Chapter

I Overview of Developments and Key Issues

Author(s):
Donald Mathieson, Eliot Kalter, Maxwell Watson, and G. Kincaid
Published Date:
February 1986
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This paper provides a description and analysis of recent developments in international capital markets and an assessment of the prospects for private financing flows. Particular attention is focused 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 prospects for flows to developing countries.

An overview of developments in international financial markets, together with a general assessment of current issues and prospects for market flows, is given in this section. There is special emphasis on the factors influencing flows to developing countries and the recent U.S. initiative to promote these flows. Section II examines the recent structural changes in major financial markets, including relevant developments in bank supervisory practices. A detailed description and analysis of developments in international bank lending is provided in Section III. Recent trends in bank debt restructuring, including the development of multiyear restructurings and banks’ monitoring procedures, are reviewed in Section IV. Developments in other financial flows, including the issuance of international bonds and short-term notes, are presented in Section V, The appendices contain some additional background information on issues related to measurement and coverage in international banking statistics; the activities of the Institute of International Finance; developments in the pattern of savings and investment flows; technical information on interest rate and currency swaps; and a glossary of terms.

As with previous papers, the scope of this paper is limited mainly to the analysis of financing flows through international capital markets. It does not address in detail questions related to concessional assistance, the flow of resources through the multilateral development institutions, or the role of the Fund in providing financial assistance in support of adjustment programs of member countries. Nor does it discuss medium-term issues affecting the world economy. A discussion of the principal findings that have emerged from the studies in the Fund setting out broad scenarios of how the world economy could evolve over the period through the end of this decade is contained in the 1985 World Economic Outlook.1

Economic and Financial Environment

The growth and pattern of international financial flows during 1984–85 have primarily reflected an expansion of financing needs in industrial countries. The combined current account deficits of these countries expanded sharply, from $40 billion in 1982 to $108 billion in 1984, while the aggregate current account deficits of developing countries declined from $133 billion to $78 billion during that period. These trends continued in 1985. As a result of these developments, total net lending through international capital markets rose substantially during 1984–85. Total net lending through international banks and bond markets increased by $68 billion in 1984 to $252 billion (Table 1), after two years of declining activity. Cross-border bank lending in 1984 recovered to its 1982 level, and net issues of international bonds rose to a record volume. A further increase in activity occurred in the first half of 1985.

The sharp increase in the U.S. current account deficit (from $3 billion in 1982 to $93 billion in 1984) more than accounted for the rise in the current account deficits of industrial countries. For 1985, the identified current account deficits of industrial countries are estimated to reach $141 billion, with the U.S. current account deficit expected to increase to $123 billion. The recent distribution of current account imbalances has been one key factor in the shift of international financing flows toward securities market transactions, in contrast with the rapid growth in bank intermediation that occurred before 1982.

The current pattern of investment and savings is characterized by increased deficits among borrowers whose high credit standing afforded them considerable access to securities markets, and by higher surpluses among savers who invested directly in such instruments. The financing requirements of the U.S. fiscal deficit were partly satisfied by large foreign purchases of U.S. Government securities. Nonfinancial companies in the United States borrowed more heavily in international capital markets. In Japan and Europe, nonfinancial corporations have used higher profits associated with economic recovery to strengthen their balance sheets by rebuilding financial assets and reducing their net indebtedness to banks.

Capital-importing developing countries have engaged in strong adjustment efforts associated with tight external financing constraints. Their current account deficit declined sharply from $60 billion in 1983 to $38 billion in 1984. Latest Fund staff estimates put their current account deficits at $44 billion in 1985. Nondebt-creating flows plus net disbursement from official sources averaged about $51 billion during 1984–85. As a result, the current account deficits of these countries were more than covered by financing from sources other than international capital markets.

Current account imbalances of many developing country groups were reduced to levels not recorded since the 1960s. The associated drop in foreign capital flows has been most evident for those developing countries which have relied on external borrowing from commercial banks (i.e., market borrowers) or its principal subgroup (i.e., major borrowers). The current account deficits of the market borrowers, which averaged 3 percent of gross domestic product (GDP) during 1973–82, declined to less than 1 percent in 1984–the lowest ratio since 1967. In contrast, the official borrowers continued to run current account deficits equivalent to approximately 6 percent of GDP in 1984–close to the average level of their deficits during 1973–82.

Chart 1.Growth Rate or International Bank Claims, 1976–84

(In percent)

Sources: Bank for International Settlements, International Banking Statistics and Anruinl Report: International Monetary Fund, International Financial Statistics; and Fund staff estimates.

1 These data do not net out interbank rede positing.

International Banking Activity

International banks’ overall cross-border lending2 grew by 7 percent in 1984, reaching $192 billion.3 This growth was entirely due to greater activity among industrial countries, as lending to developing countries slowed further (Chart 1). In the first half of 1985, overall bank lending slowed to $72 billion from $98 billion during the same period in 1984. Bank lending to industrial countries rose to $116 billion during 1984, after having declined during the previous two years. With relatively limited lending opportunities to non-banks in industrial countries, increased bank lending was more than accounted for by greater interbank lending, which jumped by $33 billion to $110 billion during 1984. However, bank lending to these countries declined somewhat during the first half of 1985 to $56 billion compared with $65 billion during the comparable period in 1984.

The rate of growth in interbank claims on industrial countries accelerated to 8 percent in 1984, in contrast with a further slowing to 3 percent in lending to nonbanks. Moreover, interbank lending continued at a strong pace in the first half of 1985. Growth in interbank lending occurred despite several factors which have been operating to slow interbank lending–including notably higher capital asset ratio requirements for U.S. banks; issuance of medium-term bonds by banks to lengthen the maturity of their funding positions; use of futures contracts rather than interbank positions for interest rate matching; and some disintermediation as nonbanks have increasingly issued debt instruments, often backed by commercial bank stand-bys, directly to other nonbanks.

A number of developments appear to explain the growth in interbank activity. A large proportion of the growth in interbank claims represents an increase in claims between banks and their related offices abroad (i.e., intrabank claims). On occasion, local funding problems of these related offices have led to greater lending to them by their parent institutions. Since the increase in interbank lending was almost entirely directed—in roughly equal amounts—to countries with major securities markets (Japan, the United Kingdom, and the United States), a part of this activity may reflect funding of trading portfolios of securities held by bank offices in those markets. Moreover, activity may have increased at times of foreign exchange volatility, as banks covered foreign exchange positions in the deposit market. Lastly, the possibility was raised by some banks that a degree of tiering in the interbank market might have caused some recycling of deposits received by highly regarded banks.

Table 1.International Lending and Selected Economic Indicators, 1979–85(In billions of U.S. dollars; or in percent)
1979198019811982198319841985 Estimates
International lending through banks and bond markets
Total1
IMF based370414434236184252
BIS based (gross)229260295230150185
BIS based (net of redepositing)148179195145130155
Bond issues (net)2231930504560
Bank lending1
IMF based347395404186139192
Growth rate272420857
BIS based (gross)206241265180105125
Growth rate2322201266
BIS based (net of redeposiling)125160165958595
Growth rate2324201088
International lending to developing countries3
Bond issues4324535
Bank lending1
IMF based598587513816
Growth rate2327221173
BIS based495653342611
Growth rate2422171072
World economic developments
Total of identified current account deficits598151175172150186223
Industrial countries2959414050108141
Of which: Seven largest123116173796130
Developing countries69921341331007882
Overall current account balance of capital-importing developing countries−61−77−113−104−60−38−44
Reserve accumulation of capital importing developing countries6 accumulation +)22.019.0−3.0−18.09.018.04.0
Growth rate in value of world trade26.321.5−0.6−6.3−2.36.41.8
Growth rate of real GNP of industrial countries3.52.01.70.42.54.52.8
Inflation rate of industrial countries (GNP deflators)7.99.18.77.24.84.13.2
Interest rates (six-month Eurodollar deposit rate)11.913.916.713.69.911.38.5
Sources: Bank for International Settlements (BIS); Organization for Economic Cooperation and Development; International Monetary Fund. International Financial Statistics; World Economic Outlook August 1985: A Revised Study by the Staff of the International Monetary Fund; and Fund staff estimates.

IMF based data on cross-border lending by banks are derived from the Fund’s International Banking Statistics (IBS) (cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower), excluding changes attributed to exchange rate movements. BIS based data are derived from quarterly statistics contained in the BIS’s International Banking Developments; the figures shown are adjusted for the effects of exchange rate movements. Differences between the IMF data and the BIS data are mainly accounted for by the different coverages. The BIS data are derived from geographical analyses provided by banks in the BIS reporting area. The IMF data derive cross-border interbank positions from the regular money and banking data supplied by member countries, while the IMF analysis of transactions with nonbanks is based on data from geographical breakdowns provided by the BIS reporting countries and additional banking centers. Both IBS and BIS series are not fully comparable over time, owing to expanding coverage.

Net of redemption and of double counting due to bank purchases of bonds.

Excludes the seven offshore centers, which are the Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore.

Unadjusted for redemptions and double counting due to bank purchases of bonds.

Goods, services, and private transfers.

Based on balance of payments definitions.

Sources: Bank for International Settlements (BIS); Organization for Economic Cooperation and Development; International Monetary Fund. International Financial Statistics; World Economic Outlook August 1985: A Revised Study by the Staff of the International Monetary Fund; and Fund staff estimates.

IMF based data on cross-border lending by banks are derived from the Fund’s International Banking Statistics (IBS) (cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower), excluding changes attributed to exchange rate movements. BIS based data are derived from quarterly statistics contained in the BIS’s International Banking Developments; the figures shown are adjusted for the effects of exchange rate movements. Differences between the IMF data and the BIS data are mainly accounted for by the different coverages. The BIS data are derived from geographical analyses provided by banks in the BIS reporting area. The IMF data derive cross-border interbank positions from the regular money and banking data supplied by member countries, while the IMF analysis of transactions with nonbanks is based on data from geographical breakdowns provided by the BIS reporting countries and additional banking centers. Both IBS and BIS series are not fully comparable over time, owing to expanding coverage.

Net of redemption and of double counting due to bank purchases of bonds.

Excludes the seven offshore centers, which are the Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore.

Unadjusted for redemptions and double counting due to bank purchases of bonds.

Goods, services, and private transfers.

Based on balance of payments definitions.

Bank Lending to Developing Countries

Measures of bank lending to developing countries are subject to considerable uncertainties. Data in this paper have been corrected for identified misrecording of lending during 1983–84 and the first half of 1985. Following these adjustments, it is estimated that the resulting data on international banking activity reflect a net underrecording of flows to developing countries.4 A further examination of measurement issues is contained in Appendix I.

The growth in bank claims on developing countries5 slowed to 3 percent during 1984 ($16 billion) from a rate of 7 percent in 1983 ($38 billion). Furthermore, bank lending to these countries dropped to $1 billion during the first half of 1985 compared with $4 billion during the same period in the previous year. The sharp decline in bank lending to developing countries was associated with lower current account deficits of those countries, which were more than covered by nondebt-creating flows and net flows from official creditors. Banks remained reluctant to lend to many developing countries–especially those experiencing payments difficulties and to those countries with whom banks had large exposures. Nearly 60 percent of bank lending to developing countries during 1984 and the first half of 1985 was in the form of concerted lending.6 Disbursements under concerted lending packages totaled $10.2 billion in 1984, of which Brazil and Mexico accounted for $9.4 billion.

In the Western Hemisphere (excluding the offshore centers of the Bahamas, the Cayman Islands, the Netherlands Antilles, and Panama), international banks increased their claims on developing countries in 1984 by $7.3 billion, or 3 percent. This increase was less than disbursements under concerted lending packages because some banks reduced their claims on certain countries in the region, principally Argentina and Venezuela. Banks’ claims on developing countries in the Western Hemisphere declined by $0.8 billion in the first half of 1985.

Outside the Western Hemisphere, a number of developing countries continued to have access to spontaneous lending. Indeed, for certain countries, access to bank credits improved in 1984. Bank claims on developing countries in Europe grew by 4 percent ($2.9 billion) in 1984, while lending to developing countries and territories in Asia (excluding Hong Kong and Singapore) rose by 6 percent ($5.8 billion). In Africa, bank claims on developing countries increased in 1984 by 2 percent ($0.7 billion). Bank claims on countries in the Middle East contracted by $1.1 billion in 1984. In the first half of 1985, bank lending to developing countries in Asia and Europe continued to increase, rising by $1.9 billion and $2.9 billion, respectively, while banks’ claims on developing countries in the Middle East and Africa contracted, declining by $2.7 billion and $0.4 billion, respectively.

Developments in new bank credit commitments to developing countries provide some indications of recent capital market conditions for these borrowers (Chart 2).7 New publicized long-term bank commitments to developing countries declined in 1984 to $31 billion from $35 billion in 1983. All regional groupings of developing countries recorded virtually unchanged or lower bank commitments in 1984, with countries in Africa and the Middle East reporting the greatest percentage reductions. New commitments to developing countries slowed further to $9 billion in the first half of 1985, compared with $18 billion in the first half of 1984. In the Western Hemisphere, new bank commitments to developing countries during the first half of 1985 dropped to $2.4 billion–virtually all was concerted lending–while there were almost no bank commitments to developing countries in the Middle East.

Chart 2.Bond Issues and Long-Term Commitments of Credits and Facilities to Capital-Importing Developing Countries, 1981–First Half of 1985

(In billions of U.S. dollars)

Source: Organization for Economic Cooperation and Development. Financial Statistics Monthly.

1 Includes a facility arranged for Mexico.

2 First half annualized.

Meanwhile, bank commitments to developing countries in Europe in the first half of 1985 reached $2.3 billion—double the level for the same period in 1984. Centrally planned economies, excluding Fund member countries, experienced a sharp increase in bank credit commitments in 1984 and the first half of 1985. During that period, these commitments reached an average annual level of $2.5 billion in contrast to the average annual commitment level of $0.4 billion during 1982–83.

Included in these commitment data for 1984 and the first half of 1985 are concerted lending packages on which nine Fund members reached agreements (at least in principle) with their bank creditors. In 1984, firm long-term commitments for concerted lending to these countries totaled $16.2 billion, or about half of new long-term commitments to developing countries in that year, which was up from about 40 percent in 1983. During the first half of 1985, five countries obtained firm commitments for concerted lending amounting to $2.3 billion, or about one quarter of new external commitments during that period. During 1984 and the first half of 1985, nearly all new bank commitments to developing countries that had recently restructured their debt (i.e., a number of countries in the Western Hemisphere, Côte d’Ivoire, and the Philippines) consisted of concerted lending.

The maturity of outstanding bank debt of countries outside the reporting area of the Bank for International Settlements (BIS) lengthened during 1983 and 1984, reflecting the restructuring of medium-term loans and a deliberate effort by some borrowers with access to spontaneous medium-term bank credits to improve the maturity structure of their bank debt. The OECD data on the maturity of new long-term bank credit commitments indicate that average maturities for industrial countries remained basically unchanged in 1984, while maturities for developing countries–especially nonoil developing countries–lengthened. During the first half of 1985, the average maturity of new commitments to developing countries shortened (Chart 3).

Spreads on long-term bank credits declined sharply in 1984 and early 1985, as banks competed heavily for creditworthy borrowers both against each other and with other segments of the international capital market, and as spontaneous bank credit commitments to developing countries increasingly were limited to the most creditworthy. As a result of these developments, the gap between the spreads applied to various groups of borrowers, which had widened during 1982–83, narrowed sharply in 1984 and the first half of 1985 (Chart 3). For developing countries with spontaneous access to bank credits, the difference between their average spread and the spreads for industrial countries was the least since 1980.

Data on the ownership of international bank claims recently compiled by the BIS throw some light on the role of different national groups of banks in lending.8 While these statistics are not adjusted for the effect of exchange rate movements, nevertheless they provide valuable insight into the relative importance of different groups of banks in lending to nonbanks, other banks, and their own related offices. Broadly, more than half of the increase in international assets of banks in industrial countries during 1984 and two thirds of total interbank activity were accounted for by an increase in claims of banks on their own related offices, an activity that was almost totally due to Japanese and U.S. banks. The increase in assets between unrelated banks was more than fully accounted for by Japanese banks. Lending to nonbanks by Japanese banks also more than accounted for the total increase in such lending. Thus, Japanese banks were overwhelmingly the dominant source of lending to other banks and nonbanks. By contrast, U.K. and U.S. banks reduced their claims on other banks and nonbanks.

Bonds and Issuance Facilities

New issuance activity in international bond markets expanded to record levels during 1984–85. Issues of international bonds reached $110 billion in 1984, consisting of $82 billion in Eurobonds and $28 billion in foreign bonds. Lending through bond markets (bond issues net of redemptions) also reached the unprecedented amount of $84 billion in 1984. In the first half of 1985, net issues rose further to an annualized amount of $119 billion. Recently, international bonds and issuance facilities have increasingly become a substitute for syndicated loans–at least for those borrowers viewed as the best credit risks.

Chart 3.Terms on International Bank Lending Commitments, 1976–First Half of 1985

Sources: Organization for Economic Cooperation and Development, Financial Statistics Monthly; Federal Reserve Bulletin for Prime Rate; and International Monetary Fund, International Financial Statistics.

1 New publicized long-term international bank credit commitments.

2 First half only.

The importance of floating rate notes continued to grow in 1984; 34 percent of new bond issues were in the form of floating rate notes compared with 25 percent in 1983. Industrial country borrowers and international organizations together accounted for 95 percent of total international bond issues during 1984 and the first half of 1985. New issues by developing countries kept pace with the overall expansion in the bond market during this period as their share remained constant, albeit at a low level (5 percent). Total issues by developing countries rose to $5.3 billion in 1984 from $3.3 billion in the previous year. During the first half of 1985, developing countries issued bonds amounting to $4.9 billion. Five developing countries (Greece, Korea, Malaysia, South Africa, and Thailand) accounted for over two thirds of the issues during 1984 and the first half of 1985.

These developments in the bond market can be attributed to several factors. First, surpluses have arisen in countries and financial sectors, with a preference for investment in securities, directly or through nonbank intermediaries. Meanwhile, deficits have arisen in sectors, many of whose borrowers enjoy sufficient creditworthiness to tap nonbank savings directly to meet their financing requirements. Certain sovereign and corporate borrowers among the industrial countries have been able to raise funds more cheaply in the bond market than in the bank credit market and, in some cases, have been tapping the bond market in order to refinance outstanding bank credits.

Second, bond purchasers have also been encouraged by continued low rates of inflation in industrial countries and, in certain markets, by a steeply upward sloping yield curve. Real yields have been sufficiently high to attract investors, while for many borrowers, the cost of these real interest rates has been offset by the advantages of restructuring their balance sheets.

The third factor behind developments in the bond market is that activity of banks in the securities markets has continued to grow. The traditional distinction between the bank credit and bond markets has become less relevant as banks have become major purchasers and issuers of bonds. Banks purchased about $24 billion in international bonds in 1984, or 29 percent of new issues; within the floating rate note market, banks played an even larger role—buying half of the new issues. Banks have increased their bond portfolio as part of a general trend toward “secuntization” of their balance sheets. In addition, banks have also been under pressure from their supervisors to increase their capital asset ratios. Banks have been the largest single issuer of floating rate notes, using the funds to increase their capital base and improve their liquidity position.

Factors related to those discussed above have influenced the growth of an international market in short-term paper. Banks have attempted to maintain business relations with those clients who wish to enter the evolving short-term international securities market by providing international backup facilities for issuance of such notes which is one element of banks’ off-balance sheet activities. Under such facilities, a group of banks stands ready, over the medium term, to purchase the borrower’s short-term notes that cannot be placed in the market on certain agreed terms. Reflecting their high creditworthiness, the most active users of these facilities have been sovereign borrowers, including a few developing countries, and high-quality corporations, especially from the United States. The amounts committed under such facilities (excluding merger-related stand-bys) jumped to $29 billion in 1984 from $10 billion in 1983. Activity in these facilities during the first half of 1985 increased to an annualized rate of $40 billion.

To some degree, the appetite of financial institutions for securities may have been influenced by factors which may not be entirely sustainable. Some financial institutions have preferred negotiable instruments to book claims, in the belief that negotiability would, of itself, increase liquidity. The steep upward sloping yield curve in U.S. dollar assets, together with declining interest rates, has enabled banks to purchase floating rate notes and other securities at a profit by funding at very short term. Also, the privileged servicing of the modest volume of outstanding bonds for countries engaged in debt restructuring may have encouraged a belief that such instruments were inherently much less risky, even if they were to account for a significant proportion of a country’s total debt. Finally, banks have raised capital to reassure market or supervisory concerns about their soundness by issuing floating rate notes which, in some cases, have been held by other banks. Although considered as part of capital by the issuing bank, these floating rate notes have tended to be viewed as a money market instrument by the purchasing bank and not as an equity instrument.

Finally, the growth in securities activity has been stimulated by liberalization and innovation in financial markets. Financial liberalization measures were announced in a number of major financial centers. In addition, the growth of currency and interest rate swaps has increased the ability of market participants to arbitrage differences in financial market conditions, especially in medium-term maturities. Such transactions were estimated at $80 billion in 1984—triple the level in 1983. Swaps have also been used by some borrowers to avoid saturating a market with debt issues in their name. Banks have been major participants in interest rate swaps. They have issued fixed interest rate bonds with an associated interest rate swap in order to secure long-term funds at variable interest rates which were below the London Interbank Offered Rate (LIBOR). During 1984 and early 1985, these developments tended to integrate international financial markets more closely.

Issues Concerning the Markets

The last three years have been marked by far-reaching changes in international financial markets. Developments in two areas are of particular importance. First, the structure of financial markets has been changed by liberalization and by the spread of innovative financing techniques. Second, new issues have arisen concerning resolution of the debt-servicing difficulties of developing countries.

Liberalization and Innovation

Banks’ recent experience with problem loans—both domestic and international—was one factor leading them to develop new techniques of risk management, impelled by market and supervisory concerns about a deterioration in their balance sheets. The debt-servicing difficulties of developing countries have therefore contributed to an acceleration in the pace of change in financial markets. Banks and supervisors indicated that these market developments responded to other fundamental sources of change also. An overview of these influences is provided below and is followed by an assessment of the key elements in the present wave of change in capital markets. This section concludes with an appraisal of the risks inherent in such rapid changes in market instruments and structure.

Sources of Change

Developments in macroeconomic policies and in the world economic environment during the 1970s and early 1980s have strongly influenced the structure of financial markets. In particular, high and variable rates of inflation and sharply fluctuating interest rates contributed to the development of floating rate instruments. Large fiscal deficits in some industrial countries increased the availability of risk-free liquid assets, reinforcing pressure on banks to pay market interest rates on deposits.

When a sustained attack on inflation was initiated in the late 1970s, the attendant increase in real interest rates and decline in output caused the creditworthiness of many borrowers to deteriorate sharply. The emergence of widespread external payments difficulties among developing countries and problem loans to various sectors in industrial economies combined to weaken the balance sheets of many banks. As a result of these developments, banks’ funding costs rose relative to the borrowing costs faced by the most creditworthy sovereign and corporate borrowers. These borrowers therefore found that they could issue paper on international markets at costs considerably below those associated with obtaining bank loans. As the share of credit flows attributable to issuance of debt instruments rose, competition between securities houses and banks intensified. This heightened competition has contributed to the wave of innovation in financial markets.

In response to a deterioration in their balance sheets, many banks have sought to increase capital asset ratios. Where banks’ stocks were not highly regarded, capital has been raised through the issue of equity-related instruments, or floating rate notes. Intense competition has limited banks’ ability to increase profits by higher spreads on lending. Banks have therefore sought to cut costs and also to develop new business activities. A further reaction has been to slow balance sheet growth, and to emphasize activities that have high rates of return relative to their capital weighting. Commercial banks have, therefore, engaged in a rapid expansion of off-balance sheet business, such as securities business, swap transactions, standby credits, and trading in financial futures and options, all of which frequently have not been included in risk categories used for official capital adequacy measurements.

The interaction between innovation and liberalization in financial markets is complex. In some cases, changes in the pattern of financial flows, financial innovations, and competition in and between markets have provided the impetus for liberalization. In some countries, supervisors have cited the desire to reduce risk concentrations and improve the quality of earnings in the banking industry as a reason for diversifying bank activities. At the same time, a generally favorable attitude toward freer trade in financial services, matched by a domestic concern to foster efficiency and competition, has led to greater liberalization in a number of major financial centers. Thus, the current wave of change in financial markets reflects a confluence of factors: macroeconomic changes, changes in the banking industry and in public policy on competition in financial services. Although the pressures for liberalization and innovation have varied among the major financial centers, it would appear that these pressures have been less intense in countries where inflation has remained relatively low, and where ceilings on interest rates or restrictions on the financial activities and geographical location have not slowed the response of financial institutions to changing conditions.

Integration of Markets and Redistribution of Risk

The developments described above have been reflected in a multitude of changes in financial markets. In essence, however, a single process is occurring. Barriers between financial portfolios are being lowered and financial risks are being repackaged and distributed into different portfolios. A key aspect of this risk repackaging is that financial claims are becoming tradable to enhance their liquidity and facilitate their placement in different portfolios.

Liberalization measures and swaps have reduced market segmentation both domestically and internationally. Domestic deregulation has encouraged the lowering of barriers, especially between the banks and securities companies, as a means to stimulate efficiency in the financial services sector. In those countries where banks and securities companies have been separated by law or custom, restrictions on competition have been eased. In some countries, restrictions on bank participation in stock exchange activity have been lifted or are under review. Banks have also been allowed to compete more keenly for savings by offering deposits at market interest rates, and by a relaxation of restrictions on products or limits on geographical establishment. Market participants have been allowed to issue instruments that previously were not permitted such as floating rate notes and zero coupon bonds.

Measures to liberalize international access to capital markets in major financial centers have contributed to the integration of portfolios that has taken place. Exchange controls have been removed in some major financial centers in recent years, permitting residents access to foreign currency investments. Restrictions on access by foreign borrowers to national markets, and on their ability to borrow in national currencies, have been eased. Withholding taxes on interest payments to nonresidents have been lifted in several countries. Moreover, competition has been enhanced as countries have liberalized rights of establishment—especially for foreign banks—in banking and securities markets.

In parallel to these official initiatives, a variety of technical innovations in the market has also resulted in greater integration of markets. The emergence of interest rate and currency swaps on a large scale represents an innovation comparable in importance to the evolution of floating rate instruments. Swaps integrate international capital markets by allowing access to portfolios in a financial market independent of the borrower’s currency or interest rate preferences, because the borrower can simultaneously undertake swaps to modify these aspects of the transactions. Participants in a swap transaction, however, expose themselves to the risk that their counterpart may not honor the contract. The extent of the associated credit risk depends on intervening currency and interest rate movements. There exists an extremely wide range of estimates for such credit risk among banks.

At the same time that portfolios have been opened up, securities houses and banks have been developing other new financial instruments to facilitate risk management in financial markets to enhance the liquidity of financial claims. Thus, currency and interest rate options and futures, as well as ECU-denominated assets, permit banks and nonbanks to hedge their exposure.

Marketability of banks’ assets has also been increased, a process that has been termed “securitization.” Examples are the substitution of floating rate notes for syndicated lending, the introduction of transferability into international credits, and packaging of existing assets for resale (e.g., mortgages, car loans, and other receivables). Banks are selling high quality assets to other investors for a one-time income gain, while freeing up capital to deploy elsewhere. “Securitization” has also been driven by a decline in the ability of some banks to intermediate credit profitably, owing to their diminished market rating relative to prime nonbank borrowers. These borrowers have recognized the opportunity to tap directly nonbank portfolios by issuing bonds and short-term negotiable instruments that compete directly with bank deposits. In an effort to retain business relationships, banks have competed to provide medium-term stand-by facilities for the issuance of such short-term instruments. Many banks also purchase this paper for their own portfolios, compensating for the low yield by “cheap” funding through swaps, by carrying paper on an interest rate mismatch basis, or by costing such transactions as part of an overall relationship with the borrower.

Some Implications of Recent Changes

The changes described above constitute a major structural development in international capital markets. Liberalization measures in a number of major financial market countries have reduced the barriers to competition among domestic and foreign banks and increased access to bond markets. At the same time, recent innovations in instruments have provided market participants with new opportunities to tap nonbank savings directly and to hedge against risks associated with volatile interest rates or currencies. These developments should generally result in capital markets that are more closely integrated and more efficient. They also have the potential to allocate financial resources more effectively, both domestically and internationally, distributing risks to portfolios better placed to evaluate, diversify, and manage those risks.

Many of the new instruments have significantly altered the sharing of risks associated with exchange rate and interest rate variability and changed the roles of various financial institutions in intermediating flows between ultimate lenders and borrowers. To the extent that these innovations are used judiciously to improve the risk-adjusted return on the assets of financial intermediaries, they can strengthen the process of intermediation. Financial futures and options can offset—or at least redistribute—the risks that arise in volatile financial conditions. Diversification into feeearning business which does not appear on banks’ balance sheets permits them to strengthen their earnings and capital position. The liquidity of banks may be greatly enhanced by improving the marketability of existing loans and by securing medium-term floating rate funding by issuing securities directly or through swaps at advantageous interest rates.

Notwithstanding these potential efficiency gains, the recent changes pose considerable challenges to supervisory and monetary authorities. They raise issues concerning the nature of the evolving capital markets—in particular, questions regarding transparency, credit analysis, and effective distribution of risk. These issues are discussed below.

The transparency of financial markets has been lessened considerably in recent years, because markets have developed in areas where statistical coverage is as yet very weak. New instruments are affecting credit appraisal by complicating the interpretation of balance sheets. Insofar as an institution’s position in swaps and financial futures is not disclosed, it may be very difficult to gauge accurately the degree of risk to which the institution is actually exposed. The reduced transparency makes it more difficult to perform credit analysis on borrowers and to evaluate conditions in financial markets.

These problems highlight the importance of the continuing efforts by monetary institutions, including the Fund, to improve coverage of financial market activity, especially with regard to holdings of securities and off-balance sheet transactions such as swaps and issuance facilities. Moreover, publication by more countries of their banks’ consolidated international claims, including the geographical distribution and the corresponding capital data, would permit a greater understanding of developments in international bank lending, especially to developing countries.

Credit analysis by financial institutions is crucial to an effectively functioning financial system. While new hedging instruments and the sale of debt instruments directly to nonbank investors reduce the apparent concentration of risk in certain portfolios, risks may, in some cases, be acquired by investors who do not fully understand the nature of these risks, or cannot readily absorb losses that may be associated with them. In the case of recent innovations such as swaps and international issuance facilities, supervisors and some market participants have expressed concern that the pricing of these instruments may not always fully reflect their credit risks. The intensification of competitive pressures in international financial markets, partially stemming from liberalization, may lead to underpricing of risk taking by market participants.

Adverse effects on individual institutions could, of course, arise where credit assessment is not adequately performed or credit risk not adequately rewarded. Moreover, as risks are unbundled and repackaged, the adequacy of risk management systems—and the division of credit assessment between different parties—may be a source of difficulty. In particular, transactors may not rely on their own credit assessment, but on the credit assessment performed by selling or agency institutions and/or the marketability of the asset. Moreover, as claims are converted to negotiable forms, the liquidity of such instruments may, at times, be overestimated. The stability of financial markets will reflect not only the marketability of claims and dispersion of risks, but whether the risks have been transferred to parties who are well placed to evaluate and manage these risks.

The spread of deposit-like liabilities and credit-like assets, widely dispersed among bank and nonbank institutions, may raise new issues for the authorities in providing liquidity support in case of emergent strains. The capacity for absorbing shock of new market structures and of liquidity arrangements is not yet fully tested. At the same time, the need to protect the payments system from the repercussions of disruptions in other segments of financial markets has not diminished. Such protection is imperative, but it carries with it a need for vigilance against a weakening of market discipline on financial institutions. Such weakening could be caused by the perception of explicit or, equally important, implicit guarantees on deposits or other financial institution liabilities. Coordinated prudential supervision of financial institutions can reduce this problem of “moral hazard” and diminish potential budgetary costs of providing needed protection to the payments system.

Issues concerning the structure of supervision arise as financial intermediaries branch into new types of activity. As the distinction between commercial banks and other financial institutions blurs, business can more easily shift between these institutions. Thus, as banks increasingly hold marketable assets, supervisory practices that apply to securities houses—including frequent marking of tradable assets to market value and full disclosure of valuations—may become more appropriate. Conversely, to the extent that securities houses engage in transactions—including interest rate and currency swaps—with a considerable credit risk component, it may be important to ensure that their credit evaluation process is well developed. Changes in the range of activities that financial institutions engage in, as well as the risk characteristics of assets in their portfolios, may require supervisors to reevaluate capital adequacy considerations. For example, as banks repackage and sell attractive assets, or extend standbys to a new class of customers, they may also increase the risk inherent in their portfolios. Whether a functional or institutional approach to supervision is adopted, detailed knowledge of financial institutions and markets and the links between them will be crucial to detect problems and to respond quickly and effectively.

The changes in financial markets discussed in this paper have led to a major strengthening of financial supervision, including concerted efforts by bank supervisors to improve the adequacy of bank capital and liquidity. Together with market pressures, these supervisory initiatives have resulted in a substantial increase in the capital and reserves of many banks, although it must be noted that banks’ exposure to off-balance sheet risks has also increased. Supervisory authorities have warned banks that new financing techniques and instruments should be subject to close management control and that concerted reviews by supervisory and monetary authorities are under way. Many banks have also responded to concerns about their liquidity by extending the maturity of their funding and by increasing the proportion of their deposits taken from retail sources and other depositors with whom they have a continuing relationship. On the asset side, many banks have viewed more critically the liquidity of their interbank claims, and acknowledged that some holdings of short-term negotiable securities, including government notes, can provide a cushion of primary liquidity, especially in times of strains in the market. Continuing coordinated efforts by supervisory and monetary authorities may be necessary to underpin the stability of financial markets, especially during this transitional period.

Monetary authorities are engaged also in a study to assess the macroeconomic implications of recent changes in financial markets. There are questions whether financial innovations may seriously complicate the definition of monetary aggregates and modify the nature of the transmission mechanism. Keener competition, reduced market segmentation, and new technology have increased the speed at which financial markets adjust, while rising protectionism and structural rigidities have hampered the ability of goods and labor markets to adjust. A greater divergence in adjustment speeds could produce increased volatility of exchange rates and interest rates. Heightened international integration of financial markets may also imply that the impact of policies can spread more widely and more quickly through the international community. To the extent that these concerns appear warranted, increased importance would be attached to enhancing the effectiveness of the Fund’s surveillance in order to promote greater harmony between economic policies, to improve resource allocation, and to foster orderly conditions in financial markets.

The Debt Situation

A number of important developments in the international debt situation have occurred over the last several years. Techniques of restructuring debt and securing new financing have evolved further. At the same time, bank attitudes toward lending to developing countries have changed regarding both concerted financing and spontaneous flows.

Developments in Techniques for Restructuring and Concerted Lending

A key development in 1984–85 has been the adoption by bank creditors of a medium-term perspective in certain debt restructurings, Multiyear restructuring agreements (MYRAs) were developed to smooth debt amortization profiles and, by providing a clear planning horizon, to facilitate the return to international capital markets of countries that had demonstrated significant domestic and external adjustment. In 1984 and the first three quarters of 1985, banks negotiated such MYRAs with Ecuador, Mexico, Venezuela, and Yugoslavia.

The practice of enhanced surveillance is seen as a means for the Fund to promote the normalization of creditor/debtor relations in connection with MYRAs. Enhanced surveillance comprises three separate elements: a quantified financial program prepared by the country’s authorities, which presents a comprehensive description of their major macroeconomic objectives along with consistent domestic policies; additional Fund staff visits to the country and supplemental Fund staff reports which would be discussed by the Fund’s Executive Board; and the release of these Fund staff reports by the member to its creditor banks. Enhanced surveillance is not a substitute for normal stand-by or extended arrangements, nor is it designed to transform the Fund into a credit-rating agency for commercial banks. For these reasons, enhanced surveillance would be employed essentially to help promote MYRAs, although not all MYRAs might be associated with enhanced surveillance. The appropriate duration of this procedure would be about the length of a MYRA’s consolidation period. To avoid the risk of the Fund providing on/off indications to banks. Fund staff would take no active part in the negotiation or in design of trigger mechanisms, although at the request of a member, the Fund staff could provide purely technical advice.

Discussions between banks and countries are under way on MYRAs for countries that would not meet the criteria for enhanced surveillance because they have not established an adequate record of adjustment. In such cases, member countries and bank creditors may agree on a multiyear restructuring to avoid the burdens and uncertainties imposed by multiple annual restructurings. In order to maintain a close link between debt relief and the implementation of adjustment policies, bank creditors may make only subperiods within the consolidation period eligible for restructuring. This approach, known as a serial MYRA, facilitates a periodic review of economic policies and prospects. However, it is important that these periodic reviews be the responsibility of creditors.

The past year has seen a number of developments in the assembling of new financing packages. The value of commitments for concerted lending during 1985 has been substantially less than the levels of 1983 and 1984. In all cases except Colombia’s, during 1984–85, bank creditors linked their disbursements of concerted lending to purchases under a Fund program. Involvement of the World Bank has increased through cofinancing operations, including the guarantee of a portion of a concerted lending package. Banks have indicated that they see an advantage in cofinancing with the World Bank, because by associating their lending with effective sector policies and productive projects, they potentially reduce their risk.

Another development has been some adaptation of restructuring and concerted lending techniques designed to preserve traditional business ties to the debtor country. In some restructuring agreements, banks have been permitted to on-lend a portion of the domestic currency counterpart of the rescheduled debt to the private sector. In addition, some recent concerted lending packages have included an option to lend in the form of trade- or project-related loans. In contrast, however, there are cases where banks have pressed for guarantees by the debtor country government on existing loans to the private sector, thereby adding to the debt burden of the public sector. Other developments in restructuring techniques, including redenominations, are discussed in Section II of this paper.

While progress has been made in resolving debt-servicing difficulties, there appears to have been a lessening of banks’ cohesion in responding to new requests for restructuring and concerted lending. Cohesion has declined as banks’ underlying business interests in debtor countries have moved in different directions and as banks have also made greater provisions for loan losses, or have written off in their own books small claims on debtor countries. This process has occurred at varying paces, depending on the nationality, exposure, and size of banks. Therefore, bank attitudes toward new financing packages have become more diverse, which has made the already arduous task of assembling the critical mass necessary for concerted lending even more difficult. The weakening of bank cohesion (which has affected restructuring as well as concerted lending) has been greatest for countries that do not pose a direct systemic risk to the international banking community.

Bank advisory committees, partly in an effort to maintain cohesion, have sought a larger commitment of official resources in new money packages. Some banks have indicated that cofinancing of project and sectoral loans with the World Bank may induce greater bank cohesion because the World Bank’s appraisal of project and sectoral policies, together with its financial involvement, reduces risk. A crucial issue may be to ensure that additional commitments of official resources effectively catalyze bank financing, rather than substitute for such lending.

Banks have also been evaluating their options for dealing with cases of protracted debt difficulties. In a very few countries with slim prospects of restoring a more normal debtor-creditor relationship in the near term, banks have agreed to cap or reschedule interest for a portion of interest payments, at least with regard to medium-term financing. In such cases, the debt burden of countries has increased substantially. However, banks have not agreed to forgive debt, presumably because of concern about reactions of other domestic or international borrowers to such concessions.

Banks’ Lending Behavior

A major issue in the present phase of the debt situation is how to catalyze a resumption of significant spontaneous private flows to developing countries that are pursuing policies to correct imbalances in their economies so that they can resume sustainable growth. In this connection, it is important to assess the implications of recent developments in bank lending. This is not an easy task, however, since data—particularly on the behavior of national groups of banks—are very limited. The trends that do emerge are complex.

The data suggest that some groups of banks may wish to restrain their exposure to many developing countries, including, but not limited to, those that have recently restructured their external debt. Notwithstanding the return of Turkey to international capital markets and some spontaneous trade finance for Brazil and Mexico, it is notable that spontaneous lending has been slow to revive for countries that have recently restructured their debt. The reluctance of banks to resume spontaneous lending has been associated with uncertainties concerning those countries’ policies and the external economic environment. Moreover, some banks have also cut back or strictly limited their exposure to countries that have not restructured their debt. Such actions may reflect banks’ assessment of countries’ economic policies and prospects, but may also reflect, in some cases, a more general reticence toward lending to developing countries. In particular, many banks with small exposures may not wish to continue general purpose lending to many developing countries at the present time.

At the same time, banks have continued to lend on very competitive terms to various countries outside the industrial group, including some developing countries in Asia and Europe. Certain centrally planned economies have regained substantial access to international capital markets in 1984 and 1985 after a period of constrained access. In some cases, banks’ willingness to lend to countries reflects their assessment of economic policies being pursued, but this is not the case in all instances.

The distribution and terms of bank lending to developing countries in 1984–85 raise some concerns. Banks undertaking substantial loans on very fine terms to certain countries have, on occasion, paid inadequate attention to the implementation of appropriate adjustment policies. At the same time, some banks have indicated an unwillingness to lend to countries pursuing adjustment programs. The absence of spontaneous lending to such countries renders the task of economic policy reform more difficult and may impair the quality of banks’ existing claims on those countries.

In light of these developments in spontaneous lending to developing countries, attention has focused on the lending pattern of different groups of banks. Analysis of international lending to countries by nationality of banks is limited by the lack of consolidated claims data, especially for banks in the Federal Republic of Germany and Japan. For Germany, data on a fully consolidated basis with a geographical distribution have recently been published, but available statistics as yet cover claims on only some countries and only for end-1984. For Japan, no official data on the geographical distribution of bank claims on developing countries are published.

Available information for the United States suggests that consolidated claims of U.S. banks on developing countries declined by $4 billion in 1984, or by about 2 percent. Increases in claims on countries in the Western Hemisphere, which were largely related to disbursements under concerted lending packages, were more than offset by the withdrawal of funds in all other regions, especially in Asia. These trends intensified during the 12 months to end-June 1985. U.S. bank claims on developing countries were lowered by $8 billion or by 5 percent. During this period, U.S. banks began to reduce their claims on developing countries in the Western Hemisphere. All size categories of U.S. banks reduced their claims on developing countries as a group, with regional banks reducing their claims most sharply (by 8 percent). Consolidated external claims of U.K.-registered banks on developing countries also declined in 1984 and the first half of 1985, although this development is difficult to interpret in the absence of exchange rate-adjusted data. An increase in claims on developing countries in the Western Hemisphere was more than offset by a decline in claims on developing countries in all other regions.

Similar concerns arise in connection with bank debt restructuring. To secure necessary net financing from banks, the restructuring process has often included agreements to maintain existing short-term exposure with concerted lending packages. Exchange rate adjusted claims data, however, suggest that disbursements under concerted lending packages between 1983 and the first half of 1985 were greater than the increase in bank claims on certain countries with concerted lending packages. Although write-offs and risk transfers may account for a portion of this difference, analysis of available data indicates that some banks may have, nevertheless, succeeded in reducing their exposure. These leakages may diminish the effectiveness of the present restructuring process and weaken bank cohesion.

The developments described above raise the question of whether some groups of banks may be attempting to hold constant or reduce their overall exposure to many developing countries. In considering the question, it is important to note that holdings of floating rate notes are excluded from the lending data available for some groups of banks. This exclusion may result in underrecording of bank flows to developing countries that issue floating rate notes because banks are holders of a high proportion of the floating rate notes issued by these countries. Also, judging by the overall rise in claims on Asia, it appears clear that national groups of banks for which data are not separately available have continued to expand their business with countries in that region. Discussions with banks suggest that Japanese banks, in particular, have expanded their lending to Asia during the period under review.

Key factors relevant to the supply of bank lending to developing countries are believed to be the exposure of banks relative to their capital and total assets. Banks have significantly reduced their claims relative to capital, in considerable part by increasing their capital and reserves. For U.S. banks, claims on developing countries have returned to the 1977 level in relation to capital and reserves (Chart 4). Nevertheless, the claims on major borrowers of some individual banks remain large relative to capital. A similar comparison for non-U.S. banks is not possible, since reserves against these banks’ claims have been substantial and are not generally disclosed. Such reserves are believed to have increased further in 1984, although the appreciation of the U.S. dollar has inflated claims (which are denominated largely in U.S. dollars) on developing countries relative to these banks’ capital (which is largely denominated in domestic currency).

Chart 4.Selected Balance Sheet Data for U.S. Banks, 1977–84

(In percent)

Source: Federal Financial Institutions Examination Council, Country Exposure Lending Survey.

Banks are also seeking to reduce gradually the proportion of their loan portfolios (as well as the proportion of their capital) that is extended to developing countries, partly in light of market concerns arising from high disclosed exposure. However, the slower growth of bank assets in many countries may mean that the process of diluting asset concentration may continue over a number of years. For non-U.S. dollar-based banks, a decline in the U.S. dollar would speed up dilution of both capital and assets.

Banks’ concern about their exposure has recently increased on account of developments in key debtor countries and greater uncertainty about the world economic outlook. (For some banks, these concerns are compounded by continuing weaknesses in their domestic loan portfolios.) Banks’ concern about countries’ commitment to adjustment policies has led them to review ways of limiting increases in their risk exposure to a considerable number of developing countries, whether by avoiding new loans or by pressing for preferred status (e.g., by obtaining guarantees from creditor government agencies or multilateral institutions, and governments of debtor countries). Indeed, data recently published jointly by the BIS and OECD suggest that there was an increase in the level of bank claims guaranteed by export-credit agencies in 1984, particularly for developing countries in Africa, Asia, and the Middle East. This would imply that the true risk-adjusted exposure of banks increased by less than overall lending data indicate.9

Therefore, there has been a growing interest among banks in forms of legal security, preferential payments arrangements, and guarantees of the debtor country. It would be a concern if the search for such protection were to divert attention from the fundamental need for economic evaluation. Other banks seem to be looking for ways to strengthen economic evaluation and are emphasizing a need to integrate country risk assessment more fully into their lending decisions. In this regard, information supplied by the Institute of International Finance (IIF) is increasingly being used by banks. Information on the activities of the IIF is contained in Appendix II.

In this environment, an issue that has attracted renewed attention is the impact of banking supervision on international lending. Bank supervisors have been engaged, over the past several years, in a coordinated effort to strengthen their banks’ balance sheets by increasing capital asset ratios and by accumulating larger reserves against potential loan losses. Capital-asset ratios of banks in most major industrial countries have improved significantly as a result.

Efforts to strengthen banks’ balance sheets may have moderated bank lending to some degree. Bank supervisors have, however, weighed the advantages of reinforcing the soundness of the international financial system against the disadvantages created by an overly rapid transition. Bank supervisors have acted in a judicious manner by accommodating the impact of concerted lending on banks’ balance sheets.

Supervisory authorities in some countries have also shown flexibility in the treatment of trade finance, when regularly serviced, as regards mandatory provisioning requirements. Nevertheless, a potential problem exists concerning the dynamic impact of provisioning on spontaneous lending, especially trade finance, for developing countries that have undertaken adjustment policies. In some cases, provisioning requirements for developing countries are set on all exposures to a group of developing countries comprising those countries that have restructured in recent years. Such a practice could create a strong disincentive for the emergence of spontaneous lending, including trade finance, because provisioning renders marginal increases in exposure unprofitable.

This potential problem has been acknowledged although other factors, such as economic policies in debtor countries, also influence banks’ decisions to lend. Supervisory authorities in several countries are reviewing the possible impact of mandatory provisioning on the availability of new finance to developing countries pursuing adjustment policies.

A number of implications for future lending can be drawn from banks’ attitudes toward developing countries. First, while a certain number of developing countries remain highly regarded, banks still are very concerned about their exposure to many of the others—particularly those that have restructured their debt. Banks recognize that appropriate macroeconomic and microeconomic policies in debtor countries remain the key to reducing the risk inherent in their claims. Consequently, they have maintained a linkage between their financing and assessment by the Fund of countries’ macroeconomic policies. In addition, they are pressing for greater World Bank involvement in improving the supply response of countries’ economies and in providing direct financial support.

Banks have reduced their exposure to some countries through a variety of approaches, including a substantial buildup of reserves in some cases. This process has proceeded at very different paces for banks of different nationalities, size, and exposure. The number of banks committed to medium-term lending to developing countries has decreased. These factors have further diminished the cohesion of bank creditor groups. Banks are, however, considerably more forthcoming as regards increasing short-term trade financing and, to a limited degree, project financing; they are seeking to shift the composition of their claims toward such financing. Banks expect trade finance to be serviced in a timely way, and it offers synergies with domestic business. For many developing countries, trade and project lending may thus account for the core of spontaneous bank financing during the period ahead.

Prospects

Fund staff projections in the World Economic Outlook for 1985 indicated that the scale and distribution of international financial flows in the near term would be strongly influenced by historically large current account imbalances in the industrial countries and small current account deficits in many developing countries. This pattern of current account imbalances suggests continuation of both a high level of international capital flows among the industrial countries and rather limited net flows between the industrial and developing countries.

Under the conditions outlined in the World Economic Outlook, especially regarding exchange rates and interest rates, it is expected that new issues of international bonds, essentially by industrial country borrowers, will continue to be buoyant both in absolute terms and relative to bank lending. Buoyancy in bond markets is expected to continue for several other reasons. Many of the recent structural changes have enhanced access to international capital markets. Liberalization—whether of access or of instruments—continues in a number of major financial centers. Financial surpluses and deficits will persist in countries and in sectors for which securities transactions provide a major channel for finance.

Commercial banks, in turn, will likely extend further the process of “securitization.” Financial innovations are expected to play an increasingly important part in credit activity, enhancing the marketability of risks and carrying further the process of matching instruments to portfolio preferences. These new developments have the potential to enhance the efficiency and stability of financial markets. However, as discussed earlier, coordinated efforts by supervisory and monetary authorities will be crucial to enhance the transparency of these developments and ensure that their inherent risks are adequately managed.

Under the policies and global conditions set out in the World Economic Outlook, the net financing flows to capital-importing developing countries are projected to continue at a low level in 1986. A high proportion of these flows are projected to be provided by sources other than private creditors. Net external borrowing for capital-importing developing countries is projected to decline to about $31 billion during 1986, of which $22 billion would be financed by long-term borrowing from official creditors.

Trends in Private Capital Flows

Banks have indicated that the availability of spontaneous financing for many developing countries may remain limited. Banks also indicated that willingness to provide such financing depends closely on policy implementation in borrowing countries and global economic conditions. To preserve or regain access to spontaneous flows, many developing countries, including countries that have not recently restructured their external debt, may thus in effect have little room for maneuver in framing their economic policies.

Trade and project lending by banks is expected to represent the core of spontaneous lending to most developing countries, reflecting among other factors its link with the export activities of banks’ customers in industrial countries. Even with adequate trade and project lending, the limited availability of general purpose funds may imply that adverse domestic or external developments affecting individual countries would require further coordinated balance of payments support.

Collaboration between the Fund and the World Bank will be crucial to promote appropriate macroeconomic and microeconomic policies, which will favor more effective investment and can be supported by external capital flows. The World Bank can play an important role in facilitating the resumption of bank lending through its involvement in project and sector policies. Export credit agencies also can play an important role, because extension of export cover to countries that are implementing appropriate economic policies can help these countries maintain or regain access to commercial financing.

The composition of capital flows to developing countries is expected to continue to reflect a higher share of foreign direct investment and official transfers. Greater foreign direct investment would also facilitate the growth and adjustment process. Such equity investment can bring with it new technology and provide greater protection than do borrowed resources against sudden changes in international costs of funds. Direct investment flows may grow only at a moderate pace, however, reflecting restrictions in developing countries on direct foreign investment and protectionism in industrial countries. Establishment of the Multilateral Investment Guarantee Agency (MIGA) can contribute to fostering greater private direct investment by reducing noneconomic risks. For many lower income countries, flows from official sources, adapted to their economic situation, will continue to dominate flows from international capital markets.

As a result of differences in the implementation of adjustment programs, as well as differences in the impact of external developments, there has been a divergence in the economic performance and prospects of debtor countries. Reflecting this divergence, restructuring techniques have continued to evolve. MYRAs with enhanced surveillance have been developed to contribute to the process of restoring countries’ access to spontaneous financing. At the other end of the spectrum, banks have rescheduled interest payments on long-term credits to very few countries judged to have little or no prospect of regaining access to financing other than trade credits.

Cohesion and burden sharing among creditors are likely to be difficult issues in the period ahead. The task of mustering concerted financing has become more difficult, because of a diminished sense of urgency among creditors, and because the passage of time has caused some divergence in banks’ longer-term business interests. In the months ahead, bank creditors are likely to review carefully the ways of providing debt relief, while keeping new techniques attuned to individual debtor countries’ prospects for access to different types of finance. Recent developments in adapting financing instruments flexibly to the situations of countries, and to the differing financial circumstances of banks, may need to be further extended.

A central task in the period ahead will concern the need to catalyze adequate financial flows. This process will depend upon several factors, including the quality of policies in member countries and the close involvement of various sources of finance. Pressures will likely continue for concerted lending packages to include a larger share of official resources or guarantees. Banks are aware, however, that official support alone is not sufficient to serve the financing needs of debtor countries. Rather, it is important that bank lending, together with that from official sources, be geared to support adjustment policies in developing countries that lead to sustainable growth.

U.S. Debt Initiative

Recognizing these difficult problems, Secretary of the U.S. Treasury, James A. Baker III, in his address to the 1985 Annual Meetings of the Fund and World Bank, proposed a “Program for Sustained Growth” to strengthen the international debt strategy. This initiative was welcomed by finance ministers in other countries who had voiced similar concerns. Secretary Baker proposed a three-point plan that would build upon the flexible, case-by-case debt strategy developed in the past three years. This initiative is aimed primarily at stimulating the process of growth and adjustment in heavily indebted developing countries and encouraging new financing flows from both official and private sources to reinforce this process. The proposals illustrate the need for financing to countries implementing appropriate economic policies. The main lines of the U.S. initiative are set out below.

The first element in the U.S. proposal is the adoption by principal debtor countries of comprehensive macroeconomic and structural policies to promote growth, balance of payments adjustments, and a reduction in inflation. In addition to the continued application of macroeconomic policies, the proposal envisages increased emphasis on medium- and long-term supply-side policies to promote growth, savings, and investment. The initiative recommends that the Fund, in close cooperation with the World Bank and other multilateral development banks, give greater attention in debtor countries to structural and institutional measures such as tax reform, market-oriented pricing, the reduction of labor market rigidities, and the opening of economies to foreign trade and investment.

The second element is a continued central role for the Fund in conjunction with increased and more effective lending by multilateral development banks. The proposal supports the role that has been played by the Fund in encouraging policy changes and catalyzing capital flows to debtor countries, and envisages a continued important role for the Fund in both respects. In this connection, it was noted that the development by the Fund of new techniques, such as “enhanced surveillance,” could be useful in certain cases in generating additional financing to support further progress in borrowing countries.

The adoption by debtor countries of economic reforms would also be supported by an increase in structural and sectoral loans from the World Bank and other multilateral development banks. The United States has suggested that annual disbursements from the World Bank and Inter-American Development Bank to principal debtor countries could increase by about 50 percent from the current level of nearly $6 billion in support of structural policy changes in debtor countries. If the principal debtors implement growth-oriented reforms, if commercial banks provide adequate increases in net new lending, and if increased demand for quality World Bank lending demonstrates the need for increased capital resources, the United States would be prepared to look seriously at the timing and scope of a general capital increase for the World Bank. The United States also proposed that the Inter-American Development Bank should strengthen its lending policies to give more effective support to growth-oriented structural reform and, on this basis, introduce a program of targeted nonproject lending.

The World Bank role in stimulating private lending to developing countries would be enhanced under the U.S. proposal, with strong support for an expansion in the Bank’s cofinancing operations. In addition, the proposal anticipates that the operations of both the recently negotiated Multilateral Investment Guarantee Agency (MIGA) and of the International Finance Corporation will assist in attracting nondebt capital flows to member countries.

The third element is increased financing from private sources in support of comprehensive adjustment programs. The U.S. initiative is aimed at overcoming the increasing reluctance among banks to participate in new money packages and debt restructuring, and at reversing the sharp decline in net new bank lending to debtor countries noted previously. It called for a public commitment from the banking community to provide net new lending of $20 billion to a group of heavily indebted, middle-income developing countries over the period 1986–88, provided that sound economic policies are put into place. U.S. officials have indicated that this $20 billion would represent an increase on the order of 2½-3 percent a year in total commercial bank claims on the group of countries. No entitlements or predetermined ceilings for bank lending were intended by the suggested percentage increase in banks’ exposure to these countries. Rather, commercial bank financing would be tailored, on a case-by-case basis, to the financial requirements of individual member countries.

A list of 15 such countries was put forward by the U.S. Treasury. This list was not intended to exclude any country from gaining access to bank lending; some countries may not need net new bank lending, while other countries may be added to the list. In addition to the provision of net new loans to the group of 15 countries, banks would be asked to continue to provide net new loans to countries now receiving adequate bank financing on a spontaneous basis, provided that these countries maintain sound policies, and to consider lending to other developing countries experiencing debt-servicing problems that require relatively small amounts of commercial bank financing under agreed adjustment programs.

A variety of techniques for generating the new bank lending could be considered in order to achieve as broad a participation by banks as is feasible. A diversification of instruments available to banks, particularly for banks with small exposures, might eventually be developed. The Secretary of the Treasury has invited the banking community to develop possible arrangements to ensure that an adequate flow of new financing is obtained.

The U.S. initiative also stresses that other sources of external finance, including foreign equity investment, private sector borrowing, and repatriation of domestic capital, must be encouraged. This should be facilitated by the implementation of sound economic policies to stimulate growth and investment, and would also be encouraged by the expansion of the role of multilateral institutions described above. In particular, policy measures must succeed in reversing capital flight if foreign financing is to increase. The U.S. Treasury Secretary also laid emphasis on the importance of enhancing foreign direct investment. He noted that it is not debt-creating, that it may have a compounding effect on growth, as well as bringing new technology and innovation into recipient countries, and that this may help to retain capital in the developing country.

In recent discussions by the Executive Boards of the International Monetary Fund and the World Bank, as stated in a press release December 2, 1985, broad support was expressed for this debt initiative. A. W. Clausen, President of the World Bank, and J. de Larosière. Managing Director of the IMF, expressed their strong support for the initiative, and stated that it should be translated into positive and concrete actions as soon as possible.

The IMF and the World Bank stated that they were ready and willing to play their parts, in close collaboration, in the implementation of the initiative and to that end would cooperate fully and constructively with their memberships, and with all parties in these concerted efforts to deal with debt problems and establish the basis for sustained economic growth.

The U.S. debt initiative has also been welcomed by the international banking community. In messages received by the Managing Director of the Fund and the President of the World Bank, banks from the major financial centers—accounting for an overwhelming majority of bank claims on heavily indebted, middle-income countries—have indicated their willingness to play their part in implementing the 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 the United States, banks accounting for more than 95 percent of U.S. bank claims on the heavily indebted, middle-income countries have indicated their support. In the aggregate, indications of support have been received from banks in financial centers that account for more than 90 percent of total loan exposure to these countries.

Medium-Term Outlook

The medium-term outlook for coping with the debt-servicing problems of developing countries remains difficult. The global economic environment has become less favorable. Output growth of industrial countries has slowed, while protectionist pressures have continued on the rise. Moreover, export earnings of developing countries have been reduced by a decline in prices for primary commodities. Finally, spontaneous bank lending to developing countries has slowed further and is likely to remain very limited, while the pattern of such lending may be subject to sharp swings owing to changes in banks’ perceptions of creditworthiness. With such challenges, a coordinated response by governments of developing and industrial countries, multilateral development banks, and commercial banks is needed to strengthen the international debt strategy.

Developing countries need to institute policies that would allow them to achieve external adjustment and growth. Such a strategy rests on policies that maintain a set of incentives for exporting, foster domestic savings, and encourage private investment. Prudent monetary and fiscal policies are necessary to create an environment of financial stability which facilitates the operation of supply-oriented policies. Essential components of this strategy for growth and adjustment are real exchange rates and real interest rates which provide adequate incentives for the production of tradable goods and the generation of domestic savings. Growth-oriented adjustment policies in debtor countries will also assist in restoring confidence in their economies and, hence, also contribute to deterring capital flight and attracting foreign equity investment.

Industrial countries also bear a significant responsibility to undertake policies that improve the world economic environment faced by developing countries. Several policy actions by industrialized countries would be required to achieve durable noninflationary growth. The public sector’s claims on available world savings should be reduced by cutting structural budget deficits and public spending where these are excessive. Such action would contribute to a lowering of international interest rates. The rise of protectionism also needs to be strongly resisted, on the part of both industrial and developing countries. Industrial countries could stimulate the flow of financing to developing countries by applying export credit cover policies in a manner that recognizes more quickly countries’ adjustment efforts, while bank supervisors could continue to show flexibility in order that bank flows are not unduly impeded, and that the quality of adjustment policies is taken into account.

Multilateral development institutions can play an increasingly important role—through their lending. their expertise on investment strategies, and their advice on long-term structural reform—in implementing the international debt strategy. Cofinancing operations with the World Bank and other institutions would aid in this process by encouraging increased project and sectoral financing. However, guarantees to banks by governments or the World Bank would only transfer risks from the private banking system to the public sector. There is a need for bank creditors to add to the financing pool made available to developing countries by official sources. In this regard, a major role of the multilateral development institutions could be to reinforce banks’ confidence in the medium-term advisability of lending to developing countries and to aid in greater total lending to these countries.

Commercial banks, by demonstrating responsibility and flexibility where effective adjustment efforts are under way, can protect the quality of their existing claims on developing countries and contribute to further progress in restoring sustainable growth. Recent improvements in banks’ balance sheets place banks in a better position to lend to countries undertaking appropriate policies. Trade finance and project lending are of particular importance in supporting exports, investment, and growth and would safeguard the security of past bank investments. However, caution must be taken so that the present tendency toward trade and project financing by commercial banks does not divert attention away from the need to disburse balance of payments financing in those cases where this type of financing would be appropriate.

Considerable progress has been achieved in handling debt-servicing difficulties and reducing systemic risks. A coordinated effort by all parties involved—debtor and creditor governments, multilateral agencies, and commercial banks—is needed to build upon this progress. With the experience that the Fund has acquired in these matters, and in close cooperation with the World Bank, the Fund will be able to assist developing countries in designing appropriate adjustment strategies and mobilizing financial support. Through its surveillance responsibilities, the Fund will be able to work with its membership to improve the global economic environment on which the adjustment effort of developing countries is conditioned.

International Monetary Fund, World Economic Outlook, October 1985: Revised Projections by the Staff of the International Monetary Fund (Washington: International Monetary Fund, October 1985).

Total cross-border lending by banks is measured 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. In interpreting the flows thus derived, it is necessary to bear in mind that the Fund’s International Banking Statistics series follows a balance of payments approach to recording credit flows. and is thus based on the geographical location of banks rather than on their nationality. As a result, activity within a money market center—e.g., lending by a British bank in London to local branches of U.S. banks—is not captured. On the other hand, lending by a U.S. bank to its own branches in Europe or the Far East will show up in the data as a cross-border flow. Thus, the review of recent developments that follows does not reflect interbank lending within the major centers, nor does it net out redepositing between banks when recording flows across borders. Because all references in this paper are to cross-border flows, the term “cross-border” is hereafter omitted.

Based on a stock of claims of $2.6 trillion at the end of 1983.

Lending is measured as the change in bank claims adjusted for exchange rate fluctuations. Overcounting of bank claims in certain developing countries may occur when loan claims on nonbanks are transferred to banks (i.e., the central bank). Such transfers should result in an increase in interbank claims offset by a decline in claims on nonbanks. However, international banks that report their claims on banks and nonbanks may not properly reclassify their claims on nonbanks, which would result in overcounting of those claims and an overestimation of lending. On the other hand, data on bank claims have been reduced, owing to loan charge-offs, sales of banks’ claims to nonbanks, and the exercise of official guarantees. Thus, recorded new lending could be underestimated. (According to an estimate by the staff of the Board of Governors of the U.S. Federal Reserve System, U.S. banks’ lending to non-OPEC developing countries may have been understated by $3½ billion during 1983–84. or by 3½ percent. Similar estimates are currently being developed for other key financial centers.) Another source of undercounting is that banks’ holdings of securities have been underrecorded because some major banking centers exclude securities from the geographical analysis of their banks’ positions.

All references to developing countries exclude the major offshore banking centers (the Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, 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.

The Nationality Structure of International Bank Market and the Role of Interbank Operations, Bank for International Settlements, May 1985. The analysis based on ownership of assets includes cross-border claims in all currencies and foreign currency claims on local residents.

Bank for International Settlements and Organization for Economic Cooperation and Development, Statistics on External Indebtedness: Bank and Trade-Related Nonbank External Claims on Individual Borrowing Countries and Territories at End-December 1984,

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