I Overview of Developments and Key Issues
- International Monetary Fund
- Published Date:
- January 1986
This study provides a description and analysis of recent developments in international capital markets and an assessment of the prospects for private financing flows. It focuses particularly on recent trends in liberalization and innovation in international financial markets, including relevant changes in supervision, and on developments in the debt situation, especially the factors that influence flows to developing countries. As with previous studies on international capital markets, it does not address in detail questions related to concessional assistance or medium-term issues affecting the world economy. A discussion of the principal findings that have emerged from studies in the Fund setting out broad scenarios of how the world economy could evolve over the next few years is contained in the 1986 World Economic Outlook.1
Economic and Financial Environment
Developments in lending through international capital markets during 1985–86 have been primarily influenced by the financing requirements of industrial countries2 and the decline in international interest rates. In addition to these macroeconomic influences, international capital markets have been affected by the continuing wave of liberalization and innovation occurring in both domestic and international capital markets of the major financial centers.
The combined current account deficits of industrial countries rose further during 1985 and 1986, reaching an estimated $147 billion in 1986 (Table 1). Over 80 percent of these deficits are attributed to the current account deficits of the United States. The combined current account deficits of capital importing developing countries declined to $75 billion in 1985. However, during 1986, these countries’ current account deficits are estimated to have risen to $97 billion, largely reflecting the impact of lower oil prices.
|Total of identified current account deficits1||154||176||174||168||205||213||244|
|Of which: Seven major||33||16||18||51||110||122||128|
|Overall current account balances of capital importing developing countries1||-78||-113||-104||-63||-37||-40||-54|
|Reserve accumulation of capital importing developing countries2 (accumulation +)||18.9||-3.5||-17.8||9.1||20.2||2.9||1.8|
|Growth rate in value of world trade||21.6||-0.5||-6.3||-1.9||6.1||1.1||9.6|
|Growth rate of real GNP of industrial countries||1.2||1.4||-0.4||2.6||4.8||3.0||2.7|
|Inflation rate of industrial countries (GNP deflators)||9.3||8.8||7.2||4.9||4.2||3.8||3.3|
|Interest rates (six-month Eurodollar deposit rate)||14.0||16.7||13.6||9.9||11.3||8.6||6.8|
The pattern of current account imbalances among industrial countries, which have well-developed securities markets, has been a major factor in the shift of international financial flows toward international bond markets and away from the bank credit market. This shift would be even more apparent if foreign purchases in domestic bond markets were also incorporated. The sectoral distribution of investment and savings has resulted in deficits among borrowers with access to securities and in surpluses among savers with a desire to purchase such instruments. The financing requirements of the U.S. fiscal deficit have been partly satisfied by large foreign purchases of U.S. Government securities which are largely unrecorded in the data on borrowing in international capital markets; nonfinancial corporations in the United States have also borrowed heavily in international capital markets.
Activity in international bond markets has also been stimulated by the decline in interest rates, especially long-term interest rates. Nominal short-term interest rates fell significantly in several of the major industrial countries during 1985 and the first three quarters of 1986, with rates falling more in the United States than in the other major industrial countries (Chart 1). In most industrial countries, nominal short-term interest rates in the third quarter of 1986 were at their lowest levels since at least 1978. Nominal long-term interest rates also declined sharply, especially in the United States. In international markets, the London interbank offered rate (LIBOR) for U.S. dollar-denominated deposits declined by more than 3 percentage points from the end of 1984 to 6¾ percent during the third quarter of 1986. The sharp decline in interest rates and corresponding capital gains have encouraged the growth in gross new issues of international bonds. In some cases, new issues have been utilized to prepay existing debt—bank and bond—in order to take advantage of lower costs; during 1985–86, early redemptions of bonds reached record levels.
Chart 1.Five Major Industrial Countries: Nominal Interest Rates, 1978-September 1986
Sources: World Economic Outlook, October 1986: Revised Projections by the Staff of the International Monetary Fund; and Fund staff estimates.
1 Monthly averages of daily rates on money market instruments of about 90 days’ maturity.
2 France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States.
3 Monthly averages of daily or weekly yields on government bonds, with maturities ranging from 7 years for Japan to 20 years for the United Kingdom and the United States.
The overall current account position of capital importing developing countries strengthened from a deficit of $113 billion in 1981 (19 percent of exports) to a deficit of $40 billion (4 percent of exports) in 1985 as a result of strong adjustment efforts associated with tight external financing constraints. Nondebt-creating flows plus net disbursements from official sources totaled $48 billion in 1985. As a result, the current account deficits of these countries were more than covered by financing from sources other than international capital markets. However, in 1986, while nondebt-creating flows are estimated to continue at about $49 billion, the current account deficit of capital importing developing countries is estimated to increase to $54 billion, resulting in a much tighter financing situation than in 1985, especially for fuel exporting developing countries.
Recent Trends in International Capital Markets
There was a rapid increase in total net lending through international bank credit3 and bond markets4 during 1985 and the first half of 1986 (Table 2 and Chart 2). This increase has also been accompanied by a continuing shift toward reliance on bond markets to finance these flows. Bond markets accounted for approximately 43 percent of net bond and bank lending (net of interbank redepositing) during this period, compared with 13 percent in 1980–81. 5 The sharply differentiated pattern of surpluses and deficits among the industrial countries contributed to a continuing high level of activity in international bond markets and to substantial foreign purchases of domestic securities which are not recorded in these statistics. Savers and investors in industrial countries have exhibited a preference for tradable assets, and they have increasingly channeled funds through securities markets rather than through banks to intermediate flows. Associated with the growth in securities transactions has been an expansion of interbank lending within the industrial country group. In contrast, the reduced external financing of capital importing developing countries has been largely met through sources other than international capital markets.
Chart 2.Growth Rate of International Bank Claims, 1976–86
Sources: Bank for International Settlements, International Banking and Financial Market Developments and Annual Report; International Monetary Fund, International Financial Statistics; and Fund staff estimates.
1 These data do not net out interbank redepositing.
2 Twelve months to June.
|International lending through banks and bond markets|
|BIS-based (gross) 3||260||294||230||152||187||308||147|
|BIS-based (net of redepositing) 3||179||194||144||131||152||181||101|
|Bond issues (net) 4||19||29||49||46||62||76||46|
|Bank lending1, 2|
|BIS-based (net of redepositing)||160||165||95||85||90||105||55|
|International lending to industrial countries|
|BIS-based (gross) 3||192||221||180||106||147||247||122|
|BIS-based (net) 3||111||121||94||87||113||120||74|
|Bond issues (net) 4||15||22||39||36||51||62||40|
|International lending to developing countries5|
|Bond issues (net) 3, 4||1||2||3||2||3||6||2|
|Total gross bond issues||38||52||76||77||110||166||109|
Lending to Industrial Countries
Total net lending to industrial countries through international bank credit and bond markets continued to rise during 1985 and the first half of 1986, primarily because of interbank activity among industrial countries. Bank lending to industrial countries continued the upswing begun in 1984 and was dominated by an expansion in interbank claims, which accounted for 84 percent of lending. The major destinations of interbank lending were the principal financial centers, where a high proportion of world securities market transactions took place. Banks in the United States borrowed $33 billion in 1985 from international banks, while such lending to Japan and the United Kingdom in 1985 totaled $42 billion and $41 billion, respectively. During the first half of 1986, residents in the United States borrowed $13 billion through the interbank market; such borrowing in Japan and the United Kingdom amounted to $32 billion and $8 billion, respectively.
A number of factors may account for these developments. One factor was the funding by bank head offices of increases in trading portfolios held by branches and subsidiaries located in major financial centers. Another factor was the further integration of Japanese financial markets into the international financial system, one aspect of which was the high level of interbank flows in and out of Japan.
Lending to nonbanks in industrial countries increased in 1985 and in the first half of 1986. Such lending totaled $28 billion in 1985, only about half of its level in 1982, but reached $20 billion in the first half of 1986. Nonbanks in the United States accounted for 70 percent of the total during 1985 and the first half of 1986. Overall, bank and nonbank borrowers in the United States increased their liabilities to banks by $54 billion in 1985 and by an additional $25 billion during the first half of 1986.
Gross international bond issues by borrowers from industrial countries expanded to an annualized level of $205 billion during the first three quarters of 1986 from $136 billion in 1985 (Chart 3). Refinancing activity in the international bond market increased markedly to $29 billion in 1986 from $19 billion in 1985 and $3 billion in 1984 as borrowers exercised call provisions in view of the sharp decline in interest rates and margins. Refinancing activity at an annualized rate slackened somewhat during the first three quarters of 1986, as the downward drift in interest rates moderated. Despite the volume of refinancing, net international bond issues (gross issues adjusted for refinancing and scheduled amortization) reached record levels during 1985–86, rising to $131 billion in 1985 and still further to $170 billion at an annualized rate during the first three quarters of 1986.
Chart 3.Gross International Bond Issues, 1976–86
Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.
1First three quarters of 1986 on an annualized basis.
An important impetus for the expansion of activity in international bond markets has been the continuing growth in bond issues associated with medium-term currency and interest rate swaps, which allowed borrowers to tap markets where their names enjoyed a scarcity value. The volume of interest rate swaps rose to an annualized flow of $113 billion during the first half of 1986 from $85 billion in 1985, while currency swaps associated with primary issues increased to an annualized amount of $46 billion during the first half of 1986 from $20 billion in 1985. These instruments have enabled borrowers to utilize markets in certain currencies (e.g., Japanese yen, Australian dollars, and New Zealand dollars) to a greater extent and have been a major factor accounting for the increased share of non-U.S.-dollar-denominated bond issues since 1984.
The increase in the swap market has been complemented by an expansion of the futures and options markets. These short-term hedging and arbitrage instruments have increased the scope for banks and nonbanks to cover financial risks associated with fluctuations in exchange and interest rates. The ability to hedge risks associated with holding securities has been a factor encouraging the growth of the securities markets.
One of the major developments in 1986 has been the expansion and evolution of international commercial paper programs. The annualized level of such nonunderwritten facilities totaled $52 billion during the first three quarters of 1986, compared with $16 billion in 1985 and less than $1 billion in 1984. At the same time, the volume of underwritten facilities for the issuance of short-term notes fell from $33 billion in 1985 to an annualized rate of $16 billion during the first three quarters of 1986. In addition, commercial paper programs were introduced in several industrial country markets.
A common reason underlying the growth of all types of securities markets has been banks’ preference for acquiring tradable assets and issuing longer-maturity liabilities. The estimated total holding of international bonds and other long-term securities by banks rose to $158 billion in 1985 from $100 billion in 1984. Banks are estimated to have purchased approximately an additional $70 billion of international bonds in 1986. Banks also held a substantial proportion of short-term notes issued, especially those of sovereign borrowers. During 1985–86, banks have issued an estimated $35 billion of floating rate notes on international markets, or 60 percent of such notes. Banks’ increased preference for longer-maturity liabilities may be due in part to the inclusion of bond issues by banks in primary capital for supervisory purposes in some countries, under certain conditions.
Banks and securities houses have also attributed the expansion of commercial paper and other securities market activities to a disintermediation of credit flows to nonbanks. This disintermediation reflected a strong interest among international investors for securities issued by nonbanks with a high credit standing (in part, this trend was related to persisting concerns about the quality of bank balance sheets) and the relatively low cost of direct borrowing through the securities markets. More generally, the deepening and integration of securities markets and the continuation of financial imbalances among the industrial countries have favored a diversification of portfolios away from bank deposits and toward a wide range of financial market assets.
Developing Countries as International Borrowers and Depositors6
The net increase in bank claims on developing countries continued to slow during 1985, and net repayments to banks occurred during the first half of 1986 (Table 2 and Chart 2). Bank lending to developing countries was only $9 billion during 1985 (a growth rate of less than 2 percent, based on banks’ total claims on developing countries of $555 billion at the end of 1984). During the first half of 1986, there were net repayments of $7 billion, spread across all regions of developing countries except Europe. The 15 heavily indebted countries repaid banks $3 billion net during the first half of 1986 after net repayments of $2 billion in 1985.
These data on claims understate actual bank flows to developing countries because of, inter alia, unrecorded bank purchases of bonds, the exercise of guarantees, and write-offs of bank claims. However, the provision of new official export credit guarantees covered a significant part of the increase in bank claims on developing countries in 1985; data for 1986 are not yet available. After allowing for these offsetting factors, banks’ underlying risk exposure to developing countries is estimated to have increased in 1985 by 1½ to 2½ percent, relative to banks’ unguaranteed claims. In the first half of 1986, it appears likely that underlying bank exposure declined, after allowing for risk transfers. Because reliable regional information is not available, flow figures in the remainder of this study have not been adjusted for write-offs, unidentified bond purchases, or guarantees.
The regional pattern of bank lending to developing countries became still more differentiated during 1985–86, regarding both sources and uses of funds. Spontaneous bank lending to developing countries was mainly accounted for by lending to countries in Asia and Europe that had not restructured their debt. The small decrease in claims on developing countries in the Western Hemisphere occurred notwithstanding concerted lending. Africa received little net bank financing, and there was a continued withdrawal from the Middle East.
Disbursements under concerted lending packages declined sharply in 1985 and 1986;7 during the first three quarters of 1986, such disbursements totaled $1.7 billion, compared with $5.4 billion in 1985 and $10.4 billion in 1984. Over 90 percent, or $6.5 billion, of these disbursements during 1985–86 went to six countries in the Western Hemisphere (Argentina, Chile, Costa Rica, Ecuador, Mexico, and Panama); the remainder was directed to Côte d’Ivoire and the Philippines.
Total publicized long-term bank credit commitments to developing countries (including an agreement in principle of $7.7 billion with Mexico in late September 1986) increased to $20 billion during the first three quarters of 1986 from $18 billion in 1985 (Chart 4). 8 An encouraging feature of developments in 1985–86 was the resumption of spontaneous bank commitments for certain countries that had previously raised financing on a concerted basis. A lending package, cofinanced with the World Bank, was arranged by a limited group of banks for Côte d’Ivoire in 1985, while similar packages were agreed in 1986 for Uruguay (also including a cofinancing) and Ecuador. However, commitments under concerted packages continued to account for a sizable proportion of new commitments. Concerted packages totaled $10 billion in 1985 and the first nine months of 1986, compared with $16½ billion in 1984. In 1985, such packages were arranged for Chile, Colombia, Costa Rica, and Panama; only one such concerted lending package was announced during the first nine months of 1986 (for Mexico in September); this package involved a substantial new commitment and certain innovative features.
Chart 4.Bond Issues and Long-Term Commitments of Credits and Facilities to Capital Importing Developing Countries, 1981–86
Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly; and Fund staff estimates.
1 Includes a facility arranged for Mexico.
2 First three quarters of 1986 on an annualized basis.
International Capital Markets: Developments and Prospects, December 1986:
On page 45, line 5 should read “$5 billion were made by developing countries…”
The following chart should be inserted to replace Chart 4 on page 7.
In September 1986, the bank advisory committee for Mexico reached agreement in principle on a financial package, covering 1986–87, consisting of new money facilities and a restructuring of existing external bank debt. In a departure from previous concerted packages, three elements were incorporated in the new money facility: a loan for $6 billion, of which $1 billion would be cofinanced with the World Bank and half of the cofinancing would have a World Bank guarantee; a contingent loan of $1.2 billion to support public and private sector investment; and a contingent loan of $0.5 billion to support economic growth—this loan would also be cofinanced with the World Bank and half of the loan would be guaranteed by the World Bank. In addition, amortization payments on about $44 billion of previously restructured debt would be stretched out to 20 years with a grace period of 7 years. The spread on all elements of this financial package would be 13/16 of a percentage point over LIBOR or domestic cost of funds.
The trend toward lower spreads on bank loans to developing countries continued in 1985 and during the first three quarters of 1986, while the decline in international interest rates also helped to reduce borrowing costs (Chart 5). A further lowering of spreads and lengthening of maturities was evident in bank debt restructuring agreements, and banks negotiated additional multiyear restructuring agreements (MYRAs), including the first MYRA in Africa (for Côte d’Ivoire). The amounts of bank debt restructured in agreements signed or reached in principle, excluding short-term debt rolled over, are estimated at $13 billion for nine developing countries in 1985. During the first three quarters of 1986, additional restructuring agreements were reached with six countries for a total of $55½ billion.
Chart 5.Terms on International Bank Lending Commitments, 1976-Third Quarter 1986
Sources: Organization for Economic Cooperation and Development, Financial Market Trends; U.S. Federal Reserve System, Federal Reserve Bulletin; International Monetary Fund, International Financial Statistics; and Fund staff estimates.
1 New publicized long-term international bank credit commitments.
Gross international bond issues by developing countries during the first three quarters of 1986 declined to $6 billion at an annualized rate after having doubled in 1985 to $10 billion. The number of developing countries borrowing in international bond markets fell to 18 during the first three quarters of 1986 from 22 in 1985. Several developing countries (e.g., Algeria, Malaysia, South Africa, and Thailand) sharply reduced, or eliminated, their bond issues during 1986. These countries issued only $0.1 billion worth of bonds during the first three quarters of 1986, compared with $4.1 billion in 1985. Bond issues by developing countries were highly concentrated during 1985–86, with 8 developing countries from Asia and Europe accounting for 80 percent of the total value of such issues. Over 60 percent of the bonds issued by developing countries were in the form of floating rate notes; these bonds may have largely been purchased by banks and, in many cases, may not have been reported as bank lending to developing countries. During the first three quarters of 1986, developing country borrowers also arranged note issuance facilities at an annualized rate of $1.3 billion, compared with a total of $1.5 billion in 1985. Purchases of notes under these facilities by banks may also have been omitted from reports of some banks’ exposure to developing countries.
Developments in Bank Exposure
Lending to developing countries also varied significantly among banks of different nationalities. During the first six months of 1986, U.S. banks’ claims on developing countries fell by 13 percent (at an annualized rate) after a decline of 8½ percent in 1985, although nearly 2 percentage points of the decline in 1985 were due to a sale of claims by one U.S. bank to a bank in the United Kingdom. U.S. banks have reduced their claims on developing countries in all regions since the end of 1984. U.K. banks’ claims on developing countries also declined in U.S. dollar terms in 1985, but this decline was wholly due to a statistical break in the data for South Africa. Excluding U.K. banks’ claims on South Africa, U.K. banks’ claims on developing countries rose by about 1 percent in U.S. dollar terms. U.K. banks increased their claims on developing countries in all regions, except for the Western Hemisphere.
Although detailed geographical data are not available on other countries, it can be inferred that the rise in total lending stemmed principally from Japanese banks, whose lending offset the drop in U.S. bank claims, especially in Asia. German banks may also have increased modestly their claims on developing countries in Europe and Asia in 1985, while in the first half of 1986 lending was recorded only to developing countries in Europe.
There has been a widespread strengthening of banks’ balance sheets since 1982, achieved in some cases mainly through a continued buildup in capital and reinforced in other cases by increased provisioning. In the United States, there was a significant increase of capital in relation to banks’ developing country claims (from 50 percent of exposure in 1982 to 80 percent in 1985) (Chart 6). For banks outside the United States, the recent sharp decline in the U.S. dollar has helped to diminish exposure relative to capital and reserves. Thus, the exposure to developing countries of banks in industrial countries, relative to their capital and reserves, has decreased considerably. However, banks’ off-balance sheet risks have increased, and the new capital raised has not all been of the same quality, especially where it has taken the form of loan capital, held at times by other banks. Moreover, provisioning levels have been uneven, varying substantially between countries and also among banks within individual countries. While significant strengthening has been achieved, the banking system would remain vulnerable to a widespread deterioration in payments relations.
Chart 6.Selected Balance Sheet Data for U.S. Banks, 1977-First Half 1986
Source: Federal Financial Institutions Examination Council, Country Exposure Lending Survey.
Depositing with Banks
Developing countries’ bank deposits declined by $18 billion during the first half of 1986, after having increased by $24 billion during 1985. Interbank depositing rose slightly during 1985, reflecting primarily a slowdown in accumulation of official reserves, and fell by $15 billion during the first half of 1986, as official reserves were reduced. Deposit taking from nonbanks in developing countries rose to $21 billion in 1985, perhaps indicating some increase in capital flight; during the first half of 1986, however, nonbanks from developing countries reduced their deposits with international banks by $3 billion.
There are considerable difficulties in assessing, or even defining, capital flight. A number of recent studies have indicated that the external position of several major borrowing countries has been weakened by large outflows of private capital. There are significant methodological shortcomings in these studies, and they do not provide adequate guides to the dimensions of capital flight. Although the estimates in these studies show substantial differences in annual and cumulative flows, some common features in the studies have attracted attention in the banking community. In particular, cumulative private capital outflows estimated for certain developing countries were observed to be significant in relation to their outstanding bank debt, while in some other countries such cumulative flows were seen to be a relatively small proportion of total bank debt. Given the general shortage of foreign savings, repatriation of flight capital could be an important source of external flows.
In discussions with the authors, banks suggested that capital flight in the aggregate for developing countries had declined since 1982–83 because of an improvement in domestic policies and a shortage of foreign exchange. They stressed the need for developing countries to tackle the problem of capital flight and insisted that their willingness to lend would be influenced strongly by action in this area, reflecting a concern that additional bank lending might finance further capital flight. This worry has heightened banks’ desire to link their lending to the pursuit by developing countries of appropriate fiscal, monetary, interest, and exchange rate policies to provide incentives for domestic savings to be invested at home.
Changes in Financial Markets
The rapid pace of change in financial markets arising from liberalization and the spread of innovative financing techniques, described in the previous study on international capital markets, 9 continued during 1985–86, increasing the integration of major financial centers and diminishing the segmentation within various sectors of domestic markets. Liberalization or deregulation in some industrial countries has been prompted by official policy in order to introduce greater competition into domestic financial markets to promote efficiency and to increase international access to domestic financial institutions. Moreover, the expanding Euromarkets have led to competitive pressures in financial markets and permitted certain restrictions on domestic financial activities to be bypassed. Many of the new financial innovations initially were designed as a response to tax or regulatory measures, but the more enduring instruments have affected the financial structure in a more fundamental manner. Some key developments in this continuing process are identified and their policy implications discussed in this section.
Recent Structural Developments
Liberalization has been carried further in several major financial markets. In France, the Euro-French franc bond market was reopened, with foreign banks permitted to be co-lead underwriters, and exchange controls were relaxed; competition among banks was encouraged in the bond market; currency swaps, financial futures, and convertible issues were authorized; and commercial paper and negotiable certificates of deposits were introduced in the domestic market. In the Federal Republic of Germany, new financing techniques were permitted as of May 1985 (e.g., floating rate notes, zero coupon bonds, dual currency bonds, and currency swaps) and the calendar system for new issues was reformed. On a reciprocal basis, foreign banks with subsidiaries in Germany were also permitted to lead-manage deutsche mark bond issues. Since June 1986, domestic subsidiaries of foreign banks may join the German Government’s bond issuing syndicate. Issuance of negotiable certificates of deposit was authorized as of May 1, 1986.
In Japan, the spectrum of domestic money market instruments was broadened in 1985 and 1986 with the introduction of money market certificates, bankers’ acceptances, and publicly auctioned short-term government refinancing bonds (treasury bills). Conditions applicable to certificates of deposit were further liberalized. In early 1986, legislation was passed to allow the opening of an offshore banking market in Tokyo. Institutional separation of banking and securities market activities has also been lessened as banks have been permitted to deal in government bonds in the domestic market since June 1984. A number of further measures were implemented to liberalize access to and instruments available in the Euro-yen bond market. Foreign financial institutions have been permitted to begin trust banking operations and to become members of the Tokyo Stock Exchange.
In the United Kingdom, a major reform of the Stock Exchange was undertaken in October 1986, involving liberalization of ownership rules pertaining to Stock Exchange firms, the abolishment of minimum commissions, and the introduction of dual-capacity trading. A comprehensive regulatory regime for the financial services industry was introduced, aimed at ensuring that the system remained sound and at increasing investor protection. The structure of the gilt-edged securities market has also been reorganized substantially. A sterling commercial paper market was established in May 1986. In the United States, geographical segmentation of banking markets has continued to lessen.
Liberalization measures were implemented in a number of other national financial markets. The segmentation of financial markets has continued to erode, as leading financial institutions have become established in each of the major domestic financial markets.
During 1985–86, use of the new financing instruments discussed in the previous study on international capital markets has expanded and has been extended to new markets. The volume of medium-term currency and interest rate swaps has expanded sharply, partly accounting for the buoyancy of international bond markets. Options and futures markets have grown, and a wider range of participants have taken advantage of the hedging opportunities available. The use of securities to intermediate savings has continued to expand. The issuance of short-term paper in the Euromarkets, previously mainly underwritten by banks, has developed into a nonunderwritten commercial paper market, and commercial paper programs are being introduced in some domestic capital markets in Europe.
Liberalization and innovation have tended to increase the efficiency of capital markets in three ways. First, intermediation costs have been sharply reduced by the substitution for bank credits of direct transactions in securities, by reduced commissions, and by increased competition. Second, new instruments have facilitated arbitrage between markets in different countries and between different instruments. Swaps have been particularly effective in arbitraging differences between markets in the cost of loan funds to individual borrowers. Recently, first signs have been emerging of an international equity market, which may narrow differences between markets in the cost of equity capital. Third, it has become possible to hedge exposure to risks associated with fluctuations in exchange rates and interest rates through a variety of techniques and over a longer maturity period, thus achieving a wider sharing of risk among market participants.
Issues Raised by Recent Developments
Many of the issues raised by recent market developments were discussed in a report prepared by a study group established by the central banks of the Group of Ten, under the chairmanship of Sam Y. Cross, Senior Vice President of the Federal Reserve Bank of New York. 10 The Cross Report noted that innovations have improved the efficiency of international financial markets but cited a number of concerns relating to the implications of innovation for macro-prudential policy, for the interpretation of financial conditions, and for the timing and incidence of monetary policy. Several dangers in the securitization process were mentioned, including a lowering in the quality of banks’ loan portfolios due to the sale of higher-quality assets and a possible decline in the ability of banks to meet sudden liquidity needs as the share of flows through securities markets expands. Market participants and country authorities have found this comprehensive survey most valuable in identifying potential areas of concern.
A key attribute of effectively functioning financial markets is the appropriate allocation of savings based on risk-adjusted rates of return. New instruments have allowed various risks to be unbundled, separately priced, and sold to new portfolios. This process has made it possible to distribute these instruments and their associated risks more widely through the financial system and to nonbanks. To the extent that such risks are priced properly, they can help financial markets to allocate resources more efficiently. A major issue is whether risks are indeed adequately priced. Some market participants and supervisors have expressed concern that the pricing of new instruments, especially swaps and note issuance facilities, may not also fully reflect the associated credit risks but may instead be influenced by efforts to gain market share. The proper market pricing of credit risk becomes increasingly important as the share of savings flowing through these markets grows relative to the share of savings flowing through the banking sector. Bankers raised the concern that traders may not rely on their own in-depth credit analysis to make portfolio decisions, but rather may depend on credit assessments performed elsewhere and also view the marketability of assets as implying that there is less need for credit analysis.
An important potential aspect of the efficient allocation of savings would be greater access by developing countries to innovative techniques that reduce borrowing costs, hedge risks, and tap new sources of foreign savings (e.g., medium-term swaps, financial options, tradable assets). Approximately 27 developing countries have tapped the international bond market in 1985 and the first three quarters of 1986, with more than half of these countries also using note issuance facilities. In a few cases, swaps have been employed to lower borrowing costs. Market participants stressed that access to such instruments depended on the borrower enjoying a very high credit standing. In addition to these examples of direct access to capital markets by developing countries, the World Bank has been an important avenue of indirect access, especially with regard to innovative techniques.
The greater marketability of assets may at times cause financial institutions to overestimate the liquidity of assets, especially if market conditions were adverse. However, the availability of new instruments has facilitated banks’ efforts to lengthen the maturity of their liabilities on advantageous terms, for example, through the swapping of issues of fixed rate bonds into floating rate debt. The risk of liquidity strains in the interbank market has been diminished by banks’ efforts over the past several years to monitor their interbank positions more closely, and to make more selective placements, as well as by the successful containment of banking disturbances in several industrial country markets. Nevertheless, banks are aware that the interbank market remains a sensitive transmission mechanism for financial strains. Overall, the liquidity of international markets remains an area where considerable vigilance appears justified.
Monetary authorities have expressed a concern that liberalization and innovation may be changing the transmission of financial impulses to the domestic economy and to the international economy. Innovations, such as swaps, and international liberalization measures have tended to integrate national financial markets more closely, increasing the sensitivity of capital flows to interest rate differentials and exchange rate movements. Greater financial integration may alter the transmission mechanism for monetary policy by increasing the responsiveness of exchange rates—relative to domestic interest rates—to monetary policy and by shifting its impact from interest rate sensitive sectors, such as housing and capital goods, to the tradable goods sector. Uncertainty concerning the impact of these changes on the transmission mechanism and on the measurement of monetary aggregates was cited as a potential problem.
A crucial characteristic of an effective market is resilience to external shocks. The widespread application of new communications and computer technology to financial transactions has permitted markets to react more quickly and to process a significantly larger volume of transactions. While the ability to process information has increased, recent innovations may have reduced the quality of information available to prudential and monetary authorities because transparency in financial markets has been reduced considerably. These developments have also made financial markets more vulnerable to equipment and transactions failure as evidenced by the problems at the Bank of New York in November 1985.
Opinions differ about the degree of concern that is warranted by the recent pace of structural change. Nonetheless, the concerns that do exist can be addressed by official actions, although the appropriate form and scope of those actions remain a topic for discussion. Structural changes in financial markets thus have implications for the supervisory agencies, monetary authorities, and the Fund, pertaining to the soundness of financial institutions, the allocation of resources, and the coordination of macroeconomic policies.
In recent years, markets have developed in areas where statistical coverage is relatively weak, such as the bond market and off-balance sheet activities of banks. Since many of the recent innovations in capital markets offer new ways of taking old risks and adapting liquidity instruments to new portfolios, the issue of transparency is arguably the central concern for monetary and supervisory authorities. This is especially true with regard to the ability of markets to withstand sharp changes in prices or perceptions of creditworthiness. Reduced transparency makes it more difficult for monetary authorities to evaluate conditions in financial markets even as the effectiveness of monetary policy is altered. While reduced transparency may represent a cost of innovation and liberalization, this cost may be highest in the short run when transparency is least and experience is limited.
These costs and risks can be diminished by effective procedures to collect information, coordinating efforts where appropriate. Efforts by supervisory authorities, and monetary institutions including the Fund, are under way to improve and broaden statistical reporting, especially of activity in bond markets and off-balance sheet transactions. Certain monetary authorities have taken measures to extend statistical reports to include data on banks’ holding of bonds. The Bank for International Settlements (BIS) is compiling information on outstanding stocks of bonds in different markets.
Regulatory authorities have also been reviewing the implications for financial market supervision in the Basle Supervisors Committee. In particular, the integration of the activities of commercial banks and other financial institutions has raised issues concerning the scope and the structure of prudential supervision. One of the major extensions in the scope of supervision has been the recent review of off-balance sheet risks. Supervisors have recently established a framework for evaluating risks associated with off-balance sheet business, and have issued a paper on this subject. 11 In some countries, capital adequacy requirements are being extended to include note issuance facilities and other types of new off-balance sheet activity.
Differences in supervisory practices may result in “regulatory arbitrage” as business is shifted to financial institutions governed by different regulatory practices. This is the case made by those who argue for a regulatory “level playing field” among financial institutions within and between countries and for an approach to supervision that applies the same rules to an activity, irrespective of the type of financial institution engaged in it. Contacts- among regulators of securities markets have intensified, focusing initially on investor protection. Regardless of the precise supervisory approach adopted, close coordination between supervisory authorities—domestically and internationally—remains crucial for maintaining the soundness of the financial system. Market discipline can also operate more effectively if the risks of contagion and financial disturbances are reduced by an environment of stable economic and financial conditions.
Recent structural changes in financial markets may also affect the conduct of macroeconomic policies. The greater degree of capital mobility associated with financial liberalization and innovation implies that while industrial countries may find it easier to finance fiscal and current account imbalances, they may find it more difficult in some cases to pursue independent monetary policies. Heightened international financial integration may also imply that the impact of policies can spread more widely and more quickly through the international community. Monetary and supervisory authorities view improved policy coordination, including a strengthening of Fund surveillance procedures, as necessary to foster more orderly conditions in financial markets and to improve global resource allocation.
Developments in the Debt Situation
The debt initiative proposed by the Secretary of the U.S. Treasury, James A. Baker III, has been welcomed by the international banking community. Banks from the major financial centers—accounting for an overwhelming majority of bank claims on the 15 heavily indebted developing countries—have indicated their willingness to play their part in implementing the strengthened debt strategy on a case-by-case basis and in collaboration with all other relevant parties, including debtor and creditor governments and the international institutions. In this context, commercial banks have indicated that their future willingness to lend to developing countries would be fundamentally influenced by developing countries’ economic policies and prospects, although at times banks may respond to changes in these policies and prospects with a considerable lag.
There were, however, significant differences in attitudes toward lending to developing countries within the banking community. These attitudes were influenced by banks’ long-term business interests, including regional trading ties and financing patterns. To the extent that banks are interested in business with developing countries, this business is largely related to trade and project lending, generally in support of the activities of industrial country clients and often benefiting from officially supported export credit guarantees. Large banks with more multinational corporate clients—and, in some cases, with significant domestic banking operations in developing countries—expressed the greatest interest in maintaining business links to developing countries. A few large banks identified as a strategic priority the development of their local banking business in selected developing countries. Differences in regulatory practices and in banks’ exposure have also affected attitudes toward lending, especially to countries that have restructured their debt.
These factors have interacted in complex ways, at times operating in a mutually reinforcing manner. In Asia, for example, these influences have, on balance, favored a growth in bank claims, reflecting the policies of developing countries in the region and strong financing ties to regional banks (e.g., Japanese), which have continued to expand their international lending.
While there is considerable diversity in bank attitudes toward lending to developing countries, there exists a continuing reluctance among banks, except to some degree among banks in Japan, to increase their exposure to developing countries in the form of balance of payments lending. The operations preferred by banks have the common characteristic that they do not result in a substantial increase in banks’ cross-border exposure and are thus not likely to be associated with a substantial transfer of resources by banks to developing countries.
Banks’ preference to shift away from balance of payments loans has been recognized in restructuring and new money agreements. These agreements have tended to include, to the extent feasible, options to match the form of these claims more closely to banks’ different interests. For example, banks have switched their claims back to the private sector and to parastatals in developing countries (via “on-lending” facilities). In addition, currency redenomination features have permitted banks, especially Japanese and Swiss banks, to hold claims in their own currencies.
Banks’ loan claims have also been transformed into longer-term investments through arrangements to convert debt to equity, although the amounts involved so far have been relatively modest. In some cases, a bank may undertake to convert its own loan claims into equity, for example, to purchase a local financial institution or to expand existing local operations. (For banks in many countries there are regulatory difficulties with equity participation in nonbanks.) In other cases, banks may assemble packages of loans and broker sales of these loans to a third party that wants to make an investment in the country, for example, a multinational company.
The divergence of banks’ interests and the diversification in banks’ claims was seen by banks as part of a long-term “healing process” that involves a normalization of creditor-debtor relations based on underlying commercial interests. The authors questioned banks on the relationship between this healing process, involving a lessening of cohesion among creditor banks, and the degree of cohesion needed for further “concerted” financing packages (that is, loans involving equiproportional increases in exposure by all existing creditor banks).
Leading banks recognized that, in order to protect existing claims and to permit desired activities to expand, there would be a continuing need in some cases for concerted lending. Banks stressed, however, that their contributions would be conditioned not only on comprehensive policy reforms in debtor countries but also on the commitment of funds by other creditors. Thus banks, while supporting the broad objectives of the U.S. debt initiative, were adopting a “wait-and-see” approach with regard to its implementation.
The conditional nature of this support for the debt strategy implies that there may be considerable operational difficulties in mustering new money packages. Banks indicated that sound policies in debtor countries would remain the key to assembling concerted financing packages. Advisory committee banks thought that economic subcommittees could play an even greater role in preparing assessments of policies and prospects in borrowing countries. These banks and their national subgroups would need to present information fully and effectively to other banks to encourage participation by a wide range of banks. In the past, the process of mustering new money has been facilitated where communications between debtors and their bank creditors have been conducted effectively.
Once initial agreement of creditor banks for a new money package has been finalized, banks anticipated that disbursements would be phased, as in the past, in line with policy implementation. Banks also indicated they would seek increasingly to link their disbursements to prior actions by other creditors—for example, specifying “minimum” contributions from the Paris Club, export credit agencies, or the World Bank. In some cases, arrangements to modify such conditions have required approval of all banks, which has involved delays. Advisory committee banks noted that limiting approval for such modifications to a qualified majority of banks has, in some instances, avoided such delays.
Burden sharing within the banking community remains a contentious issue. New money packages have continued to be based on exposures existing at the time debt-servicing difficulties emerged for each country (i.e., the base date), although, as time has passed, some banks have provisioned heavily against their exposure or even sold their claims. Advisory committee banks noted that, for this reason, the 1982–83 new money bases have become increasingly artificial. However, these banks generally felt that shifting to a later base date—one that reflected more fully banks’ current exposure—would send the wrong signals by penalizing banks that have contributed to spontaneous increases in exposure and by legitimizing the withdrawal of others. More broadly, most advisory committee banks did not consider it feasible to reach a consensus on a different basis for burden sharing.
Leading banks believed that a major problem existed in ensuring the participation of banks with small exposures. Possible approaches to the problem of banks with small exposures include notably trust funds, loan sales and swaps, applications of cofinancing, or arrangements such as a cutoff point below which banks would not be expected to participate. The discussion of this subject among banks has not advanced significantly. After studying this issue in a working group, banks reached no agreement on providing financial protection exclusively to banks with small exposures. More generally, banks saw great difficulty in setting a cutoff point below which banks would be specially treated or not approached at all; in their view, such cutoff points would be perceived as arbitrary and difficult to enforce and could also affect burden sharing among different nationalities of banks.
Advisory committee banks thus envisaged continuing to approach all banks for contributions to new money packages. Some banks noted two techniques that may, in practice, accommodate recalcitrant banks, albeit to a limited degree. First, in some cases, banks have swapped debt so as to consolidate claims with those banks that have a continuing business interest in a country. Second, formal arrangements along the lines of the discounted loans/equity conversion schemes operating in Chile and initiated in several other countries could allow some banks to dispose of their claims in a manner acceptable to other creditor banks. Banks observed that it would be crucial that legal arrangements clarify that the potential new money obligation of a “selling” bank had been extinguished in a manner that was indeed definitive and satisfactory to all parties.
In addition, it was noted that some banks, particularly those that have provisioned heavily, have stated that their reluctance to provide new money does not mean that they would not provide financial support through some other modality. This suggests that some diversification of financing modalities within a financing package may, to a limited degree, help secure more rapid assistance from banks. Nevertheless, there may be some banks that would seek to avoid any contribution to a financing package, while still receiving their full interest payments; most banks viewed such a position as unjustifiable.
Banks noted that they had recently adopted a more differentiated approach to financing, in light of countries’ varied economic situations. To a high degree, developing countries’ adjustment efforts, by determining the magnitude of financing and influencing banks’ perceptions of creditworthiness, were viewed as influencing the appropriate form of bank financial assistance. In some key cases, as discussed above, concerted lending packages were viewed as necessary. However, for some countries that have advanced to a point where their financing needs are small, and their economic policies and prospects favorable, it has been possible to shift toward managed loans. These loans will be feasible chiefly where a limited group of banks with long-standing ties are prepared to strengthen relations with the country.
Transition to spontaneous lending has generally been facilitated by special types of financing techniques. In Côte d’Ivoire and Uruguay, project loans cofinanced by the World Bank facilitated such packages, while in Ecuador a package has been arranged in the form of a trade facility to prefinance oil exports. When developing countries reach this point in restoring relations with creditors, the divergence and regional nature of banks’ interests can work to developing countries’ advantage. However, banks warned that a premature transition to spontaneous loans could jeopardize a country’s subsequent ability to arrange concerted financing if that should prove necessary.
In contrast, banks also envisaged cases in which a country’s payments situation and prospects had deteriorated to a point where a classic new money package was not deemed appropriate or feasible by the advisory committee. An example could be a low-income country with large interest arrears. In such cases, most banks recognized a need to consider solutions attuned to the particular situation of the country. In the past, banks have been prepared to reschedule or formally defer interest for a very limited number of countries whose debt problems were exceptionally serious and whose prospects for regaining access to spontaneous bank financing were considered remote.
Banks noted two considerations in this connection. First, as a principal financing modality, the rescheduling of interest obligations would signal a departure from market-oriented financing, which would be inappropriate for debtor countries that were still able to raise medium-term loans, albeit on a concerted basis. Second, while interest rescheduling was sometimes viewed as a form of debt relief, it added to countries’ commercial indebtedness to the same extent as a new loan, and could result in a buildup in obligations beyond the extent justified by a country’s debt-servicing capacity.
As far as genuine debt relief through concessional interest rates or outright reductions in principal was concerned, most banks appeared unwilling to consider this option at the present time. Banks were sympathetic to the situation of low-income countries implementing macroeconomic and structural reforms. They saw, however, a number of very difficult issues, including selection of appropriate criteria to determine eligibility for, and scale of, such relief.
Several points emerged during discussions with banks on the question of countries re-entering international financial markets. These points were based in part on experience in the case of Turkey, following its restructuring, and Hungary, which had experienced a period of constrained access to spontaneous commercial financing. They also reflected the limited experience so far with spontaneous medium- and short-term financing for countries that have restructured their debt since 1982.
Re-entry was likely to begin at the short-term end of the maturity spectrum. Access to short-term trade finance was typically the first form of financing to return. Project loans, perhaps involving officially supported export credit guarantees or cofinancing with a multilateral development bank, might also be attractive for banks with domestic customer interests in a developing country. Loan instruments that were transferable could be helpful for some countries in the transition to general purpose bank loans, as could private placement of bonds with a group of banks. Public issues of bonds would be a much later step. In this connection, it was stated that floating rate notes, principally a bank instrument, might be more accessible to developing countries, and that for fixed rate financing the Japanese bond market had been especially receptive to placements and issues by developing countries.
Developing countries that regained access to capital markets might be able to benefit from some of the current innovative financing techniques in capital markets. For countries that have rebuilt their creditworthiness, these new techniques offered opportunities to minimize borrowing costs, to hedge risks, and to tap new portfolios. At the same time, banks cautioned that on occasion borrowers have been offered expensive arrangements that would not improve their market standing because they were viewed as premature. Even techniques designed to enhance the credit rating of bonds (e.g., through collateralization) needed careful study to determine whether they were appropriate in individual cases. Rebuilding creditworthiness was not seen primarily as a matter of financing techniques: it depended rather on solid improvement in debt-servicing prospects, combined with sustainable economic growth.
The authors asked bank supervisors and banks for their assessment of the impact of bank supervisory practices on lending to developing countries. Bank supervisors have been proceeding with a strengthening of banks’ balance sheets during the past several years. Banks expressed some concern about the divergence in national supervisory and accounting regimes and the differing degrees of tax deductibility afforded to loan-loss reserves. Banks also identified a particular concern that, in certain industrial countries, mandatory provisions on all exposure to a group, or “basket,” of debtor countries for a predetermined number of years could deter a resumption of spontaneous lending and provide an unfortunate signal to developing countries pursuing adjustment policies. The basket approach assigns the same level of provisions to all countries within the basket, regardless of economic performance, and to all types of exposure, including trade finance, irrespective of the payments record. A flexible approach to upgrading debtor countries in a basket as their economic performance improves would appear more consistent with the case-by-case approach to debt problems. In addition, a return to spontaneous financing would be facilitated if trade finance, where serviced regularly, were treated flexibly with regard to provisioning requirements; this is already the case in a number of countries.
In the past two years, there has been a general move among supervisors toward using a risk-asset ratio as an indicator for monitoring banks’ capital adequacy for purposes of international comparison. Such a ratio assigns different weights to various types of assets—distinguishing, for example, among claims on public sector entities, banks, and nonbanks. In some such ratios, a higher risk weight is applied to claims on governments in developing countries, reflecting, inter alia, transfer risk. Supervisors acknowledged that there is some difficulty in arriving at an internationally accepted definition for such a group of higher-risk countries. On occasion, the Fund’s country classification has been suggested as a basis for country weightings; however, this classification was devised to facilitate economic analysis and not with a view to prudential concerns. Discussions are continuing in the supervisory community with regard to the feasibility of reaching agreement on an objective basis for such country weightings.
During 1984–85 foreign direct investment flows to developing countries averaged approximately $11 billion, or only somewhat less than the sharply reduced level of bank lending during those years. Nonetheless, these investment flows were slightly below their average level before the emergence of widespread debt-servicing difficulties and significantly below the average level of bank lending ($70 billion) during 1979–82. Direct investment in developing countries has been depressed by, inter alia, the decline in investment and economic activity in these countries.
Comments by banks concerning attitudes of their corporate customers provided some broad indications of the various areas in which changes could positively influence their investment decisions. These included sectoral entry restrictions, limitations on equity participation of foreign firms in domestic firms, restrictions on profit remittances, absence of patent protection, complex regulatory environments, and certain noncommercial risks. Banks emphasized that existing and potential trade barriers in industrial countries were also a major source of concern to their industrial clients when deciding whether to manufacture products in developing countries. This concern was seen as discouraging investment in the export sectors of developing countries.
A number of developing countries consider that there are certain broad advantages of greater reliance on foreign direct investment, principally the greater sharing of economic risks associated with using foreign savings. Some countries are studying or undertaking measures to encourage such flows; examples of recent measures are outlined in Chapter III, section on “Direct Investment.” Banks have indicated that their corporate customers were taking stock of such changes and may respond, especially where external factors—such as the sharp appreciation of the Japanese yen—provide added inducement to engage in foreign investment. Nevertheless, even with a recovery in the economies of developing countries, direct investment flows were not expected, in the near term, to increase sufficiently to offset the decline in bank lending.
The Multilateral Investment Guarantee Agency (MIGA), being launched by the World Bank, is designed to stimulate an increase in direct investment flows. The MIGA would issue guarantees for foreign investment against noncommercial risks and promote investments by undertaking research, providing information, and rendering technical assistance. A preparatory committee met in September 1986 and unanimously agreed on a comprehensive set of operational and financial policies, bylaws, and rules of procedures to be adopted by the MIGA’s governing bodies upon its establishment. Signatories of the MIGA convention totaled 50 at the end of October 1986, of which 39 were developing countries, accounting for about 64 percent of the authorized capital of $1.1 billion. The MIGA will presumably become operational in the course of 1987, upon ratification by 20 countries, which must include 5 industrial countries and 15 developing countries, representing one third of the MIGA’s authorized capital.
Some investment banks in major financial centers have indicated an interest among clients in portfolio investment in a limited group of developing countries as part of a general diversification strategy. In Japan, for example, a strong interest in Korean equity was noted. The success of the Korea Fund and the recent convertible bond issues by Korean private sector firms were cited. An equity mutual fund for India was launched in July 1986. Demand by investors for equity instruments in developing countries was seen as dependent on several factors, including suitable investment vehicles, adequate stock exchanges, proven remittance policies, and considerable effort at investor education. Multilateral institutions, such as the International Finance Corporation (IFC), can help establish the necessary capital market and legal structures, while assisting in disseminating information.
As noted earlier, some recent bank debt-restructuring agreements have included provisions permitting the conversion of debt into equity. Some banks have expressed considerable interest in debt-equity conversions; a number of heavily indebted developing countries have implemented debt-equity conversion schemes, while several other such countries are actively studying the introduction of such schemes. In several other countries, banks have purchased loan claims at a discount on the market and assembled these into packages for conversion into equity to provide an advantageous cost of financing for investment by industrial country clients. The overall scale of activity was thought to be relatively modest thus far.
Multilateral Development Banks
The World Bank and the three regional development banks—the African Development Bank (AfDB), the Asian Development Bank (AsDB), and the Inter-American Development Bank (IDB)—together made new lending commitments of $22 billion in 1985, compared with $19 billion in 1984. The World Bank accounted for 73 percent of the total, followed by the IDB (13 percent) and the AsDB (9 percent). New commitments to the group of 15 highly indebted countries by the four multilateral development banks reached $8 billion in 1985 (compared with $6 billion in 1984), about two thirds of which was accounted for by the World Bank.
Well-designed and efficiently implemented projects were seen by banks as essential for the restoration of growth in debtor countries. Such projects can also enhance export capacity and the ability to finance future development. In Africa, the AfDB has placed an increased emphasis on agricultural lending, while in Latin America, the largest share of IDB lending has been channeled to industry and mining and energy. The largest proportion of World Bank lending over the past six years has been directed to agriculture and rural development, followed by energy. Given the constraints on funds for development and investment in many debtor countries, there is greater stress on the efficiency and productivity of those investments that are made. The World Bank, in particular, can assist countries to design an overall investment plan that allocates resources well between different sectors.
A greater proportion of structural and sectoral adjustment loans were approved by the World Bank in 1985 and early 1986 in support of the broad reforms being undertaken in a number of key debtor countries. Policy-based lending commitments of the World Bank to the group of 15 heavily indebted countries amounted to $2.1 billion in fiscal year 1985/86, equivalent to almost 35 percent of the World Bank’s total lending to these indebted countries, which was a higher proportion than on average during fiscal years 1983/84 and 1984/85 (23 percent) and also well above the ratio for the World Bank’s policy-based lending to all countries. Policy-based lending has emphasized structural reforms, including trade liberalization; improved pricing policies and greater managerial efficiency in public sector enterprises; deregulation; and measures to support private initiative, particularly where this can be substituted for costly public sector investments. A substantial increase in World Bank disbursements during 1986–88 is expected to include a higher share of quick-disbursing funds under policy-based lending.
Regional development banks also may engage in policy-based lending to support sectoral reform or comprehensive country strategies aimed at promoting growth, or both. Some regional development banks have already engaged in such lending on a small scale, and others are in the process of discussing such activities. The AsDB has indicated that it is increasingly concerned with sectoral issues that affect project performance. The AfDB and the IDB are also studying this question. The AfDB has to a significant extent associated its lending with that of multilateral and regional development institutions and bilateral donors. It recently initiated policy-based lending through co-financing loans with the World Bank. At the AfDB’s 1986 annual meeting, however, it was noted that such lending would probably remain a small part of the total, especially in the early stages, given the Bank’s limited expertise and experience in nonproject lending. At the IDB’s 1986 annual meeting, the possibility of engaging in quick-disbursing sectoral loans tied to implementation of policies was raised by various governors, but a decision has not yet been taken. In some cases, it may be possible for project lending by regional development banks to be coordinated with sectoral policies supported by the World Bank.
Multilateral development banks can also add to the flow of finance to developing countries through formal cofinancing arrangements with commercial banks, for example, by fostering the association of commercial banks with viable investment activities. The World Bank has recently cofinanced loans for Chile, Côte d’Ivoire, Colombia, Costa Rica, and Uruguay. Both the AsDB and the IDB have mobilized resources from commercial banks in support of projects. The IDB and the World Bank engaged recently in parallel financing of projects in Colombia and Uruguay.
Multilateral development banks have an important role in the provision of long-term finance in support of sound projects and needed structural reforms and in catalyzing commercial financing. Commercial banks made it clear in discussions with the authors that they view World Bank involvement in debtor countries as extremely important. They emphasized their interest in linking their funding to trackable sector and project activities—designed to enhance countries’ longer-run development and growth prospects—in a framework of financial and macroeconomic stability. Export credit agencies also see a role for the World Bank in assisting in the identification of productive projects.
Developments in the Fund’s Involvement
Convincing macroeconomic and structural policies are regarded by creditors as the key to facilitating the assembly of new commercial bank financing for countries that have experienced debt-servicing difficulties. In this connection, the Fund is expected to continue to play a central role in helping developing countries resolve their debt problems and to do so in close collaboration with the World Bank. Commercial banks have increasingly associated their new lending not only with the implementation of economic programs endorsed by the Fund but with structural reforms supported by the World Bank.
More than two thirds of the 15 heavily indebted countries mentioned in the U.S. debt initiative have in place, or are now initiating, policies supported by the Fund with close World Bank involvement. In Mexico, an important program of macroeconomic and structural measures is in process of implementation. Financing for this program is being provided by a broad range of creditors, including lending by commercial banks and the World Bank and increased exposure of official export credit agencies. Nigeria has reached initial agreement with the Fund and the World Bank on a far-reaching set of policy reforms that involves a commercial bank financing package. For the Philippines, the Executive Board of the Fund approved in October 1986 a new stand-by arrangement in support of an economic adjustment program which, together with strong World Bank involvement, has helped to catalyze a resumption of concerted lending.
A number of other countries are pursuing existing programs endorsed by the Fund and the World Bank. Both Chile and Colombia represent cases where the Fund and the Bank are working closely together in monitoring policy implementation and catalyzing commercial bank financing. In Côte d’Ivoire, Ecuador, and Uruguay, effective adjustment programs have facilitated commercial bank MYRAs and a transition toward spontaneous bank financing—in two of these cases involving cofinancing with the World Bank. Bolivia also is implementing a significant adjustment program. In these cases, among others, effective policies and close collaboration between the Fund and the World Bank have provided a viable basis for coordinating financial support from creditors.
In addition to cases where the Fund is involved through arrangements to use its resources, a number of countries have requested the Fund to play a catalytic role through a strengthening of its surveillance procedures. Enhanced surveillance by the Fund was developed to facilitate the return to normal market access—through a MYRA—of countries with a good record of adjustment and in a position to present an adequate, quantified policy program in the framework of consultations with the Fund. The key objectives were to improve the country’s capacity to design, implement, and monitor economic policies and to provide information about those policies to creditors; to support banks’ risk evaluation through timely and comprehensive information and through the Fund’s forward-looking assessment of domestic policies; and to foster a shift in responsibility for lending decisions back to commercial banks by avoiding on/off financing indications from the Fund.
Under enhanced surveillance, the annual Article IV consultation reports of the Fund review and appraise the adequacy of a quantified financial program prepared by the country’s authorities, commenting specifically on the internal consistency of its objectives and targets and addressing their compatibility with sustained growth and the attainment of a viable external payments position. Interim consultations address the progress achieved in implementing the financial program and evaluate the country’s economic performance on the same basis as annual consultations. Both annual and midyear reports will be transmitted to creditor banks by the member country. While the Fund staff will assess the country’s program and review actual developments, the creditor banks will need to weigh that information, together with other available information, before arriving at a judgment about the economic performance of the country and before making their financing decisions.
Cases where enhanced surveillance has been agreed included Ecuador, Mexico, Venezuela, and Yugoslavia. Ecuador was the first country to conclude a MYRA with both official and private creditors. The bank MYRA does not envisage enhanced surveillance beginning until after the existing Fund arrangement expires in mid-1987. The official MYRA provides that the third stage of rescheduling—covering maturities due June-December 1987—may occur provided, inter alia, Ecuador is implementing a comprehensive and satisfactory economic program set forth in the process of consultation with the Fund. Thus, enhanced surveillance for Ecuador has not commenced as yet.
Enhanced surveillance for Mexico was due to begin in January 1986. The monitoring procedures in the Mexican MYRA envisaged that a material deterioration in Mexico’s financial condition could result in a return to an arrangement for the use of Fund resources. In the event, a request for renewed use of Fund resources was approved in principle by the Executive Board in September 1986. While Article IV consultation reports under enhanced surveillance have been prepared for Venezuela and discussed by the Executive Board of the Fund, these reports were not distributed to creditor banks by the Venezuelan authorities, since the MYRA had not yet been implemented. Enhanced surveillance for Yugoslavia began on the expiration of the Fund arrangement on May 16, 1986. The first Article IV consultation report under enhanced surveillance was completed in July 1986. This report has been circulated by Yugoslavia to its creditor banks.
At the time this publication was prepared, there had been no experience of creditors using enhanced surveillance reports; however, recent developments may illustrate certain important general issues. First, enhanced surveillance can only facilitate a return to spontaneous financing where countries show persistence in the implementation of appropriate policies. Second, adverse circumstances can arise that would lead a country engaged in enhanced surveillance to request a financial arrangement with the Fund. Third, official creditors have sought to exert influence on debtor countries’ economic policies by agreeing only to serial MYRAs wherein each annual restructuring is linked to an acceptable economic program. Commercial banks have moved progressively in this direction by requiring successive subperiods within a consolidation period to be subject to their approval. This practice places particular responsibility on creditors to determine the adequacy of policies. If, in their judgment, drawing—inter alia—on the Fund staff appraisal, the member country needs to adapt its policies in order to ensure a sustainable external position, then discussions between the country and its creditors will be needed to determine an appropriate course of action.
Prospects for Financial Flows
General Market Outlook
As in recent years, the magnitude and distribution of international financial flows in the near term will be influenced by current account imbalances and by structural changes in the capital markets. According to Fund staff projections in the October 1986 World Economic Outlook, aggregate current account deficits of industrial countries would remain virtually unchanged in 1987 at about $145 billion, after increasing during the previous three years. Central to this outcome is the anticipated decline in the current account deficit of the United States. The aggregate current account deficits of capital importing developing countries are foreseen to decline to $50 billion in 1987 from $54 billion in 1986. These deficits would be covered in aggregate by nondebt-creating flows plus long-term borrowing from official sources, which would ease financing requirements from international capital markets. This pattern of current account imbalances suggests a continuation of both a high level of international capital flows among industrial country borrowers and rather limited gross flows of private lending to developing countries, implying possible net repayments to private creditors.
Recent structural changes, both liberalization and innovation, have increased the range and flexibility of financing instruments and have broken down segmentation in international capital markets. This enhancement of markets will facilitate increased borrowing through long- and short-term securities transactions. Moreover, the continuance of sizable financial surpluses and deficits within the group of industrial countries—where there are large numbers of highly rated borrowers and sophisticated savers—implies that both users and providers of funds will be situated to match their positions through the securities markets and thereby minimize costs of intermediation. In this environment, new issues of international bonds are expected to expand further; bond issuance is likely to be more buoyant than bank lending as a source of financing for nonbanks. Commercial banks, for their part, are expected to continue in the process of securitizing their assets, and this will provide additional impetus to the expansion of international markets in notes and bonds.
The structural changes taking place in the capital markets have offered greater opportunities for borrowers with a high credit rating to access new markets, hedge risks, and reduce financing costs. However, these recent rapid changes have diminished the transparency of developments in financial markets. Efforts to improve statistics by authorities in industrial countries and by international organizations, including the Fund, can help improve the operation of financial policy through achieving greater transparency. Moreover, as financial markets become more integrated, it becomes critically important that supervision of both bank and nonbank financial institutions be coordinated within and among countries.
Changes in the markets have also made countries’ macroeconomic policies more interdependent, especially in the case of monetary policy. Improved policy coordination between countries, supported by Fund surveillance, has thus become all the more necessary. Such coordination can make a key contribution to improving the allocation of resources through international capital markets. The arguments for stronger coordination in the areas of macroeconomic policy and of financial supervision are not independent: sound and coordinated macroeconomic policies can help to provide a stable environment in which market discipline can operate effectively, diminishing the problem of moral hazard that greater official supervisory involvement could entail.
The Debt Situation
While major changes have taken place in the financial markets of industrial countries, developing countries have had limited access to the dynamic sectors of the capital markets. Relatively few developing countries are able to tap the international securities markets for long- or short-term financing, with the result that most countries are dependent on banks for loan financing. In the near term, banks expect gross spontaneous lending to developing countries to continue at a low level and to be concentrated among countries in Asia and Europe that have not restructured their bank debt; on a net basis, developing countries may repay banks.
Banks have indicated that their willingness to provide additional financing to developing countries depends on several factors, foremost among which are sound macroeconomic and structural policies in the borrowing countries and a healthy and growing world economy. The prospects for bank lending also vary according to the longer-term business interests of banks and the type of financing concerned. Large banks with international corporate clients express the greatest interest in maintaining business links to developing countries, and some of these banks also identify as a strategic priority the development of their local banking business in selected developing countries. Following the pattern of recent years, credit flows from banks of different nationalities may also continue to differ significantly, with perhaps some further regionalization of flows.
The dominant form of spontaneous bank lending to many developing countries is expected to be trade and project lending, associated with export activities of banks’ customers in industrial countries. In this connection, banks have noted that export credit agencies can help developing countries to maintain or regain access to spontaneous commercial financing by extending export cover to those countries that are implementing appropriate economic policies that will restore their commercial creditworthiness. They have indicated also that the World Bank can help stimulate bank lending through its involvement in project loans and structural policies.
Notwithstanding some growth in trade and project lending, a number of developing countries will still need further general purpose balance of payments support from banks. The transition to spontaneous lending packages, involving a limited group of banks, for Côte d’Ivoire, Ecuador, and Uruguay is encouraging. However, it may prove difficult for some countries with larger economies and declining terms of trade to achieve an early restoration of spontaneous lending from commercial banks.
For the strategy of co-responsibility to work in resolving the debt problem, it is essential that banks resume lending in adequate amounts and on appropriate terms to countries that put in place effective policy reforms. To catalyze this financing, concerted packages will still be indispensable in a number of cases, and the coming on-stream of important economic programs that have been negotiated in recent months provide a basis for larger concerted lending flows in late 1986 and 1987. It will be important that banks take responsibility for their contribution to the debt strategy and avoid preconditioning their participation unduly on levels of official flows or on the availability of official guarantees.
Effective collaboration among banks will be needed for the prompt assembly of financing to support growth-oriented adjustment policies. Such collaboration among banks is all the more important insofar as the mustering of concerted financing may be more difficult in the period ahead. Bank cohesion is diminishing over time, particularly with regard to banks that have a low level of claims on a country or a high level of provisioning.
Differences in the impact of external developments and policy implementation have broadened the spectrum of economic prospects faced by debtor countries, and the terms of bank financing will need to be differentiated correspondingly on a case-by-case basis. The terms of restructuring and financing packages will need to reflect each debtor country’s financial outlook and its prospects for regaining access to spontaneous financing. MYRAs and, in certain cases, new money packages appear appropriate for countries that are better placed to resume spontaneous access to credit markets. For countries in more difficult circumstances, commercial banks will need to show imagination in fashioning financing packages that correspond to the prospects faced by these countries. In particular, in the case of low-income countries that have embarked on comprehensive adjustment programs, banks will need to adopt approaches which respond realistically to these countries’ medium-term prospects.
As regards the outlook for lending by multilateral development banks, the sharp increase in recent months of commitments of fast-disbursing, policy-based lending of the World Bank, especially to heavily indebted countries, is a particularly welcome development. A key aspect of the World Bank’s involvement has been in helping to catalyze a flow of other external financing for debtor countries, particularly financing in support of structural reforms. However, financing by multilateral development banks is not to be seen as a substitute for commercial bank lending.
Nondebt-creating flows, especially foreign direct investment, are expected to represent a relatively higher share of capital flows to developing countries, although in real terms such flows have declined since the early 1980s. The World Bank’s MIGA is expected to help foster additional private direct investment by reducing noneconomic risks. Also, a number of major debtors have established or are actively studying schemes to convert bank debt to equity. Nevertheless, investment flows may expand only moderately in the near term, due to protectionism in industrial countries and limitations on equity investment in developing countries. Direct bilateral assistance will continue to provide a major share of the capital flows to many developing countries, especially low-income countries.
The role of the Fund in assisting developing countries to design growth-oriented adjustment programs is seen by banks as central in helping to secure external capital flows. In a considerable number of cases, the Fund’s direct financial support will be of substantial importance. In other cases, the Fund’s catalytic role will be of greater significance. During the period ahead, the Fund will face important challenges in seeking to extend the progress so far in solving countries’ debt-servicing problems and in helping to ensure that the finance is not lacking for countries to pursue growth-oriented policy reforms. Adequate access to Fund resources, and close collaboration between the Fund and the World Bank, will be essential both to secure a return to growth in developing countries and to help catalyze external financing in support of appropriate macroeconomic and structural policies. The package announced recently for Mexico is a manifestation of such collaboration. Support from private creditors for similar packages will be a key factor in successfully implementing the strengthened debt strategy.
International Monetary Fund, World Economic Outlook, October 1986: Revised Projections by the Staff of the International Monetary Fund (Washington: International Monetary Fund, October 1986).
The country classification scheme used for economic analysis in the Fund and followed in this study is given in Appendix I.
Total cross-border lending by banks is measured in the Fund’s international banking statistics (IBS) as the sum of cross-border interbank accounts by residence of borrowing bank and of international bank credits to nonbanks by residence of borrower, corrected for changes attributed to exchange rate movements. Net lending is calculated as the exchange rate adjusted increase in claims; it is thus net of amortization.
Gross issues of international bonds less an estimate of redemptions, repayments, and double counting due to bank purchases of bonds.
Estimates of bank lending net of interbank redepositing are prepared by the Bank for International Settlements (BIS) and are shown in Table 2.
All references to developing countries exclude major offshore banking centers (The Bahamas, Bahrain, the Cayman Islands, the Netherlands Antilles, Hong Kong, Panama, and Singapore).
Concerted lending (or “new money”) refers to equiproportional increases in exposure coordinated by a bank advisory committee.
This analysis is based on data published by the Organization for Economic Cooperation and Development (OECD). The OECD data, however, understate gross bank commitments to developing countries because they do not include commitments corresponding to the restructuring of long-term maturities. These data are also not directly comparable to the data on lending previously referred to in the text, as OECD data are on a commitments basis and cover only new bank credits that are publicized and that have an original maturity of more than one year.
C. Maxwell Watson, Donald Mathieson, G. Russell Kincaid, and Eliot Kalter, International Capital Markets: Developments and Prospects, Occasional Paper No. 43 (Washington: International Monetary Fund, February 1986).
Recent Innovations in International Banking (Basle: Bank for International Settlements, 1986).
The Management of Banks’ Off-Balance Sheet Exposures: A Supervisory Perspective, Committee on Banking Regulations and Supervisory Practices (Basle, March 1986).