Chapter

Impact on Debtor Countries of World Economic Conditions

Editor(s):
Ana María Martirena-Mantel
Published Date:
January 1987
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This paper addresses the impact on debtor countries of the world economic environment. It asks how external disturbances impinge on growth and on welfare.

The paper is organized in four parts. We start out with a conceptual framework which shows the relevance of world interest rates and the terms of trade for a debtor country’s welfare. Several special linkages to the world economy, including credit rationing, are also considered. In the following section we investigate the linkages between external shocks and the rate of inflation. The analysis highlights that real depreciation increases inflation, the more so the larger the external debt. A discussion of facts and special problems of debtor countries follows in the third section. Here we draw particular attention to the implications for debtors of alternative monetary-fiscal policy mixes pursued by the industrial countries. The paper concludes with a discussion of external remedies for debtor countries, specifically debt-equity swaps, debt relief, and a reversal of capital flight.

A Conceptual Framework

In this section we set out a simple aggregative framework that describes the principal interactions between a debtor country and the rest of the world. The most direct effects are the following two:

  • interest rates in world markets that determine the cost of existing debt service and represent the intertemporal terms of trade;

  • the conventional terms of trade or relative price of exportables and importables.

We first set out the model and highlight the role of interest rates and the terms of trade. Then we turn to several more specialized linkages.

A Model

The model is a simple one of the debtor country, which produces only two goods: domestic manufactures and traditional goods. The latter are perfect substitutes for primary commodities traded in world markets. Home manufactures are consumed at home and also exported. They are an imperfect substitute for manufactures produced in the rest of the world and imported. In addition, we separate out oil as an importable or exportable with a price given in the world market.

Let Px, Pt, and Pm be the prices in home currency of the three commodity groups. The home country takes as given the real price of traditional exportables in terms of importables, pt = Pt/Pm. The world price of oil in terms of imported manufactures is denoted by p0. Finally, the relative price of home manufactures in terms of foreign imported manufactures is denoted px=Px/Pm.

The analysis now concentrates on the terms of trade between manufactures, exportables, and importables and the level of domestic absorption, A. Figure 1 shows internal balance along II and current account balance along EE. These schedules are drawn for given real interest rates in the world market, a given external debt, and a given real price of traditional exports and of oil.1 The market equilibrium condition is

Figure 1

The II schedule is upward sloping on the assumption that substitution effects dominate. A rise in the real price of exportables or a terms of trade improvement creates substitution effects against domestic goods on the demand side while raising supply. Furthermore, given the level of absorption measured in terms of importables, A, the purchasing power of spending in terms of exportables declines. The net effect of an increased real price of exportables thus is an excess supply. Hence, spending must rise to restore internal balance. Points to the right of and below II thus correspond to a boom and points to the left to unemployment. External balance equilibrium requires

where r* is the world interest rate and d is the external debt.

The EE schedule is assumed to be negatively sloped: an increase in the real price of exportables through substitution effects worsens the external balance. But the decline in the real value of spending, for a given A, will improve the external balance. The net effect is ambiguous and we assume that substitution effects dominate. Thus, a spending cut is required to maintain the current account in equilibrium when px increases. Points above and to the left of EE correspond to a surplus and points below and to the right to a deficit.

This framework can now be used to investigate questions of comparative statics and of welfare economics. The analysis of external disturbances is straightforward:

  • A rise in the real price of oil reduces real income and worsens the external balance. A decline in the real price of domestic manufactures is required to restore internal and external balance. Thus, a terms of trade deterioration, because of increased oil prices, carries with it a further worsening in the terms of trade. This is so because of the reduction in the real price of domestic manufactures relative to those imported that is required to restore external balance. The adjustment in the equilibrium real price of domestic manufactures is larger the smaller the share in marginal spending and the less substitutable are home and foreign manufactures.

In policy terms, an oil price shock worsens the external balance and the country responds by restoring current account balance via a corrective real depreciation. A policy of sustaining the relative price would require an increase in absorption. Such a policy would, of course, worsen the external balance further. This is not optimal for permanent disturbances, since ultimately the adjustment needs to be made and households, other things being equal, prefer a smooth consumption profile. But it is clear that failure of timely adjustment to relatively permanent disturbances is one of the explanations for the extreme adjustments that were ultimately required in Latin America.

  • A rise in the real interest rate exerts two effects. First it reduces real disposable income by increasing debt service. To the extent that capital markets are tightly linked and consumers optimize inter-temporally, it also affects the preferred time profile of consumption, raising future relative to current consumption. The dominant effect, though, is likely to be the increased cost of debt service. If this is not automatically financed by the budget and by “new money,” there will be a reduction in absorption and the need for a corrective real depreciation. Thus, increased debt service brings with it a worsening of the manufacturing terms of trade. This secondary cost is larger, the larger the share of manufactures in the marginal spending pattern. It is also smaller, the less substitutable home and foreign manufactures and the less substitutable resources are between manufacturing and traditional sectors. Only in traditional exportables can production for the world markets expand without the risk of terms of trade losses.

  • A decline in the real price of traditional exports in terms of world manufactures reduces real income and demand for all goods. The excess supply of manufactures once again brings about a reduction in the equilibrium real price of exportable manufactures. Thus there is, just as in an oil price fall, a secondary burden stemming from an amplified terms of trade loss.

Welfare

The welfare economics of external shocks require an explicit welfare-theoretic framework of analysis. A minimal model was explored in Dornbusch (1985a). It was shown there that in a two-period utility-maximizing model the terms of trade and world interest rates appear as key determinants of welfare. A worsening of the terms of trade worsens welfare as does for a debtor a rise in the world real interest rate. The cost of a terms of trade deterioration is proportional to the (present value) of imports. The cost of increased interest rates is proportional to the stock of debt.

The welfare economics approach forces one to focus on the intertemporal aspects of adjustment to external shocks. Borrowing abroad to finance rather than adjust an imbalance is always possible but rarely optimal. Only when disturbances are transitory or optimal resource movements, because of adjustment costs, ought to be gradual does it pay to borrow abroad to finance current account imbalances. Of course, these exceptions may be very important. It is certainly conceivable that adjustment to higher interest rates requires expanding an exportable sector and that this in turn requires investment. Some of the investment may have to be financed by a cut in spending over and above the fall in real income implied by the shock. But naturally a good share of the resources should come from abroad. The mistake is not to leave a current account imbalance, but rather the failure to adjust consumption.

We now turn to a number of special effects that amplify the welfare and adjustments costs of external shocks.

Credit Rationing

The model of unrestricted optimization leaves no room for distortions arising from credit rationing. The costs of credit rationing, when effective, arise in two ways. The first is that the current account imbalance is smaller than it would optimally be. That means consumption smoothing is limited and/or investment is too low. These are the conventional costs associated with illiquidity, and it is apparent that a relaxation of effective credit constraints enhances welfare while a further restriction of an already effective constraint reduces welfare.

The second cost of credit constraints comes in the interaction with adverse external shocks. Since an effective constraint implies that at the margin there is no leeway for consumption smoothing or extra investment that does not come from a suboptimal cut in consumption, credit rationing reinforces the welfare cost of adverse shocks. It does so by forcing adjustment to stay off an optimal path.

A third and highly significant cost associated with the combination of adverse shocks and credit rationing is the induced adjustment in the terms of trade. Since an effective credit constraint implies that even transitory disturbances must be fully adjusted to, rather than being financed, a real depreciation is required, which further adds to the welfare costs of the initial disturbance.

System-Wide Adjustment

A second complication comes from looking at the costs of external shocks when many debtor countries jointly experience the same shock and adjust to it in the same manner. The attempt to secure extra exports to balance the current account via a real depreciation is pursued by each of the countries jointly. They compete with each other and as a result worsen their terms of trade.

The worsening of the terms of trade occurs both in respect to manufactures and traditional exports. It arises as a result of the cut in absorption required in adjusting countries. That cut in absorption directly frees resources for sale abroad, and it does so indirectly as real depreciation is used to shift resources from the home goods sector into traditional and nontraditional exports. The result is a world glut of developing country exportables and hence a decline in their real price.

As each debtor country cuts the wage in dollars and cuts its own absorption, the supply of manufactures and commodities from developing countries in the markets of creditor countries is increased and hence their real prices will decline. For commodities, the adjustment effort of debtor countries implies that prices are in fact not given but respond to the system-wide effort to earn foreign exchange by pushing traditional exports. With demand elasticities very low, the real price declines sharply. For manufactures, each country finds that the world demand curve it faces is shifting inward as a result of other countries’ competitive depreciation. Where a given x percent depreciation relative to the dollar in a particular country might have been expected to yield a 10 percent increase in export revenue, it turns out to be only 5 percent because all debtor-country competitors follow the same adjustment strategy.2

The interaction with credit rationing is quite apparent. The more intense credit rationing, the larger will be the competitive adjustment effort of debtor countries in response to a common shock and hence the larger the excess cost forced upon them by a lack of credit. Credit rationing in the context of a shock thus becomes a fire sale after the great fire. We return to this point below in interpreting the decline in the real price of commodities and exports of developing country manufactures in world markets.

It is interesting to note in this context the apparent resistance of the Fund to an interest rate facility. The lack of such a facility increases the adjustment burden and transfers benefits to creditor countries over and above their gains as lenders. The systemic redistribution implied by opposition to an interest rate facility has no foundation in welfare economics.

Foreign Demand

For a perfectly competitive economy, the level of foreign demand is of no interest except insofar as it affects the exogenous real prices of commodities or oil, or the world real interest rate. But when the export sector is less than perfectly competitive, foreign demand does matter. At the margin there is a discrepancy between marginal cost and price, and hence, at the margin, there are excess returns from an expansion in output. Increased foreign demand allows a widening of the profit margin or increased sales at going profit margins and thus they promote an increase in welfare.

The level of foreign demand and its stability and growth are also relevant in the context of scale economies. If manufacturing has scale economies, then production for the world market is a significant part of the profitability of an industry. A world recession means losses and a world boom implies profits.

Market Access and Creditor Country Policies

The adjustment problems of debtor countries to their individual and aggregate attempt to secure foreign exchange are often aggravated by the policies of the creditor countries. Two examples particularly come to mind. The agricultural policies of virtually all creditors lead to a worldwide glut in agricultural products. Particular debtor countries who would be expected to earn their way out of a debt crisis by an expansion of traditional exports find that in fact the world market for these commodities is collapsing under the weight of exports from inefficient producers.

The other vital issue is market access. As debtor countries seek expansion of their exports and contract imports, they face growing conflicts with creditors. Their export expansion runs into actual trade obstacles or, if that is not the case, at least into enough doubt about long-term market access so as to stand in the way of an effective adjustment program.

A peculiar variation on market access comes in a reverse way: developed countries have persuaded themselves that debtors should liberalize their imports. There is no question that many debtor countries, for example Argentina, have wildly inefficient industries and would be far ahead if they had never embarked on these investments. But it is doubtful that a period of external balance crisis offers the best opportunity to increase imports. One would have thought the opposite, except when there is a shortage of resources or an implicit tax on exports. For some countries, specifically Brazil, one would have to believe that import liberalization, for example of Mercedes or BMW imports as is widely claimed, would be an outright policy mistake. The same applies perhaps even more strongly to liberalization in areas where an infant industry case can be made. There is little doubt that Japan, the United States, the Republic of Korea, and Brazil have achieved their spectacular industrialization under the cover of protection. The argument that they would have done even better without rings hollow.

These same issues come up in a very striking form when free trade in high-technology products is claimed precisely to avoid the establishment of infants that could ultimately be efficient suppliers of the home market and even exporters. This argument applies not only to manufactures but, of course, also to services. Some of the Baker-Plan conditionality may therefore be viewed as a pre-emptive policy of securing markets for creditor country oligopoly profits. Resistance by debtors rightly emphasizes that when oligopoly is at stake there is something to be shared. None of this is to say that Argentina should have a car industry and an airplane industry; but it does say that Brazil might well be right in having a computer industry, and the Republic of Korea has already demonstrated that point.

Real Exchange Rate and Inflation

In this section we explore an important linkage that runs from the real exchange rate to the inflation process. Specifically, we want to argue that abrupt real depreciation, as may be associated with the news of involuntary debt service, will inevitably bring about a significant rise in the inflation rate.3

The model we use for this purpose is highly simplified. Suppose the government finances a budget deficit by money creation. The deficit, measured as a fraction of gross national product (GNP), is denoted g:

where p is the rate of inflation and R the real exchange rate. The inflation rate affects the deficit ratio because higher inflation means that lags in tax collection erode the real value of taxes, the more so the longer the lags and the less taxes are indexed. This equation is shown in Figure 2 as the O-T schedule and is referred to as the Oliveira-Tanzi schedule. The real exchange rate appears as a determinant of the deficit ratio, because the real value of the service of an external debt contracted in dollars will increase when the real exchange rate depreciates.

Figure 2

The government budget constraint states that the revenue from money creation must equal the deficit:

or

where V = PY/M is velocity and m is the growth rate of nominal money.

Let velocity be a linear function of the alternative cost of holding money:

Finally, we impose long-run monetary equilibrium so that nominal money growth is equal to the rate of inflation plus the rate of growth of output, y:4

Combining equations (4a), (5), and (6) we obtain a relation between the inflation rate, the budget deficit ratio, and the structural parameters determining the inflation tax and the growth rate of output. We can refer to this schedule in Figure 2 as the Keynes-Cagan or K-C curve.

Note that because of nonlinearity the inflation response to shocks is extremely sensitive to the level of the inflation rate.Figure 2. shows how the deficit function and the inflation function jointly determine the deficit and the rate of inflation. We have consciously picked the case where the Oliveira-Tanzi schedule cuts the Keynes-Cagan schedule from below so that there is a unique equilibrium. Issues of multiple equilibrium, the dynamics, and comparative statics have occupied fully justified attention in recent analyses.

Five points can be inferred from this model:

  • An increase in the deficit ratio, given R and p, will increase inflation. This is the conventional deficit-finance view, which is, of course, totally correct.

  • Financial deregulation, by raising velocity, raises inflation. (In terms of equation (7) the parameters a and/or b increase.) Deregulation may take the form of dollarization, interest-bearing deposits, reduction of restrictions on the liquidity of deposits, et cetera.

  • A reduction in the growth rate of output will increase inflation.

  • Other things being equal (tax structure and noninterest public spending), the inflation rate is higher the higher is the debt as a fraction of income and the higher is the real interest rate paid on external debt.

  • A real depreciation, shown as a shift of the 0-T schedule out and to the right, raises the equilibrium rate of inflation from A to A’. This view is called the “balance of payments theory of inflation” in the history of monetary thought. It invariably dominates the “quantity theory school” by telling a richer and politically more satisfying story of why there is inflation.5

A summary point is suggested by this model: debt service is immensely inflationary in a country that cannot afford it. Blaming inflation on budget deficits is not wrong but misses the point that when the resources for debt service without recourse to money creation are not available then they must come out of the inflation tax. Needless to say, the inflation tax is highly regressive, so that in the end debt service is either financed by cuts in social spending, increased social security taxes, or increased seignorage. One way or the other, debt service is primarily a poor people’s privilege. It is worth emphasizing this point to understand the solidarity, say in Argentina, between the domestic financial community and international creditors on the issue of debt service. This position contrasts sharply with Brazil, where the taxation system is less scandalous.

Some Facts and Some Problems6

Table 1 shows in summary fashion the key macroeconomic variables of interest to debtor countries. The table highlights the early 1970s when the world economy was booming, with negative real interest rates and rising real commodity prices and strong growth. By contrast, in 1980–82 real interest rates were exorbitantly high and the world economy moved into stagnation. Where the first period enhanced creditworthiness and encouraged borrowing, the second period tested the vulnerability of excessive borrowing and produced the debt crisis.

Table 1.Key Macroeconomic Variables for World EconomyAnnual averages
Inflation1OECD

Growth
LIBORManufacturesCommodities
1970–737.612.414.45.9
1980–8214.7–2.4–13.30.9
1983–859.7–0.9–0.63.3
Source: International Monetary Fund (1986).

Inflation rates in world trade.

Source: International Monetary Fund (1986).

Inflation rates in world trade.

The experience since 1983 has certainly not provided a world economic environment that unambiguously eased debt service. Real interest rates remained high, even though nominal rates declined. The reason for high real rates was, of course, the continuing decline of prices in world trade. Growth of industrial countries was above the magic 3 percent mark that had figured importantly in discussions of liquidity versus solvency, but it was not sufficiently strong to bring about export booms or terms of trade improvements.

The discussion following in the immediate aftermath of the debt crisis focused on the question whether the world economy would make a significant contribution toward a solution of the debt problem. In particular, it was argued that strong recoveries in the member countries of the Organization for Economic Cooperation and Development, the terms of trade gains associated with strong growth, and the decline in the U.S. dollar would combine to ease debt burdens significantly and help to restore creditworthiness.

Leaving aside the impact of the oil price decline, for which there are winners like Brazil and losers like Mexico, this prediction has by and large not come true. Most of the adjustment has been accomplished by a sharp cut in imports and increased export volume. The terms of trade gain between 1982 and 1985 remained roughly unchanged. The value of Latin American imports declined by 26 percent, while export revenue over the period 1982–85 remained unchanged.

Commodities

Declining commodity prices were matched by falling prices of manufactures in world trade, thus leaving the terms of trade roughly unchanged. Figure 3 shows the purchasing power of the World Bank index of 33 commodities in terms of the prices of their manufactures imports. The purchasing power declined sharply in 1980–82, but has remained nearly constant since then.

Figure 3.Real Commodity Prices

Index, 1977–79 = 100

It comes as a surprise that the real prices of commodities should not have reacted more strongly to the dollar depreciation of 1985–86. The theoretical framework developed in Dornbusch (1985a) suggests that a real depreciation of the U.S. dollar (in terms of industrial countries’ relative value-added deflators in manufacturing) will cause a rise in the price of commodities in dollars and a decline in price in terms of foreign currencies. But dollar depreciation and expansion in industrial activity notwithstanding, a significant recovery of commodity prices has failed to materialize.

The reason for the failure of commodity prices to rise must be seen in four facts. First, for agricultural commodities there is an obvious policy-induced glut, reflecting subsidization by industrial countries of their inefficient agriculture and sale in world markets at any price of the resulting surplus. The second reason is the world oversupply resulting from capacity expansion and substitution toward material-saving technology or consumption patterns. Examples that come to mind are smaller (lighter) cars that reduce steel demand, or substitution of optic fibers for copper in long-distance transmission. The third reason is the increased supply in world markets that comes from retrenched demand and real depreciation in the commodity-producing countries. Finally, the continuing high level of real interest rates keeps inventory demand depressed. The four reasons combine to more than offset the anticipated real commodity price recovery normally associated with expansion and dollar depreciation.

Interest Rates

Real interest rates remain high in all industrial countries. In the United States, they stand at a record high even after two years of relatively rapid money growth and declining nominal interest rates. Table 2 shows the U.S. real interest rate measured in terms of consumer prices for various subperiods. It is clear that the present interest rate experience is altogether unusual by historical standards. The same point is brought out by the annual average of real interest rates shown in Figure 4.

Table 2.Real Interest Rates in United StatesPercent per year
PeriodReal RatePeriodReal Rate
1926–80–0.11970–80–1.1
1950–80–0.11980–853.5
1960–701.31985–863.7
Source: For 1926–80, data are from Ibbotson and Sinquefield (1982) and for later years calculations are by the author.Note: The real interest rate is the Treasury bill rate adjusted for the rate of consumer price inflation.
Source: For 1926–80, data are from Ibbotson and Sinquefield (1982) and for later years calculations are by the author.Note: The real interest rate is the Treasury bill rate adjusted for the rate of consumer price inflation.

Figure 4.U.S. Real Interest Rate

It is true that there have been previous episodes of positive real interest rates, for example in the 1960s. But the 1960s was a period of sustained growth, which makes it easier to live with high real rates than in a period where growth is declining and expected to falter. Adjusted for growth expectations, the current real interest rate experience is therefore quite out of the ordinary.

There is considerable controversy on how to measure appropriately the real interest rate for developing country borrowers. The question is whether export or import price inflation should be used, either or both. But there is little question, whatever the exact measure, that real interest rates for debtor countries have been even higher than those for the United States. The issue then arises why real rates are so high.

One interpretation of the high real interest rates is the large U.S. budget deficit. The budget deficit as a fraction of gross national product (GNP) averaged almost zero in 1955–64 and less than 1 percent in 1965–72. In the 1975–84 period, it increased to 3 percent of GNP and in 1985–86 had already reached 5.2 percent. This large deficit is seen as absorbing an extremely large portion of world saving, thereby crowding out competing demands for funds by increasing the level of world interest rates.

This interpretation suggests that if the United States were to cut the deficit interest rates would decline. This is surely the case. The reason is that the resulting world recession would inevitably reduce money demand and hence interest rates. But it is clear that simply cutting the U.S. deficit need not necessarily help debtor countries. The resulting recession might further reduce real commodity prices and hurt the prospects for exports of manufactures from developing countries.

An alternative interpretation of the high real interest rates focuses on the typical aftermath of an inflation stabilization. When inflation disappears the demand for real balances rises. Unless the central bank accommodates the rise in real money demand by sharply increased monetary expansion (for a while), nominal interest rates will be slow to decline and real interest rates will remain high. Of course, the Federal Reserve has allowed money to grow quite rapidly, and as a result real interest rates have come down from their peak levels. But the monetization went in large measure to satisfy increased demand for real balances rather than creating a reliquification of the economy.

If this latter interpretation is correct, and it is certainly borne out by the fact that real interest rates have softened even as deficits are growing, then the correct policy advice is pushing further monetization on a worldwide scale. This would also be in the interest of debtors, except if it should risk an inflation so large that it invites a 1980–82-style tight money crunch. If the fiscal interpretation is correct, the implication for debtors is much less favorable. First, budget correction will be immensely slow and hence real interest rates are bound to stay quite high. Second, as budget correction occurs it will slow down aggregate demand and thus provide an offset to the benefits of lower interest rates.

Many observers hope for a middle course where budget correction does take place and is supported by an accommodating Federal Reserve policy of easy money. In that scenario, growth is sustained by reduced interest rates. For the time being that scenario is unlikely, since budget correction has gone out of the express lane. But even so, it is interesting to explore the alternative routes of budget correction. A recent study by Edison and Tryon (1986) simulates in the Federal Reserve Board’s multicountry model the effect of the Gramm-Rudman budget correction under alternative assumptions about U.S. and foreign monetary accommodation.

Table 3 shows the impact on U.S., German, and Japanese output and on interest rates for the two scenarios. In one case the Gramm-Rudman budget cuts take place without any monetary accommodation. In the other case the U.S. money stock is allowed to increase cumulatively by 4.5 percent above the baseline projection, and in the Federal Republic of Germany and Japan money growth is increased sufficiently to maintain constant the real exchange rate relative to the United States. For each of the scenarios we show the impact on levels of target variables in 1987 and in 1989.

Table 3.Gramm-Rudman Budget Amendment with Alternative Monetary Accommodation
United States

1987–89
Fed. Rep. of

Germany

1987–89
Japan

1987–89
No monetary accommodation
Real GNP (percent)–2.3–1.9–0.9–1.4–1.5–2.2
Interest Rate–2.3–3.4–0.8–1.2–0.4–0.6
U.S. and foreign monetary accommodation
Real GNP (percent)–1.00.7–0.10.3–0.31.8
Interest Rate–4.5–4.7–3.0–3.5–2.8–3.0
Source: Edison and Tryon (1986).Note: All numbers represent deviation from baseline.
Source: Edison and Tryon (1986).Note: All numbers represent deviation from baseline.

The table shows the impact on the level of real GNP and on the level of interest rates. The soft-landing solution is the one where monetary accommodation takes place so that there is no large impact on the path of real output. In that case interest rate reductions are very sizable. This would be the scenario that would be of very significant assistance in solving the debt problem.7 By contrast, budget reduction without monetary accommodation does lead to lower interest rates, but also to a steep reduction in activity.

Private Sector Lending

In the aftermath of the debt problem, lending by the private sector became involuntary, as did debt service by the debtor countries. The debtor countries produced sharp reductions in their current account imbalances, more than making up for the increased interest burden. This adjustment was forced on debtor countries by the lack of access to significant new money. Table 4 shows the shifts in the current account and in financing for Latin America.

Table 4.Latin America: Current Account Imbalances and Financing, 1978–85In billions of U.S. dollars
Borrowing
Current

Account
Official

Creditors1
Private

Creditors
197819.42.225.8
197921.82.727.4
198030.26.135.9
198143.36.554.1
198242.014.628.8
198311.417.72.0
19844.910.77.0
19855.95.1–0.6
Source: International Monetary Fund (1986).

Including reserve-related liabilities.

Source: International Monetary Fund (1986).

Including reserve-related liabilities.

The striking fact in this table is the large adjustment in the debtors’ current account and the disappearance of private market financing. There is little doubt that the vigor of the adjustment programs was forced by the lack of access to new money. Of course, the question must also be asked whether there is anything wrong with the massive adjustment. If in fact overborrowing did take place, and if the debt is to be serviced, it can be argued that adjustment was essential. But that, of course, presupposes that debt service should be maintained. Many consider this latter question today primarily a political question.

Investment

The external balance adjustment in Latin America has been achieved largely at the expense of investment. This point is apparent by looking at Table 5, which shows the ratio of gross investment to gross domestic product (GDP) and the noninterest surplus, likewise measured as a fraction of GDP.

Table 5.Latin America: Investment and the External Noninterest SurplusChange, in percent of gross domestic product
1977–821983–85
Gross Investment24.318.5
Noninterest External Surplus–0.64.7
Source: International Monetary Fund.
Source: International Monetary Fund.

The shift in gross investment is approximately of the same size and is in the same direction as that in investment. Thus, effectively Latin America is accomplishing the improvement in debt service by cutting down on investment. There are several channels through which the current process of debt collection makes this almost inevitable. Perhaps the most significant is the fact that involuntary debt service forces on the government budget stringency that is most easily met by postponing or simply giving up investment. This effect is quite apparent in any of the debtor countries where public sector investment has declined dramatically. For example, in Mexico public sector investment has declined by 5 percent of GDP (Dornbusch, 1986c).

A second channel through which investment is adversely affected is, of course, the recession in economic activity in debtor countries, combined with the very high cost of capital.

The fact that investment is sacrificed, rather than consumption, is entirely appropriate when disturbances are short-lived. But a serious issue of misallocation arises when, as is the case now, the postponement lasts several years and is expected to continue. The growing labor force is not being equipped with expanding job opportunities and, as a result, emphasis is on wage cutting rather than on rising real wages.

The failure on the part of industrial country policymakers to recognize this anti-investment bias of current programs must be considered the most serious shortcoming of the adjustment strategy and a criticism of Fund supervision of adjustment programs.

Solutions to Debt and Growth Problems?

The ordinary aftermath of imprudent borrowing and adverse international conditions, as in the 1920s and 1930s most recently, is to bring about default on the part of debtors. Debts are normally written down, or simply not serviced for many years, and when service is resumed this occurs without full payment of arrears and often at reduced interest rates. The major differences in the present debt crisis are two. The first is that commercial banks and governments, rather than bondholders, are the main creditors. More significant is the fact that the major industrial countries have insisted on debt service and have managed a system, with the Fund as the chief coordinating agent, of debt collection. The system avoids illiquidity by making available essential “new money” at profitable spreads over the cost of funds to banks, and it enforces the debts by behind-the-scenes political pressure. The creditors are efficiently organized in this case-by-case approach, while debtors have been unable to put up a united front.

Latin America’s problem is to gain debt relief so as to free resources for investment and develop speculation in support of the governments’ ability to develop growth without financial instability. Tax reform and improved tax enforcement is certainly the overriding instrument. Improved efficiency in the public sector is important, but measures to attract capital or secure relief on the external debt seem the most desirable or practicable. We review here three directions: debt-equity swaps, reversal of capital flight, and Bradley-style debt relief.

Debt-Equity Swaps8

In the summer of 1986 debt-equity swaps were at the center of financial attention as an attractive part of a solution to the debt problem. Clearly not the solution, but a sound contribution. A short story may help to introduce the necessary cynicism.9

A man had bought an extraordinary, fantastic dog. How much had he paid? Embarrassed silence, then the confession—half a million dollars. His friends were startled. Surely that was crazy, no dog could be worth that much, he should go back and sell the dog. Next day, when they met again, the dog owner was all smiles. Yes, he sold the dog; yes, he got a great deal. He had traded the dog for two cats. That is very much the essence of debt-equity swaps.

Developing country debts are traded at deep discounts in the secondhand market, ranging between 60 and 75 cents on the dollar for Brazil, Mexico, or Argentina. The discounts and the obvious problems in keeping Mexico afloat have shifted the creditors’ attention to ways of liquidating debts without taking outright and open losses on the entire portfolio of developing country debts. Debt-equity swaps provide the answer: A bank holding, say, Brazilian Government debt sells these bonds at a discount to a U.S. firm. The U.S. firm in turn presents the debt to the Banco Central do Brasil to be paid in cruzados. The proceeds are used for foreign investment in Brazil. It seems that everybody gains: the bank has found a way of selling some of its illiquid portfolio; the investing firm gains the advantage of buying cruzados at a discount, and Brazil gains because the Government can pay its debt in local currency rather than in dollars. Moreover, much-needed investment takes place.

So why does the government drag its feet on this scheme rather than flying into the arms of foreign investors who bring this extraordinary deal? Anytime foreign banks and investors show indecent anxiety to conclude a deal, one must suspect something is rotten. This is, indeed, the case with debt-equity swaps. At best they bring little advantage, and more likely they are a complicated squandering of national assets.

The pressure on debtor countries to free the way for the scheme makes it important to look much more carefully at what is involved. The first step is to recognize that the government will have to finance somehow the repurchase of its debt from the foreign investor. It is obvious that it is impossible to simply print money to pay off the debt. In fact, the government would issue domestic debt and use the proceeds to buy back its foreign debt as it is presented by the foreign investor. Hence, when everything is done, the government has an increased internal debt and a reduced foreign debt. The country owns less of its capital stock, since the foreign investor will have bought some, and in return the country would have redeemed some of its debt. Thus the country swaps bad debt for good capital and the government swaps low interest (i.e., foreign debt) for expensive domestic debt.

Is there any advantage for the budget? In the budget there will now be reduced interest payments on external debt offset by increased domestic debt service. Whether there is a net reduction in interest depends on two issues: at what discount the external debt is traded and by how much domestic interest rates exceed the rate on external debt plus exchange depreciation. One would expect the net effect to be an increase in debt service. This would most definitely be the case if the government does not appropriate most of the discount at which the external debt now trades. Hence, for a country with a budget problem this would seem to be a quite awful idea.

Is this an advantage for the balance of payments? Here the debt-equity swap seems to be good news: foreign debt is reduced and as a result interest payments on the debt also come down. But, of course, there is an offset: the reduced interest payments on external debt are offset, at least potentially, by increased remittances of dividends or profits of the new- foreign owners of the national capital stock. Hence, for the balance of payments, too, the trick will not do much good.

In fact, it is easy to paint a picture where things become much worse. Imagine a scenario where the ability to service the debt—domestic and foreign—deteriorates sharply, say because of a terms of trade deterioration or because of populism. Interest rates on the domestic debt will rise sharply and hence the budget deteriorates, foreign firms remit profits before the exchange rate is depreciated, or transactions become regulated. All this would happen even if no debt-equity swaps had taken place. The only difference is that now the scope for damage is much larger because the domestic debt is increased and capital has passed into foreign hands and thus benefits from a right to remit profits. In the absence of a debt-equity swap the creditor banks could be forced into increased provision of new money at extra-low rates, or into write-offs. Hence, when things go really bad the fact of having gone through debt-equity swaps makes them much worse. That, of course, accounts for the interest of the creditors, who are on the other side of the deal.

But is there not some sense in which more resources become available for investment, even if there are no net benefits for the budget or for the balance of payments? Once more the answer is “no.” Debt-equity swaps are primarily and almost exclusively a balance sheet operation, selling good assets (why else would foreigners buy them?) for bad assets (why else would some creditor banks sell them at a discount?).

One might argue that the government could regulate things so that deals will be less a transaction in existing assets and rather be directed toward new, extra investment. But that is doubtful. More likely, financial intermediaries will look for firms, domestic or foreign, who are investing. They will approach them with a new kind of financing package involving debt-equity swap, which, because of an implicit subsidy by the government, turns out to be less costly than alternative sources of finance.

Thus debt-equity swaps will finance investment, but they finance investment that would have taken place anyway. Moreover, they do so at the budget cost of a subsidy. Perhaps there may be the odd investment which becomes profitable just as a result of the implied subsidy, but that will be the exception. The dominant effect is to give away budget resources to the financial system that organizes the swaps. Debt-equity swaps, in the end, will simply become a way of financing, not an investment lever. To promote investment there are better and more directly targeted means. Balance sheet tricks are not a substitute for gaining extra real resources for investment as a result of genuine foreign saving or an improved budget position.

Reversal of Capital Flight

The wishful thinking turns to the $100 billion or more of Latin American assets that have fled from financial instability and taxation to the industrial countries, especially the United States. Reversing these capital flights, especially for Mexico or Argentina, would make it almost possible to pay off the external debt. The reason is that much of the debt was incurred in the first place to finance the exodus of private capital.

Table 6 shows estimates of capital flight for various periods arrived at by various procedures. Whatever the precise number for capital flight, there is no question that it took place on an extraordinary scale in Argentina, Mexico, and Venezuela—hence, the suggestion that reversing the mammoth outflow could help pay off the debt without tears.

Table 6.Capital Flight from Latin AmericaIn billions of U.S. dollars
World BankDornbusch (1985b)Khan and

Ul Haque
Morgan

Guaranty
1979–821978–821974–821976–82
Argentina19.223.415.327
Brazil3.51.90.23
Chilen.a.1.4–1.90
Mexico26.5n.a.32.736
Venezuela22.0n.a.10.825

The idea that private capital could be the main solution, or at least an important one, is naive. There is little or indeed no historical precedent for a major reflow, and when it does happen, it is the last wagon of the train. Einaudi once observed that savers “have the memory of an elephant, the heart of a lamb, and the legs of a hare.” Capital will wait until the problems have been solved; it won’t be part of the solution.

It is often argued that if only countries adopted policies conducive to guaranteeing savers stable positive real rates of interest the capital flight problem would not be an issue. But that argument is not very operational in three respects. First, in the context of adjustment programs it is unavoidable to devalue. Compensating savers for the loss they would have avoided by holding dollar assets would place a fantastic burden on the budget, which in turn would breed financial instability. Second, practicing high, positive real interest rates poses a serious risk to public finance. The public debt, which carries these high real rates, snowballs, and that in turn is a source of instability. Third, it is a very bad habit indeed to raise the return on paper assets above the prospective return on real capital. That is terrible supply-side economics, which ultimately erodes the tax base and deteriorates the financial system by souring loans. A country in trouble simply cannot opt to make its chief priority keeping the bondholders in place.

Capital controls, where feasible, are an essential part of a strategy to bring public finance in order rather than to paper over extreme difficulties for a while by extraordinarily high real interest rates. The latter strategy was, indeed, at the very source of the extreme mess in Argentina under Martinez de Hoz or in Mexico today.

It is also worth recognizing that the capital flight problem is to a large extent of our own doing. The U.S. administration, in an effort to fund our own deficits at low cost, has promoted international tax fraud on an unprecedented scale. The only purpose one can imagine for the elimination of the withholding tax on nonresident asset holdings in the United States is to make it possible for foreigners to use the U.S. Financial system as a tax haven. To compete with the tax-free U.S. return, anyone investing in Mexico and actually paying taxes there would need a yield differential, not counting depreciation and other risk, of quite a few extra percentage points.

There is much talk about the problems of banks putting in new money only to see it spent by debtors like Mexico on capital flight. The fact is that the large banks are the chief vehicles for and beneficiaries of the capital flight. This system on all accounts enhances the political explosiveness of the debt crises by placing on workers in the developing countries an even more serious adjustment burden. The treatment of capital flight by the banking community, with these ideas in mind, is not only outright cynical but also shortsighted.

Debt Relief

Debtor countries have failed to form an effective cartel that could impose debt relief in the form of a write-down, sharply reduced interest rates or generous grace periods, and consolidation of debt into perpetuities. On the contrary, debtor countries have competed with each other and, as a result, have wound up with poor terms and a short leash.

There were only two attempts so far to turn debt service into a major political issue. One is the case of Peru; the other is the Mexican move of the spring of 1986. In each case the extreme domestic costs of debt service and the destructive effects on investment, inflation, and growth potential led the governments to try to limit the damage. It is hard to believe that Peru got very far, but it is certain that Mexico initiated an important change in policies and procedures. The Mexican success suggests that with enough determination debtors can in fact secure reduced spreads, contingency funds, and even an underwriting of growth.

At the same time the debt problem is starting to become a U.S. political issue. This is true in part for reasons of foreign policy. But another important motivation is that the poor U.S. trade performance is seen as a reflection of the debtor countries’ need to earn foreign exchange for debt service. The most important initiative so far is that of Senator Bradley (1986a,b). The Bradley plan emphasizes the need to create a vehicle for trade-debt discussions. Focusing explicitly on the link between debtor-country trade concessions and targeted, limited debt relief, this approach makes debt consciously a political issue. Besides facilitating the regulatory system to make it easier to effect write-downs, the proposal also calls for reduced interest payments, extra money, and debt write-downs.

There are three kinds of unfavorable reaction to the Bradley plan. One reaction is to argue that the particular details—say the annual debt summit—are implausible, complicated, or undesirable. In the same vein, the write-downs are not insufficiently conditioned on performance of the debtor countries and hence not worth making. Another criticism is much more basic. It amounts to the assertion that any and all kind of debt relief deteriorates or even destroys the beneficiaries’ ultimate chances of renewed access to the international capital market. Countries who accept debt relief, it is argued, will be tainted. Only those who service humbly will see the day of voluntary lending. Historical precedent for all of Latin America would suggest the opposite.

Political solutions to the debt problem are likely to lie in the neighborhood of what Mexico secured and, unfortunately, far away from the ambitious Bradley plan. It is clear that gradually the resistance to write-downs will soften and terms will become more flexible. But it is also likely to be the case that the debt problem will remain an overwhelming burden on the growth prospects of Latin America. Taxpayers are unwilling to underwrite Latin American growth, and politicians are unwilling to underwrite the banks. Growth in Latin America will therefore depend in equal parts on a solution of the U.S. deficit problem with generous monetary accommodation and on the introduction of reasonable public finance in the debtor countries. With these two conditions in hand, and excepting extreme episodes such as the 1986 Mexican oil decline, growth can start again, although the losses of the 1980s will not be made up.

Solutions to the debt crisis involving debt relief encounter one apparently overwhelming counterargument: Latin America’s debt reflects to a large extent mismanagement and capital flight. Giving debt relief in this case, and not for countries where management was more careful, amounts to rewarding poor policy performance and thus invites repetition. But this moral-hazard argument can also with equal justification be made in two other directions. First, not giving debt relief means that creditor countries enforce bad loans. They thus encourage poor lending policies on the part of commercial banks, who expect to be able to rely on governments to collect for them even the poorest sovereign loans. Second, in the context of capital flight, it is frequently argued that amnesty for tax fraud and illegal capital transfers is an effective and desirable policy for encouraging a reflow. Of course, the same moral-hazard argument applies here because of the undermining of future tax morality. Finally, the major weakness of the moral-hazard argument in cases such as Mexico and Argentina results from the very fact of capital flight: those who pay are primarily workers whose real wages are cut. Owners of external assets are rewarded by capital gains and thus turn out to be net beneficiaries of the debt crisis. The moral-hazard issue is as much an argument for debt relief as it is against such a measure.

Throughout we assume that a country exports commodities or agricultural products—the traditional exports in our model. But the model is easily adapted to where the home country is a net importer of these goods.

These system-wide effects have been studied by Goldstein (1986), who documents their importance.

This kind of model is explored in Bruno and Fischer (1985), Cardoso (1986a, 1986b), and Dornbusch (1985a). The fiscal side goes back to Keynes and Harberger and Tanzi (1977, 1978) and Oliveira (1967).

This is the steady-state form. In the transition, allowance must be made for changes in velocity. It is easy to see from the model developed below that it affords the ingredients for hyperinflation processes where the interaction of accelerating inflation, real depreciation, and fiscal lags produces ever-growing deficits, money creation, and inflation.

On a discussion of these issues, see especially Rist (1940).

For a thorough review of the empirical evidence on linkages, see International Monetary Fund (1986), pp. 150–95.

It is worth noting that even in the case of monetary accommodation U.S. inflation slows down moderately as a result of the Gramm-Rudman budget correction.

This section draws on editorials published in Folha de Sāo Paulo and in Cronista Comercial (Argentina).

For a strong statement of support for debt-equity swaps, see Morgan Guaranty Trust (September 1986).

References

    BradleyBill (1986a) “A Proposal for Third World Debt Management” paper presented in ZürichSwitzerlandJune 291986.

    BradleyBill (1986b) “Defusing the Latin Debt Bomb” Washington PostOctober51986p. C2.

    BrunoM. and StanleyFischer“Inflation and Expectations” (unpublished; Massachusetts Institute of Technology Cambridge and Falk InstituteJerusalem1985).

    CardosoEliana A. (1986a) Inflation Growth and the Real Exchange Rate: Essays on Economic History in Brazil and Latin America 1850–1983 (Garlandforthcoming).

    CardosoEliana A. (1986b) “Inflation and Seignorage in Latin America” (unpublished; Fletcher SchoolTufts University1986).

    DornbuschRudiger (1985a) “Policy and Performance Links between LDC Debtors and Industrial Nations,”Brookings Papers on Economic Activity: 2 (1985) The Brookings Institution (Washington) pp. 30368.

    DornbuschRudiger (1985b) “External Debt, Budget Deficits, and Disequilibrium Exchange Rates,”in International Debt and Developing Countriesed. by JohnD. Cuddington and GordonW. Smith (Washington: World Bank1985) pp. 21335; reprinted in Dollars, Debts, and Deficits (Cambridge, Massachusetts: MIT Press).

    DornbuschRudiger (1986a) “Inflation Exchange Rates and Stabilization” Princeton Essays in International Finance No. 165 (Princeton, New Jersey: Princeton University PressOctober1986).

    DornbuschRudiger (1986b) “Stopping Hyperinflation: Lessons from the German Experience in the 1920s” in Macroeconomics and Finance: Essays in Honor of Franco Modiglianied. by RudigerDornbuschJ.Bossons and StanleyFischer (Cambridge, Massachusetts: MIT Press1987).

    DornbuschRudiger (1986c) “Mexico and the IMF” (unpublished; Cambridge: Massachusetts Institute of Technology1986).

    DornbuschRudiger and MarioHenrique SimonsenInflation Stabilization with Incomes Policy Support: A Review of the Experience in Argentina Brazil and Israel (New York: Group of Thirty, forthcoming).

    EdisonHali J. and RalphTryon“An Empirical Analysis of Policy Coordination in the United States, Japan and Europe,” Board of Governors of the Federal Reserve System International Finance Discussion Papers No. 286 (WashingtonJuly1986).

    GoldsbroughDavid and IqbalZaidi“Transmission of Economic Influences from Industrial to Developing Countries,”in Staff Studies for the World Economic Outlook World Economic and Financial SurveysInternational Monetary Fund (WashingtonJuly1986).

    GoldsteinMorrisThe Global Effects of Fund-Supported Adjustment Programs Occasional Paper No. 42International Monetary Fund (Washington1986).

    IbbotsonR. and R.SinquefieldStocks Bonds Bills and Inflation: The Past and the Future (Charlottesville, Virginia: Financial Analysts Foundation1982).

    International Bank for Reconstruction and Development (World Bank)World Development Report (Washingtonvarious issues).

    International Bank for Reconstruction and Development (World Bank)Commodity Trade and Price Trends (WashingtonApril1986).

    International Monetary FundStaff Studies for the World Economic Outlook World Economic and Financial Surveys (WashingtonJuly1986).

    KhanMohsin H. and NadeemUl Haque“Foreign Borrowing and Capital Flight,”Staff PapersInternational Monetary Fund (Washington) Vol. 32 (December1985) pp. 60628.

    MelnickRafi and MeirSokoler“Government’s Revenue from Money Creation and the Inflationary Effects of a Decline in the Rate of Growth of G.N.P.,”Journal of Monetary Economics (Amsterdam) Vol. 13 (March1984) pp. 22536.

    Morgan Guaranty TrustWorld Financial Markets (New YorkMarch and September1986).

    OliveiraJulio H.G.“Money, Prices and Fiscal Lags: A Note on the Dynamics of Inflation,”Banca Nazionale del Lavoro Quarterly Review (Rome) Vol. 20 (September1967) pp. 25867.

    RistCharlesHistory of Monetary and Credit Theory from John Law to the Present Day (New York: Macmillan1940).

    TanziVito“Inflation, Lags in Collection, and the Real Value of Tax Revenue,”Staff PapersInternational Monetary Fund (Washington) Vol. 24 (March1977) pp. 15467.

    TanziVito“Inflation, Real Tax Revenue, and the Case for Inflationary Finance: Theory with an Application to Argentina,”Staff PapersInternational Monetary Fund (Washington) Vol. 25 (September1978) pp. 41751.

Comments

Vittorio Corbo

Professor Dornbusch has given us an excellent discussion of the effects of external conditions on Latin American debtor countries. He has also provided a helpful evaluation of different options for the solution of the debt and growth problems. Although I agree with most of the points in his paper, I would like to elaborate on four points: (1) the conceptual framework used to describe the principal interactions between a debtor country and the rest of the world. (2) the system-wide effects of many countries reducing anti-export biases in their trade regimes, (3) the relation between debt service, the fiscal deficit, and inflation, and (4) debt-equity swaps. I will discuss each of these points in turn.

Conceptual Framework

Professor Dornbusch’s conceptual framework is based on a four-good model: domestic exportable manufactures, which are imperfect substitutes for goods produced abroad; domestic traditional goods, which are perfect substitutes for primary commodities traded in international markets; importable manufactures, which are perfect substitutes for manufactures produced domestically; and oil, which is treated as a separate commodity. He then analyzes the adjustment process under alternative external shocks (i.e., a rise in the real price of oil, a rise in the real interest rate, a decline in the real price of traditional goods in terms of importable manufactures, credit rationing, and system-wide export expansion).

In Dornbusch’s model, the key relationship that has to bear most of the burden of adjustment to external shocks is the relative price between exportable manufactures and importable manufactures. Not surprisingly, both a rise in the real price of oil for an oil importing country and a rise in the real interest rate for an indebted country, if not automatically Financed, will result in a reduction in absorption and a real depreciation. But this result is simply a strong implication of the model. An alternative model, and one that might be closer to reality, is one that assumes that exportable manufactures are perfect substitutes in world trade. In this type of model, relative prices will adjust through real devaluation rather than through a deterioration in the terms of trade. Recent empirical evidence from the Republic of Korea and Turkey, two countries that have adjusted quite successfully to external shocks, shows that adjustment took place even with an overall improvement in the terms of trade. In both cases the main contribution to the adjustment was a real devaluation. Even in Brazil, noncoffee terms of trade improved between 1981 and 1985, with a large turnaround in net exports (which reached a record level of US$12.5 billion in 1985).

System-Wide Effect of Many Countries Simultaneously Reducing Anti-Export Biases in Their Trade Regimes

In Professor Dornbusch’s analysis, if countries jointly experience the same unfavorable external shock and adjust to it by trying to increase exports by devaluing in real terms, they will compete with each other and worsen their terms of trade. I would like to raise two points here. First, even if Professor Dornbusch’s conjecture is correct, the relevant question is what would have happened if the countries had not devalued. Under such a scenario, most of the adjustment would have had to take the form of a cut in absorption, compression of imports, and ultimately a reduction in output. From a welfare point of view, this is probably a worse outcome than the combination of a real devaluation and a deterioration in the terms of trade.

Second, and more important, the share of developing countries in the markets for manufactures in most developed countries is still very small. In fact, the aggregate share of manufactured exports from developing countries in the consumption of manufactures in the developed countries is just over 2 percent. There is also great potential for intra-industry trade, as the experience of the European Communities has clearly shown. Indeed, the prime motivation for exporting in the highly indebted countries is the need to earn foreign exchange, so as to pay for badly needed imports of capital goods and raw materials and then to increase actual and potential output. Thus, there is substantial room for significant expansion of trade among developing countries and between them and developed countries.

Relation Between Debt Service, the Fiscal Deficit, and Inflation

I think that Professor Dornbusch is correct in emphasizing the fiscal implications of debt servicing. Clearly, rising official debt—often stemming from the fact that the public sector has been forced to assume responsibility for servicing the private debt—has made debt service an important component of total expenditures.1 If no room is made in the budget for this source of extra expenditure, for example by reductions in other types of expenditures and/or increases in revenues, then domestic debt will increase: the result will be to crowd out other borrowers or, if the expenditures are financed by printing money, to accelerate inflation. Thus, the fiscal effects of debt servicing should be given much more consideration in the discussion of adjustment programs. Moreover, the fiscal consequences of a real currency depreciation, which will depend on the net effects on government revenues and expenses, needs to be taken into account if the depreciation is going to be successful.

Debt-Equity Swaps

Professor Dornbusch offers a negative assessment of the role that debt-equity swaps play (or could play) in the management of a debt crisis. He is especially concerned about the fact that commercial banks are promoting these schemes, which he argues cannot be desirable. If this is true, should any trade promotion activity be seen as bad? On a more serious note, a debt-equity swap is a transaction like any other; one should be concerned with the terms of trade of any transaction before making a judgment on the fairness of the activity as such. Debt-equity swaps raise three main issues, the first of which relates to the optimal level of debt. Even for a country that is planning to service its debt fully, to pay now when you can postpone the payment until tomorrow is not necessarily the best course. In the final analysis, the decision will depend on a comparison of the opportunity cost of the resources and the interest rate on a debt whose market value is below the book value. If the latter is higher than the opportunity cost, then a debt-equity swap where debt and equity are priced at market values will be welfare-enhancing. Professor Dornbusch is right that the conversion of debt into equity when the equity is not in a public asset still requires the issue of domestic public debt to pay for the debt instrument. In this case, the public sector has substituted the servicing of domestic debt for the servicing of foreign debt.

On the balance of payments side, there is an intertemporal substitution of interest payments today for uncertain dividends tomorrow. If enough postponement is introduced into the payment of dividends, this could be an important source of transitional financing, which could in turn allow the country to finance investment and thus to perform adjustment with growth. Finally, much can be learned about specific issues of implementation from the Chilean debt-equity swap legislation. I still think that debt-equity swaps, if done properly, can make a small (but positive) contribution to the overall effort of designing a strategy that will allow highly indebted countries to restore domestic growth and eventually external creditworthiness.

Daniel Heymann

Dornbusch’s paper deals with three classes of subjects: the economic evolution of the industrial countries, the mechanisms by means of which the indebted economies adapt to external influences, and the problems and outlook regarding debt. These comments concentrate on the last two questions.

Dornbusch refers to the effect of rationing international credit and the restrictions imposed by industrial countries on access to their markets. In fact, external conditions, together with the economic policies of the Latin American countries themselves, seem to have been consistently procyclical in recent years, whereas, in the past, the international supply of funds and exchange policies tended to promote and accentuate disequilibria, with the subsequent cutback in credit, together with high interest rates and the fall in primary commodity prices, combining to impose a sharp and very severe adjustment.

The paper uses a model to analyze the characteristics of this adjustment. The model is probably better suited to some economies than others, particularly because the assumption that local industrial goods are (imperfect) substitutes for foreign manufactures is seemingly not universally valid. In some cases, industry operates as an uncompetitive sector. In such circumstances, nontraditional exports do not respond elastically to the real change rate, and an increase in the trade balance would be brought about by a contraction in activity (through fewer purchases of inputs) and a stronger reduction in absorption than when significant substitution effects are present. That is, the impression seems to be that means of adjustment depend on the overall structure of the economy, and particularly its foreign trade.

On the other hand, debt causes some additional complications not contemplated in the model. If the adjustment is contractionary, there may be an induced reduction in the expected return on investment. The existence of debt also introduces various uncertainty factors, particularly when servicing and new financing terms depend on volatile circumstances and frequent renegotiations. The economy faces an unpredictable liquidity restraint (which affects forecasts for relative prices and the viability of various activities), and the need to meet payments calls for hefty transfers of resources between domestic sectors, which are generally not defined “once and for all.” The effect of such instability is probably to reduce demand for assets in the country.

The distributive element of debt is also an inflationary factor. Dornbusch mentions various effects of debt on the public sector deficit, apart from its direct impact; in particular, an increase in the real exchange rate makes total interest payments grow in terms of domestic goods. The net effect of the real exchange rate on government finances seems to depend on the characteristics of the tax system: a higher exchange rate undoubtedly increases the burden of interest, but it can increase collections of taxes on foreign trade, particularly when they are concentrated on exports; on the other hand, if the real devaluation is recessionary, revenue from taxes on domestic activity will decline. At all events, the conclusion will stand: debt significantly contributes to increasing inflation, especially in countries with small capital markets and a small demand for liquid assets in domestic currency, where furthermore the fiscal lag effect is strongly felt. Naturally, this happens if fiscal policies are not adjusted to “accommodate” service payments. But it is difficult to see any internal agreement being reached to distribute burdens as significant as those currently implied by Latin American debt. In these conditions, it can be expected that, when they take place, fiscal adjustments will be precarious, because there would be considerable resistance to accepting a system of public revenue and expenditure which would permanently free resources to meet these external payments. Furthermore, debt (with the consequent need to increase the trade balance) implies a relative price structure that can generate resistance. It is likely that inconsistencies in price and wage fixing would be more frequent in highly indebted economies. From this viewpoint, too, debt puts obstacles in the way of stabilization efforts.

Dornbusch’s paper points to some of the more noteworthy aspects of the behavior of Latin American economies over the last few years. A very strong adjustment in the current account has taken place through a sharp contraction in imports and an increase in the volume of exports, partly offset by a price decline; all in all, the trade surplus is not able (exceptions aside) to cover the accrued interest. Adjustment has taken place at the expense of investment. Thus, not only has activity contracted (or its increase been significantly attenuated) but the sources of future growth have also been weakened.

During the period of gestation of the debt crisis and since it made its appearance, a series of messages has come from the industrial countries. At one point, it was the common view that capital flows provided an opportunity to improve allocation over time and that the accumulation of liabilities was not per se a matter for concern. When it became clear that the debt could not be serviced without disruption, financing suddenly contracted and an urgent demand arose for indebted economies to adjust. Frequent reference was made to the prospect of likely declines in world interest rates and the recovery of the industrial economies easing the debt problem and making the adjustment more bearable. In other words, we were invited to trust that forces exogenous from the point of view of those mainly concerned in the debt issue would intervene to soften the blow. In the event, the adjustment was long and costly, and the problem is still with us. No doubt domestic economic policies were frequently inadequate, but it also seems certain that external conditions did little to help indebted countries regain something of their dynamism. In a number of cases, the fall in the external interest rate was more than offset by worsening terms of trade; financing has not returned to normal and in general terms the debt issue continues to be linked to short-term renegotiations that postpone the search for any sustainable solution. Currently, stress is placed on the need to reconcile attention to debt with the need for growth. While it is important to go beyond mere adjustment by renewing emphasis on growth, the question arises of the circumstances in which such reconciliation would be feasible.

It seems obvious that growth requires more funds to be directed to investment and that they be used efficiently. There is considerable scope for improving economic policies. But it is difficult to consider this subject in isolation from debt: the instability the latter generates is a barrier to focusing on policies with a longer-term horizon, apart from its direct effect on the availability of resources. Likewise, as Dornbusch points out, it is far from certain that the capital currently invested abroad will ultimately be returned; perhaps one should consider this as a potential spin-off rather than as an alternative to relief on the payments involved. In the final analysis, the question is to define, however approximately, an economy’s ability to make transfers in such a way as to be compatible with a sufficient volume of investment and with some degree of distributive balance (without which it is difficult to envisage any lasting solution). Little progress has been made on a discussion of this subject. Dornbusch rightly points out that accounting changes from one form of debt to another do not solve the problem (especially when this change involves subsidies by the governments of the indebted countries), while, for example, to change part of the financial debt into direct investment would to a certain extent link payments to the level of income, that is, would convert an “unconditional” commitment to a conditional one.

Latin American debt has one special feature. The question of reparations in the 1920s involved governments directly and was the subject of diplomatic negotiation. For private debt, there is a mechanism for convening creditors to deal with situations in which the total amount of the debts exceeds the ability to pay. Here, neither alternative is available. Furthermore, no effort seems to have been made to evaluate the volume of resources that countries could permanently divert to service debt and whether it is thus necessary to reduce obligations, and to what extent, to reach a sustainable position. This is undoubtedly linked up with the trade policies of the creditor countries: it is obvious that with worse terms of trade and greater restrictions on market access, there will be fewer opportunities (and incentives) to meet external payments. On the other hand, it sometimes seems that the industrial countries are trying to maintain or increase the transfers they receive by way of interest and at the same time increase their exports to the indebted economies. As Dornbusch says, this position seems inconsistent.

Growth is ultimately the individual country’s problem. But international circumstances, and particularly debt, impose severe restrictions. So far, the international financial system gives the impression of having concentrated its attention on avoiding major disruptions arising through inability to pay and, this being so, on seeking adjustments that would allow trade balances to be raised. This approach is not conducive to growth in the indebted countries, and it is not clear whether it can be permanently applied. Dornbusch’s argument gives little cause for optimism about the immediate likelihood of current conditions changing. Given that there seems to be a longer-term problem, the question that remains is when and in what way it will ultimately be addressed.

“The Latin American Transfer Problem in Historical Perspective,” in Latin America and the Caribbean and the OECD, Organization for Economic Cooperation and Development (Paris, 1986).

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