Experiences of Five European Countries

Many borrowing countries have encountered three successive phases in their debt cycles: (i) a phase of rapid expansion when credits are available, with a growing proportion of short-term debt as borrowing requirements increase and doubts on the debt service capacity spread; (ii) a phase where medium-term credits are no longer available and short-term credits are not renewed—a crisis phase, overcome either through severe adjustment or through a debt rescheduling, or both; and (iii) a phase in which creditworthiness is restored, usually some years after the crisis, and the country gradually regains access to the market.

In the course of preparing this paper, special studies were devoted to five European countries at varying stages of their debt cycles: Portugal, then in a phase of rapid expansion of its debt; Turkey, which, after a major debt crisis, was re-entering the market; Romania, moving out of the second phase with the help of severe adjustment measures and debt rescheduling; and Hungary and Yugoslavia, which both faced severe external liquidity strains. The findings of these special studies may be summarized as follows.

Portugal. In 1978–79 Portugal was able to successfully implement a Fund program, but after 1980 it registered growing deficits on current account.

	1976	1977	1978	1979	1980	1981	1982	1983 (Prel.)
			(In billions of U.S. dollars)
Deficit on current account	−1.3	−1.5	−0.8	—	−1.3	−2.8	−3.2	−1.8

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	1976	1977	1978	1979	1980	1981	1982	1983 (Prel.)
			(In billions of U.S. dollars)
Deficit on current account	−1.3	−1.5	−0.8	—	−1.3	−2.8	−3.2	−1.8

As far as past policies are concerned, the success of the Fund program is a useful example for other countries at a comparable stage of development. It shows how adequate exchange rate incentives can rapidly affect export and import trends, how a decline in real wages induced by price developments associated with a devaluation can allow a rapid transfer from domestic demand to external demand, how an appropriate interest rate policy can modify attitudes toward savings and toward the building up of inventories of imported goods, and how a credible preannounced policy on exchange rates may induce a resumption of workers’ remittances and stabilize external financing flows.

Conversely, developments in Portugal during the period 1980–82 show the limits of the role of the Fund when external financing is readily available. The large gold stock, which reassured bankers, the integration of the Portuguese banking system into the European banking system, and the growing regionalization of the international market, making all Western European borrowers relatively attractive, combined to allow a rapid rate of increase in external debt to banks. Financing the deficit in the public sector by borrowing abroad added to the country’s debt service burden without necessarily contributing to the growth of its debt-servicing capacity. The widening of the current account deficit through ever larger interest payments added to borrowing requirements and thus to the future debt service.

Fundamentally, the deterioration in the public sector accounts was at the heart of the overall imbalance of the economy: the growing deficit fed the external deficit, which had to be financed. In addition, a too easy access by various entities to external borrowing eliminated any built-in incentive to reduce the current account deficit. Portuguese banks had been able to borrow U.S. dollars on the London and New York interbank markets, relending them as short-term credits to Portuguese borrowers. The prescription by the Portuguese authorities of minimum proportions of foreign financing (all imports of crude oil and essential goods had to be financed by external credits) contributed to the buildup of a significant external short-term debt by the public enterprises in charge of oil, cereals, and oleaginous imports. The Bank of Portugal had established a regulatory framework to monitor new indebtedness, but there was a natural tendency to roll over short-term debt falling due, which contributed to a deterioration in the debt profile. Thus, short-term debt rose to over one third of total external indebtedness by the end of 1982 before declining to one fourth in the course of 1983.

The Portuguese Government that was formed after the 1983 elections is undertaking a program of adjustment under an October 1983 stand-by arrangement with the Fund. The program aims at a significant reduction in the current account deficit in both 1983 and 1984, mainly through restrictive demand policies. Standards for external debt management, including a better monitoring of and ceilings for total external debt and for its short-term component, are part of this program. These standards are an essential component of the adjustment efforts of countries that must over the medium-term reduce the ratio of external debt service to foreign exchange earnings.

Turkey. In 1977–80, Turkey faced a highly critical debt situation that required massive debt reschedulings by official creditors and commercial banks, emergency aid by OECD countries, and successive adjustment programs. Starting in 1980, Turkey reversed its policy stance, making a deliberate shift toward a more market-oriented economy under a three-year stand-by arrangement with the Fund, and succeeded in gradually restoring its current account deficit to a more sustainable level.

	1976	1977	1978	1979	1980	1981	1982	1983 (Prel.)
		(In billions of U.S. dollars)
Deficit on current account	−2.3	−3.4	−1.5	−1.7	−3.7	−2.3	−1.3	−1.8
Debt relief			+0.3	+0.9	+1.5	+0.9	+0.8	+1.0

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	1976	1977	1978	1979	1980	1981	1982	1983 (Prel.)
		(In billions of U.S. dollars)
Deficit on current account	−2.3	−3.4	−1.5	−1.7	−3.7	−2.3	−1.3	−1.8
Debt relief			+0.3	+0.9	+1.5	+0.9	+0.8	+1.0

The debt crisis of 1977–79 was due largely to inadequate adjustment policies, but, clearly, inadequate debt management and the attitude of bankers contributed to the acuteness and the duration of the crisis. Problems included the buildup of an unsustainable level of short-term debt through the convertible Turkish lira deposit scheme;³³ inadequate information on the debt situation, the prolonged negotiations on the rescheduling agreement, and the exclusion from the rescheduling of large acceptance credits which had to be repaid at a time of major external constraint.

During the period 1979–81, external debt management did not play a major role in policy decisions, since short-term trade-related credits were not resumed until 1982. But it is again one of the major components of the overall economic strategy. The Fund program has been a success, although there was some back-sliding in 1983. A rapid export growth induced by the adjustment of the exchange rate contributed to a GNP growth of 4–4.5 percent in 1981 and 1982; there was a rapid increase in workers’ remittances in connection with the freeing of interest rates; there was a sharp reduction in the rate of inflation in spite of some slippages in the implementation of monetary policy; and there were improvements in the financial situation of the state economic enterprises.

Because of the resumption of large debt service payments in 1985 and the reduction in foreign aid, Turkey will have to continue to adhere to tight demand management policies and restore its ability to tap medium-term credit markets. Turkey first approached the market in 1982 to obtain medium-term financing for the acquisition of airplanes, for the prefinancing of agricultural exports, and, with the help of the International Finance Corporation, for the financing of Turkish construction firms’ activities in foreign countries. But clearly Turkey has to strengthen the financial basis of its industrial groups and of its banking system if it is to re-enter the market in a more substantial way. Through technical assistance to the central bank and through policy measures, within the stand-by program, aimed at a modification of financial instruments, the Fund can play a role in this process. Further involvement by the Fund could be associated with medium-term bank financing, which could be channeled through a “cofinancing” approach in which discussions among the Fund, a group of leading banks, and the Turkish authorities would yield a common assessment of needed financial flows in 1984, a timetable for various types of credits (including trade credits) and, possibly, an agreement on phasing.

Romania. Romania is emerging from a debt crisis comparable to the Turkish crisis of 1977–79. After a period of rapid economic growth fueled by a large investment program conducive to growing current account deficits and a rapid buildup of its external debt,³⁴ Romania suffered from the interruption of foreign short-term credits in the wake of the Polish crisis. It had to enter into agreements with its creditors for the rescheduling of its debt falling due in 1982 and 1983 and to implement a massive domestic adjustment, under a Fund stand-by arrangement, aimed at a surplus on current account.

	1976	1977	1978	1979	1980	1981	1982	1983 (Prel.)
		(In billions of U.S. dollars)
Current account in convertible currency	−0.1	−0.3	−0.3	−1.7	−2.4	−0.8	+0.7	+0.9

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	1976	1977	1978	1979	1980	1981	1982	1983 (Prel.)
		(In billions of U.S. dollars)
Current account in convertible currency	−0.1	−0.3	−0.3	−1.7	−2.4	−0.8	+0.7	+0.9

The large deficits of 1979–80 were induced by both exogenous and domestic factors. As in other borrowing countries, the exogenous factors were the second oil price shock, the rapid increase in interest rates, and the decline in demand for exports because of the recession, which was accompanied by a deterioration in the terms of trade. There were also shortcomings in the management of the domestic economy. Contributing factors were a too rapid rate of expansion, a much too ambitious investment program, the difficulty for a highly centralized economy to adjust rapidly to external developments, and an inadequate energy policy that contributed to a shift from a net oil exporter to a net oil importer position and to the perpetuation, during this period, of unprofitable processing and petrochemical activities.

These difficulties were compounded by a low level of foreign exchange reserves (representing only four to five weeks of imports and less than 25 percent of short-term external debt), an inadequate flow of information, insufficient monitoring of short-term buyers’ credits, the use of interbank short-term credits to avoid the cost of medium-term borrowing at a time when it could have been obtained, and an inadequate maturity profile with a high proportion of short-term debt and a peak of repayments in 1981. Thus, when the situation deteriorated in the second half of 1981, there was a built-in vulnerability that was aggravated by delays in the opening of discussions with bankers. In the second half of 1982, the Romanian authorities reached an agreement on debt rescheduling with governments ($0.3 billion), excluding, however, officially guaranteed short-term debt of $0.2 billion, and with Arab and Moscow banks ($0.4 billion), commercial banks ($1.5 billion), and suppliers ($0.3 billion)—all on comparable terms (80 percent of debt falling due rescheduled and a repayment period of six and a half years with a three-year grace period). Except for a larger down-payment (40 percent, including 10 percent deferred to 1985, against 20 percent in 1982), Romania was able to obtain similar terms for the rescheduling of the debt falling due in 1983.

The Fund, in the adjustment program for Romania, had to use the standard instruments such as credit ceilings, which have a limited effectiveness in centrally planned economies, or to rely on the instruments used by the country itself, with no built-in incentives to move in the direction of more market-oriented mechanisms. The use of external quantitative criteria was a substitute for other criteria, but may have appeared to financial markets as not sufficiently emphasizing the needed internal changes.

If Romania is to restore its ability to attract capital flows and return to a more adequate medium-term growth path after a period of severe adjustment from 1981 to 1984, it will have to continue to implement fundamental changes in the financial system through decentralization, in the foreign trade system through the revision of the role of foreign trade enterprises and a move toward multilateral trade relations, and in the productive sector by a decentralization of decisions on prices and investments. Such a process should be an integral part of an overall strategy aimed at a more balanced and more diversified economic policy.

Hungary. Since 1979 Hungary has been pursuing an adjustment policy aimed at reducing its current account deficit.

	1977	1978	1979	1980	1981
	(In billions of U.S. dollars)
Current account in convertible currency	−0.8	−1.2	−0.8	−0.4	−0.7

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	1977	1978	1979	1980	1981
	(In billions of U.S. dollars)
Current account in convertible currency	−0.8	−1.2	−0.8	−0.4	−0.7

In 1982, Hungary faced an acute liquidity shortage and had to intensify its efforts under a Fund-supported program, which aimed at the restoration of a current account surplus in 1983.

The 1982 crisis was largely the result of debt management in previous years. Since 1968, with some setbacks from 1974 to 1978, Hungary had been moving in the direction of a more market-oriented economy with a view to replacing plan directives by market relations among firms, limiting the scope of central price determination, linking the domestic prices of exports and imports to world market prices, and decentralizing a major part of investment decisions. These efforts had not affected the financial system, which remained totally centralized, with the central bank performing all the functions of a commercial bank and most of the functions performed in other centrally planned countries by foreign trade banks. This centralization was reflected in the overall debt structure. The high level of external debt was in itself bound to lead to difficulties.³⁵ The looming difficulties were compounded by the structure of the debt. The policy of the National Bank was to prohibit direct uses of suppliers’ credits by industrial firms except under highly concessionary terms and to limit the use of documentary credits. It relied entirely on financial credits, notably syndicated loans, bank-to-bank credits, and deposits of nonresident banks, with some associated advantages in terms of spreads and currency composition. But this policy contained a built-in vulnerability to a change in the attitude of commercial bankers, which materialized in 1982 when the withdrawal of short-term foreign deposits began.

Action by the BIS (a $510 million credit), the Fund (a $520 million stand-by arrangement plus a drawing of $80 million under the compensatory financing facility), and commercial banks (a $260 million three-year loan syndicated by Manufacturers Hanover Trust) avoided a major debt crisis in 1982. However, commercial arrears accumulated from time to time; they peaked in the middle of 1982 but were eliminated by the end of the year. The coordinated approach between the BIS, the Fund, and the parallel action by commercial banks was an especially successful example of international cooperation. It included a bridging credit granted by the BIS, based on an assessment that negotiations with the Fund on an adjustment program including immediate action on the exchange rate and interest rates were likely to succeed; close contacts between the Fund and commercial banks; and a lead given to other commercial banks by a group of major banks. Nonetheless, the debt service burden remains high through 1985, the level of reserves is low, and the attitude of commercial banks has improved only moderately. Stabilization measures under the Fund program have already brought about a sizable positive swing in the current account and are consistent with a current account surplus compatible, under normal circumstances, with foreseeable capital flows.

Hungary re-entered the international capital market with a $200 million three-year loan syndicated in April 1983 and has begun to address, in collaboration with the Fund and the World Bank, some fundamental issues. These issues include a transformation of the banking system to diversify the channels of savings, investment financing, and external borrowing; a more direct relation between the domestic economy and the external environment, to encourage suppliers’ credits and project financing; and a new approach to the use of macroeconomic policy instruments to ensure the effectiveness of changes in the exchange rate and interest rates.

Yugoslavia. After a period of rapid growth from 1970 to 1977, Yugoslavia had to adjust its economy. The widening gap between domestic production and demand and the associated inflationary pressures made it necessary to shift to restrictive demand management policies supported by a stand-by arrangement with the Fund covering the period 1981–83.

	1977	1978	1979	1980	1981	1982	1983 (Prel.)
		(In billions of U.S. dollars)
Current account in convertible currency	−1.0	−1.3	−3.3	−2.2	−1.8	−1.6	+0.3

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	1977	1978	1979	1980	1981	1982	1983 (Prel.)
		(In billions of U.S. dollars)
Current account in convertible currency	−1.0	−1.3	−3.3	−2.2	−1.8	−1.6	+0.3

Unfortunately, these measures proved to be insufficient when the shift in the commercial banks’ attitude toward Eastern European countries materialized. In 1981, Yugoslavia had been unable to raise on the market the medium-term syndicated credits it had been contemplating and had to rely on a rapid growth of short-term indebtedness. The vulnerable liquidity situation was compounded by the overall inadequacy of the foreign exchange and external debt management systems. The developing difficulties included inadequate supervision of the Yugoslav commercial banks, which entered into massive foreign borrowing; a rapid buildup of foreign exchange assets of Yugoslav citizens, who were entitled to hold freely usable foreign currency deposits with Yugoslav banks; and inadequate pooling of foreign reserves within the system, with individual republics monitoring their own balance of payments. In the absence of a national foreign exchange market, each bank had to rely on its own foreign exchange resources. The whole system was dependent on a continued increase in external borrowing by those banks that were actually running a foreign exchange deficit.

Privredna Bank Zagreb, which was engaged in the financing of several major projects and which was financing a large part of the oil imports of Yugoslavia, turned out to be the weakest element in the system. To meet its external obligations in 1981, it had to engage in short-term foreign borrowing, mainly on the interbank market. These credits were not renewed and the bank had to repay in 1982 its medium- and long-term 1982 obligations plus short-term credits obtained in 1981. As a result, there was an accumulation of arrears, which seriously harmed the image of Yugoslavia in the world banking community.

To overcome the crisis, a series of measures was adopted, including better pooling of foreign exchange and greater control by the National Bank of Yugoslavia of foreign borrowing, reinforcement of restrictive demand management policies in association with wage and price controls, devaluation of the dinar, increases in interest rates, and restrictions on the use of foreign currency deposits. In spite of an arrangement with Arab banks for the financing of oil imports ($100 million), a syndicated loan managed by a group of U.S. and Japanese banks led by Citibank of New York ($200 million), and the extension of additional trade-related credits by German, French, Italian, and Austrian banks, the inflow of private capital was insufficient to meet repayment obligations, which were amplified by the withdrawal of short-term credits and deposits.

Yugoslavia drew down its already sharply reduced reserves and requested a $500 million medium-term facility from the BIS. Since the BIS was unable to arrange such a facility, there was a need to obtain pledges of governmental assistance from OECD countries. In January 1983, the Fund succeeded in obtaining commitments to that effect from major OECD countries ($1.3 billion) which, supplemented by an agreement with commercial banks to roll over short-term debt, to refinance longer-term debt maturing in 1983, and to grant $600 million as medium-term “fresh money,” and by a $500 million short-term BIS credit, allowed Yugoslavia to meet all its commitments in 1983.

Although a general rescheduling operation has been avoided, there is a need to address the medium-term debt problems of Yugoslavia. There is a good case for an innovative approach under which, in the framework of an overall financial package, foreign banks, in addition to refinancing of debt, would agree to negotiate a partial restructuring of the debt of certain Yugoslav entities. Such an approach would help to restore Yugoslavia’s borrowing capacity and introduce some discipline into the marketplace. The ratios of foreign exchange borrowings to total liabilities or to foreign assets of a bank such as Privredna Bank Zagreb were out of line with the corresponding ratios of other Yugoslav banks. Foreign banks should have been aware of the risks attached to this structure and should be prepared to help correct this situation.

In any event, Yugoslavia is faced with a long period of economic adjustment. To help restore its credit-worthiness, it will have to implement structural measures of debt management by strengthening the financial structure through the merger of some banks, developing a unified foreign exchange market, modernizing monetary instruments, and moving toward project financing and a greater use of suppliers’ credits.

The experience of each country is unique, and the lessons to be drawn from debt management in five European countries are not immediately applicable to other countries in other regions or at other stages of development. Nevertheless, some conclusions may be drawn from these experiences. In particular, there is a need to

—implement in a timely way the required adjustment to external constraints;

—diversify the type of borrowers and the type of borrowings to reduce vulnerability risks, and, to that end, strengthen the financial viability of potential borrowers;

—introduce some form of centralized monitoring of external debt, based on adequate information, aimed at a sustainable debt burden, a viable debt maturity profile, and a manageable liquidity position where foreign exchange reserves are adequate to cope with possible adverse developments in the short-term debt;³⁶

—have greater discipline in the international marketplace to avoid inappropriate banking schemes, inappropriate interbank lending without adequate attention being paid to individual risks, and the destabilizing alternation of overlending and abrupt cuts of existing credit lines; and

—ensure adequate involvement by central banks and the Fund to help reduce vulnerability, improve the assessment of financial flows,³⁷ and obtain a more orderly process.

The Role of Central Banks

The debt crises of 1982 have underlined the need to strengthen and stabilize the system of “liability settlement” (see page 15) through improved debt management. Central banks of both debtor and creditor countries, through their monitoring of bank lending and borrowing, have a role to play in this endeavor.

The Role of the Fund

The Fund, through its annual consultations and its policies on the use of its resources, could contribute further to an overall process aimed at better external debt management.

Consultation reports could stress more the external liquidity situation, the structure of the external debt, and the vulnerability to external shocks. In many instances, the staff has had early knowledge of potential debt crises and has alerted the authorities to the risks involved. However, it is important that these views are fully reflected in the consultation reports. To be sure, it is not that easy for the Fund to appear to impair by its comments the creditworthiness of a member country, but such comments form part of its surveillance functions in a liabilities settlement system.

While consultation reports in the past had dealt with external debt matters where appropriate, the events of 1981–82 indicated that there was scope for pragmatic improvements in this area. Accordingly, recent reports have sought to provide more in-depth and systematic information on the factual aspects of a country’s debt position. In addition, all consultation reports now include as a routine matter for countries engaged in significant external borrowing operations (and not just those with stand-by arrangements in place) a technical “forward-looking” medium-term debt scenario analysis. This approach is to be welcomed. In its implementation, and in order to avoid any appearance of discrimination between member countries, it could be useful if, as far as possible, comments were made under a relatively standardized format. For example:

Debt structure—the various types of borrowers and the various channels of borrowing; the external situation of banks in the country, with a specific reference to their capital adequacy, their debt situation, their use of the interbank market, and their supervision by the central bank; the external situation of enterprises, with a specific reference to trade-related credits and their maturities; the debt maturity profile; and the availability of information on the debt structure.

Access to capital markets—recent developments in syndicated loans raised by the country, with a comparison between their spreads and maturities and average spreads and maturities in the market, as an indicator of the market’s perception of the creditworthiness of the country; information provided in the documentation of such syndicated loans on lead managers and collaterals offered to lenders; and a reference to relations with the World Bank and the International Finance Corporation (IFC), especially for countries for which graduation is contemplated.

Liquidity situation—adequacy of freely usable Reserves;⁴¹ existence of unused lines of credits; evolution of the principal ratios of the “country balance sheet” (external short-term debt/reserves or reserves plus unused credit lines, short-term liabilities/total liabilities, debt service ratio); and vulnerability to external shocks.

Medium-term debt outlook—description of possible medium-term debt scenario(s), based on assumptions regarding the external environment and policy stances by the authorities; gross borrowing requirements, including the rollover of short-term debt, in each of the five coming years; and sensitivity of scenario to changes in underlying assumptions.

Ceilings on medium-term and long-term external borrowing are included in almost all stand-by arrangements. In most arrangements, short-term debt was excluded from the ceilings since, until recently, the greater part of such debt was considered as trade related. However, this assumption is no longer valid, as it is clear that many of the difficulties experienced by many debtors were greatly exacerbated by excessive short-term borrowing for essentially balance of payments purposes. Accordingly, since early 1983, stand-by arrangements have as a general policy included as performance criteria external borrowing ceilings covering short-term debt; in several arrangements, there has been a subceiling relating to short-term debt only. This is a quite appropriate development.

Technical assistance provided by the Fund (and/or the World Bank) is a fundamental element in an overall process aimed at better external debt management. It is an area where improvements are under way through an expansion of technical assistance provided by the Fund’s Central Banking Department. This expansion will require the adequate staffing of the department or the adequate hiring of external consultants, expansion of the department’s technical assistance in external debt statistics, in consultation with the World Bank’s External Debt Division,⁴² and the establishment of permanent external debt management machinery. There is, in addition, a need to strengthen the capability of the department to provide technical assistance in the field of bank supervision, where certain initiatives have already been taken in cooperation with the BIS. A new impulse should be given to these endeavors because of the growing role of interbank transactions and thus of the need for a sound, effective, and well-monitored banking system. In consultation with the World Bank and the IFC, there is also scope for an extension of the Central Banking Department’s technical assistance activities in the setting up of foreign exchange markets, financial markets, financial instruments, and banking institutions. These should be designed to develop an adequate base for external borrowings by commercial banks, a logical step for countries entering or re-entering the international capital market.