Will we learn?
There is no guarantee that the lessons of the 1980s—simple, obvious, even trite though they may be—will be learnt. Even if they are, it is possible that future debt crises will still occur because the circumstances and the particular configuration of economic and political forces might be quite different, and memories of the 1980s dimmed. Nevertheless, it may be of interest to look, in the perspective of hindsight, at the external debt crisis that dominated—some would say “consumed”—international economic discussions in the 1980s.
Particular issues have preoccupied other periods (one thinks of energy prices and recycling in the 1970s); and there have been debt crises before, with severe repercussions (occasionally accompanied by the dispatch of gunboats to refresh debtors’ memories regarding past-due payments). But the crisis involving the debt of middle-income countries to banks—the focus of this essay—which exploded in August 1982 and still remains to be fully resolved, permeated the general social, economic, and political consciousness to a degree not previously witnessed. It called into question the soundness of the international financial and banking system. It was accused of stunting economic growth in the developing countries. It was blamed for social and political instability, specifically for endangering nascent democratic tendencies in certain countries. It mobilized religious, environmental, and other interest groups that usually remain outside the financial fray. It led to calls for repudiation, solidarity, the formation of debt cartels, and the exploitation of financial obligations to obtain concessions in unrelated areas. And it unleashed a deluge of publications that is as impressive in its dimensions as in the variety of remedies proposed: the predicament of debt ushered a pandemonium of proffered solutions (see box).
Altogether, the debt crisis has given foreign lending a bad name, but this must not be allowed to obscure the beneficial aspects of international capital flows. External lending can help promote an efficient allocation of resources internationally and can play an important role in economic development. It allows savings to move in response to higher returns, while for countries that generate insufficient domestic savings, it provides resources for viable investments that could not otherwise be financed domestically.
But the international transfer of savings, of course, is not without risk. For the creditor, there are the obvious risks of default (as well as, in some forms of lending, losses due to foreign exchange risks). For the debtor, as long as external borrowings are invested in activities that will result in a net stream of income sufficiently large to service the debt, the country can continue to borrow. Problems arise if, for instance, because of external developments, the debtor has a temporary liquidity problem; or if, on account of inadequate domestic policies, it is unable to generate sufficient income to allow it to service its debt or transform the income, at the margin, into foreign exchange. Debt problems can sap a country’s creditworthiness, leading to a reduction or loss of access to capital markets, and result in lower investment and growth.
It should not be forgotten, however, that faced with the same general economic conditions, a number of developing country borrowers did not experience debt problems and maintained their access to capital markets to great advantage. In fact, external borrowing during the 1970s and 1980s did not lead to the universal calamity that was frequently depicted.
Recapitulating the 1980s
The etiology of the 1980s debt crisis is a complex one. A confluence of several trends and developments brought about the crisis, including: (1) the two oil price increases of 1973-74 and 1979-80, which led to record balance of payments deficits for many countries and enormous surpluses for a handful of oil producers in the developing world; (2) the placement of a large part of these surpluses in banks for on-lending, or recycling; (3) a high propensity to borrow by developing countries, buoyed by negative real interest rates during the latter part of the 1970s, as well as by the enthusiasm of commercial lenders; (4) the use (or misuse) of the borrowed resources by many debtors to buttress consumption, delay adjustment, or invest in projects with low rates of return (especially in the wake of the first oil shock); (5) the deterioration in the terms of trade of borrowing countries throughout most of the 1980s; and (6) the financial and economic policies of the industrial countries, which, in an effort to eradicate the severe inflationary tendencies that they had allowed to develop during the 1970s, adopted measures that slowed their economic growth (thus reducing opportunities for the debtor countries’ exports) and sharply raised interest rates, further jeopardizing the debtors’ ability to service debt. Regarding the last two points, it must be noted that while both industrial and developing countries sought to finance the first oil shock (the former through inflation and the latter through borrowing), following the second oil shock, the industrial countries were more resolute in adjusting while many developing countries delayed adjustment. Some of these were oil exporters who felt no need for adjustment in anticipation of ever-improving terms of trade.
There is an old saying, “it takes two to tango.” In the run-up to the debt crisis, creditors and debtors acted as unwitting partners.
Paying the bill
Unless a debt problem is clearly due to a temporary, self-reversing shortfall in foreign exchange earnings (in which case it can be financed) there are, broadly speaking, three ways to cope with it. The first is to modify economic policies so as to enhance the capacity to service debt. This implies higher productivity and growth, a rise in exports, and an improvement in the balance of payments. But it takes time and can cause temporary hardship (for example, in lower consumption). Further, it may require going deeper into debt in order to finance the investments necessary for generating economic growth—a requirement that may be hard to meet since creditors are, in general, loath to lend more where existing loans are in difficulty.
When is a crisis a crisis?
The word “crisis” has been severely devalued. According to the media, we are living in an era of overlapping, unremitting crises (health care crisis, education crisis, environmental crisis, and so on). There are no longer problems or difficulties, only crises: we confront a crisis of crises. Mexico had a debt crisis in August 1982, when it could no longer service its debt obligations. From that point, the word became a generic descriptor, applied to all types of debt-servicing problems. But although some connotations of “crisis” (such as “decisive moment,” “critical phase,” and “unstable state of affairs”) are applicable, the question is whether a condition that has existed for almost a decade can still be called a “crisis”? Whatever the correct answer, the term is retained in this essay in deference to linguistic familiarity.
The second method is to reduce the burden of debt servicing. This can be accomplished in several ways, such as rescheduling (or refinancing), depending on the circumstances. By postponing (and spreading) obligations due, the debtor gains time, thus affording it an opportunity to implement corrective policies. The third approach is some form of debt reduction, which involves a shrinking of the stock of debt or interest payments, on market-based or negotiated terms.
These approaches are not exhaustive and do not encompass such extremes as outright default, which may provide a “solution” but entail far-reaching consequences, or full debt servicing at all costs—hardly a realistic proposition.
The approach actually adopted in the 1980s—the so-called international debt strategy—was a mixture of the above methods, implying sacrifices for both creditors and debtors. Debtor countries were to put into force programs of economic adjustment designed to reorient macroeconomic (as well as structural) policies and, in this way, to enhance their productive capacity. These programs were to be formulated on a case-by-case basis in cooperation with the IMF and supported by the resources of that institution. The Baker plan in 1985 reinforced this strategy by emphasizing the importance of growth-oriented adjustment, additional net lending by banks, and an enhanced role for the World Bank and other development banks, to complement the role of the Fund.
The financial contribution that the Fund could make, in the face of the magnitude of the balance of payments problem, was, however, modest. Moreover, while banks were prepared to postpone repayment of principal, they were unwilling to do the same for interest payments, meaning that additional resources of “new” money had to be assembled to refinance interest obligations falling due. Rescheduling of both principal and interest was possible for official creditors, mostly acting through a forum called the Paris Club. An underlying assumption of the debt strategy at this stage was that the debtor countries would ultimately service their debts in full. However, by 1989, with the adoption of the Brady plan, the strategy was amended to include debt reduction, backed by IMF, World Bank, and other resources.
Observers have variously judged the international debt strategy to have been a success, a failure, or something in between the two. The difficulty lies in choosing the standard by which to make judgments. If the ability of the international financial system to withstand the debt crisis is the benchmark, the debt strategy can be regarded as successful. If, on the other hand, the test is the quick resolution of the debt crisis, with debtor countries returning to full debt servicing and regaining “normal” access to capital markets, the debt strategy has not met its goal. Perhaps the truth lies somewhere in between: success was partial and uneven. A number of countries instituted important economic reforms, reforms that will have long-lasting beneficial effects on economic efficiency; even so, the debt crisis continues to pose a threat to the economic well-being of many debtor countries.
The debate on the appropriateness of the international debt strategy will continue. In reviewing the debt decade and the factors underlying the crisis, a relevant question is whether the overall experience presents any useful insights for the future, for the various parties involved.
The business of banks is to make a profit; their responsibilities are, however, broader in a system in which they are a major conduit of financial resources to developing countries.
The public attitude toward international banks has undergone considerable change during the past 15 years. Following the first oil crisis, they were encouraged to recycle petrodollars—they rose to the challenge and were applauded for it. By the time the lending spree was over, they were being urged to refinance obligations owed to them, and to make new loans so as to allow debtor countries to grow out of their debt problem. Banks had to be persuaded, pressured, or cajoled into this role, but by the middle of the 1980s, their self-interest had changed and their attitude hardened. In essence, they sharply cut back lending to debt-problem countries, and were soundly criticized for it, at the same time that those banks that had not adequately provisioned began to increase reserves against losses. Finally, as the stance of the debt strategy was amended in the late 1980s, banks were urged to reduce debt and “share the discount” on the secondary market for debt that had developed over the years, thus adding further pressure for provisioning.
In the heyday of lending, it often appeared that banks had thrown all caution to the wind. But banks were neither villains nor saints; they were caught up in the swirling rush of international lending. What are some of the lessons for them?
• In international lending, one cannot rely on a deus ex machina—some single factor, or phenomenon, that will guarantee the safety of lending. Typically, the decision to lend has to be based on a combination of key considerations (such as expected rate of return, economic and political situation of the borrower, and alternative lending opportunities). To sweep all this aside and to assume that lending is sound because of some particular guarantor of safety, or that there is no risk in loans to (or guaranteed by) sovereign governments, is a mistake. In the 1970s and early 1980s, lending to major oil producing countries was considered as “good as gold”; nothing could go wrong. President Portillo of Mexico encouraged this illusion of security by publicly declaring: “There are two classes of countries, those that have oil and those that don’t; we have it.” The banks obliged by voluntarily lending Mexico over $20 billion in 1981 alone—the year preceding the onset of the debt crisis. The same attitude was perhaps, to a lesser degree, implicit in other countries. In the case of Poland, for instance, the assumption was that the Soviet Union would come to the help of its indebted ally (this was before the advent of glasnost and the success of Solidarity).
- Good risk analysis is important, but not sufficient. Risk analysis, if heeded (which was frequently not the case), is most valuable and accurate at the time of lending, not when the loans fall due. As part of country analysis, there is a need for reliable, consistent information on debt. Further, intense attention must be paid to global macroeconomic developments, that is, to matters such as the course of commodity prices, inflation, balance of payments imbalances and, in particular, interest rates—even if one is lending at variable rates. Developments in these magnitudes can have an important bearing on how well a bank’s loan portfolio performs. Portfolio sensitivity to changing interest rates has been relatively neglected, at great cost. A sharp upward move in rates can have a more negative impact on the riskiness of lending than the positive effect of spreading the risk through portfolio diversification. It should have been clear that lending at negative real interest rates could not continue indefinitely.
- The competitive instinct is strong among banks and, as in most competitive situations, this results in the competitors acting the same way. This can be unfortunate—for the creditor as well as for the debtor. Making a loan so as not to lose the business to a competing bank creates a process whereby each bank may think, “if all others are lending, it must be safe.” Herd behavior can generate its own momentum. On the exit side, the perception of one major lender that it is time to reduce exposure can, when followed by others, precipitate a crisis for the debtor and, in this way, become a self-fulfilling prophecy.
- The problem of short-term profits versus a prudent, longer-term policy is not peculiar to banks. Interest rates that include an element of risk premium must have, as their counterpart, the buildup of provisions against losses. To the nonbanker this may sound axiomatic, but it was relatively late during the debt crisis that major banks began to do this.
An ocean of literature
The “formal” outbreak of the debt crisis in August 1982, and the efforts ever since to cope with it, released a stream of writing that soon developed into a river and then a flood; it now forms an ocean. Economists, journalists, government officials, bankers, businessmen, politicians, and research institutes have all contributed to the swelling volume. According to the records of die IMF-World Bank Joint Library, out of a total of 548 books in the Library’s collection bearing the words “external debt” in the catalogue entry, 435 (or 79 percent) have been registered just since 1982, Further, out of some 2,975 articles and working papers on external debt, 2,940 have been added since 1982. This journal has published 32 articles and reviewed 17 books on debt since the March 1982 issue.
The debtor countries
In the 1970s and 1980s, middle-income developing countries as a group faced the same global economic environment, but it bears repeating that not all of them encountered debt-servicing difficulties. The temptation to ascribe the debt crisis wholly to developments in the international economy must, therefore, be resisted. What might the borrowing countries have done differently?
- Borrowing abroad in order to “prove” that the country has market access must be avoided, as must borrowing driven by temporarily attractive interest rates. Rates can change sharply and suddenly, turning the initially favorable terms of a loan into an unexpected burden. Moreover, the borrower’s own circumstances may deteriorate, further affecting the ability to service debt. It is equally unwise to borrow on the expectation that the price of the main export commodity will be sustained. There are no guarantees.
- Providing government guarantees for borrowings by various entities is easy; honoring them is difficult. Of course, without government guarantees many bodies may not be able to borrow at all. But greater scrutiny in granting guarantees, and thorough surveillance of the investments that are financed by guaranteed external loans, are a must. Further, enthusiasm in assuming the obligations of private borrowers must be checked.
- Before a debt crisis occurs, creditors are often clamoring to lend. And it requires strong will to realize that creditworthiness may depend on not listening to these siren voices. But even in good times, the importance of appropriate debt monitoring must not be disregarded—monitoring the amount of debt; its rate of increase; the sources of the credits; and the terms of borrowing. Obvious though this advice may now sound, it is not an exaggeration to suggest that, with better monitoring, many countries would have been alerted much earlier to the dangers of rapidly mounting debt and the shortening of maturities and may have avoided or reduced the force of its impact.
- Perhaps the most important lesson of all concerns the uses to which external loans are put—the very basis of sound external debt management. If loan proceeds are devoted to satisfying immediate consumption needs, or dedicated to supporting an overvalued exchange rate, then external borrowing will have no other long-term effect than creating an advance call on future external earnings. External debt must, over time, create the ability to service that debt, and the only sustainable way of achieving that goal is to ensure that it is invested in activities with a rate of return sufficient to service the loan. Furthermore, directly or indirectly, the investment must enhance the borrower’s capacity to earn foreign exchange since external debt must be serviced in foreign currency.
- If debt-servicing difficulties are encountered, correct analysis and early action are crucial. In the 1980s debt crisis, some early observers made much of the distinction between a liquidity problem and a solvency problem, implying that the debt problem was of the former type. The distinction is generally apparent only ex post. Delaying needed policy changes in the hope that circumstances will improve may only aggravate matters.
- “There is no substitute for good policies.” Debtor countries have grown weary of hearing this refrain, but that does not diminish its validity. “Good policies” refers to the array of macroeconomic actions—affecting fiscal and monetary policy, interest rates, the exchange rate, reserve management, pricing and structural policies—as well as the choice of sound projects that will enhance the efficiency, stability, and hence credibility of the economy. Whatever the ideological considerations, there is no conflict between external and internal credibility: the policies that will enhance an economy’s attraction to foreign investors are also those that will foster confidence among domestic savers and act as a deterrent to capital flight—a phenomenon that, by some estimates, affected as much as 40 percent of borrowing in some countries.
The industrial countries
The cliché, “when industrial countries sneeze, developing countries catch cold,” has seldom been truer than in the debt crisis. This is not to absolve developing countries of responsibility for their economic problems, but to underscore that the economic actions of the major industrial countries can seriously complicate the home-grown difficulties of developing countries.
- If it is official policy in the principal industrial countries that are home to the major international banks to endorse and encourage recycling, then, when this policy leads to debt difficulties, these same governments must accept a large measure of responsibility for the debt crisis. They cannot assume that it is a problem for the banks alone, or for their foreign clients.
- The governments and monetary institutions of the creditor countries need to give greater weight to regulatory issues, in particular, to questions of provisioning and reserves. Precautionary arrangements are important not only because the governments (or central banks) are lenders of last resort for banks domiciled within their territories, but to protect the international financial structure.
- Measures taken by major industrial countries for domestic policy purposes can have a devastating effect on the debtor countries, as well as on banks. An important duty of these countries, therefore, is to maintain a reasonable rate of growth. Further, monetary and fiscal policies, taken to combat domestic inflation (which has been allowed to become serious), can lead to sharp increases in interest rates with a sudden and severe impact on the debt-servicing obligations of debtor countries. Real interest rates have remained high by historical records ever since the measures of the early 1980s. Inadequate savings rates, particularly in the United States, have contributed to this. The charge that the major industrial countries at first encouraged recycling by banks and then “changed the rules,” contains an element of truth.
Multilateral financial institutions
Several multilateral financial institutions have contributed to the international debt strategy. The relative role of each is a matter that can be debated, including whether the World Bank, which provided structural adjustment support, might have played (or should in the future play) a more prominent part. As it turned out, the IMF became a key actor and was the institution most intimately involved with the debtor countries, the banks, and the creditor governments. Again, there are certain lessons.
- Along with others, the IMF perhaps underestimated the severity and obduracy of the unprecedented debt crisis. A problem that had been so many years in the making, and that had been allowed to reach such unsustainable dimensions, could not easily be dealt with (even in the medium term) with instruments designed to cope with “normal” balance of payments difficulties.
- The Fund’s role was affected by the continuing problems of the international economy, the contribution of the creditors, and by what debtor countries were able—or prepared—to undertake. The IMF was, at times, placed in a very difficult position: if it did not lend in support of programs without being satisfied that these programs had a good chance of success, it would be accused of not caring for the plight of its members and of insisting on severe conditionality; if it lent, but without sufficient assurances that the programs would work, it would be held that Fund-supported programs do not work (to say nothing of charges of imprudent lending).
- Some have suggested that the IMF should have sought a much larger contribution from the banks. Others have speculated that the Fund should not have become so embroiled in the debt crisis; that, especially in the early years, it should not have sought to “manage” the debt problem to the degree that it did, leaving it to the parties directly involved. According to this view, the more vulnerable situation of the banks in the early days of the debt crisis, with its implications for support from the creditor governments, could have led to a substantial resolution of the problem. Hindsight is cheap, but the foregoing views continue to enjoy support in some quarters.
- Many years after the onset of the debt crisis, the IMF came to the view that, given the magnitude of the debt problem, the less hospitable international economy, persistently high interest rates, and the stronger position of the banks, voluntary debt reduction had to be part of the overall solution. The original assumption that all debt could or would be fully serviced was modified.
- There were also problems of how the IMF’s role was perceived. For instance, by insisting that arrears to banks should not increase during the period of a Fund-supported program (a position later modified in some cases), the perception was created that sacrifices were being demanded of the debtor countries so that they could repay the banks—with the Fund as collection agent. Wrong perceptions, but they existed, and the Fund might have done more to explain its policies.
A final word …
Each of us, in reviewing the past decade, will draw his or her own conclusions: that the international financial system can accommodate shocks better than was thought; that adjustment must be given greater weight; that both lenders and borrowers must be more answerable for their actions; and that there is never a single cause or a single solution to phenomena such as the debt crisis. At the same time, the review of the past decade leaves many questions unanswered, such as how to improve the market pricing of risk, and how to ensure better use of borrowed resources. All the same, as we begin the 1990s, we must hold out the hope that this will be the decade of realism, the decade of pursuing what works best in the service of our most pressing economic and social problems. We must move away from slogans and absolutes: the market works better than regulation, but not in all circumstances; “demand management” and “supply side” are not opposite, mutually exclusive, approaches, but part of the same process; finding scapegoats for economic and social problems may have a therapeutic effect, but does not contribute to improving the lot of the people; and so on. The true “silent revolution” is the recognition of what is realistic and responsible as a guide to economic policy.