The debt crisis refers to the high level of indebtedness of a significant number of developing countries in Latin America, Asia, and Africa that is generally considered to severely inhibit their ability to modernize structures within their own societies so as to make them both internationally competitive economically and more stable socially and politically. The issue for the international community is what role external finance is to play in addressing this underlying chronic condition in light of the extraordinary amount of indebtedness that was contracted in the last 15 years. It is particularly appropriate to address the issue presently in Washington, D.C., for there is a ferment of ideas concerning this subject in this city at this time. This paper will attempt to place the current debate in perspective, draw some lessons from the past, and hazard some thoughts as to the future.
The debt crisis refers to the high level of indebtedness of a significant number of developing countries in Latin America, Asia, and Africa that is generally considered to severely inhibit their ability to modernize structures within their own societies so as to make them both internationally competitive economically and more stable socially and politically. The issue for the international community is what role external finance is to play in addressing this underlying chronic condition in light of the extraordinary amount of indebtedness that was contracted in the last 15 years. It is particularly appropriate to address the issue presently in Washington, D.C., for there is a ferment of ideas concerning this subject in this city at this time. This paper will attempt to place the current debate in perspective, draw some lessons from the past, and hazard some thoughts as to the future.
II. Phase I: A Cornucopia of Finance, 1974–82
Sometime in the late 1960s, the combination of a simultaneous economic expansion in the major industrialized nations led to a fundamental change in the supply-demand equation in the trade in international crude oil supplies in favor of the producing nations: The immediately available supply of crude oil was not keeping up with the demand for it. This condition was exacerbated by the increased awareness of environmental considerations in these same countries, which placed a premium upon the availability of low-sulphur, “sweet” crude oil, as it is known in the trade. The tightening supply of crude oil in relation to demand was reflected in the negotiations between the Organization of Petroleum Exporting
Countries (OPEC) and the multinational oil companies in Tehran and Tripoli in late 1970 and 1971; it assumed explosive dimensions in the aftermath of the October 1973 war between Israel and Egypt and Syria.
The United States had run out of spare capacity—that is, the capacity to increase the production of crude oil almost immediately. The 1973 Arab oil embargo of the United States (and the Netherlands) masked severe production problems in major oil reservoirs in Saudi Arabia resulting in large part from the failure of water-injection facilities to function as planned; the production of crude oil in Saudi Arabia would have had to be curtailed if the Saudis and their associates did not wish to risk permanent damage to the producing reservoirs. (Less oil would have ultimately been recovered if production had continued under prevailing conditions.) Hence, the embargo came at a convenient time both for the Government of Saudi Arabia and the multinational oil companies that made up the Arabian-American Oil Company (ARAMCO) consortium.1
In the aftermath of the embargo, the price of crude oil was dramatically increased by the oil producers: between October 1973 and January 1974, the international price of crude oil increased by nearly 600 percent compared with what it had been in early October 1973.
U.S. Secretary of the Treasury William Simon observed in August 1974 that the revenues of the oil producing countries that made up OPEC were running at an annual rate of $100 billion, of which $60 billion needed to be recycled. Secretary Simon was referring to the fact that the greatest part of the $100 billion accrued to Saudi Arabia, Kuwait, and Bahrain, oil producers who could not spend all of their oil revenues on imports from the oil consuming states. Unless they curtailed oil production, they would earn approximately $60 billion that would need to be placed somewhere.
Simon worked out a program that enabled these oil producers (and other official agencies of foreign governments) to purchase U.S. Government securities at market prices directly from the U.S. Government using special procedures, bypassing the financial markets. This program had the advantage of assuring the foreign government purchasers’ confidentiality and, at the same time, helping to finance the U.S. Government’s fiscal deficit. The exact amount of these transactions has never been revealed. However, they were not sufficient to mop up the financial surpluses of the Gulf oil producers resulting from the run-up in oil prices. A significant part of the surplus still had to be placed in the financial markets.
The London market was particularly attractive. There, a market in dollars outside of the United States had developed in which there were no reserve requirements and virtually no regulatory standards. Each of the New York money center banks, as well as the larger U.S. West Coast, Middle West, and regional banks, had established branches or subsidiaries in London. Major Japanese and continental European financial institutions also established operations in London to cash in on the petrodollar bonanza. The London market, therefore, became the means through which a great part of the financial surpluses of the OPEC oil producers was absorbed by the Western financial world.
As Secretary Simon put it, “we observed that the private financial system was doing a remarkable job of handling very large expanded operations.”2 As for the role of governments in facilitating the flow of money in the recycling process, said Simon, “the first responsibility of governments is to maintain those economic and financial conditions conducive to sound economic activity.”3 In other words, the task of recycling the vast financial surpluses accumulated by a few oil producing states was to be left to the private banking sector, which, in Simon’s view, could be expected to act responsibly in making sound credit judgments and not lending beyond prudent limits.
Once they had accepted these interest-bearing, short-term deposits, the commercial banks faced the problem of how to lend them out at a profit. The oil importing Western industrial powers were not a promising market. As a response to the massive oil price increases of 1973 and 1974, these countries adjusted their economies by adopting severe deflationary policies. Economic activity in the United States, Western Europe, and Japan declined. In a period of recessionary economic conditions, industrial enterprises saw no need to borrow to expand capacity.
But for the oil importing developing countries, the fact that the Western financial institutions were flush with cash deposited with them by the oil producing states was fortuitous. Rather than “adjust” to the oil price increases by deflating their economies, as did the industrialized countries, Brazil, Argentina, Chile, Korea, and the Philippines, for example, preferred to borrow to pay their current oil bills and maintain high rates of economic growth.
In effect, then, recycling the financial surpluses of the oil producers meant that the oil producers became creditors of the economically strongest country in the West, the United States, through the Simon scheme, and of the great multinational banks of the Western industrialized countries. These banks, in turn, took the credit risks of lending to the economically weaker oil importing states. The risk of default by these weaker states, then, was assumed not by the oil producers who had created the need to borrow because of increased oil prices; the risk was assumed rather by the banks and—standing behind them—the central banks of the industrialized countries.
Moreover, the existence of the Eurodollar market (later a multicurrency market) in London also enabled the developing countries to escape the supervision of the World Bank and International Monetary Fund. Because borrowers were in great demand in this market to absorb the surplus oil dollars on deposit with the great banks, officials of the oil importing developing countries that were deemed by the banks to be creditworthy were exhorted by them to borrow in ever-increasing amounts. Instead of being lectured on the virtues of “sound” fiscal and monetary policies and realistic exchange rates by nagging bureaucrats of multilateral public financial institutions, officials of such developing countries were implored, flattered, and cajoled by senior officers of the most important private commercial banks in the Western World to borrow still more money.
Not only governments could borrow in the Eurodollar market. Autonomous government-owned entities with their own separate legal personalities and financial resources borrowed independently, often without a guarantee of repayment by the central government. Private enterprises in the borrowing countries, as well as official financial institutions, appeared to have unrestricted access to these bank resources with minimal, if any, accountability.
In a monograph written for the Twentieth Century Fund, The Brazilian Quandary (New York: Priority Press, 1986), the Brazilian economist Mar-cilio Marques Moreira, later Ambassador to the United States, observed with respect to Brazil:
These resources were mainly aimed at capital accumulation, not financial speculation; they complemented domestic savings and did not encourage capital flight (the proof is that the accumulated current account deficits were larger than the increase in net debt during the period); they were not the result of an overvaluation of the cruzeiro; and although they might have been used for oversized projects, they were neither spent on extravagant arms purchases (the military regime preferred to export armaments rather than to import them), nor on luxury consumption (even oil in Brazil is predominantly used for production, transportation, and distribution of goods, rather than for recreational driving or residential heating). To paraphrase Veblen, the most serious sin might have been overindulgence in conspicuous investments.4
What was true of Brazil was, to a greater or lesser degree, also true of other countries at equivalent stages of development which had access to financing in the Eurocurrency markets. The productive plant in these countries owned by the state or local entrepreneurs or some combination of these rapidly expanded. Within the space of a decade, Korea, Taiwan Province of China, Singapore, and Mexico emerged with steel, automotive parts, and electronics plants, producing for the world market. Not yet in the class of Europe and Japan, nevertheless these newly industrializing countries, or NICs, as they came to be called, were becoming world-class players in the international economy. (Not all of the borrowing was devoted to expanding productive capacity. Borrowing financed capital flight and conspicuous consumption. And some countries, such as Argentina, were hard put to show that their borrowing had led to additional producing facilities.)
A Fly in the Ointment
But there was a basic flaw in the borrowing strategy of the newly industrializing countries: the nature of the markets in which they were borrowing. The money borrowed in the aftermath of the oil price revolution often had been obtained by means of loans with a maximum maturity of eight to ten years, some of them made using innovative financing techniques and due all at once in a single “bullet” payment. The interest rate at which banks in London lent surplus funds to each other, the London interbank offered rate (LIBOR), was most commonly adjusted at three-month intervals, depending upon prevailing market conditions. Hence, this “floating” rate could be increased frequently if worldwide interest rates rose over the life of a loan. The rapid buildup of debt under those conditions was highly vulnerable to any shock which had the effect of raising rates for the increasingly indebted NICs. That shock occurred in 1979 with the revolution in Iran, which toppled the Shah and his conservative government and replaced it with a regime that, at least initially, preached austerity and reduced levels of oil production.
The multinational oil companies had allowed their oil stocks to run down to minimum levels; in the aftermath of the Iranian upheaval, fearing another oil shortage, they scrambled to replace depleted inventories and, in the process, bid up the price of crude oil, which more than doubled in 1980. The NICs, which in the aftermath of the first oil “shock” had borrowed heavily to maintain investment levels and high economic growth rates, now found themselves having to borrow to pay interest on past loans and, increasingly, to pay current oil bills rather than paying for productive investment.
The Carter administration had initially sought to rejuvenate the U.S. economy after the recessionary years that had followed the oil price revolution of 1973/74. However, by 1979, the economic expansion had overheated; inflation was in double digits; and the prime rate was dramatically rising. The appointment by President Carter of Paul Volcker as Chairman of the Board of Governors of the Federal Reserve System signaled a determination to cool off the economic boom. Monetary policy was slammed into reverse. By the time the Reagan administration assumed office in January 1981, an economic slowdown in the United States was already well underway, a slowdown which the new administration heartily endorsed as a means of braking and, ultimately, reversing inflationary expectations.
This slowdown was not limited in its economic effects to the domestic U.S. economy. The U.S. economy was the largest in the world and, relative to others, was open to a wide range of imports. It constituted the most important market for the exports of the NICs, as well as those of the fully industrialized countries. As the U.S. economy went into reverse, the demand for imports dropped precipitously. Export earnings of the NICs declined commensurately, but the financial obligations they had contracted with the major international banks remained. Conditions thus were ripe for an international financial crisis. That crisis was precipitated in August 1982, when Mexican authorities traveled to Washington and informed U.S. Treasury officials that they could not meet the interest payments on their outstanding debts.
It was not that the crisis was unforeseen. As early as 1975, the Multinational Corporations Subcommittee of the Senate Foreign Relations Committee sought to ascertain the risks to the Western banking system in the recycling strategy that Secretary Simon had celebrated in his testimony before the Subcommittee. On September 11, 1975, the Subcommittee held a session that was closed to the public because the issues to be explored were considered too sensitive to be discussed in an open session.5
The Subcommittee was trying to determine whether there was a concentration of deposits from the oil producing states in a small number of major U.S. banks and whether those same banks had become financially vulnerable by virtue of having lent large amounts relative to their capital to oil importing developing countries which could have difficulties in meeting their future debt-service payments to these same banks. The information was not published by any U.S. Government agency, and it was not being collected and analyzed by the U.S. Government. Through a questionnaire, the Subcommittee sought to collect the data.
Karin Lissakers, a Subcommittee staffer, in a question to Gaylord Freeman, stated the issue concerning the Subcommittee:
If Indonesia or Zaire or Brazil, any of the larger international powers, should default not only against your bank but against 5 of the largest banks in the United States…, what would be the impact?6
Speaking for the banks, Gaylord Freeman assured the Subcommittee, that “… the loan side is pretty well covered by the recurrent examination of the experienced examiner [sic] of the Comptroller’s office and the FDIC [Federal Deposit Insurance Corporation] and the liability side is not a prospective source of significant problems.”7 By the liability side, Freeman meant that holding short-term deposits from the oil producing countries posed no risks of sudden, destabilizing withdrawals. The assembled bankers and the officials of the Federal Reserve System and the Treasury agreed with Freeman that there was no problem, that the banks lent no more than was prudent, that federal regulators were both efficient and on top of the problem, and that there was no risk of sudden defaults by borrowing countries or withdrawals of deposits from the banks by the oil exporting states that had deposited their financial surpluses with them.
In 1977, the Subcommittee on Foreign Economic Policy of the U.S. Senate Foreign Relations Committee (which had succeeded the Multinational Corporations Subcommittee when it was voted out of existence in October 1976 by the full Senate Foreign Relations Committee because it had become too controversial) further pursued the matter with officials of the Carter administration. Anthony Solomon, Under Secretary for Monetary Affairs of the Department of the Treasury, observed, in testimony before the Subcommittee, that “The question has been raised as to whether this rapid and unprecedented enlargement of lending activity and debt has reached a danger point for the monetary system, either in the sense that large numbers of countries have borrowed beyond their capacity to service debt or in the sense that our banks and other institutions are overextended.” Answering his own formulation of the question, Solomon stated, “It is our considered judgment that the system as a whole is not in any such position of imminent danger, either as a result of excessive borrowing by large numbers of debtor nations or as a result of our financial institutions’ being overstretched.”8 Solomon noted that if the borrowed funds were properly used to support productive investment and to strengthen a borrower’s current account position, the debt need not constitute a serious future burden.
But the Senators were not convinced. Senator Jacob Javits, a Republican from New York, emphasized that there was no margin for error:
The difficulty with that theory is: It fails completely to take account [of] contingencies, increase in price of OPEC oil, particular pressure in particular places because of political situations in those places, the burden of debt becoming so great compared to developmental needs—that is, Brazil—that a situation which looked very good in credit terms may not look so good at a given time....9
Senator Frank Church, a Democrat from Idaho, questioned whether the borrowed money was being used for productive purposes, citing a study of commercial loans undertaken by the American Express Company: “In 1977, they estimated one-fourth of new loan money will go to repayment of old loans and by 1981, half…What is happening is that this new loan money is not going into the expansion of economic growth, increased exports, to enable these foreign countries to pay for their imports without having to borrow still more heavily. Just the opposite is happening.”10
Senator Paul Sarbanes, a Democrat from Maryland, expressed skepticism as to the incentive for the private banks to exercise prudence in their lending:
You think the private lenders have to a considerable extent been proceeding on the premise when they make loans to sovereign governments, that there is no possibility of default in those loans, first, because the sovereign government won’t want it to happen. But in any event even if they were not able to carry the burden, that is the sovereign governments, particularly with respect to American banks, the United States is not going to permit that to take place. Therefore they really don’t have to exercise much care with respect to making those loans?11
But these warnings were not heeded. In the Ford administration, Secretary Simon had hailed the role of the private banks in recycling the financial surpluses of the oil producers to the oil importing debtor countries through commercial loans. The private banks had assured the Multinational Corporations Subcommittee that they were prudent lenders. The officials of the Federal Reserve System and the Comptroller of the Currency were satisfied with the recycling process. And there was a sense that the NICs had graduated into the big time of international finance; Mexico, Brazil, and Korea appeared to have as much leverage with the banks, in negotiating terms, as the banks had with them. They could rely less on the multilateral development banks and more on private commercial markets to meet their development finance needs.
The alternative policy would have been to try to capture some substantial part of the petrodollar surpluses of the oil exporting countries which could then be re-lent to the oil importing developing countries by the International Monetary Fund, the World Bank, and regional development banks. The funds could have been placed with the borrowing countries on terms which were more in line with their payment and development prospects. The use of the funds for productive investments would have been more clearly assured.
That this was not wholly unrealistic, in retrospect, is evidenced by the comments made in 1973 by H. Johannes Witteveen, Managing Director of the International Monetary Fund, and Denis Healey, Chancellor of the Exchequer of the United Kingdom. According to Witteveen, “many oil exporting countries would have been willing to lend a much larger part of their surpluses to the Fund.... The Iranians and the Saudis were the most supportive.... It was interesting that they gave that support to the IMF and didn’t make difficulties about the fact that Israel could draw on the facility.”12 Witteveen observed that “…if the main countries would have given more support to the [IMF] oil facility at that point, the present debt problem would have been less serious. The influence of the Fund on these [debtor] countries would have been stronger, there would have been better adjustments, and the role of the banks would not have been so large.” But, said Witteveen, the position of the industrial countries, “mainly the United States, has been, however, that these deficits should as far as possible be financed through the markets, and only in cases where they couldn’t be completely financed through the market was there a role for the Fund.”13
Denis Healey describes his efforts:
I tried very hard, my early months as Chancellor, to persuade my colleagues to organize some sort of international, official scheme for recycling the OPEC surpluses. But the Americans, particularly, were very hostile to this idea. Basically, they didn’t believe in government mucking around in what they thought should be the role of the private sector. They would leave it all to the bankers, who were licking their lips at the thought of what they would get out of it.14
Healey and Witteveen place the blame for a failed policy primarily on U.S. policymakers. But the recycling strategy had advantages for everyone: the oil producers with surplus funds placed those funds with the strongest financial institutions (and government) in the industrialized world; those institutions expanded and made large profits; the oil importing borrowing countries received funds with very few conditions attached to them; the U.S. Government financed a significant part of its deficit with funds of the oil producers. The responsibility for reliance upon the recycling strategy may have originated with Secretary Simon and the U.S. administration, but it was a responsibility shared by the other major actors in the debt drama—the oil producers, the oil importing debtor countries, and the multinational banks.
By the end of calendar year 1982, the gross external debt of the NICs was estimated to be nearly $452 billion. The largest part of this amount was owed to private banks. Of Brazil’s total $85 billion debt, approximately $67.5 billion was owed to private banks; of Mexico’s $81 billion total estimated debt, $68 billion was owed to private banks. Of Korea’s total debt, $21 billion was owed to private banks, as was $27.5 billion of Argentina’s total debt and $24 billion of Malaysia’s. And within these totals of private bank loans, with the possible exception of Poland, U.S. banks were the single largest national group of creditors. Indeed, by 1979, the exposure of Citicorp (known as First National City Bank until March 1976) in Brazil alone exceeded its capital base.
The Mexican default in August 1982 put paid to the optimistic assessment of the effects of the recycling scheme as a means of managing the financial imbalances that had arisen in the aftermath of the oil price rises of 1973 and 1979.
III. Phase II: 1982–85
There were two distinguishing characteristics of this period: first, the widespread belief that the financial crisis resulting from the Mexican default was short term in nature and was likely to be resolved within an 18-month (more or less) time frame; second, the conviction, particularly in U.S. Government circles, that the crisis afforded an opportunity to bring the major debtor countries, especially in Latin America, back into the fold of sound financial and economic management. This objective could best be accomplished under the aegis of the International Monetary Fund and by the use of bilateral leverage between the United States and the individual debtor country. The World Bank and the regional development banks were accorded a lesser role.
In the case of the Inter-Am eric an Development Bank (IDB), the negotiations over a sixth increase in resources, the Sixth Replenishment, began in Toronto in October 1982, three months after the Mexican default. In the previous replenishment period (the Fifth Replenishment), which covered the years 1978–82, the larger Latin American countries—Argentina, Brazil, and Mexico, or the “A” countries, as they are classified in the IDB—had accepted a “cap” of $250 million per annum each on their access to the Bank’s resources. (At the time, Venezuela had voluntarily forgone its right to receive loans from the IDB.) But this had been before the Mexican default, when the “A” country access to private bank resources had been ample.
The President of the Central Bank of Brazil, Carlos Geraldo Langoni, strongly suggested that the financial situation of the “A” countries had fundamentally changed: they could no longer expect, after the Mexican default in 1982, to have continued assured access to the private financial markets. He proposed that the “cap” on their access to IDB resources which had been imposed in 1978 in connection with the Fifth Replenishment of the Bank’s resources, should, for the Sixth Replenishment period (1982–86), either be lifted altogether or, at least, increased from the level permitted in the previous replenishment. This request was rejected by the U.S. Treasury negotiators. Convinced that the problem was relatively short term in character and that the IDB could not effectively impose economic policy conditions on its largest regional borrowing member countries, the U.S. negotiating team denied the request to lift the cap. A Sixth Replenishment of the IDB’s resources was finally agreed upon by the member countries. The “A” countries desisted from their request for a listing of the “cap.” The “cap” was maintained at the 1978–82 level (but with the addition of Venezuela as an “A” country borrower).
The Mexican crisis of August 1982 was resolved by an emergency loan from the United States and advance U.S. purchases of Mexican oil for the Strategic Petroleum Reserve. But Mexico was also required, by U.S. authorities who negotiated the rescue package, to agree with the International Monetary Fund on an economic adjustment program that would bring its external accounts into better balance. Before concluding such an agreement with Mexico, however, the (then) Managing Director of the Fund, Jacques de Larosiere, insisted that the private bank creditors of Mexico agree to continued financing of Mexico’s development. A $4.2 billion “involuntary” lending package was assembled to meet de Larosiere’s condition. The pattern was established for dealing with the other major debtor countries: an immediate U.S. rescue operation including a short-term credit (for six months); a commitment to seek an agreement with the Fund; and involuntary continued lending by the private bank creditors linked to an agreement between the debtor country and the Fund.
The economic adjustments advocated by the Fund differed in detail for each country. But the emphasis was the same: shift resources from the domestic sector into activities which increased foreign exchange earnings. This strategy meant production for export, a reduction in domestic expenditures and economic activity, and a devaluation of the currency to spur exports. The reduction in domestic public expenditures, translated, in practice, into a decline in investment. The debtor country governments, generally fearing political unrest, attempted, in the first instance, to save jobs. They therefore attempted to minimize cutbacks in employment. The ax fell on the public investment programs. Finance Ministers concerned about meeting International Monetary Fund goals as a condition for further international funding slashed public investment in health, education, energy, and public construction. Demand for imports fell; import substitution by local industry was promoted; and exports were encouraged, often by means of subsidies.
The more advanced developing countries, such as Brazil, Korea, Taiwan Province of China, and Mexico, were relatively well positioned to execute the Fund strategy with regard to emphasizing export growth. The development strategy of the past two decades had expanded industrial capacity and made it more sophisticated. The increased availability of credit for this purpose in the 1960s and the virtually unlimited funds to which the NICs had access in the 1970s enabled them to expand their industrial bases without being restrained by potential competitors in the industrialized world.
Moreover, as the industrialized countries adjusted to the 1973–74 oil shock by deflating their economies, multinational corporations looked with increasing interest on investments in the NICs, particularly Brazil, Chile, Taiwan Province of China, and Korea. Low wages, disciplined labor, and financial incentives for foreign investors were attractive inducements for new investments, particularly since the products manufactured could be exported to markets in the industrialized world at more competitive prices than those on goods produced in their domestic markets. Companies increased exports from Latin America to take advantage of low-cost production and to use capacity idled by economically depressed local markets.
These advantages were further maximized by the U.S. domestic economic policy. The large tax cuts enacted by Congress in 1981, coupled with the increase in expenditures for the military budget, far outweighed decreases in domestic nonmilitary spending. The result was a fiscal stimulus which propelled the U.S. economy into a significant expansion in 1983 and 1984, which was much stronger than that seen in Europe and Japan. Interest rates in the United States remained high in historical terms, relative to inflation; these “real” interest rates attracted huge capital flows from abroad—an attraction enhanced by the image of the United States as the last, best bastion of capitalism in the Western World. The dollar increased in value relative to other currencies. This increase made imports cheaper in the United States, restraining price increases by domestic U.S. producers. Consequently, imports increasingly supplanted domestic production.
According to the International Monetary Fund, “the U.S. recovery was of fundamental importance to countries seeking export-led adjustment U.S. imports from Asian and European developing countries increased by some 80 percent between 1980 and 1984, with the growth being concentrated in 1983–84 .... Exporters of manufactures achieved remarkable success, as U.S. imports from them doubled between 1980 and 1984.”15 In contrast, other industrial countries’ imports from these regions were flat: “Virtually all the increase in exports from Latin America between the first quarter of 1983 and the first quarter of 1985 went to the United States.”16
But the “strong” dollar also made it more difficult for U.S. exporters to sell their goods in foreign markets. In the NICs, markets were already constrained by the economic austerity programs (however fitfully they were implemented in many of these countries). Hence, the relative balance which had prevailed in the 1970s between U.S. exports to, and imports from, the NICs was upset: draconian austerity programs in the debtor countries, combined with devalued currencies and reduced bank loans to them, triggered a sharp decline in debtor country imports. U.S. exports to the Latin American region fell 42 percent from 1981—the year before the Mexican debt announcement—to 1983, decreasing to $22.6 billion from $39 billion. The drop in U.S. exports to Latin America accounted for almost half of the $33.2 billion decline in total U.S. exports between 1981 and 1983. Moreover, this decline was particularly concentrated in machinery and equipment exports. As the debtor countries reduced their investments in capital-intensive development projects, they cut imports: U.S. exports of machinery and transportation equipment to Latin America dropped from $17.8 billion to $8.2 billion between 1981 and 1983, or by 54 percent; similar steep declines characterized U.S. exports to the region of automobiles, civilian aircraft, and construction and agricultural equipment. The U.S. Commerce Department estimates that each billion dollars in trade means 25,000 U.S. jobs; consequently, the $16 billion loss in U.S. exports to the Latin American region cost 400,000 U.S. jobs.
With U.S. exports to the NICs (and more generally to the developing world) falling, and U.S. imports from them soaring, the U.S. merchandise trade deficit with the NICs has inevitably grown precipitately. The trade deficit with the East Asian NICs—Korea, Taiwan Province of China, Singapore, and Hong Kong—increased to $21 billion in 1984 from $4 billion in 1980. Mexico slashed its imports from the United States and boosted its exports, converting a $4 billion trade deficit with the United States in 1981 into surpluses in 1982, 1983, and 1984 that cumulatively totaled $18 billion. In the same four-year period, Brazil reduced its imports from the United States by one half, while doubling its exports to the United States, thereby achieving a $5.8 billion 1984 trade surplus with the United States.
The developing countries as a whole, then, succeeded in substantially reducing their combined current account deficit from approximately $100 billion in 1982 to $44 billion in 1984. The aggregate deficit of the developing countries other than the Middle Eastern oil producers (which included the NICs) declined from $91 billion in 1981 (equivalent to 23 percent of exports of goods and services) to only $38 billion in 1984 (equivalent to 9 percent of exports of goods and services).17 In effect, the Fund-sponsored strategy had a significant success in bringing about a reduction in the debtor countries’ imbalances in their external accounts.
At the same time, however, there was a steep decline in private bank financing of the debtor countries. As the Fund put it,
[T]he decline in the developing countries net borrowing from market sources was the most dramatic financial development in 1981–84 .... the supply of new commitments to borrowing countries from commercial sources virtually dried up. Countries that relied predominantly on market sources for financing their external position (the market borrowers) borrowed $125 billion (net) from banks and other private creditors in 1981–82, but only $20 billion in 1983–84. Indeed, the market borrowers’ financing situation was even tighter than these figures suggest. They secured net inflows from private creditors in 1983–84 only as a result of obtaining some $23–24 billion in concerted lending packages related to debt restructuring.18
What this meant was that the debtor countries needed to use their trade surpluses to finance their debt-service obligations to the banks. Brazil, for example, which achieved a $12 billion trade surplus in 1984, also had an interest bill to the private banks of $11 billion. In 1984, the Latin American countries had a net transfer of $30 billion in debt-service payments to the private commercial banks; over the four-year period 1981–84, the net transfer of debt-service payments from the Latin American region to the private commercial banks is estimated to have been approximately $100 billion.19
Leonard Silk noted in the New York Times that “The financial markets in the United States and other Western countries have been remarkably calm in the face of the international debt crisis. This may be because the major banks, despite their heavy exposure in the debt-ridden developing countries, are not really in great jeopardy: they are protected by deposit insurance, by the recognition of regulators that, if necessary, accounting rules would be changed to protect them and by the expectation that their national central banks would rescue major banks to protect the system.” Silk also observed that “Paul A. Volcker, chairman of the [Federal] Reserve Board, told the American Bankers Association conference in Honolulu on Oct. 10, ‘We have a strong safety net under our own banking system, as do other leading countries.’”20
But there was no safety net under the factory worker displaced by the decline in export markets and the competition from foreign imports. Not surprisingly, within the United States, political pressures for protection of U.S. jobs grew stronger. The December 1985 Morgan Guaranty World Financial Markets report aptly summed up the policy and its consequences: “Average real wage gains have been negligible in this recovery, maintaining their stagnation of the last ten or more years.” Foreign competition, it noted, “has been the key factor.” And, it added, “this is not attributable solely to the higher dollar. The long-run shift of comparative advantage in manufacturing toward the NICs helped them penetrate the U.S. domestic market even before the dollar’s rise. U.S. manufacturers are keenly aware of the cost savings obtainable through contracting for production in low-wage areas abroad.”21
The 1982–85 debt strategy had a high cost not only for the U.S. factory worker but also for the debtor countries, particularly those in Latin America. The December 1985 Montevideo Declaration of the ministers of the Latin American Group of countries that had originally met in Cartagena, Colombia to discuss the debt crisis observed that “over the past five years, living standards in Latin America have slipped back by a decade.” Pressured to meet austerity targets, finance ministers slashed expenditures for health and education services. Malnutrition and infant-mortality indices increased. Investment in infrastructure and new production facilities dramatically declined. Projects financed by the World Bank and the regional development banks slowed to a halt as the debtor countries were unable to put up their shares of the funding.
When Alan Garcia was elected President of Peru in July 1985, he announced that Peru would limit its payments to creditors to 10 percent of its export earnings. The other Latin American debtor countries did not follow Peru’s lead, but by the fall of 1985 it was becoming evident that debt fatigue was taking hold. The private sector was not investing in new production facilities; nor could the public sector lead the way, both because it was too inefficient and because it was constrained by agreements with the Fund and the creditor countries.
The combination of debt fatigue in the major debtor countries and mounting political resistance in the United States to a flood of imports from debtor countries desperate to earn the income needed to pay the interest on their foreign indebtedness created a sense of crisis in Washington. Something needed to be done. The result was the Baker initiative.
IV. Phase III: The Baker Initiative
At the October 1985 Annual Meeting of the World Bank and the International Monetary Fund, in Seoul, Korea, U.S. Secretary of the Treasury James A. Baker III proposed a new initiative for dealing with the economic malaise of the major debtor countries in the developing world. The Secretary explicitly embraced the concept that economic growth was the best means of overcoming the depressing effects of the debt crisis in the debtor countries. If it did not abandon the austerity emphasis of 1982–85, his proposal did give austerity a lower priority. Secretary Baker proposed that additional resources be made available to those debtor countries that undertook major economic policy reforms, with special emphasis to be placed upon reducing the role of the public sector in the economy and liberalizing restrictions on imports and foreign direct investment:
—increased reliance on the private sector, and less reliance on government, to help increase employment, production, and efficiency;
—supply-side actions to mobilize domestic savings and facilitate efficient investment, both domestic and foreign, by means of tax reform, labor market reform, and development of financial markets; and
—market-opening measures to encourage foreign direct investment and capital inflows, as well as to liberalize trade, including the reduction of export subsidies.
—market-oriented exchange rate, interest rate, wage, and pricing policies to promote greater economic efficiency and responsiveness to growth and employment opportunities; and
—sound monetary and fiscal policies focused on reducing domestic imbalances and inflation and freeing up resources for the private sector.22
The private commercial creditor banks to the debtor countries would lend $20 billion of net additional resources (that is, money in excess of repayments of principal and interest received from the debtor countries) over a three-year period to the countries undertaking such reforms, and the World Bank and regional development banks would increase their disbursements to such countries by 50 percent over existing levels. With respect to Latin America, the Secretary observed that if the Inter-American Development Bank were to participate in such a program, it would need to make major internal changes.
There was, however, no detailed explanation of how private bank lending was to be related to that of the multilateral development banks (MDBs, including the World Bank and the regional development banks: the Inter-American Development Bank, the Asian Development Bank, and the African Development Bank): Would there be, as the private banks had demanded, joint disbursements, sharing of repayments, and mandatory cross-defaults between the loans of private and development banks, so that a default against one became a default against the other? Who was to judge whether the commitments of the debtor countries to policy reforms were sufficient to justify their eligibility for Baker initiative lending? Who was to monitor these commitments and determine whether they were being fulfilled? How did the Baker initiative lending differ from the “involuntary” private bank lending packages provided in association with Fund-supported adjustment programs? Did it substitute for them? Or was it additional? Was all MDB lending to be related to the Baker initiative? If a debtor country was not eligible for Baker initiative lending, was it still eligible for MDB loans? What was the “premium” which was attributable to the Baker initiative—that is, the lending by these institutions that would not have occurred if there had been no Baker plan? There were no answers to these questions.
But even if there had been a plan, a basic problem would have remained. The motive behind the Baker initiative had been political: the backlash building in the United States against the 1982–85 strategy and the fear that in the debtor countries, the moderates who wanted to work within the system were in danger of being overrun by more radical forces who wanted a break with the existing international financial order.23 This concern argued for a rapid infusion of funding to alleviate the debt-service obligation of the debtor countries and to act as a stimulus to economic growth. Such a stimulus, it was believed, would diminish public acceptance of the critique of the radicals.
This sense of political urgency, however, conflicted with the conviction on the part of the U.S. Treasury staff that the debt crisis afforded an unparalleled opportunity to achieve, in the debtor countries, the structural reforms favored by the Reagan administration. The core of these reforms was a commitment on the part of the debtor countries to reduce the role of the public sector as a vehicle for economic and social development and rely more on market forces and private enterprise, both domestic and foreign.
At the same time, Secretary Baker’s call for increased net new lending to the debtor countries by the private commercial banks—that is, loans in excess of debtor country interest and principal repayments to the banks—conflicted with the private banks’ strategy of reducing their exposure in the debtor countries. The resulting ambivalence of the banks would make their response to the Baker initiative less than enthusiastic. Finally, the Baker Treasury demand for an effective North American (U.S. and Canadian) veto over the loan and technical cooperation operations of the Inter-American Development Bank, the regional development bank for Latin America and the Caribbean, would lead to an impasse in negotiations over an increase in resources for that institution, preventing it from contributing in a major way to the Baker initiative.
The Baker plan, then, whatever its original motivation, can be under-stood as a rather eclectic attempt to synthesize the development experience of the previous three decades: it took the development priorities of the 1950s—emphasis upon the role of the private sector and foreign direct investment—repackaged them, and presented them as a new departure; it adapted the 1960s Alliance for Progress concept of country programming and policy reform, substituting for the social reform content of the Alliance period the classic American conservative themes of increasing efficiency and relying on market forces; and it built upon the development financing role of the private credit markets that evolved in the 1970s by more directly linking that financing to the lending of the Fund and the MDBs. Above all, by linking debtor country access to capital for development purposes to fidelity to a single economic development model which enhanced the role of market forces and private enterprise, Secretary Baker created the impression that what he sought was a return to the conditions that had prevailed three decades earlier in the 1950s.
The speech Baker made in Seoul succeeded in its primary objective: The Baker plan became the agenda for overcoming the debt crisis.
V. Phase IV: New Initiatives
Two and a half years later, there is a new interest in more comprehensive approaches to the debt problem. Indeed, the first such suggested approach was articulated by U.S. Senator Bill Bradley, a Democrat from New Jersey. In June 1986, Bradley stated that some part of the debt would need to be gradually written off, but that this should be done only for those countries that agreed to satisfactory economic (and social) reform programs.24 Bradley’s statement that part of the debt would need to be forgiven by the private commercial banks was considered a radical proposal. In other respects, however, Bradley’s approach was quite conventional and was consistent with the Baker plan’s emphasis upon the case-by-case approach. It explicitly embraced the concept of conditioning debt relief upon commitments by the debtor country to policy reform, although Bradley gave greater importance than did Secretary Baker to social equity as a part of the necessary reforms.
The details of Senator Bradley’s plan were less important than the fact that he enlarged the agenda for discussion of possible alternatives to dealing with the debt crisis beyond the Baker plan. Bradley could do this because he was respected both in the press and in Congress as an expert on economic issues.
Bradley, initially, was an isolated voice. More recently, there have emerged a plethora of proposals for more comprehensive debt relief. Three factors appear to have led to this development. First, the May 1987 announcement by John Reed, Chief Executive Officer of Citicorp, that that corporation was adding $3 billion to its loan-loss reserves as a contingency against Third World debt risks, and the action by the Bank of Boston later in the same year to actually take losses on specific loans to debtor countries amounted to an open admission by creditor banks that some part of the debt was not repayable. With most of the major banks following Citicorp’s lead to one degree or another (although not going as far as the Bank of Boston), the concept of debt forgiveness appeared to have gained a degree of legitimacy in political circles in Washington.
Second, the failure of the debtor countries to achieve sustained economic growth under the aegis of the Baker plan and the continued reluctance of the private commercial banks to lend new money aside from that associated with restructurings designed to assure the continued flow of interest payments, has led to a search for alternatives to the Baker plan. Moeen A. Qureshi, Senior Vice President of the World Bank, summed up the economic problem: “The result is that instead of growing at 4 to 5 percent per year—which was the average rate of growth we had expected was necessary—the countries overall have grown at less than one half that rate.”25 The United Nations Economic Commission for Latin America, in a preliminary report on the region’s 1987 economic performance, noted that the region’s gross domestic product increased 2.6 percent, a rate of growth lower than that achieved in the previous three years and one that permitted per capita growth of barely 0.5 percent.26
Finally, there has appeared to be a growing realization that a resolution of the U.S. trade deficit may be linked to the economic recovery of the debtor nations, particularly those in Latin America. A recent report of the Overseas Development Council observes that “the economic welfare of the United States is now inextricably linked to developments in the global economy and in the developing countries.”27 More specifically, the same report notes: “The negative impact of the economic downturn in the developing countries on the U.S. economy was direct and measurable: U.S. exports to all developing countries dropped from $88 billion in 1980 to $77 billion in 1985. If exports had grown in the first half of this decade at the same rate as in the 1970s, they would have totalled about $150 billion in current dollars. The impact on employment also was dramatic. The actual and potential employment loss (if exports had grown as they did in the 1970s) amounted to 1.7 million jobs—or nearly 21 per cent of total official unemployment in 1986.”28
Fueled by these developments, a lively debate has broken out in Washington. Secretary Baker, supported by Mr. Paul Volcker, contends that there is no alternative to the Baker plan. Others in the U.S. Congress contend that if there is no alternative to the Baker plan, they cannot support the General Capital Increase (GCI) for the World Bank. The GCI thus runs the risk of being caught in this cross fire. It is worthwhile, then, to understand some of the major alternatives being considered in political Washington.29
The most comprehensive congressional legislative initiative to date on Third World debt is contained in the omnibus trade bill that was recently approved by a Senate-House conference (at which members of the House and the Senate that have, in accordance with normal procedure, formed a special committee to reconcile the two bills on the same subject matter passed by the two chambers). The two major bills under review were H.R. 3, the Trade and International Economic Policy Reform Act of 1987, and S. 1420, the Omnibus Trade and Competitiveness Act of 1987. The debt initiative had its antecedents in proposals made as far back as 1986 but were most clearly articulated in March of last year (1987) by Congressmen John J. LaFalce, a Democrat from New York who introduced H.R. 1423 in the First Session of the 100th Congress,30 and Bruce A. Morrison, a Democrat from Connecticut who introduced H.R. 1453 in the same session,31 of the House Banking Committee. As approved in May 1987 by the full Banking Committee, the initiative’s key provision was the establishment of an international debt-adjustment facility which would (a) assist creditor banks in voluntarily disposing of sovereign loans in the private sector, (b) encourage developed countries with capital surpluses to invest these in debtor countries, and (c) purchase sovereign loans at a discount, passing along the benefits of such a discount to the corresponding debtor country. One of the express goals of the proposals was some “genuine reduction in the debt servicing burden now stifling growth in the developing world.”32
Debtor countries would ask the facility to purchase some of its debt and present a plan for the “future economic management of the country.” Once a debt discount and an amount to be purchased were established, the facility would make offers to the debt holders and would purchase any loans tendered by using funds it had raised itself in private credit markets; any borrowing by the facility would be backed by either the commitments of developed nations or the Fund’s gold reserves. The facility, in its new role as creditor, would then further seek to reduce the debtor’s burden on the discounted debt by engaging in debt restructuring such as debt-for-equity swaps, debt buy-backs by the debtor at the discounted price paid by the facility, or long-term securitization of debt with a contingent claim on some key debtor export at a specified price. Capital surplus countries, such as Japan and the Federal Republic of Germany, would be encouraged to provide more support for the facility than other participating countries.
The legislative initiative calls for the analysis of existing regulatory impediments to negotiated reductions in sovereign debt obligations and to the sale of such debt at a discount in secondary markets, as well as possible changes to current reserve requirements. Significantly, there is also a statement of congressional intent to the effect that bank regulators should provide “maximum flexibility” to encourage negotiated reductions in principal and interest obligations. The legislation also tackles the problem of capital flight by requesting further studies on possible solutions—for example, of countries which serve as “resting places” for flight capital—might help debtor countries to identify its sources. There are also requests for various additional studies on such subjects as the impact of past International Monetary Fund austerity policies on debtor nations and how to mobilize more private capital for developing nations.
The Senate trade bill was generally compatible with the House bill, and the Omnibus Trade Bill voted out of the conference committee is more akin to the Senate bill. The two bills’ proposals regarding the facility were essentially the same, calling upon the Secretary of the Treasury to explore negotiations with other developed countries for its creation. However, the Senate version provided that the Secretary could decline to enter such negotiations if he should make a finding that to do so would cause “(1) a material increase in the discount at which sovereign debt is sold, or (2) [would] materially increase the probability of default on such debt, or (3) [would] materially enhance the likelihood of debt service failure or disruption.”33 A new provision of the conference bill would require the Treasury to report 6 months and 12 months from the date that the bill became law on any such problems; in light of the Treasury’s opposition to such a facility, it is unlikely that such reports will be encouraging. The most restrictive part of the Senate bill, which was incorporated into the conference proposal, is a provision that prohibits such a facility from requiring any financial backing from the U.S. Government.
Another comprehensive approach to the problem was unveiled by American Express Company Chairman and Chief Executive Officer James D. Robinson III at a speech before the Overseas Development Council in Washington, D.C. on February 29, 1988.34 Similar to the legislative initiative described above, the proposal, in Robinson’s words, would serve as a “comprehensive approach to deal with the major imbalances and present realities.” Robinson has proposed the creation of a new international agency that would purchase sovereign debt of debtor countries at a negotiated discount, provided they adhered to an agreed economic adjustment program. In exchange, Mr. Robinson’s so-called Institute of International Debt and Development would issue interest-bearing, long-term bonds and participating preferred stock to the banks.
The Institute would be sponsored by the governments of major developed countries and would constitute a joint venture of the World Bank and the Fund. The sponsoring governments would provide the initial capital of the Institute, whether it were paid-in, callable, or obtained through other unspecified arrangements to be made with the World Bank and the Fund. Robinson would expect the Institute’s obligations to receive the highest credit ratings as a result of the contingent commitments of the sponsoring country governments—that is, those of the major developed countries. Debt purchased by the Institute would be subordinated to all new debt issued subsequently, as long as the economic adjustment program agreed to with the debtor country remained in place. This would presumably encourage new lending, since any new loans would have a prior claim on debtor country resources.
As expected, the proposal has come under severe criticism from those who advocate a continuation of the “muddle-through” approach followed so far. Secretary Baker has complained that the scheme “puts the solution squarely on the backs of the taxpayers in the creditor countries.” Clearly, the proposal would create unknown costs for major developed country governments which served as sponsors. Critics have further pointed out that (a) banks would be taking losses on their investments and (b) it is not clear that a debtor country which could not deal politically with creditor banks or with policies imposed upon it by the International Monetary Fund would find it easier to deal with a behemoth Institute such as the one envisioned by Robinson. On the other hand, as Robinson points out, under the comprehensive approach suggested in his proposal, everyone would share the burden and everyone would reap the benefits. The participating countries would receive debt relief if they agreed to, and continued to, implement sound economic policies. The banks would get high-grade paper in exchange for their low-grade loans. Finally, Robinson emphasizes that the developed countries should contribute to improving the soundness of the global economy and international financial system and to opening markets that have been closed in recent years.
Like the Baker and Bradley plans, both the LaFalce/Morrison and Robinson schemes emphasize the need for agreed economic policy reforms in the debtor countries. Whatever the differences among them, there appears to be a broad consensus linking additional lending (Baker) or debt relief (Bradley, LaFalce/Morrison, Robinson) to policy reform within the debtor countries. (An interesting variation of this theme has been proposed by Congressman Donald Pease, a Democrat from Ohio. He would introduce a two-tier concept of conditionality, with the first tier consisting of balance of payments targets. Only if these targets were not met for two consecutive years would more detailed policy conditions enter into the discussion. Congressman Pease would locate a proposed debt-purchase facility in the International Monetary Fund rather than the World Bank, as proposed by Robinson and LaFalee/Morrison.)
The tentative nature of the debate surrounding the debt issue is reflected in the regulatory, accounting, and tax thicket. Loans to developing countries can be quite profitable for the banks, which constitutes an incentive for the banks to continue lending to debtor countries. But the degree of profitability may depend upon the tax status of the individual bank. For example, where a debtor country uses a gross-up method for computing the income tax theoretically withheld on interest income earned by the bank in the debtor country, the bank is allowed a foreign tax credit under the U.S. Internal Revenue Code, although the full amount of the tax may not, in fact, have been actually paid in the debtor country. But the value of the foreign tax credit depends upon whether the bank has sufficient foreign-source income against which it can use the foreign tax credit earned in the debtor country as an offset. For those banks that do not have such foreign-source income, interest received on outstanding loans from debtor countries is increasingly being used to pay down the loans—and thus to get out of the business of lending further money to the debtor countries.
The tax status of the individual bank—that is, whether it can use a foreign tax credit earned in a debtor country—may determine whether it stays in the game. In 1986, however, the Congress manifested its belief that the foreign tax credit regime had resulted in significant inequities, and even in abuses by the banks. It therefore provided for a phaseout of the provisions as they had previously existed. It ameliorated the severity of this decision by exempting for a limited time 34 of the debtor countries, thereby permitting the banks to claim foreign tax credits for income taxes paid there, although such credits could only offset foreign-source income of the banks.
The situation is further complicated by new capital-adequacy rules. On December 10, 1987, the Basle Committee on Banking Regulations and Supervisory Practices of the Bank for International Settlements (Basle Committee) published its proposal to achieve a common standard for measuring a bank’s capital adequacy on the basis of the degree of risk assigned to its asset base. [The Basle Committee consists of representatives of central banks and supervisory authorities of the Group of Ten countries (Belgium, Canada, France, the Federal Republic of Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States).]
This proposal is generally similar to the U.S./U.K. proposal on primary capital and capital adequacy assessment issued on January 8, 1987. The proposal establishes a framework that (1) makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations; (2) takes off-balance-sheet exposures into explicit account in assessing capital adequacy; and (3) minimizes disincentives to holding liquid, low-risk assets. The critical recommendation of both proposals is that capital adequacy be related to risk-weighted assets held by the banks. It is proposed that by 1992 the standard ratio of capital to weighted risk assets should be 8 percent (of which the core capital elements—equity and retained earnings—should be at least 4 percent).35
However, loan-loss reserves will no longer be eligible for inclusion as part of a bank’s primary or core capital for purposes of the capital-adequacy test. Moreover, the U.S. Internal Revenue Service (IRS) will no longer allow banks to anticipate loan-loss reserves as deductions in the year in which they are established, thus reducing net income for that year. The deduction, according to regulations proposed by the IRS, would only be taken in the year in which the specific loan was actually written down. (On the other hand, the Securities and Exchange Commission allows such anticipated losses to be shown as part of the financial statements of the enterprise.)
A similar ambiguity is reflected in the regulatory scheme that governs debt-equity swaps. The debt-equity swap idea has been around for some time. Prior to 1987, Chile and Mexico were actively sponsoring such schemes; some additional countries used the idea to originate proposals to swap debt for conservation and ecological commitments and programs (e.g., Bolivia and Costa Rica). Beginning in mid-1987, however, other countries and banks further developed the debt-equity swap idea, and by the beginning of 1988, Brazil (November 1987), Argentina (October 1987), and Venezuela (April 1987) had programs in place.
Euromoney, which ran a supplement to its January 1988 issue on “Global Debt: The Equity Solution,” correctly pointed out (p. 3) that “Many bankers have pinned their hopes on debt/equity swaps. They are seeking to convert their devalued loans into power plants in Chile, textile mills in Brazil, and car plants in Mexico—in short, building industrial empires from the ruins of their LDC debt portfolios.” These expectations are probably unrealistic. Nationalism and public image in the countries must be considered when foreign interests attempt to buy control or partial ownership in important industries or business sectors. But an equally severe problem, making it difficult for a U.S. bank to participate even if it is willing to do so, is posed by the U.S. regulatory and accounting regulations which must be met.
Regulation K of the Bank Holding Company Act36 limits bank investments overseas to activities of a banking or financial nature or related incidental activities. Depending on the amount of the investment, an overseas targeted company must have a minimum specified percentage of its assets involved in authorized activities. The Federal Reserve Bank liberalized Regulation K in August 1987 and again in April of this year (with changes made effective as of February 1988) to deal specifically with investments made through debt-equity conversions in the countries that, since 1980, have restructured their sovereign debts held by foreign creditors. Pursuant to the amended Regulation K, banks are allowed to purchase up to the entire stock of an unauthorized (e.g., nonfinancial) company in the heavily indebted countries referred to above if it is purchased from the government (i.e., if it forms part of a privatization program) and up to 40 percent of the shares of a foreign company if it is part of the private sector. There are limits to the amount of the investment and any subsequent lending to the company specified in the regulation. The disposition period has been expanded to within 2 years of the date on which the bank is permitted to repatriate in full its investment, but, in any event, within 15 years of the date of acquisition. For previously acquired shares or other ownership interest purchased to prevent a loss upon debts held, the disposition period is a mere 2 years, although the Board of Governors of the Federal Reserve System can extend this period.
On the accounting side, one accounting problem related to swap-asset valuation has been resolved.37 The “fair value” of the debt and the “fair value” of the acquired equity are to be considered in calculating the fair value of the swap. However, a further problem involves the accounting treatment of those loans which are to be traded. To avoid the “contamination” of other loans to the same country, the accountants seek to have the banks divide their loans into investment and trading portfolios. In this way, any concerns which arise on collectibility or marketability of loans held in the trading portfolios (for swaps) would affect neither the high-grade loans held on the investment side nor, consequently, the banks’ overall portfolios.
The regulatory and tax schemes reflect the fact that there is not at present a completely coherent approach among the different agencies in Washington that have responsibility in the debt area. This ambiguity, in turn, reflects the tensions among sometimes conflicting objectives. On the one hand, the regulators have a responsibility to maintain the solvency of the institutions for which they have oversight responsibility; they desire to avoid being criticized by Congress for not doing an effective job of regulation. As is the case with the foreign tax credit scheme, the regulators are also increasingly sensitive to possible abuses in the system.
On the other hand, regulators do not wish to be responsible for imposing disincentives which can be blamed for creating a liquidity crisis by giving the banks an excuse to reduce still further their exposure in the debtor countries; the conflict among these objectives leads to an appearance of incoherence in the regulatory and tax regimes as they impact on the continued willingness of the private banks to maintain—and increase—their lending to the debtor countries. This appearance of incoherence, however, is symptomatic of a broader lack of consensus in Washington between the administration and important parts of the Congress as to how best to approach the debt issue.
The tentative approach of the parties to the debt issue is perhaps best illustrated by the experience with the Mexican/Morgan Guaranty swap scheme.38 Under this proposal, Mexico offered banks an opportunity to swap government loans at a discount for new high-yield bonds whose principal would be backed by a special issue of zero-coupon U.S. Treasury securities issued only to the Mexican Government. The Mexican proposal could have resulted in a significant move toward debt forgiveness, since participating banks would have forgiven the amount of the discount to face value of their loans in tendering them. However, only 139 out of more than 500 creditor banks made any offers and only 95 of these proposed discounts were acceptable to Mexico. Accordingly, Mexico’s debt was reduced by only $1.1 billion, far below the $10 billion it had set as a target. Mexico’s director of public credit has been quoted as saying that Mexico will continue its efforts to reduce its debts and will probably try “.... a number of variations on this scheme ....”39
The Mexican bond issue reflected the frustration of the debtor countries in not being able to capture a part of the discount on their debt in the private secondary market for their own benefit. Discounts in that market itself might be a somewhat misleading indicator of the true value of that debt, since it is a relatively thin market. On the other hand, it is the only market signal that presently exists. Although the result of the Mexican bond issue was generally considered disappointing, in my opinion it did mark an evolution in official thinking regarding the debt issue. For the first time, the U.S. Treasury participated in a scheme which had as its explicit purpose a voluntary “forgiveness” by the private banks of a part of the principal amount of the outstanding debt.
Moreover, the Mexican scheme led to a further definition of the “common law” governing the prevailing accounting and regulatory rules. The bank regulators (and the accountants) accepted the idea that exchanging a given amount of existing indebtedness for new issues in a lesser face amount would not contaminate the remainder of the debt retained by the banks. Hence, the remaining indebtedness would not have to be written down to the level of the discounted debt that had been exchanged. In other words, the regulatory and accounting authorities implicitly accepted that debt forgiveness might actually enhance the value of the outstanding indebtedness.
Understood in perspective, then, what we are witnessing in Washington is a period of experimentation. Ideas are percolating; they are tested, discarded, modified, sent back for retooling, or abandoned altogether. There is as yet no consensus between the administration and important parts of the Congress as to how to approach the debt and development issue. With this in mind, let me venture to suggest six considerations that should be kept in mind in the evolution of any new consensus.
First, the debt crisis did not result only from mistaken policies in the debtor countries. The responsibility for its solution should be shared among debtor countries, creditor banks, and creditor countries. During 1974–82, each one of the parties had a part in ignoring the clear warning signs of the impending storm. Judgments as to the relative responsibilities of the major parties to the debt crisis—that is, efforts to place the blame on mistaken policies of the debtor countries, shortsighted lending policies of the private banks, the failure of public officials to appreciate the gravity of the problem, and excessive reliance on a market solution to the problem—are therefore inappropriate. No one party should disproportionately bear the burden of the economic adjustments that are the consequence of the recycling strategy of 1974–82.
Second, it became evident in 1974 and thereafter that a group of highly indebted newly industrializing countries had achieved world-class status in the international economy. In 1974, as the industrialized countries generally adjusted to the domestic oil price rises of 1973/74, by adopting deflationary economic policies, the continued borrowing and economic expansion of the NICs provided a growing market for industrialized country exports, particularly capital goods, that eased their domestic economic contraction. Whether this was a wise policy on the part of the NICs is not at issue here. The significant point is that the economies of the NICs as a group were of sufficient size to mitigate significantly, by virtue of their continued imports, the recessive effects of the economic adjustment effort in the industrialized countries. They cannot be relegated to bystander status when major decisions as to the future shape of the international economy are made. They are demanding a significant voice in decision making in the institutions which are at the center of the international economy. This is reflected in the impasse that unfortunately exists in the negotiations concerning an increase in resources for the IDB.
Third, the emergence of the NICs in the international economy as world-class players means that they, too, have had to accept limitations on their own economic autonomy. Brazil’s unilateral moratorium on debt-service payments had to be abandoned, in large part because the São Paulo industrial entrepreneurs had become such an integral part of the international economy that they could not afford to be isolated from conventional financial and economic relationships. Unilateral action to limit debt service is therefore perceived as more harmful than useful by a politically powerful part of Brazil’s economic leadership. Conversely, as a recent report of the Overseas Development Council observes, it is likely that the United States will find it more difficult to resolve its trade imbalances without renewed and sustained economic growth in the NICs, particularly those in Latin America. It is in the economic self-interest of both the United States and the debtor countries for the NICs to resume their role as net importers, rather than net exporters, of capital.
Fourth, a debt strategy that places disproportionate emphasis upon the highly indebted countries running huge trade surpluses with the United States as a means of paying the debt service on their outstanding loans is likely to create a political backlash in the United States. To the extent that a trade surplus is achieved by compressing imports as well as aggressively exporting to the U.S. market, the perception in the United States will grow of an unfair trade imbalance that prejudices the interests of American factory workers. That is essentially what happened as a consequence of the strategy that was followed during 1982–85.
It may be that, in fact, the exports of the highly indebted countries are, relatively speaking, not that great a factor in the U.S. trade deficit, compared with the trade surpluses of Japan and the European Community. But to the extent that the perception exists that the imbalance is unfair, it will lead to increased demands within the United States for greater industrial protection and more aggressive measures to open foreign markets to American goods. As a means of coping with this problem, the devaluation of the dollar is of limited usefulness, both because of its questionable feasibility in an open international trading system and because it cheapens U.S. domestic assets for foreign purchasers. A debt strategy that relies excessively on trade surpluses earned in the U.S. market by means of aggressive debtor country exporting and compressing of their imports will be self-defeating.
This is not to say that there should be less emphasis upon becoming internationally competitive in exports. On the contrary, this is a sine qua non in an increasingly competitive international economy. It is to say that a better balance among exporting, importing, and development finance is essential. My own view is that some element of debt relief will need to be a part of such a balance. However, a consensus on the form and amount of such relief has not yet been reached.
Fifth, it is unlikely that a single development model can be imposed upon the diverse conditions that prevail in the debtor countries. The debtor countries vary considerably in the ways they have adjusted to the oil price revolution of the 1970s and the changed economic circumstances of the 1980s. It would therefore be a mistake to believe that what worked in Korea can be easily transposed to the Latin American context. The social and political conditions are too different (even among Latin American countries themselves). There are going to be differences of emphasis among the countries, given competing considerations of social equity, economic efficiency, and political systems. The result, at times, is likely to lead to less-than-optimal economic efficiency. But economic efficiency is not the only criterion that countries will consider in their decision making.
The dilemma in Latin America may be most acute in regard to redefinition of the role of the state in economic and social development, a central tenet of the Baker plan. It is true that with the advent of the debt crisis in 1982, the economic model of high economic growth achieved by means of foreign borrowing, largely by the public sector, was discredited. Moreover, the association in Latin America of such public sector expansion with the military governments of the 1960s and 1970s helped to create an internal climate in a number of countries which was propitious for reducing the scope of the public sector in the economy. But there are other factors that militate against too radical an attack on the role of the public sector. Private enterprises in São Paulo, Brazil and Mendoza, Argentina, for example, may have resented the explosive growth of the state-owned autonomous entities, but these private firms themselves are often undercapitalized. They depend upon the national development banks for credit and, often, upon the public sector for orders, although this dependence may now be diminishing as they become internationally competitive.
In the 1960s, the Alliance for Progress, with its emphasis upon social reforms, however modest, encouraged an expansion of the education system in Latin American countries. In the 1970s, the fruits of this expansion began to be apparent, as the cadres of university graduates increased. In Brazil, for example, between 1970 and 1985, the number of university graduates tripled; in many cases, graduates found employment in state-owned enterprises.
In effect, the public sector became a vehicle for social mobility and the path to middle-class status for significant numbers of Latin Americans. And it was the middle class that was the backbone of the opposition political parties that turned against the military governments and came to power in the mid-1980s.
Mario Brodersohn, Argentina’s Secretary of the Treasury, recently observed that there is a general consensus within Argentine society that the public sector must be slimmed down and made more efficient.40 This observation, in my opinion, is now generally shared in most countries in Latin America. But the pace at which this objective can be accomplished is also limited by past development experience.
Hence, there is a fundamental ambivalence about the role of the public sector in Latin America. Understood in this context, major advances have been achieved in trimming and defining a different role for the public sector in economic growth. External pressure, however, which seeks to force the pace beyond the tolerance of domestic political possibilities could engender a dangerous political backlash in debtor countries.
Finally, any economic adjustment program which is to be sustainable must, in my opinion, deal with the Social Question. That Question, as Hannah Arendt, the noted political scientist, has observed in her classic work, On Revolution, is “what we may better and more simply call the existence of poverty. Poverty is more than deprivation, it is a state of constant want and acute misery whose ignominy consists in its dehumanizing force.”41 The return to democratic forms of government in much of the Southern Hemisphere is subject to the tensions that derive from this condition for great numbers of people in the debtor countries. As Arendt noted, “the transformation of the Rights of Man into the rights of Sans-Culottes was the turning point not only of the French Revolution but of all revolutions that were to follow.”42 No elected government can ignore the Social Question, given the abysmal conditions of life that exist among too much of the population in many of the highly indebted countries. Hence, an economic adjustment program that ignores this question is not likely, over time, to be politically and socially sustainable—a fact which is increasingly being recognized in the international financial agencies.
EDWIN M. TRUMAN
It is customary when commenting on papers, and this is a very thoughtful and provocative paper, to say that there is a great deal one agrees with and then to point to major disagreements. I think it will probably be a little more honest this time to say there is a great deal I disagree with in this paper, but there are a few things I do agree with; on balance, there is more in it that I think is wrong.
Let me start by outlining the points I agree with. I will take up where Mr. Levinson left off on his six final considerations, some of which I split up. Thus I have ten points, four agreements and six disagreements.
I will start with the agreements. The debtor countries, the banks, and the creditor countries do have joint responsibility in dealing with the international debt problem, and I would argue that they have generally been living up to their responsibilities. I agree that the problem is not a financial one.
Second, it is in the economic interest of all parties to restore the debtor countries to economic health.
Third, the economic model, as Mr. Levinson refers to it, of high economic growth largely through public sector external borrowing has been discredited.
Fourth, whether we are lawyers or nonlawyers, we do tend to get lost in some of the technical details involving the debt problem and thus lose sight of the big picture, which is the restoration in these countries of growth on a sustained basis and access to the international market.
Let me move on to enumerate those of Mr. Levinson’s points with which I disagree. First I disagree, profoundly, with Mr. Levinson’s analysis of the role of the newly industrializing countries (NICs) in the world economy in the 1970s as an engine of growth. They grew rapidly, and that was good for the world economy. I do not accept the proposition that this growth, ipsofacto, entitles them to greater voice than they now have in the decision making of international institutions, whatever the merits of the current dispute over the structure of the Inter-American Development Bank.
My second, and, I think, most important point is that Mr. Levinson is wrong when he says that the United States cannot resolve its trade imbalances without sustained growth in Latin America. In this connection, I would like to make a small economic point: part of the decline in our exports in Latin America and our increase in imports from that region was a function of the dollar’s appreciation against other currencies more generally; many of the countries that are participants in this seminar come from places that were better able to compete in Latin America than we in the United States were. Moreover, the years 1980–81 were aberrations in terms of U.S. exports in Latin America: in 1980, $39 billion worth of U.S. goods were exported to Latin America, and in 1981, $43 billion. In fact, since 1983, the values of annual U.S. exports to Latin America have been larger than in any year since 1979. In addition, from 1983 to 1987, U.S. exports to the world grew by 25 percent, and U.S. exports to Latin America grew by 40 percent. Finally, the U.S. economy is very close to, if not at, full employment, and if we are to export more to Latin America, then we must export less to other countries, import more from the world, or further compress domestic demand.
Third, I disagree with plans for so-called comprehensive debt relief, such as are implied by the various debt-relief proposals. In my view, comprehensive debt relief would represent a failure to deal with the debt problem, not a solution to that problem. My colleague Mr. Michael Brad-field has recently given a speech on this subject, and I understand he will distribute it to this group.
Fourth—and this is a matter of judgment—I would argue that pleas, such as the one made by Mr. Levinson, that structural changes in these countries be implemented slowly are invitations to block change, inhibit progress, and court disaster.
Indeed, and this is my fifth point, I think a political backlash in the borrowing countries is much more likely if there is no progress than if progress is too rapid.
I make my sixth point with some hesitation. I am afraid I do not believe that the basic issue in the debt problem has to do with a “social question” of poverty versus democracy. It is a political and economic question of achieving economic expansion, largely through mobilization of internal resources, rather than through reliance on external charity. There is not going to be a Marshall Plan that will allow countries with external debt problems to avoid structural change. Indeed, if you go back in history, you will observe that the Marshall Plan carried with it a considerable degree of conditionality and that it was designed primarily to help countries that were determined to help themselves.
Let me go on to a few other issues on which Mr. Levinson and I differ, and then I will close with some issues on which we agree so that we can round off this discussion a little bit. The oil crisis of the 1970s did not cause the debt crisis. Nor did Secretary of the Treasury William Simon, whatever his faults, cause the international debt problem of the 1980s by advocating private sector recycling in the 1970s. Although, in many respects, his policies were regarded by many as wrong, and although many officials at the Federal Reserve said so at the time, the fact is that a very small fraction of the surpluses of Organization of Petroleum Exporting Countries (OPEC) members ended up in international banks. (Incidentally, I think that if you examine the record, you will find that the Reagan administration did not endorse the recession in 1981 and 1982.)
A somewhat more serious point is the question of what people were doing about the debt crisis in 1982 and how long they thought it was going to continue. I think no one knew the answer in 1982. I think many more suspected that it was going to be a longer-term problem than Mr. Levinson’s remarks suggested and that it would not lend itself to a quick fix. However, I would argue that to the extent people felt that this problem would be solved quickly, they held various views—in the creditor countries, among the commercial banks, and, more importantly, among the borrowers—as to how this could be done.
I think Mr. Levinson gave very short shrift to the fact that the debt problem is multinational in character. The United States or the Reagan administration is not in one camp, with Latin America in the other. There has been an international effort involving the creditor countries, the commercial banks, the various international institutions, and the borrowing countries. In particular, most of the so-called rescue operations—that is, the bridge loans—that have been effected were organized deliberately on a multilateral basis.
Now I come to an economist’s point—an error commonly made by economists. The payment of interest is not a transfer of resources but rather a payment for the services of capital. If one does not want to use the services of that capital any longer, one pays it back. The 15 Baker plan countries are not transferring capital to industrial countries. They are still running a current account deficit as a group, and they should be; therefore, there is a net transfer of resources into the Baker plan countries. A related fact is that the Baker plan called for $20 billion in new net lending over and above not the payment of interest but rather the payment of principal.
In my view, it is unrealistic to think that the Bradley, La Falce, Morrison, Robinson, and similar plans are going to be more effective in bringing about economic reforms than the present program. My evidence for this, I am sorry to say, is that people who advocate these solutions in the borrowing countries are not the people who advocate substantial change. The problem with talking about these kinds of solutions is that it tends to delay meaningful change and stretch out the process of solving the debt problem. In the end, I think, debt relief is a prescription for economic isolation.
One further point which Mr. Levinson did not mention in his remarks, but which he did cite in the paper, concerns the Federal Reserve Board’s Regulation K, which affects the capacity of banks in the United States to engage in debt-equity swaps. He refers to the revision of Regulation K in August 1987 but not its further liberalization in January 1988. The further liberalization, I think, essentially responds to all of his criticisms, some of which were factually wrong to begin with.
Let me return to a few issues where Mr. Levinson and I agree. I agree that the borrowers were foolish to borrow large amounts at floating interest rates. However, I am not so sure that it is the role of the U.S Treasury, the Federal Reserve Board, the International Monetary Fund, the World Bank, or the Inter-American Development Bank to tell countries—sovereign countries—that they cannot borrow in the market.
The initial response to the debt crisis was remarkably successful on the external side; Mr. Levinson emphasizes, and I agree, that in many respects it was too successful. It was too easy for these countries to reduce their trade and current account deficits and increase their trade surpluses without resolving some of their internal problems. (As a group, these countries had had a trade surplus when the debt crisis began—a fact that is often forgotten.) However, their efforts were remarkably successful.
Third, I believe that the response of the banks to the Baker plan has been disappointing. There is an increasing lack of cohesion among the commercial banks, which, I think, Mr. Watson* discussed yesterday and Mr. Kincaid may discuss today. There are a lot of reasons for the banks’ failure to respond. There are at least five hundred banks around the world involved in this business. They have very different interests, which, over six years, have begun to diverge further. I would argue that what really undercut the Baker plan was the collapse of oil prices in late 1985, which meant that a third of the Baker plan countries did not need relief, since they, in some sense, got a windfall. Another third of them were left substantially unchanged and the remaining third—the oil exporting countries among them—did not know at what level oil prices would bottom out and consequently found it difficult to figure out what to do.
Mr. Levinson said in his paper—and I don’t think this was in his oral remarks—that it is unlikely that this U.S. Treasury—and, I would argue, the next Treasury, no matter who is President or Secretary of the Treasury—will make a favorable report on the debt-facility idea. I have already explained my reasons for holding this view.
I agree with Mr. Levinson that debt-equity swap programs, though useful, cannot solve or offer a general solution to the debt problem, and I agree with him that the debt problem involves the balancing of conflicting and complex interests in Washington and around the world. I would go on to say that “magic,” or comprehensive, solutions are nonsolutions.
I have essentially five conclusions to present. First, although the international debt problem remains serious, a lot of progress has been made in dealing with it.
Second, there has been more progress made in many of the borrowing countries than they have received credit for.
Third, it has been a lot more difficult for borrowers to achieve that progress than was initially anticipated by many of the people who have been involved since the start of the debt crisis. Those few of us who are left—who are members of what I would describe as the first team—are getting awfully tired.
Fourth, loose talk by financial leaders, congressmen, academics, and even lawyers about broad-based debt relief, is, in my view, counterproductive. The proposed comprehensive debt-relief plans treat the symptoms and not the underlying economic problems. If I may just come back, for a moment, to the question of the U.S. trade deficit, I would like to go through a little arithmetic exercise with you. International commercial banks’ claims on Latin America are $250 billion. Let us assume that a $250 billion debt carries an average interest rate of 10 percent. That means that if the interest were completely forgiven for a year, the borrower would not have to pay $25 billion. If it was all devoted to additional imports, how much of that would come from the United States? Our average share of imports by the Latin American countries is about a third; that might conceivably increase to a maximum of 40 percent. Forty percent of $25 billion is $10 billion a year. Quite frankly, $10 billion is about a quarter of the error in our annual forecast of the U.S. trade balance today. It is “peanuts” in terms of the current U.S. trade deficit.
My fifth conclusion is that no country’s leaders should seriously consider debt relief unless they are prepared to cut themselves off from the international financial community for decades.
Thus, my last conclusion is that there is no realistic alternative to the current cooperative approach to the international debt problem. Progress must be evolutionary, not revolutionary.
The ideas expressed are my own and in no way reflect, officially or unofficially, a position of the Inter-American Development Bank. This paper was published previously in J.I. Levin-son, “A Perspective on the Debt Crisis,” 4 Am. U. J. Int’l. L. & Pol’y (1989), 489.