Chapter 5 Approaches to the Debt Crisis
- Robert Effros
- Published Date:
- June 1994
It is probably an oxymoron to call something that lasts for years a crisis. Crises, by their nature, are acute and short term, but debating the choice of words is not to deny that debt problems are still painful and difficult.
It is helpful to think about the evolution of previous approaches to the debt problem to get some sense of what has gone before and where we are now. In this regard, four general points should be made. One is that a cooperative approach to these problems is preferable, although this type of approach is breaking down. Second, there has been considerable progress in resolving debt problems over the past years. Third, the process of dealing with these problems has been evolutionary and is likely to continue to be so. Fourth, with the possible exception of Eastern Europe, the international debt problem is basically winding down.
The making of the international debt crisis involved three elements. One was miscalculation by those countries that borrowed large amounts of money in the late 1970s and early 1980s and did not always use the funds effectively. Second, lenders also miscalculated how much to lend, overlending in what was essentially a fad by the commercial banks. Last, there was a change in the economic environment from low or negative real interest rates in the 1970s to high real interest rates and also slow growth in the industrial world in the early 1980s.
In the first phase, 1982-85, the debt crisis was treated broadly as a sort of liquidity crisis. That treatment was criticized, even at the time, for being too narrow. Yet, the desire to buy some liquidity, or breathing space, to escape from the more painful adjustments is understandable.
At the time, most countries seemed to want it that way. Many of the countries that had external financing problems did not want them to cause a complete break in the way of doing business with their creditors but wanted to mend relations and move forward. Thus, the initial approach to the debt problem focused on stabilization measures and adjustment policies. The commercial banks were encouraged to restructure loans and provide new lending. In a few cases, official agencies and creditors provided some bridge financing, and the International Monetary Fund, which played a central role in the first phase of the crisis, increased its resources for this purpose. The effort was seen as cooperative, one in which everyone moved forward together. One key element of that approach was the policy of financial assurances that was adopted by the Fund, according to which it would not disburse funds until it had reasonable confidence that the needed commercial bank financing was in place.
That phase of the crisis was successful in that the disasters expected to strike the international financial system did not occur, and a certain amount of progress was made in macroeconomic stabilization. By 1985, however, it became clear that the problems ran deeper than was originally thought. Many of the borrowing countries had not been able to restore their growth, and fatigue set in at the international institutions, as well as in the borrowing and creditor countries.
In response, U.S. Secretary of the Treasury James Baker initiated a new phase focusing on sustained growth, with an increased emphasis on growth and structural adjustment activities with the more prominent involvement of the World Bank as well as that of other development banks. In particular, multilateral development banks were called upon to fund $27 billion in new loans over three years for the “Baker 15” countries, an amount that was thought to involve lending of about $20 billion net of repayments.
In the event, lending over the three-year period 1986-88 was only about $10.5 billion on a net basis for two reasons. The first reason was that not all countries that were eligible for funds took advantage of the Baker Plan. The second reason had to do with the depreciation of the dollar. Since much of the lending had been in nondollar currencies, the repayments required were rising as the dollar depreciated. Although difficult to calculate, the gross lending under the Baker Plan was $22.5 billion.
Both the net and gross lending by the commercial banks were substantially less than had been envisioned in the plan; they were expected to lend $20 billion, gross. Banks during the first three years of the debt crisis recycled about a third of their interest receipts into new lending. In the next three years, it was more like 20 percent. For the big three countries, the ratio went from 43 percent to 27 percent. Thus, the banks were putting in much less than they were taking out; in other words, bank exposure declined. For U.S. banks from 1982 through 1988, bank exposure declined from 136 percent of capital to 54 percent of capital, and was 39 percent of capital by 1990. The nine largest U.S. banks had a decline in exposure from 200 percent in 1982, to 92 percent in 1988, and 78 percent in December 1989. This decline was partly because of building up of capital and partly because, in later years, there was an absolute reduction in bank exposure by about 25 percent from 1984 to 1988, 13 percent in 1988, and 19 percent in 1989.
This period did witness some successes. A number of countries—Chile, Colombia, Morocco, and the Philippines—did have growth, averaging in a three-year period more than 4 percent. These rates did not match those experienced in the 1970s but showed respectable positive growth in real income per capita. One of the problems, however, in terms of perceptions, was that there were no big success stories. No large debtor country succeeded in restoring growth on a sustained basis.
Moreover, it was clear that debtor countries faced tight financial constraints and that the need for internal adjustment was much greater than had been anticipated. A useful and interesting study has been done by John Williamson at the Institute for International Economics, The Progress of Policy Reform in Latin America.1 He documents quite well that in almost all areas these countries took substantial steps in terms of reform. The absolute level of what they have attained is a different issue, however. The adjustment actions were stronger and more consistent on the external side (liberalized exchange rates and less restrictive trading systems) than on the internal side (improved public finances and greater deregulation).
The objective, then, is to create the circumstances conducive to sustainable growth, or, as some would say, to noninflationary growth. The basic problem, however, is one of generating enough savings, external and internal, to finance that growth. From the experience, it seems clear that financing is not going to come predominantly from commercial banks. Although the banks will be involved, they have become increasingly reluctant to lend to the public sector, which is ironic given that in the first phase of the debt crisis the commercial banks spent much of their time trying to get the public sector to assume private debt—a process some refer to as the socialization of debt—and they still hesitate to lend to the private sector. The reluctance is also linked to a change in international economic philosophy in the direction of privatization.
Thus, in the sense that policies have improved, the environment for international lending has improved as well. However, an improved environment for lending does not necessarily correlate strongly with actual lending. For one thing, the overhang of external debt is a problem. In technical terms, the debt overhang is hard to demonstrate: the size of a debt and the implications for investment decisions are not always straightforward. A good economic argument holds that the uncertainty associated with high levels of debt means that prospective investors may not even know what their taxes will be and, therefore, cannot estimate expected rates of return. Thus, uncertainty can discourage both capital formation and growth.
In terms of perceptions as well, debt is considered a problem; for that reason it is a problem. In fact, debt burdens are down substantially in a number of countries from their peaks in the early 1980s. Despite movement in the right direction, the general perception was that the problem had not been dealt with adequately, which frustrated and challenged developing countries, increased the burden on international financial institutions, and made creditor countries unwilling or unable to help with that burden.
All this led to the five basic elements of the Brady Plan. First, it envisaged a continuation of economic reform: stabilization efforts sanctioned by the Fund and the Bank. Second, support from the international financial institutions for a debt reduction and debt-service reduction was to be supplied through two separate pools of funds: one devoted to debt reduction, financed out of existing programs, and the other devoted to additional lending to support interest payments. However, and this is the third element, it was made clear by the United States, by other creditor countries, and eventually by the decisions of the Executive Boards of the Fund and the Bank, that this official support was to be limited. The fourth point was that the countries would have to rely more on repatriation of flight capital to attract savings from abroad.
The last element was a modification of the policy of the Fund and the Bank as far as financial assurances were concerned. The Fund and the Bank, partly in an effort to speed the process and partly in an effort to disengage themselves from the process, declared a willingness at least to consider disbursing at the start of programs in circumstances in which an agreement had not been fully worked out with commercial banks and, indeed, where there might be arrears to commercial banks. This change of philosophy meant that a less cooperative air surrounded that phase of the debt strategy. The strategy had once been motivated by the realization that everyone had an interest in avoiding failure. With the crisis over, interests tended to diverge.
It took several years to act on the Brady Plan. Secretary Brady gave his speech in March 1989. The first Brady proposal arrangements were signed in February 1990 and implemented in March of that year. Part of the delay was due to dealing with a new set of rules of the game, which had to be negotiated and agreed. Then the banks and borrowing countries had to haggle over lending terms and arrangements. Five agreements, or agreements in principle, had been reached under this new framework as of April 1990.
The Mexican agreement was a comprehensive package of debt reduction and new lending. The Philippine agreement involved the restructuring of debt, a debt buy-back, and some new lending, partly with the help of the World Bank. The Costa Rican agreement dealt with arrears, and was the first to do so. Interestingly, the arrears due to commercial banks were referred to as past-due interest, and the agreement involved a buy-back and substantial debt-service reduction on the residual amount of the debt and the capitalization of the residual past-due interest. The Venezuelan agreement contained a longer list of elements: a bond exchange that involves new lending; a debt reduction instrument of 30 percent; an instrument for temporary debt-service reduction; and a possible buy-back. In this case, the package was more loosely structured in that several disparate instruments were lumped together and some choice was involved about which to pursue. The Moroccan agreement concluded in the spring of 1990 comprised a two-stage operation: a rescheduling of about $3.2 billion of commercial bank debt and an IMF program involving a buy-back. The terms were indicative; only with the IMF program in place would the banks proceed. Discussions continued with other countries that sought further agreements.
The clock cannot be turned back; the process has been evolutionary. In hindsight, the debt crisis might have been handled more adeptly, but it is impossible to return to 1982 and start over. Instead, policymakers must focus on the problem of indebtedness to the extent that it exists today. On the external financing side, an encouraging development has been that financing packages with commercial banks have more diverse elements than before, and the financial community seems to have discarded its “cookie cutter” approach. The different packages reflect the unique circumstances facing each country and facing the banks themselves. The banking system has changed dramatically in the past decade, and commercial banks are different institutions from what they were when the loans were first made. New lending, as a result, should be a part of this process, although, in the past, it has fallen disappointingly short. There is resistance to developing a longer-term financial relationship with borrowing countries, one that goes beyond occasional marginal trade financing. Unfortunately, the case for a longer-term partnership has not been strongly made.
A second comment is that both sides had inflated expectations. The banks felt that the public sector would take over more of the debt than creditor country governments were prepared to do. On the other side, the borrowing countries had been receiving less money than expected and believed that greater debt reduction would be the result.
At the same time, heavy pressures faced the countries that participated in debt relief. In the case of Mexico, the final deal involved $48 billion of debt, less than half of Mexico’s external debt, and an average debt reduction of 35 percent. Effectively, that meant 17½ percent of the interest burden was relieved. It was a significant reduction—as Groucho Marx used to say, “bigger than a breadbox,” but not the whole house. What remained was the residual amount of the debt, the medium- and long-term debt to commercial banks, debt to commercial banks in the form of trade credit, short-term credit, debts to bilateral official creditors, and debts to international and financial institutions.
Another point concerns which instruments to use. Serious analytical work has been done on the effects of various instruments. In my view the fundamental arithmetic is compelling: the best approaches are to reduce the principal and to support interest burdens by rolling guarantees. One earns the same basic return, cosmetics aside, no matter what the mechanism, although the debt buy-back seems to have a slight advantage.
Three basic problems emerge when discussing the future course of debt reduction. First, debt reduction by itself is often not successful. The effective financing provided is cumulative, so that over time a country may receive a lot of financing. But if a country faces a cash flow problem today, financing that accumulates over time is not particularly helpful. Second, negotiating support from the Fund and the Bank is complicated, with much disagreement among the countries involved, both creditors and borrowers. It was only with great effort that the framework for doing the financing was settled. At least some creditors are reluctant to enter the ring again.
Another aspect of future debt strategies is a fundamental conflict in the way the Fund and the Bank do business with indebted countries. They are unwilling to lend when it is unclear if they will get the money back. Special repayment provisions and other mechanisms might be designed to alleviate the institutions’ worries, but they are difficult to arrange and enforce. The Fund has been able to do this in a few areas. In addition, commercial bank negotiations did not move quickly. It took nine months to a year to complete an agreement, and it was frustrating for everyone involved. Thus, the aim of the strategy—to make the connection between Fund programs, World Bank programs, and commercial bank financing more flexible—has not been achieved. The basic reason for the rigidities and delays is that commercial banks found other ways to increase their capital and to reduce their exposures, reducing the threat posed by their loans to these countries.
Basically, the banks were bailing out. It was recognition that the banks were already doing so that led the U.S. authorities to put forward the Brady proposal. Put simply, the proposal tried to set a high price on bailing out in order to make sure that the borrowing country, rather than only the middlemen, got the benefit from it. This approach contributed to a breakdown of the cooperative atmosphere that characterized much of the early phase of the international debt crisis. Moreover, the banks’ bailing out created incentives for countries to delay paying their interest in an effort to push down the price of their debts on the secondary market. In terms of debt buy-backs, this strategy is clearly at work.
It is true that countries can go back to the banks again after their Brady packages have been implemented, but it is an extraordinarily difficult process to renegotiate these instruments. The breakdown in relations has implications for the international financial institutions as well. They may have to carry a greater burden, and if they are unable or unwilling to do so, the borrowing countries may have a tremendous struggle. In external financing, one lesson may be to get as much from the banks as one can while still able to bargain.
Debt negotiations do continue, of course. The Paris Club is used by the creditor countries. The Paris Club throughout this process tended to reschedule interest. This interest coverage can be compared with 30 to 50 percent of interest coverage provided by new lending by banks. This dropped off to roughly 20 percent to a quarter in the last three years through 1988. The interest coverage supplied by the Paris Club has been much larger, often 100 percent. That does add to the debt, and if one worries a lot about the debt overhang per se, then it is an issue.
Finally, the role of banking supervisory and regulatory frameworks must be considered. This has been a persistent issue in the debt strategy. There is general agreement, at least among the industrial countries, that bank supervisors have done as much as they reasonably can to design a system that is neutral to the various approaches to debt-service reduction. However, some would like the regulatory systems to be used to manipulate the environment in a way that promotes debt service.
Frankly, these practices are dubious: changing the rules to make balance sheets look healthier is a very questionable supervisory practice. The S&L crisis in the United States may be proof that when financial institutions no longer have a stake in the creditworthiness of their borrowers, they have an increased incentive to play at the roulette table, especially when it is taxpayers’ money that is being played with. The cost to the banks is zero. Another questionable proposal is to provide special tax breaks. This tends to be a political issue and not a particularly attractive one.
There is one supervisory issue that is serious, however. It is one about which central banks in particular should worry: the graduation problem. Some indebted countries are now doing well and should be welcomed back to international financial markets. Yet, current supervisory rules may tend to discriminate against these countries and work against their recovery. If the regulatory authority mandates reserves of its banks excessively, it may happen that such countries receive too few or no credits; there is not an appropriate response from the banking system. The Federal Reserve took the approach, for which it was harshly criticized, that once a borrower has reserves on an old debt at a certain level, a new loan is possible. It is not clear that reserves need to be put up on a new loan unless or until that loan goes bad or is rescheduled.
In summary, realism is an important, and sometimes missing, part of the debt strategy. It must be recognized that the pot is not likely to get richer and that a longer-run vision must be formulated. The fact of the matter is that the external financing side of the problem, which was so severe, is much less relevant today. The basic issue involves so-called structural reform because the availability of external financing is limited. Moreover, Eastern Europe and other countries will be competing for that limited financing. Basically, the highest aim must be to have countries recover and reenter the international capital markets.
WILLIAM R. CLINE
It is a pleasure to comment on Mr. Truman’s presentation, about 95 percent of which I agree with very much. In the interest of discussion, let me focus on those areas where there is some disagreement and join in the ongoing debate about the Baker period, including the role of financial flows over that period.
Looking at the exposure of the banks does not give a full story of what the banks were doing. To see what banks did in the Baker period, a first place to look is the new lending that they put together. It amounted to about $12 billion for the Baker 15 countries, which was about two-thirds of their target. Few banks, if any, were getting paid back cold cash; rather, there were many deals that were essentially discounted debt buy-backs by the private sector and debt-equity swaps. The Institute of International Finance has calculated that about $26 billion worth of such operations took place. Because those deals are part of the solution to the problem, not part of the problem, one needs to add back that figure to the exposure figures to get the full picture.
I will not go into chapter and verse, but I did publish in a compilation by the World Bank and also in the American Express Essay Prize Contest some analysis that suggests the typical picture of what happened during this period.1 To say that the banks were hopelessly failing to achieve their targets is a bit inaccurate. At the same time, the public sector was not living up to the capital flows that had been expected. In particular, the International Monetary Fund had gone from positive flows to the Baker countries of $6 billion a year to a negative flow of $1 billion a year.
Mr. Truman indicated that countries managed to improve their creditworthiness as measured by the ratio of debt service to exports. That is important and shows that an adjustment process has been under way. Indeed, countries such as Chile and Colombia that reviewed and reformulated their economic policies managed to come through the process relatively well.
Let me turn to the Brady Plan. Exactly what is the conceptual framework of the Brady Plan? I would distinguish two different ways of looking at it. Case A focuses on the concept of an overwhelming debt overhang that must be reduced before a country can grow. By contrast, case B focuses on the market opportunity out there: because a secondary market is discounting the debt, there is an opportunity for a country to benefit. My own diagnosis tends toward the second view rather than the first.
One particularly sharp formulation of the debt overhang argument is the so-called debt-relief Laffer curve proposition (debt relief reduces the possibility of default in the future so the expected value of payments on future contracts becomes more secure). The strong advocates of debt reduction argue that both the banks and the debtors would be better off if the banks forgave a certain amount of debt. Ironically, the biggest enthusiast of this concept was Jeffery Sachs. In his article with Harry Huizinga in the Brooking) Papers on Economic Activity, he set out an equation for the secondary market price.2 Using his equation, one can show that most debtor countries are not in this “mutually advantageous” section of the debt-relief Laffer curve, and that instead only a few extremely impoverished African countries—again, according to that equation—are on this “wrong” side of the debt-relief Laffer curve.
I would submit that, for the major debtors, there is little evidence that a debt reduction would make the creditors better off in this strong sense of a debt overhang. What about in the weaker sense? Clearly there is some truth to the proposition that the uncertainty caused by high debt discourages investment. In countries like Argentina and Brazil, however, a far more direct cause of the decline in investment was their chaotic domestic macroeconomic condition. No one will invest when inflation reaches 1,000 percent a year or 20,000 percent a year, and it is a bit misleading to attribute the low investment in such an environment to the debt overhang.
In the case of Mexico, it received a 35 percent cut on what amounts to $50 billion. Suppose they had received a full 50 percent cut. Fifteen percent of $50 billion is $7.5 billion principal, or $750 million a year in corresponding debt relief. Mexico’s export earnings including services are about $30 billion a year. It is implausible to argue that $750 million, as against $30 billion, is the difference between an oppressive debt overhang and its somehow being alleviated.
I am suggesting that the case for completely eliminating an overwhelming debt overhang is ambiguous, and that the more appropriate way to approach the problem is to ask, What is the market opportunity? How can a country like Mexico benefit from the fact that many creditors holding claims are prepared to exit at a steep discount? That approach leads in turn to the recognition that there are two classes of banks. In the first class are the “exit” banks—the banks that simply want to take a deep discount, get cash, and get out. They will happily accept 50 cents on the dollar if it actually is 50 cents. In the second class are banks that have been in the debtor country a long time. They were there long before the 1970s, when the great syndicated loans came in, and they expect to be there for the next 50 years. They are long-term “partner” banks, and they are not likely to go out at those rates.
These considerations suggest a market-oriented approach, with a heavy emphasis on buy-backs rather than on mandated packages. Again, the Mexican case is instructive. From the banks’ point of view it seemed that the Mexicans went to the U.S. government and the IMF and in effect the official sector returned with a blueprint that said, this is what has to be done and accepted. The banks perceived an arm-twisting atmosphere, which caused an undue amount of alienation and transformed a number of banks that would normally have been long-term partners into exit banks, so that only 10 percent stayed in for new money, while 90 percent essentially chose to exit.
Ironically, Mexico could have done about as well using buy-backs instead of debt reduction instruments. If Mexico had taken the $7 billion of enhancements and paid $6 billion of official enhancements and $1 billion of its own money, and if it had bought back its debt at the going market price of 37 cents on the dollar, Mexico could have retired about $20 billion, resulting in net savings of about $13 billion under this hypothetical strict buy-back approach. By comparison, the actual reduction in debt that Mexico received was worth $15 billion.
It is true that if Mexico had focused on buy-backs, those transactions might have pushed up prices in the secondary market, and Mexico consequently might not have been able to reduce as much of the debt. But would that have been a good outcome or a bad outcome? Again, it is ambiguous. If the case for the debt overhang is less than 100 percent, one starts to think about going back to the market, and the only complete return to the market will be precisely when the secondary price of debt is back to 100 percent as it is, for example, for Denmark or for any other country in more normal circumstances. The current structure is still tilted in the direction of favoring a somewhat patterned solution, with the interest-reduction bonds and so on. The most concrete instance of it is that in the IMF and World Bank enhancement pools, the amounts cannot be pooled. There is no fungibility: a country cannot use the half of the enhancements that are earmarked for the interest-support conversion bonds if it wants to do it all in buy-backs.
The Philippines ran up against this constraint when they decided that they wanted the market-oriented approach. Accordingly, they had access to only half of the enhancement that would have been otherwise available to them because the other half was earmarked for interest-reduction conversion bonds. A sensible reform would be to make those pools fungible so that entities that want to take a single approach can do so. It is encouraging that the package for Venezuela has buy-backs and is more oriented toward the particular interests of the banks. The negotiating process in the Venezuelan case involved accepting proposals from individual banks rather than a straitjacket from the advisory committee.
The issue raised on the intercreditor issue is an important one. The banks will wax eloquent on this, and they will say, “My goodness, we’re being asked to forgive money, and here the governments continue to maintain their claims on these countries. Why don’t we have the Exim Bank and the other export credit agencies forgive 35 cents on the dollar of their claims?” In a sense it goes back to the conceptual framework. If one thinks that there is an oppressive debt overhang, that becomes more germane, because it may be there in perpetuity. If the debtor thinks that the underlying debt burden is manageable and has creditors with amnesia who are pleased with those improved debt-to-export ratios (instead of thinking about how they were burned last time)—then the debtor would be less concerned about the absolute level of the debt and more concerned about making sure that refinancing is in place for what is coming due. The Paris Club can follow policies that keep a zero or positive cash flow with a country. If the Paris Club or the IMF or the World Bank or all of these institutions are prepared to undertake the new lending programs needed to finance what is coming due, it seems that the argument for pressing official creditors to forgive the debt is not that compelling.
Mr. Truman mentioned supervisory issues. The most severe here is the practice in Canada and in much of Europe that automatically levies a contingency reserve charge of 50 cents on the dollar for any new money lent to a country regardless of whether that country is in the process of working out a Brady Plan package. Clearly that policy is misguided; it puts an extreme burden on any bank that would like to be a lending bank or would like to be a long-term partner of a debtor country. The practice in the United States basically suggests that if a debtor has a package that is supposed to be a resolution of its difficulties, then any new money should not require reserving. Liberalization is necessary if we are going to move toward normalizing the relations between the banks and the debtor countries. Nevertheless, we are certainly not going to go back to the kind of bank lending that we saw in the 1970s.