III The International Debt Crisis: What Have We Learned?

Abstract

“Let us live in as small a circle as we will, we are either debtors or creditors before we have had time to look round.” Goethe

The 1980s will almost certainly go down in economic history as the decade of the international debt crisis, a period during which the debt-servicing difficulties of the developing world became a virtually constant feature of the international economic scene. Since the crisis erupted, much has been done to redress those difficulties, though a definitive resolution to the indebtedness problems has remained elusive.

A good amount has been written about the debt crisis since its abrupt entrance onto the international stage in August 1982, with the announcement by Mexico of its inability to continue servicing its external debt obligations.36 The bulk of this literature has focused on the genesis and development of the debt crisis,37 proposals for its resolution,38 and the examination of analytical issues in external debt management as well as of a multiplicity of financing modalities and techniques.39 This section does not add to the variety of these topics so much as develop a number of essential lessons from the protracted struggle the international economy has been waging with the obdurate problems of external indebtedness. One significant insight gained from the evolution of the debt strategy is the difficult balance between national autonomy and the need for international rules.

In order to lay out these lessons, it is first necessary to go briefly into the history of the past two decades. This is well-trodden ground, but when approached from a new perspective it reveals the need for balance between rules and discretion. This historical setting also provides the canvas for a stylized sketch of the debt strategy in its various phases. This sketch is followed by a summary outline of the role of the International Monetary Fund and the adaptations made to the institution’s policies and procedures in response to the evolution of the debt strategy. Finally, a number of critical lessons are drawn that should help the international economic system cope with similar problems in the future. The section concludes with a few final observations about the debt crisis and the need for certain basic norms of behavior.

Background

A striking feature of the 1980s is the extent to which the decade was dominated by events that took place in the 1970s. Even more striking is how the factors that complicated the 1980s included not only the problems of the 1970s but also their solutions.40

In a nutshell, the 1970s will enter economic chronicles as a difficult decade, one that saw sharp changes in the terms of trade and corresponding shifts in current account imbalances as well as high inflation and faltering growth. Attempts to resolve these problems with the recycling of petrodollars and large capital flows, particularly from commercial banks to sovereign borrowers, only confounded matters. In a fundamental sense, it can be argued that the 1970s witnessed a revolt against the close interdependence and integration of the international economy during the previous two and a half decades. This revolt was made particularly evident by a surge of protectionist pressures in many countries, but it was also clear in the generalized move from fixed to flexible exchange rates, which reflected the search for autonomy in national economic policymaking. Another important trend tended to counter these two effects, however: the emergence of growing capital movements, which for some time, at least, provided cohesion to the international financial system. It was therefore understandable that the expansion of the international lending-borrowing process was perceived as part of the solution to some of the period’s problems; after all, the growth in lending had kept trade flowing more fluidly and made exchange rates less variable than would have otherwise been the case.

Yet, by the early 1980s, strains began to show; in fact, a better illustration of the intertemporal interdependence of economic phenomena would be difficult to find. Those years show clearly the ease with which the correction of one imbalance can thwart the solution to another. Among the industrial countries, the negative experience with inflation in the 1970s swung the pendulum toward domestic policies aimed at bringing the price increases rapidly under control. In turn, the resolution of the inflation problem was accompanied by the emergence of high real interest rates and a slowdown in economic activity. As a result, decisions made in borrowing countries when real interest rates were negative became untenable, and the consequences soon surfaced: creditworthiness concerns among lenders mounted and the flow of international loans and capital accordingly and abruptly dried up.

In effect, the legacy of the 1970s included problems, such as inflation, which called for decisive policy action, and solutions such as recycling and large capital flows, which resulted in significant external asset-liability accumulations across countries. Although other factors—most notably, the quality of countries’ domestic policies—were also accountable, the actions required to control inflation in the industrial world in the early 1980s (measures that were absolutely necessary to restore a critical element of balance to the international economy) contributed to the emergence of debt-servicing difficulties. The experience since the 1970s has thus shown not only how elusive autonomy in national economic policy can be—that is, flexible exchange rates fell far short of insulating country economies—but also how the cohesion fostered by capital flows and recycling can suddenly give way to the dispersion of the debt crisis, a disorder reminiscent of the absence of rules.

Sketch of the Debt Strategy

The large accumulation of external debt liabilities by developing countries in the period through 1981 and the abrupt interruption of capital flows in 1982 called for a prompt response from the international community to contain potential disruptions to international economic relationships. The immediate aim was to avert irreparable damage to the fabric of the international economic and financial system. The general perception was one of impending systemic danger, the avoidance of which required contributions from both creditor and debtor countries, private and official entities, and national and international institutions.

Initial Approach

When the debt crisis erupted, time was of the essence, and in its initial conception the debt strategy sought to lift the obstacles that blocked international financial flows. The central aim was to ensure an amount of external financial support that would permit debtor countries to undertake adjustment efforts which offered reasonable assurances that debt service could and would be eventually resumed. The requisite amounts of financial assistance included new funds as well as the refinancing and rescheduling of old debts on traditional terms.

It was promptly realized, however, that, important as an appropriate amount of financial support was, it would not be sufficient. It would also be necessary to make the terms of foreign financial assistance compatible with the prospects for balance of payments recovery in debtor countries. A primary feature of this second element of the original debt approach soon appeared in the form of multiyear rescheduling arrangements, which creditors began to make available to debtors as their adjustment progressed. These multiyear arrangements extended the coverage and maturity of rescheduled loans over significantly longer periods than those traditionally granted in the past.

The essence of the initial debt strategy was to assign to each of the various actors a specific and mutually supporting role, rather than let the outcome of the debt crisis be determined solely by market forces.41 There was a fundamental logic behind the original debt strategy: adequate financial support for the adjustment efforts of debtor countries would help restore their debt-servicing capacity. With it, their creditworthiness would improve, and spontaneous capital flows would correspondingly resume. The strategy did prove effective in defusing the threat posed to the international financial system by the debt crisis. But the resumption of spontaneous capital movements did not materialize as quickly as had been expected, and modifications in the debt strategy therefore became necessary.

Baker Initiative

The first adaptation of the debt strategy came in 1985 in the form of an initiative by U.S. Treasury Secretary James Baker; it recognized that the debt problem would take time to resolve.42 The basic philosophy of the original strategy remained unchanged in that the central aim was to restore debtors’ capacity to service debt, their credit-worthiness, and their access to spontaneous capital flows. In addition, though, the resolution of the debt difficulties was seen as requiring the promotion of economic reforms in debtor countries to foster development and growth. The process of debt resolution was thus broadened to encompass, besides balance of payments stabilization and restoration of creditworthiness, longer-term development and growth objectives.

This broader agenda for solving external indebtedness had implications for both debtors and creditors as well as for other sources of capital and financing. On the part of the debtors, the extended time horizon and the consequent emphasis on growth led to structural reform to promote efficiency in the economy. As for creditor countries, their contribution was to be made mainly through the multilateral development banks, which were to increase their lending to debtor countries significantly. The initiative also called for continued commercial bank lending.

The Baker initiative emphasized several important aspects of the resolution of debt difficulties. The longer time perspective meant that macroeconomic management would have to be supported by microeconomic measures to enhance efficiency and productivity, and thus growth. The initiative also highlighted the importance of continued external financial support over an extended period to give economic reforms sufficient time to yield results.

Menu Approach

Though effective in removing the systemic threat to the banking system and to the international trade and financial network, the debt strategy up through the Baker initiative was still unable to eliminate the debt problems of individual countries. In addition, the flow of international capital remained constrained, and many debtor countries continued to confront debt-servicing difficulties.

Further adaptations to the debt strategy became necessary to prevent the process of debt resolution from stalling. These took the form of innovations in financing modalities and techniques. Emphasis on the market-based nature of the adaptations led to the introduction of a “menu approach” to new lending in 1987 and the cautious acknowledgement of the option of voluntary debt reduction.

The menu contained a variety of options including debt-equity swaps, debt buybacks, debt exchanges, exit bonds, and the like.43 These options have proved useful in specific countries, but like the Baker version of the debt strategy they failed to provide a definite solution to the problems of indebtedness and limited access to capital markets; both problems remained.

Brady Plan

Given the insufficiency of the preceding approaches, U.S. Treasury Secretary Nicholas Brady proposed further changes to the debt strategy in 1989. The Brady plan endorsed the existing debt strategy in all its key aspects—adjustment-cum-reform in debtor countries, continued external support, and a case-by-case approach to debt resolution. The central innovation of the plan was its focus on the actual reduction of debt stocks and debt-service flows as a complement to external financial support. In its first three phases, the debt strategy had focused consistently on the importance of new lending and more lenient repayment schedules for past borrowing; voluntary debt reductions had also been considered, though clearly as a secondary possibility.

The Brady plan brought debt and debt-service reduction to the fore. In effect, it acknowledged that such an option properly belongs within the debt strategy. To this end, the plan envisaged that official resources be used to facilitate such reduction. It is clear, however, that the reduction of debt and debt service by external parties will not solve the indebtedness problems. The debt strategy continues to treat the policy efforts in debtor countries as the crucial ingredient for the resolution of the debt crisis.44

Role of the International Monetary Fund

Any examination of the role of the International Monetary Fund in the resolution of the debt crisis must take account of two fundamental institutional principles. First, consideration has to be given to the universal character of the institution. Its membership includes all varieties of countries: developing and developed; debtor and creditor. This principle of universality makes the institution responsible for protecting the interests of all countries, not just those of particular groups among them. Second, recognition must be given to the advantage to all countries of the free flow of trade in goods, services, and capital. This principle of freedom of trade, a cornerstone of the IMF, explains why the institution has always sought to encourage the integration of member countries into the world economy.

These two principles are imbedded in the Articles of Agreement of the IMF, which outline a code of international economic conduct to which all members have subscribed. These principles, which partake of the nature of rules, represent certain constraints the institution must observe in the discharge of its general responsibilities and in its involvement in the debt process. In this latter endeavor, the challenge for the IMF has been to contribute to the resolution of debt problems in a manner that fosters efficient economic expansion and promotes interdependence and integration, thus strengthening the code of international economic conduct.45

Adjustment, Financing, and Growth

The essential challenge for the IMF and its member countries has been to buttress the critical—but elusive—relationship that binds together adjustment, financing (including external debt flows), and growth. Strengthening this relationship in a universal setting and in accordance with well-tested norms of conduct can only occur if all major parties participate. Thus, although the IMF has contributed directly with its own resources to the financing pack-ages arranged for debtor countries, its primary responsibility and attention has focused on their adjustment policies. This emphasis has enabled the IMF to become the vehicle to which all the other elements of a cooperative approach can be attached.

A basic rationale behind the approach has been that there is no substitute for the pursuit of sound domestic policies in the debtor country. While perhaps not sufficient, sound economic policies have been seen as a necessary condition for the resolution of debt-servicing problems. The IMF has sought to ensure observance of this necessary condition through its specific policy understandings with debtor countries in the context of their financial arrangements with the institution. Policy conditionally has therefore been an essential element in the debt strategy. Not only can it correct imbalances in the economies of debtor countries but it can justify financial support from lenders and, in time, it can pave the way for the resumption of international saving flows in response to market incentives. In this fashion, countries have a measure of national discretion to pursue their own interests (the correction of imbalances) by means consistent with agreed international rules of behavior.

In the early phase of the debt strategy, conditionally focused mainly (though not exclusively) on macroeconomic management aimed at balancing the demand for and the availability of resources. As the horizon for policy formulation lengthened to include the medium run, macro-economic management was explicitly supplemented by structural reform and microeconomic policy actions to ensure efficient resource use. These measures included the liberalization of trade and the opening of the economy, both of which were to enhance efficiency, strengthen competition, and encourage the resumption of capital flows. Together with the re-establishment of a balanced macroeconomic framework, they were also expected to arrest the outflow of domestic resources and help reverse capital flight.46

With regard to creditors in general, a key aim of the debt strategy, as noted above, was to reverse the abrupt interruption of capital movements. Circumstances at the time did not encourage lenders to provide further resources to indebted countries, and this situation called for an important innovation in IMF policies and procedures—the introduction of “concerted” lending packages.47 The IMF began to require creditors to provide firm assurances of the availability of external financing before it would move with its own support of the debtor adjustment program: a “critical mass” of commitments of external assistance became a prerequisite for the completion of an arrangement with the IMF. In this way, the IMF moved to catalyze capital flows toward countries willing and able to undertake an adjustment in their economies. In turn, international lenders linked the availability of resources to progress made under the adjustment programs. Thus, a balanced distribution was sought between the efforts required from debtors—that is, adjustment—and those required from creditors—that is, financing. In the process, a measure of conditionally was exercised on creditors as well as on debtors, and a fine balance between international rules and national discretion began to emerge.

Money Packages and Menus

The financial arrangements of the IMF with debtor countries increasingly became the instrument around which the collaboration between debtors, creditors, banks, and multilateral institutions was built. As the debt strategy developed, the arrangements were adapted to encompass the new elements. Thus, with the Baker initiative, emphasis was placed on the growth and structural reform aspects of the adjustment process;48 this initiative focused attention on the adjustment and structural reform efforts to be undertaken by debtors, that is, it broadened the policy conditionality of the strategy.

Adaptations were also made on the financing side. The concerted lending approach, which had envisaged the provision of new loans and the refinancing or rescheduling of old loans, evolved into broader and more sophisticated money packages and menus, which, as described earlier, added a variety of novel financing techniques, including voluntary debt relief. Still, the principal focus of the debt strategy remained the restoration of credit-worthiness through policy corrections in debtor countries—to reduce imbalances, enhance productivity, and foster growth—and through easing the burden of debt service by extending the maturity of loans or by refinancing outstanding debts.

Debt and Debt-Service Reduction

With the introduction of the Brady plan, and its focus on the actual reduction in debt stocks and debt-service flows, arrangements with the IMF began to include such debt and debt-service reduction options. Indeed, it was soon decided that IMF resources could be made available, albeit on a limited scale, to finance these operations.

In addition, a number of other important steps were taken by the institution to increase the usefulness of its participation in the debt strategy:49 a modification of the policy of assuring financing, so that arrangements with the IMF could become effective even before the completion of negotiations with creditors on a financing package; the enhancement of the Extended Fund Facility (EFF), both in the duration of and access to IMF resources; the expansion and adaptation of a financial facility to deal with unforeseen contingencies (Compensatory and Contingency Financing Facility (CCFF)); and a cautious tolerance of arrears, typically linked to a well-defined plan for their eventual elimination.

The various changes made in the debt strategy represented a simple recognition of the intractability of the problem of international indebtedness. The IMF contributed with the instruments at its disposal—conditional financial assistance and the requirement that other lenders also participate in the joint effort. In addition, the institution sought to tie the effectiveness of the debt strategy to the quality of economic policies in the major creditor countries. This line of activity went beyond the institution’s specific aims of encouraging trade openness, which provided debtors with an opportunity of earning foreign exchange, and of seeking a resumption of capital flows and external financing. There was more at stake in the debt crisis than the consistency of the cooperative approach with respect to the trade and capital accounts. Accordingly, the appropriateness of industrial country policies was seen as instrumental to the stability of the world economic environment. Enhancing the quality of those countries’ policies would help debtors manage their economies even more effectively than could adapting the debt strategy alone. For this reason, increasing attention has been paid by the IMF to industrial country policy and to its impact on the economies of individual members or groups of members, including debtor countries and the developing world at large.50

Practical Difficulties

The task of bringing together a group of separate interests is rarely simple, and cohesion can prove the most elusive of aims. In the process of implementing the debt strategy, examples of such elusiveness have often cropped up. During the negotiation of financial arrangements with debtor countries, pressures have developed as each party has sought to protect what it perceives as its immediate interest. Frequently, but perhaps not surprisingly, those frustrations have been directed at the IMF, since the institution has provided the focal instrument that makes the operation possible (that is, the financial arrangements).

To a large extent, the pressures have reflected a possibly excessive amount of attention given to the apparent substitutability between adjustment and financing. This has led debtors, on one side, to stress the importance of financing, or the contribution of creditors, and has led creditors, on the other side, to underscore the necessity of adjustment, or the contribution of debtors. There is a certain logic in these positions: for debtors, financing would permit them to stretch out the adjustment effort; for creditors, a determined adjustment effort would justify their provision of financing. From a fundamental standpoint, however, adjustment and financing complement one another, and this is the aspect of the relationship on which the IMF—which represents both creditors and debtors—has based its approach to the issues of indebtedness.

In principle, the issues posed by these divergent perceptions would be settled once the expectations of debtors and creditors, and consequently their understandings regarding adjustment and financing, have been aligned; yet, the pressures do not vanish at that stage. Once agreement has been secured, it becomes necessary to ensure that the various components of the financial package not only materialize but do so at the appropriate time. Otherwise, the adjustment path carefully mapped out by the debtor can be thrown off track. In other words, such deviations tend to distort the carefully crafted balance of interests built into the original agreement, thereby giving rise to a vicious circle: debtors contending that the adjustment effort has been derailed by the failure of financing to conform to the programmed path; creditors arguing that financing cannot proceed precisely because the adjustment effort has faltered. The complications caused by these different perceptions have often been compounded by the linkage typically made between the disbursement of financial flows and policy performance in the debtor country. Yet this linkage has been a necessary feature of the approach, given that in its absence external financing could hardly be expected to resume.

Broad Issues

These practical difficulties point to an important lesson concerning the areas on which the various parties involved in the debt problem should focus. While it is undeniable that each party has unique interests, the effectiveness of the whole strategy can critically hinge on the ability and willingness of everyone to focus on the common aspects of those diverse interests. For debtors, adjustment programs that contemplate financing on terms that are not compatible with the economy’s productive capacity and its prospects for balance of payments recovery will contribute neither to adjustment nor to growth. Conversely, for creditors, financing that constrains debtors excessively will obstruct the adjustment effort and ultimately impair the value of their past loans. Clearly, financing that supports efficient adjustment provides the best means for its own protection. Apart from this practical lesson, however, several other fundamental issues from the indebtedness decade transcend the problems of debt and point to the importance of the existence and observance of certain rules for the efficient operation of markets.

Moral Hazard

Behind creditors’ concern with the strength of adjustment efforts and their reluctance to entertain debt relief is the risk of moral hazard.51 Most frequently, concern about the moral-hazard risks reflects the possibility that unless new financing flows are clearly associated with a serious adjustment effort on the part of the debtor, a clear danger will arise that such external support, rather than encouraging the pursuit of corrective policies, will only contribute to the continued pursuit of inappropriate economic management.

The risk of moral hazard is perceived most strongly in the context of debt forgiveness or debt reduction,52 because consideration of these options tacitly acknowledges that debts cannot be repaid, an acknowledgement that can undermine the lending-borrowing process. Because of this risk, it is generally agreed that debt reduction should be infrequent; if possible, it should be a one-time event so as to avoid the recurrence of debt problems.

This moral-hazard risk is the fundamental rationale behind the insistence that the adoption of adequate policies be a prerequisite to the extension of external assistance in the form of new funds, debt relief, or debt reduction. Fundamentally, it is in the interest of both creditors and debtors to ensure that external resources support, rather than hinder, efficient adjustment efforts. Only on that basis can international capital flows be expected to resume and persist.

A risk of moral hazard can also arise with respect to creditors. While concerns over debtors focus on the insufficiency of their adjustment effort (or its counterpart, unduly severe adjustment), the concern with regard to creditors revolves around the insufficiency of their financing (or its counterpart, excessive or inappropriate financing). An approach that ensures full servicing of outstanding debt at any cost, that is, even when the debtor is in irreparable difficulties, would tend to dampen creditors’ incentive to maintain efficiency in their lending.

These two moral-hazard risks are interconnected: total elimination of moral hazard for debtors would ensure the emergence of moral hazard for creditors and vice versa. As was the case with the mix of adjustment and financing, here again the issue is one of balance. And the signals for assessing balance are best sought in the market, with such market criteria going beyond traditional indicators of macroeconomic performance to encompass the efficiency of the lending-borrowing process. Thus, the market separates efficient and productive lending and borrowing decisions from those that are inefficient and unproductive; on this basis, “good” loans, or assets, are distinguished from “bad” loans, or liabilities.

However, the initial urgency of the debt crisis meant that the first approach treated all outstanding debts equally,53 thereby raising the specter of moral-hazard risks. If debtors and creditors had perceived that inefficient decisions on their part would have no cost and would be treated like efficient ones, they would inevitably have become indifferent to the risks inherent in their transactions. Fortunately, a measure of hedge against moral hazard has been provided by the exceptional character of debt relief and has been supported by the willingness of debtors and creditors to accept that if excess borrowing can be seen as the counterpart of excess lending, debt reduction is consistent with a market-determined outcome. Indeed, when the market distributes losses and gains—as is typically the case in the context of national economies—the allocation is perceived to be based on objective criteria (market rules) rather than discretion.

Public Versus Private Risk

Another important issue when dealing with countries’ indebtedness problems concerns the firmness of the separation between private and public risks. An immediate example is the extension of government guarantees in connection with private borrowing-lending transactions. As is the case with all types of insurance, these guarantees blur the frontier between private and public risk and can be expected to affect the behavior of economic agents.

The perception that the line between these two kinds of risks can be softened is likely to give rise to pressures that may be difficult to resist. For example, in circumstances of debt difficulties, debtor governments typically face pressure to guarantee or even to assume private debts. And the pressure comes from both sides of the original transaction: from the private domestic debtor, who would like to share the burden of the liability with other taxpayers (and thus pass it on); and from the private foreign creditor, who perceives a reduction in the risks associated with the asset.54 Thus, from the standpoint of both the private debtor and the private creditor, there is an advantage in having the government guarantee or assume the debt. To the extent that those pressures are allowed to prevail—thereby reducing or eliminating the separation between private and public risks—dangers of moral hazard similar to those already discussed will arise. Therefore, for the same reasons that the debt strategy should seek to replicate market outcomes, practices or actions that can easily convert private risks into public ones should be avoided.

Role of Government

This discussion of risks leads directly into the fundamental question of the role of government.55 An important share of the literature in economic theory and policy has been based on a clear distinction between the public sector and the private sector. Blurring or softening that distinction has important policy implications because it affects the pattern of economic behavior.

A clear example of the dangers of ambiguity is the argument that economic imbalances that originate from private sector behavior are not matters for public policy because they are essentially self-correcting. There are at least two levels on which this argument needs to be closely examined. One is the extent to which it can be clearly demonstrated that an imbalance originated exclusively in the private sector, which is not always easy to do; an example is the case where a private sector imbalance has been caused by inappropriate government policies. The second is the extent to which government and private sector domains remain separate in practice, that is, the government’s ability to resist intervening when pressure from private imbalances builds in the economy at large.

The more permeable the line between the government and private sectors, the higher is the risk of moral hazard. Here again, the importance of either keeping the separation intact or openly facing the consequences of blurring the boundary cannot be overstressed. A government that is in balance and that invariably sticks to the separation between public and private affairs can argue plausibly that private imbalances will correct themselves. A government less credible on this issue must be ready to correct even privately originated imbalances.

Importance of Rules

The common thread linking all the issues discussed in this section is the importance of a clear code of conduct—a transparent set of rules governing economic behavior—for minimizing the numerous risks of moral hazard. In addition, the code of conduct should provide for a clean separation between government and the private sector, thus distinguishing public risks from private ones; such identification is relevant in both the domestic and the international economic spheres. At present, however, the domestic economic domain conforms better to the principle of separation between the two sectors than the international economy does. On the international level, not only is there no authority comparable to a national government but the rules of behavior are less well defined (and observed) than in the domestic setting and the consequent risks of ambiguity and moral hazard are larger.

In the specific context of the debt strategy, the need for a balanced distribution of the burden among debtors and creditors illustrates both the importance of rules and the difficulties that can arise in their absence. Consider the general principle of the “sanctity of contracts,” which is generally agreed to be of enormous relevance for reducing uncertainty and for forming expectations. In the domestic domain, the principle prevails and its observance is protected by well-established procedures that deal with situations when the terms of a contract become difficult or impossible to meet, for example, bankruptcy law and procedures.56 The absence of an equivalent law or of similar conventions at the international level renders the resolution of external indebtedness problems and other international conflicts all the more difficult. Such an absence again increases the appeal of letting objective market forces handle the debt problems, though examples abound, both nationally and internationally, of the reluctance to entertain the market option, particularly when the problems are thought to be systemic.

It is indeed paradoxical that governments that often act together to develop a debt strategy and other cooperative actions are so unwilling to establish a clear code of conduct to steer the actual implementation of their national economic policies and their cooperative initiatives.57 It may well be time to ask whether the case-by-case approach should be buttressed by well-defined rules. Without them, the piecemeal approach can set precedents that are difficult to reconcile with each other or that perpetuate the application of the lowest common denominator to the quality of economic policies or to the responsibility of economic agents.

Final Observations

Broadly speaking, in its various phases—adjustment with austerity, adjustment with growth, and adjustment with debt reduction58—the debt strategy has effectively reduced the debt crisis from its original level of a systemic threat to that of a difficult and pressing, but relatively contained, problem. The strategy has been less effective in reaching a definitive solution to the debt-servicing difficulties of individual countries, largely because of the complexity of initiating a growth process and the reluctance of capital flows to resume. Indeed, the strategy has yet to succeed in its avowed objective of restoring normalcy to international capital markets, if such normalcy includes access to those markets by debtor countries.59

After more than a decade’s worth of experience in dealing with debt difficulties in a variety of countries, what are the general lessons to be learned? One urgent lesson from the past two decades is that the solutions devised for current difficulties should not be allowed to become problems later on. This means approaching imbalances in the national and international domains with a view to their durable solution. To this end, sound and sustainable, not necessarily expedient, initiatives are required.

At each stage of the debt strategy, difficulties led to successive adaptations. At first, slower-than-expected balance of payments and economic recovery in debtor countries severely constrained their ability to generate resources; hence, the emphasis of the strategy moved toward reform and growth-oriented policies. The difficulty in restoring lending and capital flows, in turn, led to the introduction of a variety of financing modalities and menus; later, it contributed to the international support for voluntary debt and debt-service reduction. At each point, there was scope for dissent; and dissent did surface on each occasion concerning the proper mix and sequence of reform, such as whether the debt strategy had attained a balanced blend of adjustment and financing and which element should come first. Similar dilemmas surfaced at later stages as perceptions evolved regarding the appropriateness of an adjustment effort, the adequacy of a financing package, the proper rate of growth, and the relevant scope for a debt-reduction package, to name just a few.

In the process, however, care should be taken to keep attention focused on the fundamental challenge of re-establishing normal capital flows, with normalcy entailing the resumption of an appropriate level of capital movements as well as the restoration of an appropriate composition or structure to those movements, particularly in the form of foreign private direct investment and equity flows. Another significant concern for the years ahead will be for countries to pursue policies that ensure that international capital flows—both in level and structure—spontaneously conform to a market-determined pattern of economic incentives.

This section has also raised a number of thorny issues that may affect the future of the debt strategy. In its implementation, it will be important to minimize the moral-hazard risks that can materialize either from the policies of debtors or from those of creditors. Short of solutions that rely fully on market forces, this objective will be greatly helped by the establishment of an agreed set of rules, which can be applied to individual countries on a case-by-case basis, that is, with discretion.

The set of rules should include a clear separation between public and private risks, but when this is not possible the rules should be complemented by clear guidelines on how to handle such a situation. Such rules will strengthen the credibility of governmental policies. It must be noted that this requires addressing the question of the role of government on at least two levels: an abstract one, which separates the functions and responsibilities of government from those of the rest of the economy, and a practical one, which ensures that the government will not bail out sectors in the economy from the consequences of their own decisions.

From this standpoint, the critical importance of a commonly agreed code of conduct can hardly be overrated. Such a code contributes a measure of objectivity to cooperative strategies, which, in dealing with economic problems, inevitably must rely on an element of judgement. In addition, it helps establish uniformity and comparability of treatment among countries, both debtors and creditors. It also contains the incidence of policy impasses (such as those that arise between creditors and debtors when each group points to the shortcomings of the other as justification for their own inactivity) by indicating clearly where the primary responsibilities for action lie. Finally, the existence of a broad set of common norms is the only operational basis on which to exercise the flexibility required to deal with diverse countries in different situations.

36

The full list of articles and books on external debt issues is extensive and cannot be included here. A sample of volumes on the subject includes Mehran (1985), Smith and Cuddington (1985), Kahler (1986), Frenkel, Dooley, and Wickham (1989), Dornbusch, Makin, and Zlowe (1989), Calvo and others (1989), Husain and Diwan (1989), and Stoll (1990); also see McDonald (1982).

37

See, for example, Cline (1984) and Guitián (1987a); also see Dornbusch (1987, 1989); John Cuddington’s essay “The Extent and Causes of the Debt Crisis of the 1980s,” in Husain and Diwan (1989); Nowzad (1990); and Solomon (1990a).

39

See K. Burke Dillon and David Lipton’s article, “External Debt and Economic Management: The Role of the International Monetary Fund,” in Mehran (1985), as well as the collection of papers in Frenkel, Dooley, and Wickham (1989); also see Sachs (1984) and Guitián (1987b, 1989a, and 1989b).

40

For brevity’s sake, only global developments are discussed and no reference is made to the role played by policies pursued by specific countries. The importance of this caveat cannot be overstressed because in many respects the global trends outlined in the text are the joint results of all those policies. An extensive discussion of the genesis of the debt crisis can be found in Cline (1984); also see Guitián (1989b).

41

The view that governments should not interfere in the debt process and that the solution of the debt problem should be left to the market has been advocated by some authoritative econo-mists; see, for example, Friedman and others (1984), in which Friedman states that the solution to debt problems is “to require the people who make the loans to collect them. If they can, fine, and if they can’t, that’s their problem” (p. 38).

42

For a detailed exposition of this initiative, see William Cline’s essay, “The Baker Plan and Brady Reformulation: An Evaluation,” in Husain and Diwan (1989); also see Sachs (1989) and Solomon (1990a).

43

For a description and analysis of these various options and modalities, see Regling (1988), Dooley and Watson (1989), and the collection of articles in Frenkel, Dooley, and Wickham (1989).

44

Analysis of debt-reduction schemes can be found in Williamson (1988) and in Paul Krugman’s “Market-Based Debt-Reduction Schemes” and Elhanan Helpman’s “Voluntary Debt Reduction: Incentives and Welfare,” in Frenkel, Dooley, and Wickham (1989); also see Jeffrey Sachs’s essay, “Efficient Debt Reduction,” in Husain and Diwan (1989) and El-Erian (1990).

45

For additional views on the role of the IMF in the debt crisis, see de Larosiere (1986, 1987); Richard Erb’s “Current Developments in the Debt Crisis” in Stoll (1990); Jeffrey Sachs’s “Strengthening IMF Programs in Highly Indebted Countries” and Guillermo Ortiz’s “The IMF and the Debt Strategy” in Gwin, Feinberg, and contributors (1989).

46

For a discussion of issues of capital flight, see Cuddington (1986), Khan and Ul Haque (1985, 1987), and Ize and Ortiz (1987).

47

For an excellent discussion of the role of creditors and debtors in the debt strategy, see de Larosière (1986).

48

In effect, growth and efficiency have always been ultimate aims in the adjustment effort, in general, and in those undertaken to overcome debt problems, in particular; but these aspects were enhanced with the Baker initiative. For a discussion of the issues of adjustment, growth, and debt, see International Monetary Fund and World Bank (1987) and Selowsky and Van der Tak (1986).

49

For additional expositions of these adaptations, see Richard Erb’s “Current Developments in the Debt Crisis” in Stoll (1990) and Guillermo Ortiz’s “The IMF and the Debt Strategy,” in Gwin, Feinberg, and contributors (1989), an article that also contains an extensive discussion of the most recent arrangement with Mexico, which includes many of the adaptations discussed in the text. Since then, other countries have also completed Brady-type arrangements with creditors.

50

Such policy interactions are examined in the IMF’s World Economic Outlook as well as in individual consultations of the institution with major industrial countries.

51

For an ample discussion of these issues, see Cohen (1989), who, besides moral hazard, lists the following related concerns over debt relief: contagion, loss of creditworthiness, weakening of discipline, and legal and political issues.

52

A hurdle to which debt reduction gives rise is the difficulty of reconciling it with demands for continued new lending.

53

This is by no means necessary and, as noted earlier, strong arguments can be and have been made to the effect that the resolution of debt problems would be best left to the market; see Friedman and others (1984).

54

See, in this context, Jeffrey Sachs’s “The Debt Overhang of Developing Countries” and, in particular, George L. Perry’s “Comment” on Sachs in Calvo and others (1989) for further discussion of these points.

55

This is a subject that straddles many areas and disciplines and can only be cursorily discussed here. Consensus on the role of government is critical for domestic economic management and for international economic policymaking; it is also one of the central issues now confronting the reforming economies of Central and Eastern Europe and the former Soviet Union.

56

See Jeffrey Sachs’s “The Debt Overhang of Developing Countries” in Calvo and others (1989) for an extensive discussion of these issues.

57

A similar point was made in the Group of Thirty (1988) report on international macroeconomic policy coordination, where it is noted that the debt crisis in the developing world led to “an impressive display of economic cooperation among a wide range of countries” (p. 19).

58

These various phases represent a progressive “softening” of the constraints facing adjusting countries or conversely a progressive “hardening” of those constraints confronting parties involved in external financing. Again, the phases can be seen as steps in the search for a balanced distribution of efforts among countries. In this context, models that stress the importance of rules are preferable to those that focus on bargaining’, see for further discussion Kenen (1989, 1990b) and Section II of this paper.

59

A discussion of the outlook for the debt strategy in the current decade can be found in Fischer and Husain (1990).

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