1. Introduction
Determination of policies towards borrowing from abroad and external indebtedness represent a crucial part of the adjustment strategy for many developing countries. Emergence of serious external debt servicing problems in several countries in the early 1980s has heightened concerns with this area of economic policy.
This chapter initially reviews debt management issues for individual countries, focusing on policies to avoid external debt crises. Subsequently, successive sections consider the magnitude of the external debt problem, the evolution of the debt strategy, and the role of the Fund in this strategy.
2. Debt management
Two general requirements of effective debt management strategy should be emphasized.
The appropriateness of borrowing depends on the use of the resources. External borrowing supplements domestic savings and provides the debtor country with scarce foreign exchange which enables it to finance a greater volume of investment. For developing countries there is a strong presumption that foreign savings can and should be utilized to augment the stock of domestic capital over and above what could be provided by domestic savings. In addition, short– and medium–term borrowing (such as the use of Fund resources) may be used to compensate for external disturbances. External debt crises may occur when external borrowing is used to finance unproductive activities, and/or unexpected factors with significant adverse effects on the balance of payments emerge.
The effectiveness of debt management depends on the appropriateness of other policies. Trade, exchange rate and pricing policies, as well as domestic monetary and fiscal policies, directly affect the return on investment and therefore the appropriate level of foreign borrowing. Further, the level and terms of external indebtedness have important implications for policy options in these areas. Therefore, debt managers should have a clear understanding of expected macroeconomic developments, while policymakers must have a good grasp of expected new borrowing requirements and debt service payments.
a. Objectives of debt management
Effective debt management should consider both growth and stabilization objectives.
(1) Growth
Over time, external borrowing should be used to promote high and stable rates of economic growth, that are consistent with the achievement of a sustainable balance of payments position over the medium and long term. This requires that the use of borrowed funds—with appropriate support from other policies—generates an adequate future stream of external real resources so as to permit the timely servicing of the foreign liabilities incurred. Thus, a principal objective of external debt management is to ensure that the growth of external obligations is kept within the country’s capacity to service debt.
(2) Stabilization
In the short run, the level of external borrowing should be determined in such a way that the financial flows, both domestic and foreign, are consistent with the level of aggregate demand that is compatible with internal and external balance. Thus, external debt management should complement policies influencing domestic credit expansion, thereby ensuring that aggregate demand is maintained within appropriate limits. This is particularly important when internal and external imbalances arise as a result of deficits in the operations of the public sector; in such cases, control of public sector external borrowing directly complements limitations on its domestic financing.
b. Principles of debt management
The principles of debt management relate to the determination of borrowing capacity and to the conditions that need to be satisfied to ensure the servicing of the debt by the debtor country.
(1) Capacity to borrow
In order to increase the growth rate of national income, the marginal product of capital should exceed the interest rate charged on foreign borrowing. Following the law of diminishing marginal productivity, this principle implies that a country cannot always achieve higher growth targets solely by stepping up the reliance on foreign borrowing, even if foreign credits are used entirely for investment purposes. It also implies that policies aimed at improving efficiency of resource allocation and raising capital productivity will increase debt capacity and the chance of achieving higher growth through borrowing abroad.
(2) Ability to service the debt
To the extent that an increment to external debt adds more to investment income payments than to the capacity to make such payments, the “error” implicit in obtaining these resources must be reversed through net exports of goods and services. Failure to do so will lead to additional debt being incurred to make payments, and debt growing faster than debt service capacity. A shorthand way of stating this concern is that the interest rate paid on additional debt should not persistently exceed the growth rate of exports. Similarly, growth of external debt that persistently exceeds that of income can give rise to concerns as to future debt servicing capacity. Some commonly used debt indicators are reviewed in Box VI.1.
Debt Indicators
Debt ratios offer various measures of the cost of, or capacity for, servicing debt in terms of the foreign exchange or output forgone. Exports of goods and services and gross national product may be used as scaling factors. Both stock and flow indicators are used in assessing a country’s external debt situation. The former emphasize the extent of past dependence on contractual capital inflows. Flow indicators are often used as indices of short–run rigidity in a country’s balance of payments; the higher the ratio, the greater the external adjustment required to compensate for adverse balance of payments developments. The following are frequently referred to measures:
debt outstanding and disbursed to exports of goods and services;
debt outstanding and disbursed to gross national product;
total debt service to exports of goods and services (the debt–service ratio); and
total debt service to gross national product.
Although these ratios may be helpful in signaling possible debt problems, two countries facing similar ratios may face considerably different economic circumstances. A full assessment of a country’s debt position requires consideration of the overall macroeconomic situation and balance of payments prospects.
c. Debt management in practice
The practical task of external debt management is complicated by uncertainties relating to many of the main determinants of debt capacity. For example:
the growth of exports for most developing countries is subject not only to the caprices of weather conditions (for agricultural products) but also to the changes in the level of economic activity in industrial countries (for mineral and manufacturing products);
the terms of new debt are generally determined by forces in international capital markets which reflect overall supply and demand conditions; and
interest rates may change on existing debt that is contracted at floating rates.
A satisfactory system for registering, approving and monitoring external debt is an essential starting point for decisions on the level and composition of external debt.
(1) Managing the level of external debt
Several rules of thumb have been suggested for managing the level of external indebtedness, such as limiting the total debt service ratio to a specific number, say 20 percent. However, ability to sustain any particular debt service ratio depends on a number of factors including the outlook for exports, import requirements, the reserve level, future terms of trade and interest rate developments, and the flexibility to adjust policies and economic structure.
A formal ceiling on borrowing may be useful inasmuch as it encourages discipline and helps focus official attention on macroeconomic management. Official borrowing rules can be especially helpful if they cover projects that are not always easy to control for political reasons. However, the overall debt structure can be biased by partial controls. Limitations on the public sector’s foreign borrowing may help control a potential source of excess indebtedness. This advantage may be lost if the public sector then borrows heavily from the domestic market, forcing the private sector to borrow abroad, often at higher interest rates and shorter maturities than the government could have obtained.
The extent to which the central government controls external borrowing varies across countries. A few countries have statutory rules limiting the amount of external borrowing by the public sector and by the country as a whole. Some have no clear borrowing guidelines, allowing each investment to be judged on its own merits and on the availability of foreign funds. Most countries announce overall guidelines either in the form of the absolute value of new commitments in a particular year or in terms of some debt or debt service ratio. Usually target levels of public debt are approved by the government or by parliament at the beginning of a fiscal year.
(2) Managing the composition of external debt
Determination of the appropriate composition of external debt requires decisions on the following issues:
the terms of foreign borrowing, including interest, maturity, and cash flow profiles;
the balance between fixed rate and floating rate instruments;
ways of sharing risk between lenders and borrowers, including the balance between debt and equity;
the currencies in which foreign liabilities are denominated; and
the level and composition of international reserves.
The following guidelines may prove helpful in making these decisions:
a country should maximize its use of any highly concessional funds before resorting to commercial markets;
loan maturities should, to the extent possible, be matched with the payoff period of the investments that are financed;
if floating rate loans are obtained, it is essential to project future debt service payments based on various assumptions about interest rates;
it may be advantageous to increase the share of foreign equity in total capital inflows, particularly in a situation of high real interest rates;
the currency composition of debt should help insulate the economy from exchange rate volatility; and
higher reserves should be maintained the more variable are export earnings, the higher is debt exposure, the less flexible are economic structure and policies, and the more uncertain is access to a steady flow of foreign capital.
3. Evolution of the debt problem
a. Origins of the debt problem
The debt crisis had its origins in the substantial rise in the external liabilities of the developing countries during the second half of the 1970s and early 1980s, in an environment of large–scale recycling of the oil exporters’ surpluses, rising world inflation, and negative real interest rates. At the time many viewed this recycling of funds as a positive development: creditors were able to identify new investment outlets and debtors could acquire funds needed for development purposes.
The development of this situation into an external debt crisis was due to:
a drastic deterioration in external economic environment in the form of higher interest rates, lower commodity prices, and severe recession in the industrialized economies;
economic mismanagement and policy errors in debtor countries; and
excessive lending by commercial banks to some countries, with little regard to country risk limits.
The emergence of external debt problems may be clearly related to the earlier discussion of debt management. In particular, difficulties of many countries stemmed, in part, from the failure of external borrowing to be put to uses that yielded adequate return. There is by now substantial evidence that many of the funds borrowed in the 1970s were used to sustain declines in the saving ratio, and to finance capital flight or projects that were not viable at prevailing market prices. Furthermore, even in some cases where funds were invested wisely ex ante, unforeseen adverse movements in interest rates and the terms of trade made the ex post rate of return inadequate. In these circumstances, many of the heavily indebted countries accumulated large external debts, but did not generate sufficient capacity to service them.
b. The size of the debt problem
Approximately 60 percent of the total external debt of developing countries is owed by countries with recent debt–servicing difficulties. Most problem debtors are either middle–income countries, largely from Latin America, or low–income countries from Africa. While both groups of debtor countries face major challenges, the nature and magnitude of their problems differ substantially. Table VI. 1 provides debt indicators for fifteen heavily indebted middle–income countries (HICs) and for Sub–Saharan Africa (SSA). The following points may be noted.
Levels of external indebtedness for both groups of countries were substantially higher in the 1980s than in the previous decade.
Debt for the middle–income countries had risen by the early 1980s to levels that gave rise to concerns as to its impact on the international financial system. Although debt ratios have declined somewhat in recent years, they remain high in comparison to earlier periods.
For most Sub–Saharan countries official debt accounts for more than 80 percent of total external debt. By contrast, the largest part of the debt of the middle–income countries is owed to commercial banks.
Although debt levels are substantially lower in Sub–Saharan Africa than in the middle–income indebted countries, debt ratios tend to be higher and have risen since 1982. For both groups of countries the scheduled debtservice ratio is significantly higher than actual payments given the extent of debt relief and arrears.
4. Evolution of the debt strategy
a. Principles of the debt strategy
The strategy for dealing with the debt situation since 1982 has been based on three fundamental principles:
Principal Debt Indicators: Fifteen Heavily Indebted Countries (HICs) and Sub–Saharan Africa (SSA)—Selected Years
(In percent: unless otherwise indicated)
Principal Debt Indicators: Fifteen Heavily Indebted Countries (HICs) and Sub–Saharan Africa (SSA)—Selected Years
(In percent: unless otherwise indicated)
| 1975 | 1982 | 1985 | 1990 | ||
|---|---|---|---|---|---|
| Total Debt | |||||
| HICs | … | 330.3 | 419.2 | 508.2 | |
| SSA | … | 54.0 | 65.5 | 130.1 | |
| Debt/Exports | |||||
| HICs | 133.9 | 267.5 | 284.3 | 247.7 | |
| SSA | 65.2 | 213.6 | 257.0 | 390.9 | |
| Debt/GDP | |||||
| HICs | 18.5 | 41.0 | 45.5 | 38.8 | |
| SSA | 17.1 | 51.3 | 61.9 | 83.7 | |
| Debt Service/Exports | |||||
| HICs | 27.7 | 51.1 | 40.9 | 27.9 | |
| SSA | 8.2 | 21.5 | 22.4 | 22.5 | |
Principal Debt Indicators: Fifteen Heavily Indebted Countries (HICs) and Sub–Saharan Africa (SSA)—Selected Years
(In percent: unless otherwise indicated)
| 1975 | 1982 | 1985 | 1990 | ||
|---|---|---|---|---|---|
| Total Debt | |||||
| HICs | … | 330.3 | 419.2 | 508.2 | |
| SSA | … | 54.0 | 65.5 | 130.1 | |
| Debt/Exports | |||||
| HICs | 133.9 | 267.5 | 284.3 | 247.7 | |
| SSA | 65.2 | 213.6 | 257.0 | 390.9 | |
| Debt/GDP | |||||
| HICs | 18.5 | 41.0 | 45.5 | 38.8 | |
| SSA | 17.1 | 51.3 | 61.9 | 83.7 | |
| Debt Service/Exports | |||||
| HICs | 27.7 | 51.1 | 40.9 | 27.9 | |
| SSA | 8.2 | 21.5 | 22.4 | 22.5 | |
debtor countries need to pursue strong adjustment programs, supported by determined structural reforms, aimed at increasing domestic resource mobilization, attracting non–debt creating flows, and reducing impediments to growth;
creditors and donors need to ensure the provision of adequate external financing in support of such programs on a case–by–case basis; and
the international economic environment must be conducive to the success of these efforts.
b. Strategy for commercial bank debt, 1982–88
Although the principles of the debt strategy remain valid there have been considerable adaptations in its implementation.
(1) Initial approach
The debt crisis that surfaced in 1982 was initially viewed as a problem of liquidity rather than solvency. Thus, it was believed that debtor countries, or at least the middle–income countries of Latin America, would be able to regain the confidence of financial markets in time.
Immediate concerns stressed the avoidance of widespread defaults that might endanger the international payments mechanisms and the financial stability of heavily exposed creditor banks. The Fund played a major role both in directly providing resources and in putting together concerted financing packages involving commercial banks and others.
Between 1982 and 1985, the indebted developing countries, faced by severe financing constraints, had no choice but to focus on the immediate need to reduce current account deficits. These efforts, supported by the more favorable external environment during 1983–1984, led to a rapid reduction in their external deficits. This reduction was, however, achieved primarily through severe cuts in imports and investment, with adverse consequences for future growth and payments capacity. Thus, it became increasingly apparent that rapid turnaround in the performance of many developing countries would be more difficult to achieve than had initially been envisaged. Moreover, despite progress with adjustment, the needed financing flows from private creditors did not appear to be forthcoming.
(2) The “Baker Initiative”
Against this background the Program for Sustained Growth launched by then U.S. Treasury Secretary James Baker III in October 1985, was directed toward the fifteen heavily indebted countries (HICs) and emphasized the need for a longer–term commitment by both creditors and debtors. In particular, the “Initiative” called for new lending in support of growth–oriented macroeconomic and structural reforms, setting specific goals for increased financing efforts from both commercial banks and the multilateral development agencies.
In spite of the resumption of growth in real GDP and in export volume in the HICs, the response to this initiative was in several respects disappointing. Specifically:
commercial bank financing turned negative from 1985, contributing to a large resource transfer from the indebted countries;
policy adjustments in many of the indebted countries did not adequately address the underlying need to raise domestic savings and improve the efficiency of investment; and
relatively high real interest rates and weak commodity prices complicated the adjustment problems of the indebted countries.
Such problems were reflected in continuing high external debt ratios and a sharp rise in secondary market discounts for the debt of heavily–indebted middle–income countries.
c. Proposals for commercial bank debt reduction
Proposals for debt reduction reflect concerns that the large stocks of external debt accumulated by many developing countries, and the resource transfers required to service them, may act as a deterrent to growth and adjustment. Thus, in situations in which a debtor country is not fully performing on its external obligations, debt payments (or the conditions obtained in a rescheduling agreement) are likely to reflect the economic performance of the country. If, for example, the value of its exports increases, a part of the additional resources may have to be used to service the debt. This may weaken incentives to invest from the point of view of the debtor country, because the effective return to investment is reduced.
In 1988 and 1989 various proposals were made by France, Japan and the United States to strengthen the debt strategy by focusing on a reduction of debt and debtservice. An underlying assumption of the debt strategy up to this stage had been that the debtor countries could ultimately service their debts in full. The Brady Initiative, as articulated by U.S. Treasury Secretary Nicholas F. Brady in March 1989, arose out of a consensus that debt and debt service reduction operations may indeed be necessary in certain instances. More concretely, severely indebted countries with sound adjustment programs would get access to debt and debt service reduction facilities, supported by financing from international organizations and official creditors. A three–pronged approach thus emerged:
adoption of sound economic policies, with stronger emphasis on measures to increase foreign and domestic investment and the repatriation of flight capital;
timely support from the IMF and World Bank for countries’ reform programs, in part through financing for debt and debt–service reduction transactions; and
active participation by commercial banks in providing financial support through the negotiation of debt and debt–service reduction and new lending, where needed.
Debt reduction operations have broadened the menu of financial options to address the diverse needs of both debtors and creditors. The following techniques have been widely used: debt for equity swaps; debt buy–backs; debt exchanges; exit bonds; securitized new money claims; and fees to encourage early participation by banks in restructuring agreements. Some commonly used debt reduction mechanisms are reviewed in Box VI.2.
Debt Reduction Mechanisrns
Buy–backs
Debt buy–backs permit countries to repurchase their debt at a discount for cash. When negotiated directly with the debtor country, buy–backs normally require waivers from creditor banks of certain provisions in loan or restructuring agreements. Either the country’s international reserves or foreign exchange donated or borrowed from official or private sources may be used for such operations.
Swaps
Debt–equity schemes allow foreign banks to swap their loan claims for an equity investment, while foreign nonbanks may purchase loan claims at a discount in the secondary market to finance direct investment or purchases of domestic financial assets. In some cases, resident nationals of the country may also purchase bank loan claims, employing their own external assets (including flight capital) in order to convert them into domestic assets (such as privatized public entities). A few countries have applied two additional conversion schemes: debt–for–export swaps and debt–for–nature swaps.
Exchanges
Debt exchanges involve the exchange of existing debt instruments for new debt instruments denominated in domestic or foreign currency. The terms of the two claim; will normally differ substantially. For example, the face value of the new claim may reflect a discount from the face value of the old claim; or the face value may remain unchanged while the contractual interest rate on the new claim is lower than the old claim. The value of the new claim may be enhanced, for example, through collateralization of principal or interest.
d. Policy response of official creditors
A major development over the past three years has been the progressive adaptation of policies by official creditors (Paris Club) to the chronic and deep–rooted problems of the heavily indebted countries with high levels of official debt. For low–income countries, most significant has been the adoption of the “Toronto terms” in June 1988 followed by the more generous “Trinidad menu” in December 1991. These initiatives provided for the first time a menu of options, including the partial cancellation of debt service, extensions of maturities, and interest rate concessions. Moreover, the Trinidad menu included a “good will” clause under which the Paris Club agreed to consider farther debt relief after the expiration of the consolidation period, and a commitment to meet at the end of three to four years to consider the matter of the stock of debt. Initiatives for middle income countries have been largely limited to the extension of maturities. In the middle of 1991, notable exceptions were made for Poland and Egypt for which the stock of debt was reduced by about one half, in present value terms, over the next several years.
5. The Fund and external debt
The Fund has played an important role throughout the debt crisis by providing both policy advice and financial assistance. Such assistance, in turn, mobilizes funds from other sources, because it assures the international financial community that appropriate policies are being implemented.
a. Policy advice
The Fund may contribute advice and input on external debt policies in the context of consultations with member countries and debt restructuring operations.
Article IV and use of Fund resources discussions emphasize sound debt management policies that are consistent with the achievement and maintenance of sustainable external payments positions. Medium–term scenarios, which assess balance of payments and debt prospects under different assumptions, provide a focal point for such discussions. Further, in cases where Fund resources are made available in support of an adjustment program, the stand–by or extended arrangement usually includes provisions regarding new borrowing (mainly limitations placed on new nonconcessional foreign loans with maturities of over one year) during the period covered in the arrangement.
In the framework of Paris Club restructuring of official debt, the Fund may provide technical assistance to the debtor and, in the context of the creditors’ meeting, furnish an objective assessment of recent economic performance, the main elements of a current adjustment program with the Fund, and the debtor’s balance of payments prospects and external debt outlook. The role played by the Fund in negotiations between debtors and commercial bank creditors is less straightforward, reflecting the Fund’s attitude of avoiding any direct role in negotiations, as well as the importance of maintaining the confidentiality of a member’s relations with the Fund.
b. Financial assistance
Since the outbreak of the external debt crisis the Fund has provided substantial support to the indebted countries through its various facilities. Creation of the Structural Adjustment Facility (SAF) and Enhanced Structural Adjustment Facility (ESAF) and modifications of the Extended Fund Facility (EFF) have enhanced the ability of the Fund to support programs with the indebted countries. In addition, the Fund has developed and adapted policies on financing assurances (see Box VI.3).
In 1989, the IMF adopted guidelines governing its support for debt and debt–service reduction operations. Eligibility of members for this support are governed by the following criteria:
Financing Assurances
The key objectives of the Fund’s policy on financing assurances are to ensure that adjustment programs are adequately financed, that financing is consistent with a return to a viable balance of payments position and with the member’s ability to repay the Fund, and that the program, if appropriately implemented and supported, would contribute to the maintenance or re–establishment of orderly relations between the member and its creditors.
In May 1989, the Fund modified its policy on financing assurances in light of changes in the financial environment and the possibility that debtors may need more time to agree on financing packages with their creditors. The modifications were as follows.
The Fund may, on a case–by–case basis, approve an arrangement outright before agreement on a financing package is concluded between a member and commercial bank creditors, (1) if it is thought that prompt Fund support is essential fox the implementation of the adjustment program and (2) provided that negotiations between a country and its creditors have begun and that it can be expected that a financing package consistent with external viability will be agreed within a reasonable period. Progress in the negotiations with bank creditors would be closely monitored.
In promoting orderly financial relations, every effort will be made to avoid arrears. Nevertheless, an accumulation of arrears to banks—though not to official creditors—may have to be tolerated where negotiations continue and the country’s financing situation makes such arrears unavoidable.
the member is pursuing an economic adjustment program with strong elements of structural reform, in the context of a stand–by or extended arrangement;
voluntary, market–based, debt and debt–service reduction will help the country regain access to credit markets and achieve external payments viability with economic growth; and
financial support for debt and debt–service reduction represents an efficient use of scarce resources.
According to the guidelines, under an extended or stand–by arrangement the proportion of IMF resources committed that could be set aside to finance operations involving a reduction in the stock of debt would generally be about 25 percent. Further, the Fund would be prepared to approve additional access to its resources, in certain cases, provided that such support is decisive in promoting further cost–effective operations and in catalyzing other financial resources. Such additional access—up to 40 percent of the member’s quota—can be used as collateral for debt instruments paying below–market interest rates in connection with debt– or debt–service reduction operations.
References
Feldstein, Martin, Herve De Carmoy, Koei Narusawa, and Paul R. Krugman, Restoring Growth in the Debt–Laden Third World a Report to the Trilateral Commission: No. 33 (New York: The Trilateral Commission, 1987).
Frenkel, Jacob A., Michael P. Dooley, Peter Wickham, Analytical Issues in Debt (Washington: International Monetary Fund, 1989).
International Bank for Reconstruction and Development, World Debt Tables 1989–90 (Washington: International Bank for Reconstruction and Development, 1990).
International Monetary Fund, Annual Report, Chapter 2 (Washington: International Monetary Fund, 1991).
International Monetary Fund, Annual Report, World Economic Outlook, Chapter III (Washington: International Monetary Fund, October 1991).
Sachs, Jeffrey D., editor, Developing Country Debt and the World Economy, National Bureau of Economic Research Project Report (Chicago: University of Chicago Press, 1989).