond our wildest dreams, I suspect that the problems of international debt, and the implications of those problems as they unfolded in the 1980s, will still be with us at the end of this century. Indeed, it is fair to say that such problems have been with us since the first international loans were made many centuries ago.

WHERE HAVE WE BEEN?

It is precisely because international debt problems are and always have been with us, as well as because U.S. policies with respect to them have been evolutionary, that it is useful to look back briefly at how these problems have evolved over the 1980s and what the responses to them have been.

I believe that the proximate cause of the international debt problems of the 1980s lies in the changes in the environment of international lending in the early 1980s: recession in the industrial countries, deterioration in the terms of trade of the borrowing countries, and increases in nominal and real interest rates. These changes were part of a worldwide process of disinflation that began in the late 1970s but did not become a generally recognized feature of the international economic environment until several years later. (1)

Among the more fundamental causes of the international debt problems of the 1980s were the extent of lending by commercial banks around the world to developing countries; (2) failure on the part of the leaders of the borrowing countries to recognize that a day of reckoning (which could be defined in terms of a return to positive real interest rates) was inevitable; and the inappropriate macro- and microeconomic policies that many of these countries followed at the time.

In a recent study, Steven Kamin, Robert Kahn, and Ross Levine have analyzed how the interaction of heavy international borrowing from commercial banks, the economic policies of the borrowing countries, and the external economic environment during the 1970s and 1980s affected real gross domestic product per capita in Argentina, Brazil, Chile, and Mexico. (3) They did so by comparing the actual level of GDP per capita in 1987 (the "present" in their study) with what the level would have been under three sets of hypothetical circumstances. Their results suggest the following conclusions.

First, each of these countries benefited from external borrowing in the 1970s in the sense that, at its pre-crisis peak, real GDP per capita was 4 percent to 16 percent (Mexico and Chile respectively) above the level it would have been if the rate of real external borrowing had remained unchanged from 1975 to 1987 and if the funds had been used as efficiently as the actual borrowing was used. (4)

Second, under the same assumptions, three of the four countries (the exception is Argentina) would have been better off in 1987, both absolutely and relative to the simulated pre-crisis peak level, if they had borrowed less in the 1970s and early 1980s. The reasons are the abrupt change in access to international capital markets in the early 1980s and the ex post change in the terms of access before the crisis--the rise in international interest rates in real terms. Argentina is an exception because weakness in agricultural exports held real GDP per capita below the actual and simulated pre-crisis peak level and because a return of flight capital after the Austral plan in 1985 boosted the actual level of real GDP per capita in 1987 above the simulated level.

Third, the countries would have been better off in 1987 if their external borrowing, at the actual rate or at the hypothesized reduced rate, had been used as efficiently as their borrowing had been before the buildup of external debt in the 1970s. Even if they had sustained this higher level of efficiency of investment, the countries would have been as well off (Argentina) or better off (the other three countries) in 1987 with the hypothesized lower (but steadier) rate of external borrowing than with the actual level of borrowing because of the increased real cost of the larger external debt in the late 1980s.

Such generalizations aside, these four countries, and many others in Latin America, experienced severe external debt crises in the early 1980s. However, though the problems were similar, the circumstances of each country as it encountered the crisis were quite different. These differences were one reason for adopting the so-called case-by-case approach to the international debt problem. In practice, of course, that approach has proved to be less flexible than the descriptive words suggest, to the considerable frustration of all involved. The approach was implemented using a common overall framework consisting of four elements:

1. Appropriate adjustments in economic policies by the borrowing countries.

2. Restructuring of existing debts to commercial banks and continued lending by the banks to the borrowing countries on a concerted basis.

3. Official bridge financing, in some cases, while the economic adjustment and financing programs were assembled.

4. An increase in the financial resources of the International Monetary Fund in 1983; the Fund was destined to play a central role in the overall process.

It was understood that the countries' adjustment efforts would founder in the absence of improvements in the economic environment in the industrial countries. Bilateral official credits, which were a relatively small proportion of the total debt of most of the heavily indebted, middle-income developing countries, were in most cases rescheduled in the Paris Club.

During the crisis period of 1982-83, the various parties with an interest in the international debt situation worked together very harmoniously. They had their differences, of course, but under the watchful eye of IMF Managing Director Jacques de Larosiere, the borrowing countries adopted economic adjustment programs; the commercial banks supported those programs through concerted "new money" loans and rescheduling of existing maturities; and the international financial community worked effectively together to support countries that adopted sound economic adjustment programs.

One key feature of the approach was that no party provided medium-term financing until all parties were ready to do so. This was the policy requiring a "critical mass" of financial support from the commercial banks and creditor governments. It was designed to reinforce the IMF's longstanding policy that, prior to its own disbursements, the Fund should have appropriate assurances that a program it supported financially would be adequately financed overall. This policy with respect to medium-term financing was reinforced in a few critical cases by temporary bridge financing provided by the major industrial countries, normally in cooperation with the Bank for International Settlements.

By early 1985, remarkable progress had been made in dealing with international debt problems; the immediate crisis was over. However, the underlying economic and financial problems of the borrowing countries were by no means resolved. Economic recovery stalled in the developing as well as in the developed countries. Tensions mounted as international pressures for continued external adjustment by the borrowing countries came into conflict with the natural desire of those countries to resume economic growth in an environment in which their political leaders could respond principally to the demands of their own citizens. Moreover, the international commercial banks were increasingly reluctant to continue lending on a concerted basis even to countries making strong efforts at economic reform.

For these reasons, James A. Baker III, then Secretary of the Treasury, sought to breathe new life into the process through his call for a Program for Sustained Growth, presented in Seoul in October 1985. That program envisaged a continuation of efforts at economic reform, but in the context of a resumption of economic growth. He called for the international commercial banks to supply new lending of 2-1/2 percent to 3 percent per year above the outstanding indebtedness to a group of fifteen heavily indebted, middle-income developing countries during 1986-88. He also advocated an enlarged role for the World Bank in promoting growth-oriented economic policies.

The Baker Paln, as it came to be called, was a plausible evolution of the efforts to deal with the international debt problems that had been brought on by the changes int he environment for international lending in the early 1980s. It also had some positive results, which I discuss below. However the probability of its success was lowerd by a change in the intenrational economic environment shortly after it was announced: the collapse of international oil prices. This collapse means that the oil-exporting developing countries had no firm basis on which to calibrate their economic policies and calculate their external financial needs. The oil-importing developing countries experienced a windfall as the cost of oil declined. This windfall weakened perceptions of the need to adopt economic policy reforms. The countries that were neither oil exporters nor oil importers were not sufficiently numerous to play a leadershi role in a new phase of dealing with international debt problems. Therefore, by the time the Mexican program was developed in mid-1986, much of the momentum of the Baker initiative had been lost.

WHERE ARE WE?

A careful analysis supports the conclusions that the economic policies of the developing countries are substantially better today than they were in the early 1980s. The progress of reform has not been even. In a few countries little or none has been made. But, in the vast majority of the heavily indebted countries, economic policies have substantially improved: exchange rates are more competitive, real interest rates are positive, fiscal deficits (especially primary deficits) are narrower, subsidies have been eliminated, tariff policies are more rational, and recognition is widespread that the role of the public sector in the economy should be reduced and that market mechanisms and the private sector must be relied upon more heavily to generate sustained economic growth.

Moreover, in some countries economic performance has substantially improved. In four of the "Baker-15" countries--Chile, Colombia, Morocco, and the Philippines--economic growth averaged more than 4 percent per year in 1986, 1987, and 1988. (Venezuela did as well, but its growth was fueled by a rising budget deficit and a rundown of international reserves. Uruguay's growth averaged 4 percent per year, but it slowed sharply in 1988 and inflation accelerated.) In each of these countries, inflation was kept reasonably under control. In all four, the ratio of gross interest payments to exports of goods and services declined substantially. Ratios of external debt to exports of goods and services declined as well. In one case (Chila), the decline was dramatic (48 percert between 1985 and 1988); in the other cases, the decline was in the range of 15 to 20 percent over the same three years. Interestingly, for Brazil the decline in the ratio was 30 percent from 1986 to 1988, and the decline for Mexico was almost that sharp over the shorter period.

Despite some very positive accomplishments, the three years of the Baker initiative did not produce a breakthrough in economic growth or performance on the scale that was hoped for. One reason was that economic reform efforts by the borrowing countries were less vigorous than has been envisaged when Secretary Baker laid out his ideas in Seoul.

One consequence of the shortfall in economic reform efforts was that many countries fell out of compliance with IMF-supported economic programs or declined to accept new programs; as a result, IMF disbursements declined. Over the period 1986-88, the IMF received net repayments of principal from the Baker-15 countries of about $3 billion. Because the Fund is a monetary institution whose lending is supposed to be repaid over a relatively short period so that the funds can be relent to other countries, such net repayments are viewed as a positive development if they are accompanied by real economic and financial recovery in the borrowing countries. Unfortunately, that was not the case during 1986-88.

A second consequence of the shortfall in economic reform efforts was a shortfall from anticipated disbursements by the multilateral development banks (MDBs). Secretary Baker had anticipated that MDB disbursements over the 1986-88 period would total $27 billion; in fact, they were about $22 billion--20 percent less than what had been expected. Moreover, in October 1985, it was anticipated that $27 billion in gross disbursements by the MDBs would translate into net disbursements of about $20 billion. In fact, net disbursements were about $10-1/2 billion, barely half what had been expected. The explanation for the larger shortfall in net disbursements is that the dollar depreciated during 1986-87, raising the dollar value of repayments of non-dollar borrowing from the MDBs. Thed dollar's depreciation also contributed significantly to the increase in the dollar value of outstanding MDB and IMF claims on the borrowing countries and to a rise in the share of those institutions in the total outstanding debt of these countries relative to that of the commercial banks, a large proportion of whose claims are denominated in the U.S. dollar.

Secretary baker in Seoul called for about $20 billion in net new lending by commercial banks to the fifteen heavily indebted countries during the 1986-88 period. It is very difficult to estimate with any precision the amount of this lending during this period. Clearly, however, it was substantially less than had been anticipated.

Total disbursements under concerted lending packages negotiated after 1985 were about $12-1/2 billion during 1986-88. One way of assessing this figure is to ask what proportion such disbursements were of total scheduled interest payments to the commercial banks by the baker-15 countries. The answer is about 21 percent; for the three major borrowers in Latin America (Argentina, Brazil, and Mexico), the figure was about 27 percent. That is, banks disbursed about two bits for every buck they received in interest. During the 1983-85 period, disbursements to the fifteen countries under concerted lending packages represented about one-third of scheduled interest payments; the figure was about 43 percent for the three major Latin American borrowers.

Some might argue that this declining coverage of interest payments is symptomatic of the progressive loss of consensus among the international commercial banks in support of the Baker Plan. From another perspective, one that recognizes that concerted lending is an unnatural process that at best mimics normal market practices, the declining coverage of interest payments might be viewed as progress. The important point is that the borrowing countries do not see it that way: they see an underfinancing and lack of appreciation of their economic adjustment efforts.

It is also important to recognize that Venezuela repaid a substantial amount of public sector debt during the 1986-88 period, and a few other countries repaid smaller amounts. Meanwhile, significant amounts of private sector debt were repaid or otherwise settled. Moreover, in 1987 and 1988, many commercial banks adopted strategies of aggressively reducing their exposures to the heavily indebted borrowing countries. For example, claims of U.S. banks on the Baker-15 countries dropped by about $16 billion, or almost 20 percent, during these two years. In most cases, there reductions in claims were at a discount, with the borrowing countries capturing a part of the discount.

Thus, debt reduction by international commercial banks has been going on for some time. In other words, the recent emphasis on debt reduction in U.S. policy can be viewed as representing a further step in the evolution of that policy and a recognition of what had already been occurring.

Overall exposures of U.S. and foreign commercial banks to the heavily indebted developing countries have declined dramatically--absolutely and relative to capital--since the outbreak of the debt crisis. For all U.S. banks reporting on the Federal Reserve's Country Exposure Lending Survey, exposure to the Baker-15 countries declined from 136 percent of capital in June 1982 to 54 percent in December 1988. On average for the nine large money-center banks, the ratio declined from 201 percent to 92 percent over the same period.

This very progress in reducing banks' exposures has helped diminish the sense of urgency among the commercial banks in dealing constructively with the continuing problems of the heavily indebted countries. This loss of urgency, in turn, was one of the many factors underlying the widespread perception that something new was needed to reinvigorate the process of dealing with international debt problems.

In my view, the situation in early 1989 had two other notable features: most of the progress that has been made in terms of economic performance (positive growth rates combined with moderate inflation) has been made by small countries; and external performance has been superior to internal performance.

It is worth considering this second factor in detail. External adjustment is easier to bring about than internal adjustment. All that is necessary for the former is that a country maintain a competitive exchange rate and reasonably supportive macroeconomic policies. However, unless the country gets its macroeconomic policies right, the result is very high real interest rates or very rapid domestic inflation or both. Thus, an important element of the overall adjustment process is getting the internal balance between savings and investment right. Given the limited scope for supply-side adjustments to take hold in the short run, achieving this balance usually means reductions in fiscal deficits or, in some cases, fiscal surpluses. Moreover, when the incompleteness of internal adjustment is manifested in rapid rates of inflation, it undercuts political support from the middle class for overall efforts at economic reform.

WHERE ARE WE GOING?

It was against this background that Secretary Brady, on March 10, 1989, called for a revitalization of the debt strategy. His proposals built on the lessons and achievements to date.

He stressed the importance of economic growth, the crucial role of sound economic policies and policy reforms to achieve that growth, the continuing need of borrowing countries for extenal financial resources, and the case-by-case approach. At the same time, he recognized the need--which in some cases may be more political than economic--for voluntary debt and debt-service reduction, and he called on the international financial institutions (the IMF and the World Bank) to support such operations. However, he clearly stated that the resources available from these institutions for this or any other purpose are limited. He therefore called upon developing countries to adopt policies that would encourage the exploitation of alternative sources of extenal financing--the return of flight capital and the encouragement of direct foreign investment.

On March 16, following his return from a trip to Europe, the Federal Reserve issued a statement by Chairman Greenspan that is useful to quote:

I fully support the principles put forward by Secretary Brady last Friday [March 10] for helping the heavily indebted developing countries to resolve their economic and financial problems: continued economic reform in orther to achieve sustained economic growth; timely and adequate external financial resources to support economic development; and ... voluntary debt reduction supported by the international financial institutions. The challenge ahead for all of us is to reinvigorate the process and to ensure that it works.

How are we--borrowing countries, commercial bankers, international financial institutions, and creditor countries--going to make this process work?

The initiative lies property with the borrowing countries. Fortunately, and in contrast with the situation in 1986 after the start of the Baker initiative, some countries are ready to resume their efforts at economic reform or to build upon the progress already achieved. The list includes Mexico, the Philippines, Venenzule, Morocco, Costa Rica, and Uruguay. The readiness of the leaders of these countries to embark upon a new phase is an advantage, but their readiness also underlines the urgent challenge to the other participants in the process, particularly the commercial banks.

One problem is that some other countries, which do not need IMF financial support for their economic programs, face economic and political pressures to produce concrete results in their dealings with the international commercial banks and the international financial community. One such country is Colombia, whose "jumbo" refinancing loan was completed after more than a year of effort. Anoter is Chile, which has compiled an admirable record of economic reform and growth over the past several years but lacks the access to the international financial markets that these achievements might have been expected to open. It is important to find a way not to penalize countries like Colombia and Chile, but rather to reward tham for their accomplishments. Chile, in fact, has turned to the Fund and World Bank for new programs to help finance a retirement (buyback) of its debt to commercial banks under a 1988 arrangement with the banks.

In another category are countries like Argentina and Ecuador that are struggling to implement programs, of economic reform. The people and leaders of these countries must have a sense of hope and the confidence that they will not be left out of the reinvigorated debt strategy. Of course, the best way for a country not to be left out is to improve its efforts at economic reform and its actual performance, but that is easier said than done.

Another problem is unrealistic expectations about the scale of the assistance from the international financial community to those countries that are prepared to help themselves. The international financial institutions have limited resources to support debt- and debt-service-reduction operations.

The limited experience with such operations suggests, as a first approximation, that countries get what they pay for in such operations. If the secondary market price of a dollar of a country's debt is 40 cents, that country can use a dollar to buy back $2.50 of debt, saving about 25 cents (gross) in annual interest payments, assuming an interest rate of 10 percent; and it can save 15 cents net of the interest paid, or that otherwise could be earned, on that dollar. If, instead, it uses a dollar to enhance the principal or interest in an exchange offer, more of its old debt may be retired, but part will be replaced with new debt and the net interest saving will be about the same. This equivalence should not be surprising because in both cases the calculations assume that the borrower is offering cash, or collateral with a cash equivalent, in return for promised payments with the same present value to the marginal creditor. However, these types of approximations fail to distinguish between banks that are situated differently and, therefore, prefer different methods of debt or debt-service reduction and are prepared to act accordingly.

These types of calculations also assume that participation by lenders in debt- and debt-service-reduction transactions is voluntary in that the debtor cannot dictate the size of the discounts, "take it or leave it;" they also assume that lenders need not participate at all in this aspect of a financing package. This thought underscores the importance of maintaining as orderly and as businesslike a process as possible. Otherwise, what is now a positive-sum game, benefiting all participants, easily can turn into a negative-sum game, in which the borrowing country probably will be a loser along with most commercial banks and the rest of the international financial community. These calculations also suggest that voluntary debt- or debt-service-reduction transactions, backed by limited funding from the international financial institutions, are likely to provide only limited, near-term cash-flow relief to the borrower. Thus, borrowers with large external financing needs will continue to need "new money" loans.

Another risk is that commercial banks may have unrealistic expectations about the financial support that is available from the public sector--the international financial institutions or bilateral lenders, like Japan--in connection with debt and debt-service reduction. Except when a bank is able to dispose of its debt in a cash buyback operation, commercial banks must expect to retain considerable risk on their books even if the probability of principal or interest payments on their claims has been enhanced.

As I noted earlier, commercial banks in different circumstances can be expected to have different preferences for methods of debt or debt-service reduction. Moreover, some banks will prefer not to engage in such operations at all unless they take the form of debt-equity swaps. In fact, for some borrowing countries, the majority of the banks (weighted by size of existing claims) may prefer to advance new money, or capitalize some or all of interest payments coming due, instead of participating in debt or debt-service reduction. Their preferences should be accommodated as well.

What about combining debt or debt-service reduction with new loans to the same borrower as part of a single financing package? Commercial bankers argue with considerable force that the two are incompatible; indeed, convincing a bank's board of directors to do both is not an easy task. However, as long as a bank expects to receive interest payments from a borrower in excess of any effective financing the bank provides through debt or debt-service reduction, a strong case can be made to support the recycling of a portion of those expected payments if the alternative would be to receive nothing at all.

Assuming that the borrowing country follows a sound program of economic reform that is supported by the Fund and the World Bank and recognizing the uncertain nature of projections of a country's need for external financing, the fundamental issue is whether that country's economic program receives external financial support adequate to enable it to meet its scaled-down obligations. One way to ensure that the program is adequately financed is to provided the maximum conceivable amount of debt or debt-service reduction. Under such an approach, the commercial banks would provide more than enough financing in the "fat years" to cover the "lean years." They effectively would provide less financing if they did less debt and debt-service reduction and provided fresh credits to cover the lean years. Moreover, the provision of fresh credit, especially on a conditional basis, would be a less permanent form of financing than debt or debt-service reduction.

Some argue that banks that take the new-money route, in whole or in part, impose a heavier debt burden on the borrowing countries and will not discharge their responsibility to assist the countries in debt or debt-service reduction. I would argue that what is most important is that a commercial bank help meet the borrowing country's overall financial needs viewed from a long-term perspective; the form of its participation is much less important.

The issue of "new money" is closely connected to the issue of the long-term external financing of the economic development of these countries. It should be clear that debt or debt-service reduction is an abnormal form of financing and that it has natural limits at the forgiveness of 100 percent of the claims. It should also be clear that yields of LIBOR plus 13/16 percent on jumbo loans to a government with recent interruptions to debt service do not represent normal market access; the perceived risk associated with funds advanced by commercial banks through such arrangements is much higher than the risk that spread would cover. In the foreseeable future, most commercial banks are likely to limit their truly voluntary direct lending to developing countries to financing trade and small projects, primarily in the private sector. It is essential that the policies of bank supervisors on loan-loss reserves not discourage such lending, but it is not likely to produce large net flows to the countries that have experienced debt-servicing problems in the 1980s.

How, then, can these countries expect to finance development in the future? This is the central issue raised by Secretary Brady's speech to the Bretton Woods Committee in March. Aside from domestic savings, which one may hope will be employed more efficiently than in the past, and aside from limited financing from the multilateral development banks, the developing countries must look primarily to three external sources for financing: direct foreign investment, international capital markets, and the return of flight capital.

In the near term, direct foreign investment is probably the most promising source since the investor obtains a direct claim on assets in the country and can employ those assets to produce a real return. However, the climate must be conducive to such investments. "Climate" here means not only the rules governing access to the country and the repatriation of earnings but also the macroeconomic (and microeconomic) policy environment.

As for access to international capital markets, the yields implicit on commercial bank claims that are traded in secondary markets suggest that direct financing would be rather expensive today. However, for a few countries--Chile and Colombia come to mind--the yields are little higher than those on bonds of below-investment grade. Mexico recently raised $100 million through a bond placement with a yield of about 17 percent. Clearly, access to such markets offers the best long-term hope for private sector financing from abroad. A stable financial climate and a demonstrated record of servicing obligations are necessary to open such access.

In the meantime, the return of capital that domestic residents have sent abroad is a potential source of financing. (5) The permanent return of flight capital in substantial magnitude is likely to be a medium-term phenomenon, however, coming after macroeconomic stability has been reestablished but before full access to international capital markets has been achieved.

In summary, I believe that much has been accomplished in the past seven years in dealing with the multiple underlying problems included under the rubric of "the international debt problem." The economic policies of most of the borrowing countries have substantially improved; many of these countries have taken long strides toward sustained economic growth; a few may have reached it. The fresh appreciation of the crucial role of market forces and economic incentives by the leaders of these countries is impressive.

At the same time, I believe that we are engaged in what is, at least potentially, a positive-sum game. Both the borrowing countries and the commercial banks must continue to recognize this fact. It justifies a role for the public sectors of the creditor countries, acting primarily through the international financial institutions. It also imparts to the entire effort a sense of the consequences of failure and an associated sense of urgency.

(1) For a more extensive treatment of the origins of the international debt problem, see Edwin M. Truman, "The International Debt Situation," International Finance Discussion Paper 298 (Board of Governors of the Federal Reserve System, December 1986).

(2) Official encouragement to the private commercial banks to deal with the "recycling" problem in the 1970s was not a major cause of the international debt problem. The proportion of the OPEC surplus that was actually recycled through the banking system was very small, judging by data on the liabilities of commercial banks to the OPEC members, especially to the so-called low absorbers, whose surpluses were more permanent.

(3) Steven B. Kamin, Robert B. Kahn, and Ross Levine, "External Debt and Developing Country Growth," International Finance Discussion Paper 352 (Board of Governors of the Federal Reserve System, May 1989).

(4) Efficiency is measured in terms of incremental capital-output ratios and, along with capital flight, is assumed to be a function of the quality of economic policies. However, it was assumed that capital flight would have been reduced proportionately with the volume of international lending.

(5) It is important to appreciate that flight capital is difficult to measure and that links between measured capital flight and economic variables that are important to the development process, such as investment, are difficult to establish; see David B. Gordon and Ross Levine, "The Capital Flight 'Problem,'" International Finance Discussion Paper 320 (Board of Governors of the Federal Reserve System, April 1988). Nevertheless, in many developing countries some residents undeniably hold a substantial portion of their wealth abroad.

This article was prepared by Edwin M. Truman, Staff Director, Division of International Finance, Board of Governors of the Federal Reserve System. It is adapted from a paper presented at a conference sponsored by the University of California at Berkeley/Stanford University, Joint Center for Latin American Studies, at the University of California at Berkeley on April 27-28, 1989.