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Overview of East Europe's debt: the evolution of creditworthiness in the 1980s.

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Prior to 1989 only three countries in Eastern Europe were forced to reschedule their external debt; the other countries retained access to the international credit markets. U.S. banks were quite active in lending to Eastern Europe in the 1970s, but lending reversed after 1980 due to deteriorating credit conditions, slim profit margins and limited trade with the U. S. By contrast, West Germany and japan expanded their lending dramatically. Future bank lending strategies will depend on the perception of worsening credit risk due to political change and the increasing role of western governments in trade and financial relations. Unless economic reform accompanies political reform, western direct investment in Eastern Europe will be limited.

THE TOTAL FOREIGN debt of Eastern Europe, including the Soviet Union and Yugoslavia, is estimated to have grown from $95 billion at the end of 1981 to $146 billion at the end of 1988. Preliminary data for 1989 indicate a further rise in indebtedness to approximately $158 billion. In order to provide a perspective on the burden represented by such debts, Table I presents data on the net-debt-to-export ratio for each country, along with comparisons with China and fifteen highly indebted countries.

The debt-to-export ratio is a convenient measure of a country's total debt, net of hard currency reserves, compared with the country's earnings from sales of exports and services for hard currencies that are available to service the debt. As a rule of thumb, any ratio over 2.0 indicates an excessive debt burden (with a high probability of default and rescheduling), while a ratio below 1.0 indicates a modest debt burden. In order to draw any overall judgment on creditworthiness, however, these data must be supplemented with other information on a country's domestic economic policy and performance.

DEBT RESCHEDULING IN THE 1980s

During the period prior to the 1989 political upheavals in Eastern Europe, three countries were forced to reschedule: Poland in 1981, Romania in 1982 and Yugoslavia in 1983.

Poland was unable to generate sufficient foreign exchange to service the interest on its rescheduled debt after 1981, and as a result its total debt rose from $25 billion to $38 billion as interest arrears (primarily to government creditors) accumulated and were converted (after considerable delay) into new loans. Although interest service on debt owed to commercial banks continued current until September 1989, when the new Solidarity-led government defaulted on these obligations, only a few new trade-related credits from banks were forthcoming.

In spite of the Polish economic reform program introduced on january I of this year, banks do not view Poland as creditworthy. For this reason, the prospect of new bank lending in the foreseeable future is slim. The key issue with regard to the bank debt is whether a Brady-type debt reduction agreement is feasible. In negotiations earlier this year with the Bank Advisory Committee for Poland, Polish authorities proposed a buy-back of the bank debt at about 17 percent of par, or near the price of the debt in the secondary market. Because banks account for less than 25 percent of the total debt, any agreement along the lines of Mexico's debt reduction bonds would have to be accompanied with comparable debt reduction from official creditors, who hold the bulk of the debt. And, inasmuch as Poland expects to achieve a current account surplus of as much as $2 billion in 1990, most banks believe Poland could afford to pay the banks substantially more than is being offered. European banks, especially German banks, may be expected to take the lead in discussions with Polish authorities on these issues.

By contrast, Romania ran current account surpluses during the 1983-88 period and paid down its debt, reducing total debt from over $11 billion to under $2 billion and eliminating all long-term loans owed to commercial banks. Romania's communist government announced its intention in 1988 to avoid new borrowings in the future. The costs of this policy of export-at-any-cost, however, have been severe on the domestic economy. The new Romanian government will likely seek to borrow new funds in the foreseeable future, but banks will also be reluctant to extend new term loans to the country. Bank activity probably will be restricted to modest short-term financing lines. For the time being, new long-term loans probably will be limited to credits from official western governments or from multilateral institutions, such as the World Bank.

Yugoslavia was able to service all interest obligations during this period, thanks to continuing current account surpluses and modest amounts of new money from banks and governments. Total foreign debt stabilized during 1984-87, and during 1988-89 a marked decline in debt was achieved as net repayments were made to the IMF and World Bank and bank debt was reduced via debt-to-export conversions and buybacks.

Although Yugoslavia's debt burden has dropped in impressive fashion during recent years, banks remain reluctant to extend new credits, due in large part to the worsening domestic political and economic situation in the country. During 1989 inflation surpassed Latin American levels, reaching an annual rate of over 2,000 percent in the fourth quarter. An economic stabilization program, introduced in january this year, has brought inflation down to zero by mid-1990 and international reserves have soared to more than $8 billion, nearly 50 percent of the total foreign indebtedness to commercial banks. In spite of these impressive successes, continuing domestic political instability has acted to perpetuate a mood of caution on the part of commercial banks.

Yugoslavia's debt burden cannot be considered high and most banks do not believe that Brady-style debt reduction by itself will help solve current problems. Domestic economic stabilization of a permanent sort is needed, and the impetus for such reforms must come from within Yugoslavia itself. Given a serious reform effort, such as the current one, it would be up to western governments to respond with assistance appropriate to the circumstances, e.g., IMF and World Bank programs, and rescheduling and new money from the Paris Club governments. The appropriate role for commercial banks with regard to the old debt could only be defined after these key components are in place. Most likely, a successful reform would be followed after a lag by Yugoslavia's reentry to international credit markets.

EAST EUROPE'S MARKET BORROWERS

The other Eastern European countries retained access to international credit markets during the 1981-89 period. Several distinct patterns are evident in these countries' debt-to-export ratios. Hungary and Bulgaria, for example, saw rapid rises in their debt ratios as new borrowings far outstripped export growth. Both countries were able to tap new financings, although as the ratios approached the "danger" zone, it became increasingly difficult to raise new loans. Indeed, by 1989 many bankers considered both Hungary and Bulgaria as candidates for rescheduling.

Hungary has successfully avoided rescheduling, thanks to substantial support received from japan, Germany, the European Community, the IMF and the World Bank. A consequence has been that the share of bank debt in total debt has fallen as official and multilateral creditors stepped in with new loans. In the period preceding and following the April 1990 elections that turned out the previous communist government, banks reduced short-term financing lines by an estimated $1 billion in response to uncertainties regarding the new government's debt policy. A series of new loans - primarily from government sources - were arranged after the IMF approval of the new government's mini-budget in july, which has stabilized the country's liquidity situation for the time being.(1)

Bulgaria's experience in debt management has been less successful than Hungary's. Faced with an imminent debt crisis, the new Bulgarian government requested a rescheduling and new money from its creditors on March 28 of this year. A bank advisory committee was set up, headed by Deutsche Bank; negotiations are continuing at the present time.

The remaining countries - Czechoslovavkia, the GDR, and the Soviet Union - have successfully maintained debt-to-export ratios in the moderate range. The trend in the ratio has generally shown a tendency to fall during 1981-84, followed by a modest rising trend. These countries have enjoyed relatively free access to international credit markets up through 1989.

The GDR's external indebtedness was, in effect, taken over by the Federal Republic of Germany upon effectiveness of the monetary union on july 1, 1990. New cross-border loans to GDR borrowers enjoy the same low country risk of West Germany; the real issue is the credit risk of the borrower, i.e., the ability of the GDR borrower to earn the DM necessary to service the loan. In effect, the issue of GDR country risk has been replaced with that of the domestic credit risk of each borrower.

Czechoslovakia's debt policy has remained very cautious throughout the 1980s, giving the country the lowest debt level in Eastern Europe after Romania. Although a more flexible debt policy seems indicated by the successful public DM250 million bond issue in july, the country's financing requirements remain modest. Little change is anticipated in the near future.

By contrast with these countries, the Soviet credit rating has suffered dramatically since 1988. Although the Soviet Bank for Foreign Economic Affairs has met all its direct obligations, substantial arrears have built up to western suppliers on the part of Soviet foreign trade organizations, ministries, and enterprises. Although the exact size of such arrears cannot be known, western estimates put the arrears at some $3-5 billion dollars. News reports indicate that a large DM 5 billion loan from German banks (with 90 percent guaranteed by the German government) will be used to repay arrears to German companies.(2) In addition, the Soviet Union received a $1 billion loan from the Swiss arm of De Beers Consolidated Mines using an equivalent amount of diamonds as collateral.(3)

All indications point to continued turmoil in Soviet debt management in the near term, mirroring the state of disarray of overall Soviet economic management. Several of the Soviet Republics, for example, are seeking greater control over intrare-public operations of Gosbank (the Soviet central bank).(4) Other significant changes are afoot. In a first step toward eventual membership in the IMF, the Managing Director of the IMF, Michel Camdessus, visited Moscow for discussions with Soviet officials.(5)

PATTERNS OF BANK LENDING TO THE EAST

A new perspective on the debt is gained when the debt statistics are disaggregated by creditor groups. Table 2 provides a breakdown of the debt for 1981, 1984 and 1988 by major creditor groups: official bilateral (government), commercial banks, multilateral institutions and other (mostly supplier credits).

The claims of commercial banks on East European countries rose about 30 percent in nominal terms during 1981-88. The commercial bank share in total debt declined only moderately, from 59 percent to 51 percent of the total. The share of official bilateral claims in the total rose modestly during this period from 25 percent to 27 percent and a larger increase took place in lending by the IMF and World Bank - from 2 percent to 6 percent of the total.

Disaggregation of these data by creditor is possible only for claims by commercial banks, and for 1981 such data are only available for five countries - fortunately the key countries. The data are taken from individual country reports to the Bank for International Settlements.(6)

The aggregate data shown in Figure I tell a story of substantial divergences in bank lending strategies in different countries. Although U.S. banks were quite active in lending to Eastern Europe in the 1970s, a sharp reversal occurred in their activity after 1980. In 1988, U.S. banks accounted for only 3.4 percent of total claims, and if lending to Yugoslavia is excluded, the U.S. share drops to 1.7 percent. A similar, though less marked, shift is evident for the U.K. banks.

By contrast, German and japanese banks have expanded their lending dramatically. Such lending was concentrated in Hungary, the GDR and Bulgaria, where German and japanese banks are the leading creditors, and in the Soviet Union, where German and French banks hold the leading position.

Decisions by U.S. banks to reduce exposures were taken in response to deteriorating credit conditions, slim profit margins and limited U.S. trade with the countries in the area. These decisions were further influenced by the generally high exposure of U.S. banks to problem LDC credits in Latin America. Given their relatively large LDC exposures and pressure on their capital bases, the U.S. banks could not justify maintaining long-term lending to the East at the interest rate margins prevailing in the market.

This pullback from international lending was also part of an overall reorientation in strategies by U. S. banks that found some focusing on domestic banking opportunities and others on international underwriting instead of long-term foreign lending. As a rule, the declines in exposure to the USSR and China were motivated primarily by the low profitability of such lending, while declines in other countries were more a response to U. S. banks' perceptions of worsening creditworthiness.

The activities of German and japanese banks reflect many parallels: sharp increases in lending to the USSR, China, Hungary and the GDR; significant, though less marked, increases in loans to Bulgaria and Czechoslovakia. The strategies of U.K. banks represent an amalgam of these strategies: sharp declines in claims on the GDR, Hungary and Czechoslovakia, but increases in the USSR and China.

The major puzzle that emerges from these data is the sharp divergence in lending strategies among German and japanese banks on the one hand and U.S. and (to a lesser extent) U.K. banks on the other. One possible explanation lies in the pattern of trade flows to the East. Table 3 shows aggregate exports to the East and commercial bank claims on the part of the major western countries.

West Germany holds a commanding lead in total exports, thus providing a plausible explanation for the prominent position of German banks in financing these countries (though the export share far exceeds the share in claims). The relative size of in total exports and, if estimates of short-term loans are included, japan's share of total bank debt rises to about 32 percent (compared with an export share of 21 percent). Factors other than the size of export flows are clearly significant in explaining japanese bank lending. More striking, perhaps, are the large relative shares of French and U.K. banks in total bank claims. Banks in all three countries appear to have viewed the Eastern market as a safe region for the expansion of financial credits.

NEW DIRECTIONS IN PRIVATE AND PUBLIC FINANCING

Two factors will play significant roles in influencing future bank strategies in lending to the East: the perception of worsening credit risk due to political change in the area; and an increasingly active role of western governments in trade and financial relations with the East.

There is little doubt that in the past many banks viewed the lack of political change in Eastern Europe and China as a positive factor in creditworthiness. Most communist governments placed a high priority on servicing foreign debt and they were prepared to act to ensure prompt servicing of external obligations. As rapid and far-reaching political changes got underway in many countries, many banks reacted by reducing country risk ratings for countries in the area and by taking a wait-andsee posture.

Whether banks continue to sit on the sidelines or not will be determined by the success western governments have in implementing new initiatives to help facilitate the countries' transition to market economies. If banks perceive that essential structural changes are in fact being introduced in given countries, they will most probably act to extend and deepen their financial involvement. Such activity thus would provide further support to the political goals western governments are seeking to translate into reality. On the other hand, there is also a risk that banks may use the opportunity that comes with an increased public role in financing to reduce their own exposure. This would be the case if banks see western aid being used by the recipient country to postpone genuine reforms and the inevitable internal sacrifices. The obvious outcome would be a substitution of public loans for private bank exposure, leaving the country no better off than before.

These considerations underscore the critical role conditionality must play in the new assistance programs under development. The heart of the problem lies in a basic conflict between the dynamics of political change and the requirements of systemic economic change. Even though political structures have changed radically in most countries, the economic systems remain largely unchanged, unreformed and, if anything, more inefficient - given the current disorder - than under the previous political regimes.

while the political system is moving to greater pluralism, economic reform requires a coalescing around a central reform strategy. But there is not even a clear vision anywhere of how to change the economic system in a way that is compatible with current political realities that demand quick results. Coherent programs with timetables and priorities setting out the key changes necessary to transform socialist economies into market-oriented, private systems are so far lacking. And past reform failures in Hungary and Yugoslavia, for example, given scant cause for optimism, because a successful transition model is still missing.

Private banks are not prepared to support any given list of reform objectives just because new political leaders in Eastern Europe are seen as serious or deserving in the eyes of western public opinion. The banks will support countries that privatize and restructure state enterprises, countries that open to free markets by changing antiquated property laws, but they will not put their money at risk in countries that merely talk about these goals without acting on them.

The banks' emphasis on structural reforms derives from their realization that greater involvement of their domestic clients in East European economies requires such changes. Improved fiscal and monetary policies and reduced trade deficits are all desirable and necessary, because there is little hope of implementing far-reaching reforms without them. But stabilization policies are not enough. Without structural reforms, western direct investment in the East will amount to dribs and drabs, rather than the infusion that can catalyze an economic turnaround. The challenge is to design programs that integrate traditional stabilization efforts with system economic reforms. Banks are looking for Eastern European governments to develop coherent strategies for dealing with these issues. Lacking such strategies, many banks will respond by cutting loan outstandings.

The implications of the above for public policy are several. Unless public policies toward Eastern European countries embrace these same goals for structural reform and back them up with concrete policies, we will find the public and private sectors acting at cross purposes. Public money will simply go to bail out private loans and the hoped-for inflow of western investment will fizzle. If the banks pull out their loans, western governments are unlikely to step up their capital infusions to make up the shortfall. This suggests that in order to meet their longer-term goals western governments should seek to create conditions under which private western capital will prosper and thrive, even if this causes eastern policy makers some discomfort in the near-term.

Secondly, western governments should realize that they have little knowledge of how such structural reforms might best be implemented, nor do they have the skills needed in the process. The IMF and the World Bank clearly pay a vital role in this regard. Governments may also find that banks and other private companies have much to contribute to the process of structural reform; strategies to evolve public-private partnerships for specific tasks could prove valuable, especially in the fields of business management, credit training, accounting and marketing. Unless western politicians want to keep pumping public money into the East, they should seek to create conditions under which foreign capital will thrive and prosper. The best way to do this is by working with the capitalists themselves.

FOOTNOTES

1 Financial Times, "Bridging loans help ease Hungary's financial crisis," july 18, 1990; Financial Times, "Bank loan bolsters Hungary's liquidity," july 27, 1990.

2 Reuters, "W. German Companies Paid by Soviet Union, Bank Says," july 25, 1990.

3 Neil Behrmann, "Soviets to Sell Diamonds to De Beers' Swiss Arm," Wall Street journal, july 26, 1990, p. A12.

*Lawrence J. Brainard is Senior Vice President-International Economics, Bankers Trust Co., New York, NY.
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Author:Brainard, Lawrence J.
Publication:Business Economics
Date:Oct 1, 1990
Words:3392
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