Chapter

10 Developing a Strategy for the Debt Crisis, August 1982 — December 1983

Author(s):
Margaret De Vries
Published Date:
March 1987
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With the onset of the debt crisis, the balance of payments problems that erupted for several developing members beginning in August 1982 were far and away the most serious and urgent that any country had encountered since the 1930s. The authorities of the indebted members that could no longer readily meet their debt service obligations fully realized that this was their worst crisis in 50 years. Private bankers envisaged the dreaded possibility of a widespread repudiation of debts, such as had occuned in the 1930s: at that time, the debt owed by debtor countries to industrial countries was mostly in the form of securities issued by debtor countries in the United States and in the form of bonds sold abroad. In the 1980s, the debt was almost entirely in the form of short-term and medium-term loans from commercial banks in the industrial members. Monetary authorities of industrial members instantly realized the urgency of the problem posed for the world’s banking system. This time the situation could be much worse than that of the 1930s. The aggregate exposure of private bankers in overseas lending in the 1980s and the ratio of loans to developing members to total capital was much greater than in the 1930s. Moreover, since bankers, not only in the United States but in Europe and Japan as well, were deeply involved, the banking systems of several industrial members could be in jeopardy. In addition, developing members were now such a large and integral part of the world economy that the whole of world trade was potentially at risk. Severe cuts in imports by developing members would endanger the effort of industrial members to expand their own economies.

Fortunately, because of the efforts of those who had created the Bretton Woods organizations, unlike in the 1930s, intergovernmental institutions were in place to help in just such an international payments crisis. Financial officials of both creditor and debtor members immediately turned to the Fund, as an international instrument, to help work out and implement a solution.

The debt crisis is commonly said to have been brought on by a combination of three sets of circumstances. One, most observers take the view, certainly with hindsight, that the borrowing by developing members and the lending by private commercial banks that went on from 1973 to 1981 was excessive.1 Two, the deep and prolonged world recession that had begun in 1980 and that was continuing well into 1982 had severely increased the balance of payments deficits of non-oil developing members. Three, most officials, including Fund officials, have argued, partly with the benefit of hindsight that the payments deficits of non-oil developing members had been aggravated by the kinds of domestic economic policies that many of them had been pursuing, especially after 1979, and by failing to take appropriate adjustment policies.

Prelude to the Crisis: Overborrowing and Overlending

After the first round of increases in oil prices in 1973, several non-oil developing members became heavy borrowers, preferring to accumulate external debt rather than reduce imports as a way to finance higher payments for imported oil. Cutbacks in imports would, in the short term, in all likelihood have reduced their rates of growth. In several developing members, such as Brazil and Mexico, these rates of growth, especially from 1963 to 1972, had been markedly higher than previously, as described in Chapter 5, and the authorities of these members were understandably reluctant to take action that would entail a return to lower growth rates. Most important, to their surprise they found that they had an alternative. For several non-oil developing members, especially in Latin America, credit from private sources proved to be readily available. Moreover, the rates of interest on that credit were low and even negative compared with the prevailing high rates of inflation and the relatively high prices prevailing for primary product exports—circumstances that encouraged borrowing.

On the lenders’ side, steadily rising deposits, particularly as oil exporting members banked their vastly enlarged oil revenues, encouraged creditors, especially private commercial banks, to extend credit readily to non-oil developing members. In addition, private bankers were favorably impressed by the economic performance and growth rates of several Latin American members in earlier years. For the first time in recent economic history, commercial bankers began to lend substantial amounts to governments of developing members for balance of payments financing; previously, bank lending to developing members had been to private entrepreneurs for trade and project financing. Also for the first time, private bankers began to lend substantial amounts for general balance of payments financing rather than for specific investment projects.

Public officials in industrial members encouraged the recycling of petrodollar funds through private markets. Recycling through private channels alleviated the need for official financing and was in tune with the growing preference of officials in most industrial members for undertaking as many activities as possible in the private sector. While some officials began to worry about the piling up of huge external debts by developing members, few foresaw a quick end to the willingness of private creditors to continue to lend.

The availability of large amounts of private financing meant a decline in the use of the Fund’s resources after the expiration of the oil facility in early 1976. Members with access to private sources of finance preferred the absence of conditionality on loans from commercial banks. In fact, the Fund’s conditionality came under mounting criticism and authorities from many developing members, several economists outside the Fund, and even staff of other international organizations, such as the World Bank and the UNCTAD, blamed the Fund’s conditionality for the relative low use made of the Fund’s resources.2 A few economists, particularly those in commercial banks, suggested even after the second oil crisis that Fund members could be divided into two categories. There were those members who could borrow from the market, for example, Argentina, Brazil, Korea, Mexico, and Venezuela, and were creditworthy in the eves of the private bankers. These mostly middle-income borrowers would continue to obtain the bulk of their balance of payments financing from private sources. The other members, for example, most African members. Bangladesh, India, Pakistan, and some members in the Caribbean, could borrow from the Fund because they could not obtain funds from private sources. These borrowers were low-income countries and were later to become known as “official borrowers” while the other borrowing countries were considered “market borrowers.”

The position that members without access to private markets would borrow from the Fund was in line with the view increasingly being expressed outside the Fund that the Fund would, and should, be a “lender of last resort.” The term characterized a lender that took action after all other sources of finance were no longer available.3 The idea of the Fund’s being a lender of last resort was, however, contrary to what Fund officials were advocating; the latter regretted the circumstances that had caused the Fund to become such a lender. That members were approaching the Fund for assistance only when their financial positions had already suffered extreme deterioration and when the possibilities of borrowing from other sources had either sharply diminished or had even temporarily disappeared dismayed Fund officials.4 They were urging all members, whether they could borrow in private markets or not, to come to the Fund at an early stage in their balance of payments difficulties so they could begin to take the adjustment measures required to prevent their difficulties from worsening further. As described in Chapter 8, the Fund’s advocacy of members coming to the Fund at an early stage of their payments difficulties became one of the crucial guidelines of the Fund’s new decision on use of its resources in March 1979.

Much to the surprise of several observers, borrowing by non-oil developing members and lending In commercial banks continued even after the second round of oil price rises in 1979. In fact, most non-oil developing members increased their external borrowing substantially from 1979 to 1981. Some continued to experience economic growth and both borrowers and lenders were optimistic about future prospects. Mexico, for example, had a burst of growth averaging 8 percent a year from 1978 through 1981. Bankers themselves remained confident that many borrowing members were creditworthy and that both creditors and lenders were following appropriate guidelines.5 In this regard, some observers alleged specifically that private creditors did not assess the risks involved in their lending to the same degree as they had in the past when they undertook lending for specific investment projects.6

Banks from several countries were involved. According to one study done in the Fund, there was an inner circle of about 25 large banks based in the member countries of the OECD and an intermediate circle of about 3,000 banks all over the world.7 The terms international banking and international banking system, referring to the taking by banks of deposits of countries with surpluses and the extending by banks of credits to countries with deficits, became commonly used. The term international payments system, distinct from international monetary system, also emerged to describe the way in which balance of payments deficits of developing members were financed. The continued willingness of nearly all bankers to continue lending as well as their later sudden decision to stop became the topic of a special study on the psychology of the banking community.8

Whatever the complex of reasons for the combined borrowing and lending, the external debt of non-oil developing members kept accumulating and by the end of 1981 it was approaching $555 billion. This amount compared with $336 billion three years earlier, at the end of 1978. It was four times the amount of the debt of non-oil developing members at the end of 1973. The external debt of non-oil developing members grew more rapidly than their gross domestic product (GDP) or their export earnings. The ratio in non-oil developing members of external debt to GDP thus rose from about 20 percent in 1973 to nearly 30 percent in 1981.

It was, of course, well established that a country’s external indebtedness may at times grow more rapidly than its aggregate output. But such a rapid growth of external debt was unusual, and the Fund management and staff, along with economists outside the Fund, needed at least some rough measure of the capacity of a debtor member to accumulate and service external debt. They used the ratio of debt to GDP as indicative of the ability of the debtor member to service its debt out of its current national income. They used the ratio of a member’s external debt to its exports of goods and services to judge the debtor member’s ability to generate foreign exchange to meet debt service requirements and to pay for essential imports. Over the period 1973 to 1981, the ratio of non-oil developing members’ external debt to their exports of goods and services rose from 115 percent to nearly 130 percent. For the major borrowers—Argentina, Brazil, Indonesia, Korea, Mexico, the Philippines, and Venezuela—the debt/export ratio rose from 160 percent to nearly 190 percent. The expansion of debt was also accompanied by a sharp decline in the protection provided by gross international reserves. Reserves of non-oil developing members, which had been more than twice the size of their total external indebtedness at the end of 1973, were only 85 percent of their indebtedness at the end of 1981.

There was also an important change in the nature of the creditors. Before the 1973 oil crisis, governments and multilateral institutions, such as the Fund and the World Bank, had been by far the main source of borrowing by non-oil developing members. In the period 1973–81, however, banks’ claims on developing countries increased at an average annual rate of 28 percent, and banks’ claims on non-oil developing countries at an average annual rate of 25 percent.9 the ratio of private financing to total financing of the balance of payments deficits of non-oil developing members increased from 40 percent in 1973 to 63 percent in 1981. The increase in the relative size of indebtedness to the private sector is significant. When borrowers faced serious debt-servicing difficulties after mid-1982, private creditors, especially commercial banks, had to be concerned about the impact on their profit and loss positions, on their loan portfolios, and on their capital positions of any arrangements to ease debt servicing. Government creditors can presumably bear a stretching out of debt maturities or actual losses on debts more readily than can private creditors. By 1981, there was a significant change, too, in the terms of private financial flows. There were considerably more syndicated bank loans at variable interest rates and less of the traditional types of private finance such as bonds, suppliers’ credits, and direct investment. There was, moreover, a rapid expansion of short-term debt in several non-oil developing members. From 1979 to 1981, short-term debt—debt with a maturity of one year or less—nearly doubled.

Debt service payments—interest payments on all external debt and amortization payments on long-term external debt—of non-oil developing members increased even more rapidly than their aggregate external indebtedness. From 1973 to 1981, debt service payments rose fivefold. The higher volume of external debt accounted for two thirds of the increase. The larger share of total debt contracted at variable interest rates, combined with the steep rise in nominal interest rates after 1979, was responsible for the remaining increase. The debt service ratio, the percentage of receipts from exports of goods and services needed to meet debt service, another ratio which the Fund staff used to gauge the debt-bearing capacity of members, rose from 16 percent in 1973 to 21 percent in 1981. For the seven major borrowers listed above, the debt service ratio rose even faster, reaching 35 percent in 1981.

There were, of course, important differences in the developments in external debt in the non-oil developing members of different geographic regions that are not reflected in the aggregated figures given above. External indebtedness expanded more rapidly in Africa, excluding South Africa, than in any other region; however, because foreign borrowing by African members was heavily concentrated in loans from official sources contracted on concessional terms, the debt service payments of African members rose more slowly than those of members in other regions. Nevertheless, because of their markedly weaker export performance, the debt service ratios of African members rose more sharply than members in other regions. Asian members, unlike other non-oil developing members, had a faster growth of exports than of external debt. As a result, in 1981 their debt service ratio of 9 percent was the same as it had been in 1973. Developing members in the Western Hemisphere began and ended the period from 1973–81 with the highest indicators of total debt and debt-servicing ratios of any geographic region. External debt of these members was equivalent to nearly 225 percent of their exports in 1981 and their debt service ratio was 45 percent. Moreover, in 1981, the short-term debt of developing members in the Western Hemisphere was equivalent to close to 60 percent of their total imports, compared with only 15 percent for Asian members. In addition, the international reserves of the developing members in the Western Hemisphere covered only about 60 percent of their short-term debt, compared with 115 percent for Asian members.

Recession and High Interest Rates Aggravate Payments Difficulties

Because of the heavy indebtedness of non-oil developing members and the exposure of private commercial banks, the unusually deep and prolonged recession in industrial members that began in 1980 and persisted until late in 1982 had an even more serious impact than it might otherwise have had. As was described in Chapter 8, the recession sharply limited the growth of markets for developing members’ exports that had been going on in the 1970s and brought about a further deterioration in their terms of trade. The intensification of the debt-servicing burden because of declines in prices of primary commodity exports in the early 1980s also contrasted sharply with the experience of the 1970s, when the real cost of debt service was almost continually eased by increases in commodity prices. In addition, the stagnation of world trade and the high rates of unemployment in industrial members that were generated by the recession provoked a considerable increase in protectionist pressures in industrial members. Rising trade barriers in industrial members against imports from developing members further obstructed the growth of export earnings of indebted members.

Moreover, by 1982 the balance of payments positions of oil exporting members had also deteriorated. A combination of weak aggregate demand, conservation efforts, inventory reductions, and substitution among fuels and among sources of supply all led to a sharp reduction in the volume of their oil exports. By early 1982, the Fund staff was projecting a combined current account surplus for the 12 major oil exporting members of only $25 billion for 1982, a sharp drop from the peak of $115 billion in 1980.10 The imports of these members, which had been rising dramatically since 1974, were also declining, reducing the export markets of non-oil developing members as well as of industrial members.

Another source of external payments problems that aggravated the payment of debt service by indebted developing members by 1982 was the substantial rise in interest rates in industrial members that accompanied the disinflation process. Interest rates in the United States, for example, reached their highest nominal levels since the Civil War. Even in real terms, interest rates were higher than for many, many years. Thus, whereas average nominal interest rates on the external debt of non-oil developing members from 1973 to 1978 were only about 5¾ percent a year—much lower than the rates of growth of their exports or their GDP in nominal terms—they reached 9¼ percent in 1980 and 10¾ percent in 1981. The higher interest rates generated large and unexpected additions to the debt service costs of non-oil developing members, not only for their new borrowing but also, under the floating interest rate arrangements increasingly applicable to most international commercial bank loans, for a considerable proportion of their debt already outstanding. The contracting of debt at variable interest rates had made borrowing members particularly vulnerable to the large increase in international interest rates. Larger debt and higher interest rates raised the debt service ratio considerably. The rise in interest payments as a percentage of export earnings was especially marked among the middle-income members exporting mainly primary products.

The relative burden of debt service was further increased in the early 1980s by the continued appreciation of the U.S. dollar from 1980 to February 1985. As the dollar rose in terms of other currencies, there was downward pressure on the dollar prices of the exports of developing members, which increased the real burden of their payments for interest and amortization on their dollar-denominated liabilities.

In addition, possibly because of the worsening payments positions of the debtors, credit flows dropped sharply. As Arthur F. Burns, former Chairman of the Board of Governors of the U.S. Federal Reserve System put it: “By 1982 an increasing number of commercial bankers and other suppliers of credit finally realized that they had been less than prudent in accommodating—in fact, often even encouraging—the eagerness of developing countries to pile up indebtedness.”11 Consequently, in the second and third quarters of 1982, private financing flows were abruptly and severely cut back. The aggregate of net inflows of capital by non-oil developing members actually declined from 1981 to 1982 by $35 billion, chiefly because of the reduction in borrowing from commercial banks. The sudden sharp cutback in lending by commercial banks, and requests by banks even that short-term loans now be repaid, triggered the crisis. “Once lending to these countries was curtailed, one after another of them found it impossible to meet its scheduled debt repayments or even the interest due on its debts. To prevent outright bankruptcy, their governments had to plead for financial assistance from the International Monetary Fund, other governments, and the private financial community; but such help could not remove the need to practice austerity—particularly to cut imports and expand exports.”12

Impact of Domestic Policies of Borrowing Members

Third in the set of circumstances leading to the world debt crisis concerns the domestic economic policies of indebted members. These circumstances have been especially emphasized by the Fund. In the Annual Reports and in public speeches of the Managing Director, Fund officials repeatedly spelled out the impact of domestic policies on the balance of payments positions of the indebted members, especially in the late 1970s, and the need for drastic changes in these policies.13 In the 1970s, especially after 1978, several non-oil developing members adopted expansionary fiscal and monetary policies. For some years, the trend had been particularly toward extremely large fiscal deficits and this trend not only continued after 1978, but in many indebted members fiscal deficits grew even larger. For example, between 1978 and 1982 the ratio of fiscal deficit to gross domestic product in the three main debtor members, Argentina, Brazil, and Mexico, more than doubled.14 As in many industrial members, in many developing members a rapid increase in social transfers and subsidies to uncompetitive industries had gradually been occurring. In addition, as growth rates started to decline in 1981 and 1982, those non-oil developing members that relied heavily on the taxation of export activities were severely affected by a shrinking tax base. As described in foregoing chapters, because of the small markets for government securities and the limited supply of private savings, large fiscal deficits in non-oil developing members were often quickly monetized, that is, financed by borrowing from the banking system. In members that had flexible exchange rates, the fiscal deficits and high rates of money growth often led to a vicious circle of inflation and exchange depreciation. In members that had fixed exchange rates, exchange rates became greatly overvalued. Overvalued exchange rates had many unfavorable effects. For instance, overvalued rates led to relative price distortions that weakened the position of export or import-competing industries. Trade and exchange restrictions were retained or even tightened. Often, too, inappropriate low levels of domestic real interest rates were maintained.

Taken together these policies in indebted members tended to reduce domestic savings, to affect unfavorably the efficiency of investment, and to discourage the growth of exports, particularly of manufactured exports. Furthermore, capital outflows of sizable magnitudes began to occur. For example, for members in the Western Hemisphere, negative errors and omissions, frequently an indicator of capital outflows, rose from 4 percent of exports during 1977–79 to 19 percent during 1980–82. By 1980–82, moreover, they were equivalent to 37 percent of the net external borrowing of these members. Weaknesses in domestic policies were often closely related to the way in which external debt was managed. For example, to help finance fiscal deficits, public authorities expanded external debt. Also, they were often lax in recording and monitoring the undertaking of external debt, both by the public and private sectors. In many members, the authorities simply did not know how much debt had been contracted.

Another problem concerned the uses that indebted members made of the funds they borrowed. Since money is fungible, it is, of course, difficult to determine these uses. Nonetheless, it has often been said that in several indebted members, such as Argentina, Chile, Mexico, and Venezuela, investments in nontrade sectors of the economy were often financed by external debt. Hence, borrowed funds were not used in ways that would later help provide the foreign exchange needed for subsequent debt servicing. It has been alleged, too, that in some of these members purchases of arms were undertaken by the military, which at the time often controlled major public enterprises in these members, and that public debt often financed not had investment nor unsustainable consumption but private capital flight.15

Whatever the truth of these allegations, in early 1986 when the Fund staff compared developments in domestic investment and savings in members that had encountered debt-servicing difficulties with members that did not, it was inclined to conclude that in many members with debt-servicing problems, foreign savings had substituted for domestic savings. According to the staff, for the heavily indebted members the domestic savings rate tended to decline from the period 1974–75 to the period 1978–82. Growing inflows of foreign savings thus seemed to have been used largely to maintain the existing investment ratio rather than to increase it. In effect, foreign savings were, at the margin, financing a reduction in available domestic savings that were also held down by capital outflow. The staff further noted that when foreign savings dried up after 1982, the domestic investment ratio plummeted. Members that did not encounter debt-servicing difficulties had a different history. Although savings in these members generally represented a smaller share of national income, savings ratios tended to rise after 1977. Hence, foreign borrowing seemed to have been used largely to support additional investment.

The Fund’s Responses

The debt crisis erupted just a few weeks before the Governors of the Fund and of the World Bank were to hold their Annual Meetings in Toronto in September 1982. The Finance Minister of Mexico advised monetary officials of creditor nations in August that Mexico could not meet its forthcoming debt service payments. ‘The announcement by Mexico’s authorities had a dramatic impact. Financial officials of the leading industrial creditor countries and private bankers were literally stunned and suddenly fearful. Mexico was a major borrower. Furthermore, officials and bankers had regarded Mexico, itself an oil exporter, as among the least likely of the heavily indebted countries to announce suddenly that it could not meet its interest and amortization payments. The prospects for other heavily indebted developing countries being able to manage their huge debts looked dismal indeed. Moreover, not only had the balance of payments positions of several heavily indebted members become extremely difficult, raising the question of whether these members could service their debts, but the inability of some major borrowers to roll over maturing loans threatened a major crisis of confidence in the banking system and a cumulative contraction of credit-financed imports that could seriously reduce world trade and the prospects for world economic recovery. In brief, there was fear that some major banks in the leading creditor nations might possibly go bankrupt, endangering the banking systems in the United Kingdom, the United States, Japan, the Federal Republic of Germany, France, and other industrial nations, virtually the whole world banking system. And there was fear that world trade would decline sharply. Visions of the 1930s began to occur. The situation was one of dire emergency.

Action had to be taken immediately. Since Mexico was a neighbor of the United States and was important to U.S. foreign policy, U.S. officials were particularly concerned and soon became closely involved with the Mexican authorities and with Fund officials to shape a strategy to deal with the crisis. In a rescue operation, the U.S. Government gave Mexico a series of very short-term bridging loans. U.S. officials made it clear that the loans were to allow time for a program supported by the use of the Fund’s resources to be arranged. Thus the Fund was asked, especially by U.S. officials, to respond to the crisis. The Managing Director, immediately seeing an important role for the Fund, responded positively. Negotiations with Mexican officials started at once. Within weeks the debt crisis spread to Brazil and Argentina, also major borrowers from commercial banks. The members with debt problems that were most in the financial news from 1982 to 1986 were the non-oil, middle-income developing countries of Argentina and Brazil and the middle-income developing oil exporter, Mexico. But beginning in 1982 debt-servicing problems were also soon encountered by other oil exporting members, particularly by Nigeria and Venezuela, by other non-oil developing members, such as Chile, Peru, and the Philippines, by numerous low-income members, such as the Sudan and several other members in Africa, by members with centrally planned economies, such as Romania and Yugoslavia, and by a few countries not then members of the Fund, such as Poland. (Poland was to join the Fund in 1986.) For this reason, the crisis was commonly referred to as the world debt crisis.

A number of decisions had to be made quickly. A first decision concerned whether to proceed country-by-country or whether to think and act in terms of some overall global solution. Soon after the onset of the crisis, several officials, a few in the banking community itself, and economists in universities advanced a gamut of global solutions. In their view any genuine resolution of the problem of the huge indebtedness that many developing members had accumulated had to involve some across-the-board action. Some officials and economists proposed, for instance, that there be a whole, or at least a partial takeover by international organizations, such as the World Bank, of commercial banks’ indebtedness. Others proposed that there be some degree of forgiveness of interest payments or even of the debt itself. Since interest rates as of August 1982 were still very high and it was possible that they would rise even higher or at least that higher interest rates would gradually be applied to debt contracted earlier at lower interest rates, some officials and economists proposed capping interest rates at existing levels.16

As is well known, the strategy worked out jointly by creditor governments, debtor members, private bank creditors, and Fund officials involved a case-by-case approach. One reason for the adoption of this approach, at least in August 1982, was of course pragmatic: the Mexican situation was urgent and had to be dealt with immediately. But, as already noted, most observers expected the quick spread of debt-servicing problems to other indebted members. Hence, other, more important, reasons explain why global solutions were rejected. Certainly global solutions were adamantly rejected by the main lending banks. In general, bankers took the view that they could not afford to incur the losses that would be involved in any arrangement other than current debt servicing by debtor members. Some of the global solutions suggested would, moreover, have involved a massive infusion of official financing from the industrial world. Such financing clearly was not forthcoming. Officials of industrial members were deep in the process of domestic budget cutting. In some industrial members, particularly in the United States, foreign financial assistance was not politically popular, especially at a time when domestic unemployment was substantial and when expenditures for domestic social programs were being severely reduced. In any event, officials of most industrial members wanted solutions to the debt crisis that had little governmental involvement and that relied as much as possible on the private sector and on market-oriented financing.

The reality of the situation presented Fund officials with few alternatives. The strategy adopted was worked out in conjunction with officials of the governments of industrial members—certainly with the endorsement of Paul A. Volcker, Chairman of the Board of Governors of the U.S. Federal Reserve System—of other major institutions, such as the BIS, with private commercial bankers, and with the acceptance of the authorities of the debtor members concerned. In the next several years, the strategy in which the Fund played a decisive role was widely endorsed time and again by officials of the large industrial members. This endorsement took place formally in the Executive Board and in the Interim Committee and informally in many discussions and conversations between Fund officials and other participants in the debt strategy. Thus while at many key points, the Fund—the Managing Director, in particular—certainly took a decisive lead, the Fund was an instrument of the international community, seeking to help implement a widely endorsed strategy.

The main strength of techniques that relied on market-based financing was that these techniques were seen as likely to do the least damage to debtor members’ creditworthiness. In defense of the case-by-case approach. Fund officials explained that each member’s situation was unique. Each had different creditors, different financing requirements, different adjustment needs, and different payments prospects. Furthermore, they pointed out that the debt of most concern, although widespread, was really not a global problem. It was concentrated among a relatively few large and relatively developed countries of Europe, the Western Hemisphere, and the Far East. Of the 115 non-oil developing members, 20 advanced members with good access to international capital markets accounted for 73 percent of total external debt outstanding as of early 1983 and 84 percent (or $350 million) of the debt owed to private creditors, the component that was the source of greatest concern.

Fund officials, working in close conjunction with officials from member governments and with private creditors, adopted what they termed a cooperative strategy. This strategy was so termed because it was a Strategy in which all the interested parties, the governments of the indebted members, the governments of the industrial members, private creditors, and international financial institutions, such as the Fund, the World Bank, and the BIS, all collaborated. The strategy contained two main elements, adjustment and financing. Adjustment is usually described first, with adjustment being the condition required of members if they were to receive financing. But adjustment and financing can also be viewed as the two sides of a single coin. Continued financing on the one side can be regarded as the condition required of commercial bank creditors if on the other side the indebted member undertook appropriate measures to adjust its payments position. Either side may be treated first.

The Financing Side In addition to its own financing, the Fund—in particular, the Managing Director, Mr. de Larosière—helped arrange financing packages for debtor members from governments, central banks, private commercial banks, the BIS, and the World Bank. As they Started to confront the debt crisis in late 1982, Fund officials, again primarily the Managing Director, assisted by the staff, were struck by the sudden stark payments difficulties faced by Mexico, and soon thereafter by Argentina and Brazil and by other indebted developing members, brought on by the unexpected virtual curtailment of private credit that had occurred in late 1981 and the first part of 1982.

The need for net new lending by private creditors was stressed emphatically by Mr. de Larosière. At the end of 1983, for example, he declared that

... it is simply not possible for borrowing countries to go from a situation in which they were absorbing $50 billion a year of net new lending from commercial banks to one where inflows are zero or negative without disastrous consequences for both current welfare and future development prospects. It is certainly true that too much was borrowed in the past in too short a time with too little consideration of the consequences. But the correct solution is not to cease all lending and let the chips fall where they may. That would provoke disproportionate economic hardship that might well lead to political instability the consequences of which could not fail to rebound on economic and financial structures in industrial countries. The task, therefore, is to achieve a smooth transition in which sufficient external financing is available to indebted countries to enable them to scale back their dependence on foreign savings in an orderly fashion, while preserving their ability to invest and grow in the medium term.17

In brief, he believed that the reliance of the indebted members on commercial financial flows had been so great that any reasonable degree of policy adjustment to the new situation made by these members would fail unless some sufficient financing would still be forthcoming. He considered this additional financing so essential to the success of adjustment programs that in an unusual innovation he asked other creditors, particularly private commercial banks, to make their commitments before he would recommend to the Executive Board that the Fund approve the program and agree to the Fund’s own provision of financial assistance. Bankers had to agree to continue to supply agreed amounts of financing. Terms such as forced lending and involuntary lending were used to characterize the lending that commercial banks were pressured into supplying. Fund officials originally used the term “non-spontaneous lending.” In 1985 and 1986, the term “concerted lending” was more frequently used. By acting as a mobilizer of funds from other sources, the Fund filled an international void and accepted a new international role for the institution: that of leader of coordinated balance of payments assistance.

The Fund quickly found itself in a major role of financial organizer for many of the members that used its resources. Mr. de Larosière referred to his marshalling funds from commercial banks as “bailing the banks in” His remark was meant to counter the accusation that the Fund was “bailing the banks out.” The Fund could influence other creditors by its willingness to stake its prestige and its resources on a particular adjustment program, provided only that the other creditors did their duty in filling the remaining gap. If they did not, the Fund would not act either; the balance of payments situation of the member concerned would remain unsolved, and its creditworthiness would plummet even further. In the process, it inevitably fell to the Fund to determine the relevant magnitudes: the maximum balance of payments adjustment it considered feasible, the extent and phasing of the Fund’s credit, and the targets that it determined as the indispensable contribution of other providers of funds.18 In determining these magnitudes, the Fund management and staff necessarily worked closely with the other potential providers of money to determine the amounts of financing that could be considered realistically feasible. The arrangements with commercial banks for concerted bank lending broke new ground in relations between the Fund and the commercial banks.19

The Fund also immediately greatly enlarged use of its own resources. The use was primarily in upper credit tranche stand-by arrangements and in extended arrangements in support of adjustment programs negotiated and agreed with the member concerned. Thus, in December 1982 the Fund agreed to use of its resources totaling SDR 3.6 billion by Mexico, SDR 3.4 billion under an extended arrangement and SDR 200 million available immediately as a drawing in the first credit tranche. Also in December 1982 the Fund approved a drawing by Brazil of nearly SDR 500 million under the compensatory financing facility. In January 1983, the Fund agreed to use of its resources by Chile, totaling SDR 795 million. Of this amount, up to SDR 500 million was under a two-year stand-by arrangement and SDR 295 million under the compensatory financing facility. In January 1983, too, the Fund agreed to use of its resources by Argentina totaling SDR 2 billion, SDR 1.5 billion under a stand-by arrangement and SDR 500 million available immediately under the compensatory financing facility. In February 1983 the Fund approved an extended arrangement for Brazil of SDR 800 million. Other members sought the Fund’s support. By April 30, 1983, there were 39 Fund-supported adjustment programs in effect for a commitment by the Fund of SDR 25 billion, up considerably from SDR 16.2 billion a year earlier.

The eyes of the international financial community quickly turned toward the Fund as the central element in the search for a constructive solution to the debt crisis. Early in 1983 the Interim Committee advanced their meeting scheduled for the end of April 1983 to take place two months earlier to take action to give the Fund more money. At their meeting on February 10–11, the Interim Committee agreed to increase Fund quotas from about SDR 61 billion to SDR 90 billion under the Eighth General Review of Quotas and urged governments to act promptly to bring the quotas into effect by the end of 1983. On November 30, 1983, these new quotas did go into effect.

Use of the Fund’s resources continued to increase sharply. By April 30, 1984, the Fund had, since August 1, 1982, approved extended arrangements not only for Mexico and Brazil, but also for the Dominican Republic, Grenada, and Malawi. In addition, in this period it had approved numerous stand-by arrangements. Adjustment programs supported by stand-by arrangements with the Fund had been introduced by 43 members.20 Five tables in the Appendix provide specific details, fable 1 lists the total purchases and repurchases in which the Fund engaged in each financial year from 1978 to 1986. Table 2 lists the stand-by arrangements approved for each member from January 1, 1979 to April 30, 1986. Table 3 lists the extended arrangements from the time of the first such arrangement in July 1975 through April 30, 1986. Table 4 lists the actual drawings made by each individual member for each of the Fund’s eight financial years 1979 through 1986. Table 5 lists the quotas of each member as of June 30, 1986.

Adjustment Programs and Their Rationale The other side of the Fund’s debt strategy was adjustment. The adjustment programs that debtor members undertook as a condition for using the Fund’s resources and as a condition for the Fund’s willingness to help organize other credits did, indeed, involve strong measures. The program into which Mexico entered in January 1983, for example, aimed at a major deceleration of domestic inflation and a turnaround of the overall balance of payments from a large deficit in 1982 to a surplus in 1983. The current account deficit was to be reduced substantially in the next three years. The key policy aim of the program was a strengthening of public finances. The public sector deficit was to be lowered from 16½ percent of GDP in 1982 to 8½ percent in 1983, 5½ percent in 1984, and 3½ percent in 1985. The program envisaged tax reforms, increases in prices of public goods and services, and a substantial restraint of expenditure. To strengthen domestic saving, interest rates were raised to more competitive levels, while bank credit expansion was made subject to stringent limits. To help provide more efficient resource use, the scope of price controls was sharply reduced. Wage policy was to be cautious. The controlled exchange rate of the peso was to be depreciated on a daily basis in line with projected inflation. In the meanwhile, in 1983, Mexico was expected to attain relief from a postponement of external debt with commercial banks and to receive new credits from commercial banks and from international development institutions and national official agencies.

Argentina’s program under a 15-month stand-by arrangement approved in January 1983 called for a reduction in the overall balance of payments deficit from about $6.5 billion in 1982 to $0,5 billion in 1983, on the strength of a further improvement in the current account. The overall deficit of the public sector was to be reduced from 14 percent of GDP in 1982 to 8 percent in 1983, on the basis of increases in public sector prices and export taxes, wage restraint, and strict control of other expenditures. The exchange rate and interest rates were to be managed flexibly. Meanwhile, the external debt was to be restructured, with the aim of improving its profile by reducing Argentina’s dependence on short-term foreign borrowing.

Under the program agreed with Brazil in February 1983, the current account deficit was to be reduced from almost $14.5 billion in 1982 to $7 billion in 1983. The public sector deficit was to be reduced from 17 percent of GDP in 1982 to 9 percent in 1983 on the strength of new tax measures and tight spending policies. In the monetary area, credit subsidies were to be reduced substantially during 1983. Also, in February 1983 the cruzeiro was depreciated by 23 percent and this depreciation was followed by a continuation of the system of frequent and small minidevaluations equal to the rate of domestic inflation. Wage policy was also modified to ensure that wage adjustments facilitated achievement of the objectives of the program.

The adjustment programs on which debtor members embarked thus contained the same basic general policy prescriptions both for controlling demand management and for effecting structural reform as those described in Chapter 9. Under the circumstances, however, the measures required were necessarily much stronger and more specific than those of the programs that the Fund supported earlier, including those as late as 1979–81. Hence, the adjustment programs included restraints on government spending so as to substantially reduce fiscal deficits. Emphasis was placed especially on containing payments for subsidies and increases in wages and on postponing capital projects while streamlining other capital projects or reducing their rate of implementation. Adjustment programs also included control of the rate of expansion of domestic credit. In addition, the majority of programs included a marked depreciation of the real effective exchange rate. Because members needing adjustment could no longer postpone it through new external borrowing, an active exchange rate policy was usually essential both to reverse the inflation-induced erosion of profitability in the traditional tradable goods sectors and to provide incentives for the production of new tradables to counter the unfavorable external developments.21 Still other adjustment policies related to price controls, public enterprise management, the level and distribution of development expenditures, and the implementation of tariff protection.

Adjustment measures were based on several understandings of what was to be achieved. The first was that adjustment programs had to be such as to restore the confidence of creditors in the viability of the debtor members as quickly as possible so that creditors would resume voluntary lending. Obviously, the way out of the crisis was for creditors again to resume financial flows on their own. Fund officials were convinced that creditors’ confidence could only be rebuilt through a thoroughgoing reorientation of the debtor member’s policies that could be regarded as a credible and enduring effort toward restoring the member’s capacity to service its debt.

The second understanding was that the authorities of the debtor members were committed to fully servicing their debts on a continuing basis. Such an understanding was obviously essential if Fund officials were to ask commercial bank creditors to make more financing available. In any event, in the interest of continuing their creditworthy status, the debtor members themselves wanted to service their debts. To enable debt servicing to proceed, however, Fund officials regarded it as essential for debtor members to restore their debt-servicing capacity and strengthen their ability to attract future capital flows. To this end, Fund officials regarded it as necessary for debtor members to take immediate substantial measures to improve their balance of payments positions. Indeed, at least some debtor members would have to achieve sizable trade surpluses.

The third understanding was that adjustment programs were essential to restore domestic and external balance in the economies of debtor members and thus to set the right conditions for sustainable growth over the medium term. This understanding was based on the conviction that earlier policies had been instrumental in bringing on the debt crisis and that changed policies were imperative to reduce the payments deficits as soon as possible. But as Fund officials often emphasized, the belief was that changed policies would, in the medium term, also be conducive to a resumption of economic growth in indebted members. The staff made more frequent use of medium-term scenarios to help assess the need for and the proposed speed of adjustment and to provide a framework for assessing the appropriateness of current and prospective policies.

Fund officials were fully cognizant of the comprehensiveness of the adjustment measures that they asked members to take and of the considerable hardship and high social and political costs involved in the implementation of these measures. But they considered fairly profound adjustment measures as the only way to get the debt crisis under control. And, as the Managing Director emphasized many times in his public speeches, they were convinced that the alternatives to “orderly adjustment” with the aid of the Fund’s financial support would entail much harsher effects on the economies of indebted members.

In the circumstances of late 1982 and early 1983, Fund officials viewed the debt crisis at least in part as a liquidity crisis, because developing members were having difficulty in earning the foreign exchange needed to service their debts. Non-oil developing members had encountered temporary deficiencies of liquidity because of exceptional circumstances—the prolonged worldwide recession involved in disinflating the economies of industrial members, the sharp deterioration in the terms of trade of indebted members, the unusually high interest rates of the early 1980s, the sudden and severe cutback in financial flows from private creditors, and the lack of sufficient official development assistance. There was no basic inability of indebted members to deal with their debt obligations over time and under more normal circumstances than the world recessionary conditions of 1982 and 1983. In the medium and long run the productive capacity and potential for growth in economies, such as those of Argentina, Brazil, and Mexico, were more than sufficient to service their external debt and yet permit these members to import sufficiently so they could regain the momentum of domestic economic development. While a liquidity crisis might normally be handled by making more financing available, such as it was in the 1960s with the advent of the SDR, in the debt crisis of the 1980s such financing, certainly in the magnitudes needed from private creditors, was not forthcoming. Hence, the solution lay with indebted members taking sufficient adjustment measures to give Fund officials a basis for insisting that commercial bank lenders continue to lend, at least on a temporary basis, until world recovery took shape.

Working in conjunction with all the interested parties, Fund officials based their strategy almost entirely on the assumption that world recovery would soon come about and be buoyant enough to alleviate considerably the debt-servicing difficulties of the heavily indebted members currently in crisis. Early in 1983 the staff stated that “to the extent that debt operations have represented an exchange of financial liabilities for productive physical assets yielding rates of return above their financing costs, debt-servicing problems should ease with recovery of the world economy.”22 The staff estimated that an increase of 1 percent in aggregate real GNP of industrial countries meant an increase in export earnings of non-oil developing countries of 2½ percent to 4 percent.

It is also to be noted that at the beginning of 1983 the OECD also reported that the primary elements of financial and economic stress in indebted developing countries were “reversible.”23 Like Fund officials, OECD officials were focusing their attention on the extreme weakness of world trade and of commodity prices in 1982 and the severe impact on the export earnings of debtor countries. They expected that world recovery would shortly produce much higher export earnings for indebted members, giving these members the wherewithal to service their debts. The OECD survey also emphasized that since the developing country debt burden manifested itself at the level of individual countries, rather than in aggregates, policy analyses and prescriptions had to address specific country situations; the OECD, like the Fund, emphasized the case-by-case approach.

In developing a debt strategy in late 1982 and early 1983 financial officials, including those in the Fund, also expected that as inflation in industrial members ended, interest rates would fall. The Fund staff estimated that a reduction of 1 percentage point in market interest rates would, after a year or so, reduce the flow of interest payments of non-oil developing countries by roughly $4 billion.24 Fund officials, moreover, expected that after debtor members had taken strong adjustment measures, the sharp drop in private financial flows would be reversed. And, while debtor members were taking the appropriate adjustment measures to see them through the emergency, they should also continue to receive some continued flow of funds from their creditors.

In addition, the Managing Director in his speeches urged that industrial members increase their official development finance for low-income members. Mr. de Larosière stressed repeatedly that the adjustment efforts of these members were hampered by the weakness of their resource base, their underdeveloped infrastructure, and the difficulty of actions that might compress further their already low living standards.

All in all. Fund officials, as well as the authorities of the debtor members themselves, were eager to avoid failure in debt servicing or any other sign of default. Many officials were particularly mindful of the defaults on debt of the 1930s and were well aware that it had taken some forty years for private creditors again to lend in substantial amounts to countries that had defaulted or repudiated their debts. Monetary authorities of indebted members also recognized what Mr. de Larosière often referred to as the realities of their situations. Without more financing available, the indebted members had few options but to take drastic measures to curtail, or even reverse, their payments deficits if they were to service their debts. Fund officials stated time and again that adjustment was not something that was imposed at the will or behest of the Fund. It was ultimately dictated by the scarcity of external resources. Finally, it is again to be emphasized that the strategy for the debt crisis in which the Fund was a central figure and its implementation through the Fund were widely endorsed by the authorities of industrial members.

This was the context and framework in which the Fund proceeded with its cooperative strategy based on adjustment and financing. The Fund’s effort was in effect aimed at addressing three principal concerns: how to link financial support effectively to economic policies that would restore debtor members’ creditworthiness; how to provide relief for the balance of payments difficulties of debtor members that would rebuild debtor-creditor relations; and how to coordinate support among large and diverse creditor groups.

Other Features of the Strategy Another feature of the debt strategy that the Fund helped to develop was an unprecedented number and scale of debt restructurings and financing packages, both by banks and by official creditors operating through the Paris Club.25 Beginning in mid-1982, a large number of debtor members approached commercial banks for new financial arrangements. As events turned out, over the period 1983–85, 31 countries reached agreement with commercial banks affecting some S140 billion of debt. During the same period, through the Paris Club, official creditors came to agreements with 31 countries (not identical with the 31 involved in restructurings with commercial banks) to restructure official and officially guaranteed debt. An important development by 1984 was the negotiation of muitiyear debt restructuring agreements (MYRAs) between commercial banks and several debtor members. The agreements were long-term arrangements—for example, for 15 years—instead of the usual short-term, year-to-year agreements. The Managing Director, assisted by the staff, pressed the commercial bank creditors hard to introduce the technique of muitiyear debt restructuring. At the same time, the Fund management pressed banks to reduce spreads and fees and lengthen maturities to make the terms of restructuring arrangements more realistic when compared with the capacity of debtor members to pay. As a result of the debt restructurings, it was possible to stretch out maturities of large debt repayments coming due in this period. The financial packages made it possible in a number of cases for debtor members to reduce substantially their overhang of short-term debt, in effect exchanging it for debt of longer maturities. The most heavily indebted members were thereby able to reduce both their debt service ratios and the absolute amounts of short-term debt, even though the overall debt ratios remained relatively stable.26

In addition to pursuing the cooperative strategy and helping with debt restructuring, the Fund engaged in other activities to alleviate the debt problem. It acted to prevent future debt crisis by strengthening its surveillance over the external debt policies of members. It launched a new technical assistance program to help members monitor their external borrowing. It expanded its work on compiling and publishing statistics on debt. And it broadened its consultations to include a more detailed review and analysis of external debt, especially the prospects for external debt and its servicing over the medium term. These activities thrust the Fund into the forefront of the attack on the external debt problems of developing members.27

Fund officials also increasingly advised developing members, particularly those with debt problems, to place greater emphasis on policies designed to attract foreign direct investment. Not only did such investment avoid creating an overhang of debt but it often facilitated the transfer of technology and skills and was directly tied to productive capital formation.28

In sum, beginning in late 1982 the Fund, in conjunction with all interested parties, developed a comprehensive strategy for the debt crisis. It continued to implement this strategy in the next few years. Chapter 11 examines the experience with this strategy.

1An interesting opposite view has recently been advanced by Friedman (1986).
2The nature of the mourning criticism of the Fund’s conditionality in the late 1970s is described in M.G. de Vries (1985, Vol. I, pp. 490–94). Criticisms of the Fund’s conditionality in connection with the debt strategy are discussed in Chapter 11.
3The concept of lender of last resort was initially advanced in a different context by Charles P. Kindleberger, of the Massachusetts Institute of Technology. Professor Kindleberger’s concept was that of a lender needed to prevent the collapse of the international financial system analogous to the function of the central bank as the lender of last resort in a country’s domestic financial system. Professor Kindleberger doubted, however, the suitability of the Fund for the purpose. See, for example, Kindleberger (1978, pp. 183–226).
4See, for example, Dale (1983).
5Canons for borrowers and lenders were written, for example, by a former member of the staff of both the Fund and the World Bank who had become Senior Advisor for International Operations at Citibank. See Friedman (1977) and (1978).
7See Mentré (1984, pp. 3–14). According to some Fund stall, the figures in Mr. Mentre’s study may exaggerate the number of banks that were serious lenders, as judged by the involvement of commercial banks in the debt-servicing operations that began in late 1982. Thus, the advisory committees that the banks set up in 1983 and later to coordinate concerted bank lending to debtor members and to negotiate debt rescheduling worked on the basis of 14 leading banks. However, for most debtor members, up to 50 major institutions were involved. Few groups of creditors for the debtor members that had rescheduled their debt as of October 1986 included more than 500 to 600 commercial banks.
9To eliminate the effect on these figures of purely interbank transactions, the concept of developing countries used here excludes seven offshore banking centers—The Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore.
10The 12 major oil exporting members were Algeria, Indonesia, the Islamic Republic of Iran, Iraq, Kuwait, Libya, Nigeria, Oman, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.
11Burns (1984, p. 1059).
12Ibid., pp. 1059–60.
13See, for example. International Monetary Fund (1983a, pp. 40–41) and (1984a, pp. 12–14 and 31–32).
14A discussion by Fund staff of the part played by domestic policies in bringing on the debt crisis in several Latin American members can be found in Wiesner (1985a, p. 24).
16Global solutions that were being suggested by hue 1983 included those, lot example. Of Kencn (1983). Rohatyn (1983), Burns (1984, p. 1067). and Roosa (1984).
17Remarks to the American Enterprise Institute, Washington, December 5, 1983, de Larosière (1983b, p. 382).
18Further discussion of the Fund’s role in organizing funds can be found in Mohammed (1985).
19A discussion of this relation is in Mentre (1984, pp. 25–27).
20Argentina, Bangladesh, Barbados, the Central African Republic, Chile, Costa Rica, Ecuador, The Gambia, Ghana, Guatemala, Guinea, Haiti, Honduras, Hungary, Kenya, Korea, Liberia, Madagascar, Malawi, Mali, Mauritius, Morocco, Niger, Panama, Peru, the Philippines, Portugal, Senegal, Sierra Leone, Solomon Islands, South Africa, Sri Lauka, Sudan, Thailand, Togo, Turkey, L’ganda, Uruguay, Western Samoa, Yugoslavia, Zaire, Zambia, and Zimbabwe.
21The subject of exchange rate policies in programs supported by the Fund is covered in Johnson (1985b).
22International Monetary Fund (1983b, p. 69).
23International Monetary Fund (1983d, p. 7).
24International Monetary Fund (1983b, p. 17).
25A description of the Paris Club can be found in M.G. de Vries (1985. Vol. II, pp. 924–25).
26Further information on debt restructuring can be found in Brau, Williams, Keller, and Nowak (1983) and in Dillon, Watson, Kincaid, and Puckahtikom (1985).
27Further discussion of debt restructuring and of the statistical aitisities of the Fund in regard to external debt can be found in Mehran (1985).
28A study by Fund staff of this topic can be found in International Monetary Fund (1985b).

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