Chapter

The Role of External Private Capital Flows

Editor(s):
Mohsin Khan, Morris Goldstein, and Vittorio Corbo
Published Date:
September 1987
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Author(s)
John S. Reed

This symposium on growth-oriented adjustment programs addresses the right issue at the right time, for the real challenge facing developing countries is how to reestablish long-term sustainable growth. This paper provides background information on the role that private capital from abroad can play in helping countries meet this challenge. In particular, it focuses on the role that commercial banks can play in the process.

During the ten years prior to 1982, commercial banks provided a significant portion of the total external capital supplied to developing countries. Since the debt problem emerged in 1982, banks have continued to provide normal financing to many developing countries, but they have limited their financing of countries with severe balance of payments problems to lending packages arranged in connection with rescheduling agreements.

The current system for managing the debt problem is based on unparalleled cooperation among private banks, debtor countries, creditor country governments, and the Bretton Woods Institutions. It is, however, widely agreed that this system is coming under increasing stress owing to the discrepancy between the climate for investment created by certain countries and the conditions for investment required by the world capital markets.

This stress can be resolved in one of two ways. First, countries can succeed in improving the climate for investment and compete for capital on the terms established in the global capital markets. Over the long run—and sustained growth requires a long-run view—we believe this can result in a large, steady flow of funds to developing nations. Alternatively, countries can seek to force providers of private capital to make special off-market concessions. This may give some short-term relief, but it will not attract funds in the global capital markets. This approach will force troubled countries to depend almost entirely on official flows of capital (which are in short supply) to supplement their own savings in financing economic development. Ultimately, official flows come from taxes paid by households and businesses in industrial countries. In this situation, debtor countries will be required to compete for resources in the political arenas of the industrial countries.

The choice between these approaches will be made largely by the developing countries themselves, since they make the policies that determine the path they will follow. The thrust of this paper is to show that it is in the best interests of all parties, particularly the capital-short countries, to take the measures necessary to maintain a creditworthy status in the global financial markets.

History

Starting in the early 1970s, just as the Bretton Woods system of fixed exchange rates was breaking apart, developing countries began to attract significant amounts of private foreign capital. Although the bulk of investment capital in developing countries continued to come from domestic savings, large external capital inflows added a significant boost to investment programs and permitted these countries to accelerate their economic growth in both aggregate and per capita terms.

Most of the external capital came from the world’s private capital markets through loans syndicated by commercial banks in the major industrial countries. By the late 1970s, net external borrowing from these intermediaries accounted for over three fourths of the total net inflow of funds from abroad into capital importing developing countries, while inflows from official creditors accounted for less than one third of the total.1

Several factors accounted for this large increase in private external lending. The banks were willing to lend because developing countries appeared to be good risks in the 1970s. The prices for commodity exports were buoyant, and the outlook for continued growth in export earnings looked excellent. In effect, the developing countries appeared to have the capacity to carry larger amounts of external debt. From these countries’ point of view, borrowing dollars was cheap with interest rates often less than inflation.

Another reason why developing countries turned to the private capital markets for funds during the 1970s was that the resources of the Bretton Woods Institutions were not keeping up with world trade and the financing needs of these countries. As late as 1970, the resources of the World Bank and the Fund were equivalent to over 15 percent of world imports and to over 70 percent of the external debt of the developing countries. During the course of the 1970s, however, these two percentages fell to approximately 6 percent of world imports and to less than 30 percent of external debt. As a result, when the world economic environment started to change in 1979 because of the second oil price shock and the anti-inflation policies adopted in the United States and other leading industrial countries, the financing requirements of the developing countries had grown out of proportion to the resources of the Bretton Woods Institutions. Consequently, the resolution of the debt problem required a great deal of cooperation among the Bretton Woods Institutions, the private lenders, and the developing countries.

As is well known, the debt problem emerged in August 1982, when Mexico declared itself unable to service its debt in a timely fashion. Since then some 65 capital-importing developing countries have had trouble servicing their external debt, while 60 have not.2 A comparison of countries in these two categories gives many clues as to why this is the case. By and large countries that had difficulty servicing their debt went into the debt crisis with higher ratios of debt to income and higher barriers to trade and investment.3 Also they had higher rates of money growth and inflation, which in turn frequently led to overvalued currencies and depressed export receipts (see Table 1).4 In combination, these policies meant that countries with debt-servicing problems went into the debt crisis with much higher ratios of external debt and debt service to exports—a situation that left the countries more vulnerable to a world recession.

When that recession came in 1979-82, these countries in many cases compounded their difficulties by clinging to the inward focus of their old policies. They tried to postpone adjustments by borrowing more. They further increased their rates of money growth and inflation. In many cases (e.g., Argentina, Chile, Mexico, Venezuela), they allowed their currencies to become enormously overvalued, which had disastrous effects on their current accounts. Coupled with the rise in short-term dollar interest rates, the lack of adjustment caused the ratio of interest payments to exports to jump 2½ times to 24.0 percent between 1978 and 1982.5 At the same time, foreign exchange reserves plummeted from 25 percent to 10 percent of imports (see Table 1). This decline in reserves relative to financing requirements was the final blow that closed countries’ access to the voluntary capital markets and brought about the debt crisis of 1982.

Since then, there have been two phases in resolving the debt problem. The first, which began in 1982, involved reestablishing cash flow equilibrium, or balance in the current account, through short-term adjustment programs under the aegis of the Fund. The second phase may be said to have started in October 1985, when Secretary Baker launched a new growth-oriented adjustment concept designed to help countries get back on the path to long-term sustainable growth.

The first phase of resolving the debt problem occurred in relatively favorable economic circumstances. Industrial countries, led by the United States, recovered rapidly from the severe 1980-82 recession, and this helped reverse the decline in exports that the troubled debtors had experienced in 1981-82. Interest rates declined significantly from their peak in 1981, although they remained relatively high in real terms. Initially at least, commodity prices rebounded (before falling again in 1985).

Within this favorable economic environment, troubled countries and their creditors began to work out a resolution to the debt problem. The approach was country by country, since the problems and the solutions were also largely dependent on the economic policies that each country chose to adopt. By and large, countries that rescheduled their debts took policy measures needed to improve their balance of payments. Often these policy changes were a precondition for the country to receive a Fund loan and to receive new money or restructured maturities from private lenders and governments. The policy changes usually included a devaluation of the currency, a reduction in money growth, a decline in the government budget deficit, and the elimination of wage and price controls. Each country negotiated the timing and content of its particular program with the Fund and then negotiated rescheduling and new money agreements with the banks.

These policies were effective in reducing the aggregate current account deficit of the problem countries from $66.7 billion in 1982 to $21.1 billion in 1986 and in bringing about a slight reduction in the average ratio of interest to exports of goods and services, from 24.0 percent in 1982 to 21.3 percent in 1986 (see Table 1). Essentially, the adjustment programs stabilized the debt situation.

This inevitable adjustment in the balance of payments was not always carried out smoothly and at minimum cost. In many cases payments arrears developed, essential imports were not available, and the nature of the cutbacks in expenditures was influenced by the political constraints in each country. Unfortunately, from the standpoint of long-term growth, there was a marked decline in the rate of gross capital formation in the troubled debtor nations from 24.3 percent (1979-82) to 18.0 percent (1983-86). Real economic activity stagnated or declined. Total gross domestic product (GDP) rose by only 4.6 percent from 1983 to 1986, and real GDP per capita actually fell by 2.1 percent.

Although the external accounts of most developing countries were brought into reasonable balance by 1984, the problem remained how to renew a process of sustained economic growth.

Table 1.Major Economic Indicators(In percent)
CountriesCountries
withwithout
Debt-ServicingDebt-Servicing
ProblemsProblems
Real growth
Total GDP
1969-785.55.9
1979-822.74.5
1983-861.55.9
Per capita
1969-783.13.7
1979-820.32.6
1983-86-0.74.1
Gross capital formation
197827.229.0
1979-8224.327.7
1983-8618.026.5
Terms of trade
1969-781.50.7
1979-821.00.6
1983-86-3.6-2.0
Non-oil commodity prices
1969-788.910.0
1979-82-0.40.2
1983-86-0.3-1.4
Debt/GDP
197831.419.9
198245.524.9
198654.832.5
In teres t/exports of goods and services
19789.64.6
198224.07.7
198621.37.3
Reserves/imports
197825.226.3
19829.921.9
198616.032.0
Growth in export volume
1969-782.38.4
1979-82-0.25.3
1983-863.110.5
Exports of goods and services/GDP
197817.521.2
198218.826.0
198618.128.5
Money growth
197838.820.7
1979-8250.227.1
1983-8679.522.5
Inflation
1969-7822.910.5
1979-8241.714.6
1983-8680.610.9
Source: International Monetary Fund, World Economic Outlook, April 1987.

This need is at the heart of the Baker Initiative. As originally presented, the Baker Initiative is a three-pronged program involving the debtor countries, the Bretton Woods Institutions (and other multilateral development banks), and the private commercial banks. The scheme is simple: if debtor countries adopt growth-oriented, market-driven economic policies, both the multilateral institutions and the commercial banks are to provide the largest troubled debtor nations with a sustained injection of external capital.6

According to Secretary Baker’s speech in Seoul announcing the Initiative, the growth-oriented, market-related policies that countries should adopt in order to qualify for new money include:

  • maintenance of market exchange rates, interest rates, wages and prices

  • the adoption of sound monetary and fiscal policies

  • the implementation of growth-oriented structural reforms.

To obtain new money, countries are to correct the economic policies that caused the debt problem in the first place. In return for adopting these growth-oriented, market-driven policies, countries are to receive additional loans from official and private sources. Specifically, both the Fund and the World Bank are to provide additional credit, provided these countries adopt the necessary structural policy changes. Indeed, Fund and World Bank loans are to contain conditionality clauses to that effect, and the World Bank is to shift its emphasis from project finance to adjustment lending to help assure that countries do adopt the needed reforms. Finally, commercial banks are to supply $20 billion in new financing to the largest troubled debtor nations, again provided that the countries adopt the necessary structural reforms. The Baker Initiative is clear: new money to support new policies.

Like many new initiatives, the Baker Initiative has been slow getting off the ground. Despite these delays, in some countries it is bringing about important changes in attitudes and policies. As the title of this symposium implies, the emphasis is now increasingly on growth, and that is all to the good. In fact, many countries (including Chile, Côte d’Ivoire, Ecuador, Morocco, Nigeria, and Turkey) are now moving toward implementing the initial reforms required to produce sustained growth. In most cases, the reforms fall short of the ideal, but the willingness of countries to change deeply ingrained policies is certainly a step in the right direction.

The Current Situation

Logically, then, the current situation should represent a transition from the stabilization programs begun in 1982 to the growth phase announced with the Baker Initiative in October 1985. In practice, however, a debate has arisen concerning whether countries should proceed along these lines at all or whether instead they should seek to “resolve” the debt problem through some form of debt relief. This latter approach calls for concessions from the banks and could lead to a breakdown of the bank restructuring committee process. This is an important turning point in the resolution of the debt problem and the long-term growth prospects for the countries.

Before turning to the debate, it is useful to review the debt situation as it now stands. Total external debt of the developing countries amounts to just over $1 trillion (see Table 2). More than half of this amount ($624 billion) is owed by countries that are experiencing problems in servicing their external debt in a timely fashion. These countries owe approximately $400 billion to private creditors, principally commercial banks from the industrial countries.

Debt owed by countries with debt-servicing problems is concentrated in 15 large, heavily indebted nations, and it is precisely on these nations that the Baker Initiative focuses. These 15 nations account for over two thirds of the total debt owed by all countries with debt-servicing problems and for over four fifths of the debt owed by such countries to private creditors (see Table 2).

By any modern standard, the debt burden is high for these problem countries. At year-end 1986, their interest payment requirements averaged 21 percent of export revenues, and for the largest troubled debtors, the figure was 27 percent, or approximately four times the level of interest service due from countries without debt-servicing problems (see Table 3). It should be noted, however, that countries with debt-servicing problems have rebuilt their foreign reserves from the extraordinarily low levels reached in 1982, and in some cases (e.g., Venezuela) reserves amount to a significant percentage of the outstanding debt.

Table 2.Developing Country Debt Profile, Year-End 1986(In billions of U.S. dollars)
CountriesCountries
withwithout
Debt-ServicingDebt-Servicing
ProblemsProblemsTotal
Total debt623.5408.11,031.6
Due to official creditors213.9170.2384.1
Due to private creditors1409.6237.9647.5
Of which:
Fifteen heavily indebted countries2
Total debt434.4
Due to official creditors92.4
Due to private creditors342.0
Source: International Monetary Fund, World Economic Outlook, April 1987.
Table 3.Developing Country Debt Profile, Year-End 1986(In Percent)
FifteenCountriesCountries
Heavilywithwithout
IndebtedDebt-ServicingDebt-Servicing
Countries1ProblemsProblems
Debt/GDP48.454.832.5
Interest/exports of goods and
services27.321.37.3
Reserves/imports22.316.032.0
Annual rate of growth in real debt:2
Total debt
1978-829.98.74.1
1983-860.41.47.0
Debt due to private creditors
1978-8211.59.56.1
1983-86-2.1-2.26.5
Source: International Monetary Fund, World Economic Outlook, April 1987.

Also, it should be noted that countries without debt-servicing problems continue to enjoy normal access to the world capital markets. In other words, for countries that continue to meet the standards of the market, lenders are willing and able to supply new money (see Table 3). We feel this also can be the case for countries with debt-servicing problems if they take the measures necessary to make themselves creditworthy again.

Indeed, many banks are now in a much stronger financial position to extend new credit to troubled countries than they were when the debt problem started in 1982. Through building up their reserves and capital, U.S. banks’ exposure to troubled debtor nations now accounts for a much smaller portion of capital and earnings than it did in 1982. Also, the debt problem has largely been discounted in the price of U.S. bank stocks. In the case of the German, Japanese, and Swiss banks, the decline of the dollar relative to their currencies has effectively reduced the portion of problem country exposure in their balance sheets by 30 percent or more. Furthermore, it is widely believed that many of these banks have reserves that fully cover this exposure.

Ironically, the financial cost suffered by the banking system increases the strength of the banks and is putting a great strain on the bank restructuring process. Banks are now more able to lend new money, but they are also more able to “walk away” from the process entirely. Demands for concessional terms by debtor countries will drive many banks away from the restructuring and new money agreements. There is a great concern that more pressure for concessions will cause a breakdown of the bank restructuring process, especially if creditor governments should join in advocating such concessions.

Table 4.Members of Bank Advisory Committees(Percentage Share of Committee in Total Bank Exposure)
ArgentinaBrazilChile
Bank of AmericaArab Banking Corp.Bank of America
Bank of TokyoBank of AmericaBank of Nova Scotia
Chase ManhattanBank of MontrealBank of Tokyo
Citibank1Bank of TokyoBankers Trust
Credit LyonnaisBankers TrustChase Manhattan
Credit SuisseChase ManhattanChemical Bank
Dresdner BankChemical BankCitibank
Lloyds BankCitibank’Credit Suisse
Manufacturers HanoverCredit LyonnaisDresdner Bank
Morgan GuarantyDeutsche BankManufacturers Hanover1
Royal Bank of CanadaLloyds Bank1Marine Midland
(24 percent)Manufacturers HanoverMorgan Guaranty
Morgan Guaranty1(35 percent)
UBS
(30 percent)
MexicoPhilippinesVenezuela
Bank of America1Bank of AmericaBanca Nazionale del Lavoro
Bank of MontrealBank of Montreal
Bank of TokyoBank of Tokyo1Bank of America1
Bankers TrustBanque Nationale de ParisBank of Tokyo1
Chase Manhattan1Chase Manhattan1
Chemical BankBarclaysChemical Bank
Citibank1CitibankCitibank
Deutsche BankChase ManhattanCommerzbank1
Lloyds BankChemical BankLloyds Bank
Manufacturers HanoverDresdner BankManufacturers Hanover
Morgan GuarantyThe Fuji BankMorgan Guaranty
Societe Genera leManufacturers Hanover1Banque Paribas
Swiss BankMorgan GuarantyRoyal Bank of Canada
(26 percent)(36 percent)Swiss Bank
(27 percent)

Typically, a committee of 10 to 14 banks represents the hundreds of banks around the world that are creditors to a country, and separate committees exist to conduct negotiations with each problem country. Members of the committee come from many different nations. They are chosen by the debtor government on the basis of their exposure and geographical representation and are to represent the views of the banks of their country or region in the negotiations. Although banks on a committee are usually the largest bank lenders to the country in question, the committee members in aggregate generally represent only 25 percent to 35 percent of a country’s total external debt to commercial banks. Thus, the committee itself cannot finalize a deal; it must “sell” it to hundreds of banks, small and large, in many countries (Table 4).

For this reason, much of a committee’s function involves communicating with all other participants in the rescheduling process. In effect, a committee serves as a go-between for the debtor country and the hundreds of banks that have extended it credit, and a committee must seek to negotiate terms and conditions that are acceptable to the debtor country and that will encourage other banks to participate in the new financing. In addition, a committee is responsible for coordinating the efforts of the commercial banks with those of the Bretton Woods Institutions and with those of the creditor country governments.7

The ability to sell a particular deal to banks around the world depends on the economic policies the country is following and on the terms and conditions of the deal itself. Structural adjustments along the lines proposed under the Baker Initiative and appropriate macroeconomic policies are essential, since they establish the fundamental conditions that determine the outlook for economic growth and the ability to service debt; however, structural adjustments and good policies are not sufficient in themselves to attract new money. They must be accompanied by market-related pricing and terms in order to be sold to banks around the world. After all, the commercial banks are intermediaries between the world’s capital markets and the debtors. Since banks fund themselves at market rates, anything less than market rates represents a loss for them, and they are reluctant to go along.

The difficulty experienced in placing the recent Mexican debt restructuring is a clear example of this. Even more important than the low spread, the package includes concessions in the form of contingency financing and does not offer a menu of options, including on-lending to the private sector. Certain banks around the world have been reluctant to participate in the package and placing it is exhausting goodwill in some areas of the banking community. We now see countries with relatively good economic performance and policies having difficulty in their negotiations because they are demanding on-market features that in their novelty raise substantive and accounting issues. Citibank has been vocal about this because we feel further demands for concessions and unusual arrangements will damage the bank support system and curtail the early momentum of the Baker Initiative.

Turning Point

Currently there appears to be general acceptance of the principles espoused in the Baker Initiative, that is, that the problem is how to get the troubled debtor nations back on the road to long-term sustainable growth, and that the solution invariably entails adopting growth-oriented, market-related economic policies. But what should those policies be, how fast should they be adopted, and should they be accompanied by market terms and conditions on the new funds that troubled debtor nations seek to obtain from abroad? Those are the open questions, and how they are resolved will determine the amount of external financing that developing nations can expect to receive from commercial banks and other private sources of capital during the coming years.

Two schools of thought prevail on how to resolve these open questions. One school argues that lending should be on concessional terms and that countries should be given a longer period of time in which to phase in the new market-oriented economic policies. Some would go so far as to say that the concessions should take the form of debt relief or debt forgiveness.

The other school of thought says that if countries want to return to the market, they should adapt to the conditions of the market. If they meet these conditions, they will restore their creditworthiness and attract new private capital for economic growth. If they do not, investors, be they commercial banks or other sources of private capital, will direct their capital into other uses, and the problem countries will not be able to obtain the external capital they need for economic growth.

Each school of thought bases its recommendation, to some extent, on a calculation of the funds that troubled debtor countries can expect to receive. Those who argue for concessional terms focus on the short term, on the easing of the debt burden that troubled debtor nations can expect to achieve during the next two to three years. Those who argue for market-related terms focus on the funds that countries can expect to receive over the longer term and on the contribution that such funds can make to help countries achieve long-term sustainable growth.

The concessional school of thought implicitly assumes that the major source of funds to the troubled debtor nations are those funds that can be “extracted” in the form of concessions from existing lenders. Proposals for concessions range from not-so-freely negotiated reductions in the spreads on new or existing money to mandatory forgiveness of interest and principal. Virtually all proposals envision that the problem countries must adopt market-oriented structural reforms along the lines of those outlined in the Baker Initiative in order to qualify for debt relief. But even the most far-reaching of these proposals offers relatively little in the way of additional resources to the countries concerned. For the 15 heavily indebted countries, the debt relief envisioned under these proposals amounts to less than 4 percent of the country’s exports of goods and services and less than 1 percent of the country’s GDP, and for no country would the proposed relief exceed 6 percent of the country’s exports of goods and services. It is therefore hard to see that debt relief, by itself, will put countries back on the path to long-term sustainable growth.

If countries are, in any event, to take the market-oriented policy measures envisioned under the Baker Initiative (and under the proposals for debt relief), countries will also find it in their long-term interest to agree to market-related terms and conditions on any new money that they receive from the world capital market. This will assure that these countries have sustained access to the world capital markets, just as the developing countries without debt-servicing difficulties continue to have (see Table 3).

Pricing is only one part of what is meant by market terms and conditions. In fact, this concept represents a broad menu of possible programs. Some are designed to improve the balance sheet of the troubled debtor nation by bringing more equity investment into the country, either from foreigners or domestic residents repatriating capital held abroad. Others are designed to channel credit to the private sector and to support structural reform efforts. The mechanisms by which these programs are implemented can be as varied as the programs themselves. Debt-equity swaps, the creation of mutual funds, and on-lending to private enterprises can be valuable tools in promoting a market-related environment.

As countries adopt market-driven strategies, there will be clear improvements in the investment climate. More investors, both domestic and foreign, will be attracted by investment opportunities, and greater investment flows will be channeled into the economy. This will ease the country’s debt burden by reducing its dependence on debt finance today and by improving its income-producing potential in the years to come. Both of these developments would make it possible, in our opinion, to conclude debt reschedulings and new money packages at lower spreads.

Some examples of the gains from market-driven programs are striking. Canada, for example, has traditionally relied on external capital to supplement its domestic savings. In fact, Canada has about the same reliance on external capital relative to GDP as Argentina, Brazil, and Mexico. However, Canada’s policies have created an environment more conducive to investment and capital inflow throughout most of its modern history. As a result, Canada has funded its external balance sheet primarily through equity and securities, while Argentina, Brazil, and Mexico have relied heavily on bank debt.

If countries opt for the concessional school of thought, and the associated confrontational attitudes, it is safe to say that they can expect little or no new capital from private sources, especially commercial banks. The little they may attract from private sources would be very expensive. Private investors have a full range of investment opportunities; they have no reason to put their funds where they cannot expect to receive a market rate of return and where repayment is in serious question. That is particularly true for commercial banks, which are only intermediaries between borrowers and depositors from whom the banks themselves borrow money.

Furthermore, if countries opt for the concessional school, it is likely that they will have to depend, at least for a number of years, to a significant degree on official sources of foreign capital to supplement whatever internal savings their economies may generate. How large are such flows likely to be? It is worth noting that during the last four years (1982-86) the large troubled debtors almost doubled their share of net new official credit, and they received over half of the increase in net new official credit supplied to developing countries (see Table 5). Even so, this much larger share of official capital has been meager. During the height of the debt problem (1982-86), large troubled debtor nations received official credits amounting on average to 1. 1 percent of their GDP. Earlier (1978-81), these countries had received annual credit inflows amounting to 6 percent of their GDP. Even today countries without debt-servicing difficulties receive total annual credit inflows amounting on average to 2. 8 percent of their GDP, or two and one-half times as much as the large troubled debtor nations have been receiving from official sources (see Table 5). Clearly, returning to the world capital markets holds out prospects for greater inflows of resources from abroad and for faster economic growth.

Furthermore, there is no guarantee that the large troubled debtor nations will be able to continue to secure such a large share of the official credit given to developing countries, or that official credit will continue to expand at the same rate it has in the past. There is considerable political competition for the resources of official organizations. For example, there are many contenders for the official credit currently available, and a strong case has been made that a greater share of official credit and aid should be given to the truly needy African countries rather than to the relatively well-to-do problem debtor nations.

Table 5.Analysis of Official Credit to Developing Countries, 1978-86
FifteenAll CountriesCountries
Heavilywithwithout
IndebtedDebt-ServicingDebt-Servicing
Countries1ProblemsProblems
Net new official credit2
(in billions of U.S. dollars)
1978-8215.848.041.2
1982-8646.289.556.3
Share of net new official
credit (in percent)
1978-8217.753.846.2
1982-3630.458.837.0
Net change in long-term
borrowing from official
creditors as percent of GDP
1978-810.71.41.2
1982-861.11.81.1
Total net external
borrowing as percent of GDP
1978-816.05.72.8
1982-862.35.92.8
Source: International Monetary Fund, World Economic Outlook, October 1986.

There is also considerable internal political competition for funds that provide the source of official credit—that is, taxes in industrial countries. In most industrial countries the capital contributions for the entities that grant official credit must be appropriated by the legislature. That puts the Fund, the World Bank, and other multilateral development banks into direct competition with domestic constituencies for health care, unemployment benefits, military expenditures, farm aid, and industrial programs, particularly programs for declining industries that might be harmed by greater exports from the countries to which official credit often is granted. That battle has proven to be a losing one for the proponents of more official credit to developing countries.

Thus, staking one’s economic future on the ability to attract official inflows of capital seems a hazardous proposition. If countries are to take the market-oriented policy measures needed to qualify for debt concessions under the proposals made to date, then it would seem in their long-term self-interest to incorporate market-related terms and conditions into their debt reschedulings and new money packages. That is the way back to the world capital market, and that is the way toward long-term sustainable growth.

Conclusion

We are at an important turning point in the resolution of the debt problem with developing countries. We must choose whether we are going to permit the financial disciplines transmitted by the banking system to run their course and restore corrective action or whether these disciplines are to be temporarily avoided by support for concessional lending and slow progress on fundamental economic reforms.

In our view, banks are intermediaries between savers and debtors. Banks borrow from savers and relend to debtors. Savers provide funds to banks, but on terms and conditions that are beyond the control of banks. The reality is that savers will not provide significant amounts of funds to banks, unless borrowers from banks also meet market terms and conditions. Consequently, it is the role of the world capital market to bring pressure to bear on any borrower—be it a domestic manufacturer or a troubled debtor nation—when the borrower takes steps that will jeopardize its ability to service its debt in a timely fashion. This pressure usually takes the form of refusing to lend, unless and until the borrower takes the steps necessary to restore its creditworthiness. Thus, the pressures transmitted by the world capital market should be viewed as part of the recovery process that will induce countries to take the steps necessary to get back on the path to long-term sustainable growth. In this sense, the role banks play by not lending when conditions are wrong is as important as the role that banks play by lending when conditions are right.

We believe the principles set forth in the Baker Initiative are sound. We also believe that banks and other private sources will provide capital to troubled debtor nations as long as countries adopt market-oriented policies and as long as countries adapt to the conditions imposed by the world financial markets. Banks stand ready, willing, and able to help debtor countries cultivate access to these markets, but banks cannot change the fundamental conditions demanded by these markets, for banks themselves are ultimately subject to the discipline of these same markets. Debtor countries must recognize this, if they wish to enlist bank support in restoring and sustaining the high rates of economic growth they need and deserve.

International Monetary Fund, World Economic Outlook (Washington: International Monetary Fund, October 1986), p. 87. These figures refer to the net external borrowing of capital importing developing countries from official and nonofficial sources, as derived from the borrowing country’s current account balance. The data cover the period 1978-80. The total borrowing from official and nonofficial sources adds to more than 100 percent since countries built up reserves during these years.

International Monetary Fund, World Economic Outlook, April 1987, p. 110. Figures in this paper and the tables have been updated following the publication of the April 1987 World Economic Outlook.

Much of this can be traced to import substitution policies that were started decades earlier. These policies led to protected markets that stymied domestic competition and encouraged the rise of large, inefficient, government-dominated industrial sectors that could not compete on world markets.

In other relevant categories, however, the two sets of countries were not significantly different. Their rates of real economic growth were about the same; the prices of their non-oil commodity exports grew at about the same rate; and the gross rate of capital formation was only slightly lower in the countries with debt-servicing problems (seeTable 1).

In contrast, countries that did not subsequently have debt-servicing problems went into the global recession in a stronger position and reacted quickly to the changed international environment. They allowed their ratio of debt to income to rise only modestly, so that their interest burden remained relatively manageable (see Table 1).

Countries included in the Baker Initiative are Argentina, Bolivia, Brazil, Chile, Colombia, Côte d’Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, Philippines, Uruguay, Venezuela, and Yugoslavia. Together, these countries account for over 70 percent of the debt of the 65 countries with recent debt-servicing problems.

Much of this work is done by subcommittees that focus on particular aspects of a deal. For example, the economic subcommittees evaluate the economic data supplied by the debtor government to the banks, brief the banks on developments in the country’s economy and on changes proposed for the country’s economic policies, and work closely with economists from the Bretton Woods Institutions, the debtor country government, and the creditor country governments to provide input into policy decisions by the debtor country government. Depending on the individual country and negotiation, there are also subcommittees that focus on trade financing, cofinancing (with the World Bank), interbank lines, and other matters. These subcommittees have worked to maintain critical short-term financing and to develop a wider menu of financing options. As are the committees themselves, the subcommittees of each committee are comprised of many different banks from a number of different countries.

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