David R. Bock
The year 1987 may well mark a transition in the international debt strategy. Despite a pickup in growth in the heavily indebted middle-income countries and some lightening of their aggregate debt-service burden (as measured by the ratio of interest payments to exports of goods and services), 1987 saw a rise in payment arrears and increased difficulties in marshaling concerted financial packages. (Under concerted financing packages, which are coordinated by a bank advisory committee, groups of creditors provide new lending in the same proportions as their existing exposure.) There was a widespread move by private lenders to increase provisions against potential losses on their LDC loan portfolios. This move was accompanied by an acceleration of asset disposal and writeoffs by some banks, leading to a substantial decline in the secondary market for commercial bank claims on the heavily indebted countries.
There is little disagreement about certain elements of the international debt strategy. In particular, most observers agree that the only viable path to a restoration of normal debtor-creditor relationships is through a recovery of growth driven by structural adjustment in the debtor countries and a supportive external economic environment. Most agree, too, that the international institutions such as the World Bank and the IMF have indispensable roles to play in facilitating this process. What is more at issue is whether growth is being restored fast enough and whether enough incremental financial support from the creditor community will be forthcoming to achieve an average GDP growth rate of 4-5 percent a year.
The recent developments pose new challenges for the World Bank, which is the single largest source of new financing for the heavily indebted countries. The Bank’s commitments to the major debtor countries were more than $33 billion in FY1981-87. (These countries are: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, C6te d’lvoire, Jamaica, Mexico, Morocco, Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.) Together with the Fund, the Bank is one of the principal international institutions with the capacity to help the heavily indebted countries formulate and implement the medium-term, growth-oriented strategies they need if they are to grow out from under their debt burdens.
To strengthen its leadership in the debt resolution process, the Bank has been intensifying its policy dialogue with the borrowing countries, broadening and deepening its country assistance strategies and lending programs, and expanding its catalytic role not only in helping to mobilize new money from other lenders but also in fostering market-oriented initiatives for reducing debt. This article outlines the principles underlying the Bank’s approach to the debt crisis and some of the recent developments in financial markets that are affecting its role in relation to other sources of finance for the heavily indebted countries.
The Bank’s role
The Bank’s assistance strategy in the heavily indebted middle-income countries naturally reflects its objectives as a development institution concerned with long-term growth and poverty alleviation. In reorienting its lending programs and giving much higher priority to structural adjustment issues, the Bank is seeking to assist these countries to return as quickly as possible to sustainable growth paths and to creditworthiness.
Broadly speaking, the Bank’s assistance strategy in the heavily indebted countries calls for:
increased financial support for structural adjustment, often in the form of fast-disbursing policy-based operations;
intensified policy dialogue with member governments toward the identification of needed structural changes and agreement on the required policy reforms;
sustained investment financing, re-focused as necessary on rehabilitating and restructuring projects, enterprises, and investment programs as well as expanding productive capacity;
continued efforts to alleviate poverty, including measures to cushion the impact of the debt crisis and of adjustment on the poorest groups; and
increased assistance in mobilizing support from commercial and official lenders.
The rationale for this assistance strategy lies in the fact that for these countries, renewed growth is essential for a return to creditworthiness. The resumption of growth depends critically on both domestic policy reforms and structural change and on the adequacy of external finance in the adjustment period. Obviously, adjustment programs differ from country to country. Nonetheless, they are all medium term in their perspective, and all consist of a series of operations, each of which is intended to address specific adjustment and investment requirements. In all the programs, individual operations are integrated within an overall macroeconomic framework and assistance strategy.
Progress thus far
Since the debt crisis began in 1982 projections by Bank staff have consistently shown that almost all the heavily indebted middle-income countries could resume satisfactory rates of growth while gradually reducing their debt service ratios over time, provided that they make reasonable efforts to adjust, provided that adequate new money flows are made available to them, and provided that the external economic environment does not worsen unexpectedly. Similar conclusions have been reached by analysts elsewhere, notably in the Fund, and have provided the intellectual basis for the current international debt strategy.
In a few cases, for example Chile and Uruguay, the projections and the assumptions underlying them have thus far held up reasonably well. In most cases, they have not. In some countries, the major factor may have been an unforeseen deterioration in the terms of trade, but some countries have failed to take the necessary stabilization and adjustment measures. Economic stagnation has continued. Heavy debt-service burdens have persisted or worsened. In many countries, per capita income is still lower than a decade ago. The social and political tensions now evident after years of austerity pose real limitations on the policy actions many governments can undertake.
To work their way out of indebtedness, the heavily indebted countries must, in the Bank’s view, sustain a 4-5 percent annual growth rate over the next five to seven years. Countries must continue their efforts to improve macroeconomic management and adjust the structure of their economies—not, in the first instance, for the sake of foreign creditors, but because the enhancement and efficient use of domestic saving is an essential step toward the restoration of a sustainable growth process.
Efforts in the debtor countries must be accompanied by inflows of financial resources, to permit the simultaneous growth of consumption, investment, and exports. Contractual debt-service burdens in these countries are large in relation to GDP; they cannot be serviced in full without reducing the resources available for investment and essential imports to levels too low to support the resumption of growth. Debtor countries thus continue to need near-term cashflow relief from creditors in the form of new lending, or rescheduling of the obligations coming due, or both. Whatever form they take, the net capital inflows that are needed should be reasonably stable and predictable. In other words, if the debt strategy is to be sustained, both the adjustment efforts and related financial packages must be cast in a medium-term framework.
Sources of finance
What sort of financing is now required? The Bank’s projections indicate that the 17 heavily indebted countries as a group are likely to run an aggregate current account deficit of about $14-15 billion annually over the next several years. Together with the necessary build-up in reserves of at least $2 billion, the aggregate annual financing requirement for the group is $16-17 billion net of any repayments or rescheduling of principal.
It is likely to be very difficult to secure the needed financing exclusively through the conventional concerted new money packages. Foreign direct investment and official transfers could probably provide $3-5 billion in net flows, leaving an average medium- and long-term capital requirement of $11-14 billion a year. Of this amount, about $4 billion could come from the World Bank and other multilateral development banks—assuming that adjustment programs are strong enough to warrant the higher level of financing that the Bank is in a position to supply. The amount of financing to be raised from private sources, primarily commercial banks, is thus likely to be in the range of at least $6-9 billion a year. Over the past three years, net flows from this source have been less than $4 billion a year.
Commercial banks have changed their attitude toward the debt strategy in recent years, and this change was accentuated during 1987. The factors underlying the change will not be easily reversed. First, bankers recognize that the process of restoring creditworthiness in the major debtor countries will be long and uneven, and that success has become less likely, in part because of the mounting political difficulties governments face in implementing reform programs. Such concerns have been exacerbated by higher levels of arrears on interest payments, some of them in the form of unilateral moratoria on debt-service payments.
Second, banks themselves face more intense pressure, both regulatory and competitive, to strengthen their balance sheets. Depressed prices in the secondary market for LDC loans have damaged the share prices of major banks with large exposures and made their managers more averse to further increases in exposure. Moreover, banks face the prospect of additional provisioning on both existing and new lending, making participation in concerted new money packages at best marginally profitable.
Third, differences have re-emerged in the long-term business interests among commercial banks. In the early years of the debt crisis, banks shared an interest in protecting the international financial system and in buying time to reduce their exposures in relation to capital. Though large international banks still have this commonality of interest, most banks’ decisions on new money participation are governed increasingly by their own exposure levels and business strategies. Even among the larger banks, financial interests and objectives differ: those with multinational corporate clients—and, in some cases, with significant banking operations in LDCs—can be expected to maintain a direct interest in improving the liquidity of specific debtor countries, while other banks endeavor to leave the debt-restructuring process, even at the cost of significant write-downs.
Sustaining the concerted new money process will require adaptations and new approaches whose success is as yet uncertain. In particular, the sharing clauses inherent in debt-restructuring agreements make it possible, in effect, for some creditors to collect the full interest due on their outstanding claims without contributing to the new loans which help provide the resources to pay that interest. This so-called “free rider” problem has grown as new money participation rates have fallen; for the larger banks, it is a strong disincentive against new lending.
Given these considerations, the number of banks participating in any new money packages is likely to narrow further, as is the number of countries for which such financing can be arranged. Prospects are that all countries will continue to experience serious difficulties in mobilizing support from commercial banks.
A failure by the heavily indebted countries to secure enough financing from other sources raises serious problems for the World Bank, and the Bank thus has a strong interest in, as well as responsibility for, seeing that sound adjustment programs are adequately financed. The Bank thus seeks to play an important catalytic role in the search for market-oriented, negotiated solutions, wherever the strength of adjustment programs and countries’ circumstances warrant such support.
The main aspect of the Bank’s catalytic role is in its policy dialogue and substantial direct lending in support of countries’ adjustment programs. The Bank’s own commitments give other creditors an important signal of its confidence in the country’s adjustment efforts and prospective economic performance. Moreover, the Bank has stepped up its efforts—both informal and through consultative groups, the Berne Union, and the Paris Club—to inform bilateral lenders and credit insurers with respect to the adjustment programs, prospects, and financing needs of the heavily indebted countries and to mobilize resources in support of these programs as well as of high priority investment projects.
On a case-by-case basis, the Bank plays a more specific catalytic role, making use of two types of instruments: formal linkages between its own lending and that of other lenders, and specific credit enhancement of selective parts of new money packages. The use of either of these types of instruments depends upon the individual country situation and is in all cases worked out in negotiations between the government in question, the Bank, and commercial lenders.
The Bank’s catalytic role in the concerted lending process is guided by five principles:
The financing plan for the debtor must be based on an adjustment program that is well designed, robust, and realistically funded.
The efforts by the creditor banks in assembling the financing package must reflect appropriate burden sharing.
The Bank’s role must be to facilitate a negotiated settlement, taking into account the circumstances of both debtor and creditor.
The Bank only provides credit enhancement in cases where its presence is seen as essential to bring the transaction to a successful close, and where the new financing required from commercial banks represents reasonable efforts on their part in relation to existing exposure.
The exposure associated with credit enhancement must be incorporated into the Bank’s guidelines on exposure applicable to the borrower in question.
Changes within the banking community have led to attempts to expand the “menu” of alternatives within new money packages. The Bank has closely followed these developments. Whether or not it will support a particular technique through use of its credit enhancement powers depends on four major institutional considerations. First, the use of its credit enhancement powers must be set in the context of its overall assistance strategy for the borrower country in question, and must meet the test of making the best out of scarce capital resources in that situation. Second, the Bank’s role is governed by its Articles of Agreement—which require that use of its capital in making loans or guarantees be for productive purposes connected with the economic development of its member countries—and by its overall policies, as well as by special Bank-borrower relationships. Third, the Bank’s credit enhancement capabilities must be used so that they facilitate, rather than replace, market-oriented solutions. Finally, the Bank fully intends to preserve its prime standing in the financial markets; it must thus balance any expanded support for adjustment programs with careful and prudent assessment of the risks involved.
These principles inevitably constrain the Bank’s catalytic role to some degree. But acting within these principles, the Bank can use its credit enhancement powers in a wide variety of ways to respond to particular country circumstances and to the specific problems involved in mobilizing financial support from other creditors. Moreover, because the Bank’s approach is to facilitate market-oriented financial techniques, it must be prepared to adapt its catalytic role in response to changes in the financial markets themselves. The search for new ways to sustain the collaborative approach through various techniques for converting and/or reducing debt thus also raises issues as to how the Bank’s catalytic role should evolve.
Proposals for debt conversion and debt reduction have been part of the debate over solutions to the debt crisis since it began. For many of the low-income debt-distressed countries of Africa, the need for debt relief that significantly reduces the present value of (mainly official) creditors’ claims has been accepted. In the highly indebted middle-income countries, no consensus has emerged as to the need for, or feasibility of, large-scale debt conversion programs or facilities: most of the claims are held by the private sector; there is a much broader range of opinions about these countries’ ability to pursue growth-oriented adjustment programs without rupturing their relationships with private sources of capital; and the absolute size of outstanding obligations is very large. Most such proposals could only be implemented with very extensive support from the OECD governments and would entail a large-scale shift in the holdings of claims from the private sector to a publicly-sponsored institution of some type.
In the meantime, the markets have been driven by the recognition that the heavily indebted middle-income countries need a predictable flow of financial relief in order to grow and that it is better for all parties concerned if this financial relief can be provided through a consensual, negotiated approach rather than by unilateral resort to arrears. For example, commercial banks have strongly encouraged countries to introduce debt-equity programs, especially in the context of new money negotiations. In Chile and Mexico, debt-equity conversions have, if anything, strengthened creditworthiness and access to new funds.
For the Bank to play a role in debt reduction and conversion, more is involved than simply a matter of credit enhancement; its role in policy dialogue and its ongoing lending relationships with borrower countries are as indispensable here as in helping mobilize new lending. Indeed, the Bank’s contribution to assisting countries and their creditors to develop new forms of consensual financial relief will depend far more on the credibility of medium-term adjustment programs and the Bank’s willingness to provide sustained, policy conditioned support for them than on the availability of credit enhancement tools.
The Bank is prepared to take a stronger role in helping mobilize incremental financing for the heavily indebted middle-income countries from other creditors. In this process it will rely primarily on the quality of its own policy dialogue and the adjustment programs that it is prepared to support. But it will also enhance its broader catalytic role, striking a balance in each case between encouraging new lending from other creditors and itself assuming a disproportionate share of debt.
In some cases, it may be appropriate for the Bank to play a role in facilitating debt conversions and reductions, especially in cases where adequate amounts of new money are not forthcoming. Fortunately, the same developments that are likely to frustrate the new money process seem in many respects likely to open doors for more innovation with respect to alternative, consensual forms of financial relief. The Bank cannot and should not replace these market forces. But it can, consistent with the objectives of its Articles of Agreement, use its own lending presence and credit enhancement powers to facilitate such innovations on a case-by-case basis.