What have we learned?

One must extract lessons with a great deal of humility. If the debt crisis has taught anything, it is the fallibility of forecasts. It was not only Citibank President Walter Wriston, but a sizable part of the world’s financial and economic community that believed in the late 1970s that sovereign countries did not go bankrupt. Even after the crisis broke, the pessimists did not predict the kind of stagnation suffered by the debtor countries during the 1980s, and many people dismissed the disruption in payments as simply a liquidity problem. As recently as five years ago, few could have predicted that much of Latin America would today be wrestling with the question of how to manage large-scale capital inflows. In that spirit of humility, listed below are ten key lessons.

(1) Systemic thinking is crucial to avoiding bad lending decisions. For much of the 1960s and 1970s, the growth of income in most countries significantly exceeded interest rates. In this environment, it was difficult for a country to appear insolvent. Even nations that borrowed to pay all of their interest bills could have improving debt indicators. Neither lender nor borrower questioned what would happen if the international economic environment changed dramatically, as it did with the sudden and sharp disinflation in the industrialized world in the early 1980s. As Chart 1 illustrates, growth collapsed just as real interest rates rose sharply.

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Growth plummeted as real interest rates soared

Citation: Finance & Development 29, 003; 10.5089/9781451952094.022.A001

Sources: World Tables (World Bank); International Financial Statistics (IMF).¹ Weighted rate in 34 severely indebted developing countries (Algeria, Argentina, Bolivia, Brazil, Burundi, the Congo, Costa Rica, Côte d’Ivoire, Ecuador, Egypt, Ethiopia, Ghana, Guinea-Bissau, Guyana, Honduras, Kenya, Madagascar, Malawi, Mauritania, Mexico, Morocco, Niger, Nigeria, Peru, the Philippines, São Tomé and Príncipe, Sierra Leone, Somalia, Syrian Arab Republic, Uganda, Uruguay, Venezuela, Zaïre, and Zambia).

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One after another, countries to whom bankers had been eager to lend only months before ran into problems servicing their external obligations. Indeed, within two years of Mexico’s default, 30 developing countries —representing half of developing country debt—were failing to service their debt as originally scheduled (see Chart 2). The pervasiveness of the debt problem is testimony to the dominant role played by a changed international economic environment. It also demonstrates the folly of assuming, as some prominent bankers did at the time, that simply spreading exposure across developing countries was an adequate way to diversify risk.

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Soon after Mexico’s default, debt restructurings took off

(In millions of dollars)

Citation: Finance & Development 29, 003; 10.5089/9781451952094.022.A001

Source: Debtor Reporting System (World Bank).Note: Numbers in parentheses refer to total number of countries that are subject to restructuring arrangements. New entrants are determined by the formal initiation of a restructuring agreement.

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(2) Heavy borrowing that is not accompanied by productive investments is a disaster for creditor and debtor alike. If the money borrowed during the 1970s had been used wisely—that is, to finance high-return investments, or to underwrite necessary structural changes—debtor countries could have ridden out the disinflationary storm of the early 1980s. Indeed, some countries—such as Korea, whose external debt went up ninefold over the 1970s—followed precisely such a strategy and were able to stay their development course through the 1980s. Unfortunately, however, in too many other developing countries, the easy availability of international credit in the 1970s was used to postpone, rather than catalyze, necessary economic reforms.

Telltale signs that all was not well were rationalized by both borrowers and lenders in a willing suspension of disbelief. Neither side carefully examined what was happening to fiscal deficits and public enterprise losses; nor was the connection made between why residents were transferring funds abroad in ever increasing amounts, even as foreign creditors transferred resources in to shore up sagging public finances. The problem was exacerbated by the paucity of information and poor bookkeeping on how the borrowed funds were actually being used. The net result was to build up the “liabilities” side of the debtor country’s “balance sheet,” without a commensurate increase in the stock of productive “assets.” Sorting out this disequilibrium would preoccupy national policymakers and international agencies for the subsequent decade.

(3) Countries that “opted out” of the international financial system have generally done worse as a result. During the last decade, a few countries tried at various times to resolve their debt problems unilaterally by opting out of the international financial system. They stopped servicing their external obligations and broke off relations with their creditors. Sometimes, this was preceded by a breakdown of negotiations on a stabilization and adjustment program with the international financial institutions. In the end, these actions have generally proved detrimental to the debtor country involved. One reason is that the financial costs associated with the building up of arrears has been added to the cost of delaying much needed adjustment—these costs include reduced trade and interbank credit lines, as well as higher prices (the “spreads”) that have had to be paid for these lines. But even more important and damaging have been the adverse effects of isolationist action on domestic confidence. Trying to get the best deal within the mainstream, with the support of official development agencies, seems to be a more fruitful avenue for country action than trying to go it alone.

(4) Good national policies are the key to capital market access. The debt crisis was at least as much a symptom as a cause of bad economic performance. It is important to emphasize that private capital has continued to flow during the 1980s to a number of developing countries, notably the prudently managed economies of East Asia. For that region as a whole, net resource flows from private sources have been positive in every year of the 1980s, and foreign equity flows have gone up eightfold over the decade. A more recent phenomenon is the return to capital market access of a number of the debt-distressed Latin American countries, including Argentina, Brazil, Mexico, and Venezuela. It is not a coincidence that among these, Mexico, the country with the strongest track record in economic management in the region, is also by far the largest recipient of private portfolio flows to developing countries.

Underlying this widening access to international capital markets has been a revolution in economic policies across much of the developing world. Fiscal deficits and inflation are down, and exchange rates reflect market realities rather than national pride. Macro-economic stabilization has been accompanied by deep-rooted structural change. The role of government is being greatly curtailed, trade barriers have come down, and the privatization of public enterprises is underway in virtually every World Bank borrower. One of the painfully learned lessons of the last several decades is that sustained growth depends on governments choosing an appropriate economic role—doing those things that governments need to do, such as providing infrastructure and basic human services, but leaving to the market that which the market can do best.

(5) Economic adjustment takes time and things often get worse before they get better, so attention to the political and economic sustainability of reform is in the interest of both the creditors and debtors. It is now clear from the experience of Chile, Ghana, and Mexico, among others, that market friendly policies can help to improve the economic performance of economies previously hamstrung by a plethora of controls and distortions. But dismantling controls and opening up an economy takes time and involves substantial dislocations. This means that output at first declines, before gradually increasing—a process that creates enormous political pressures to reverse reform policies. The situation is greatly exacerbated when adjustment coincides with import cutbacks, which are caused by the need to use scarce foreign exchange to service foreign debts.

For policymakers, import compression during adjustment poses a cruel dilemma. Either they can seek to maintain consumption and reduce capital goods imports, thereby compromising the long-run economic viability of reforms, or they can seek to reduce consumption, even as economic dislocations increase, thereby risking political- instability. Since creditors have a strong stake in the success of reform efforts, it may well be in their collective interest to avoid import compression. Yet no individual private creditor has an incentive to accept debt reduction or to put in new money; each would prefer to “free ride” on the activities of other creditors. This is where the presence of official lenders, with a longer-term stake in the debtor country, makes a vital contribution by limiting the need for initial cutbacks in consumption without distorting the short-term adjustment process to regain creditworthiness.

Trade deficits turn to surpluses, but economic growth turns down

Sources; World Debt Tables 1991-92: World Tables 1992.

Trade deficits turn to surpluses, but economic growth turns down

	External debt		Trade balance
		(As percent	(As percent of GNP)		Real GDP growth rate
	$ billion	of GNP) 1982	1979-B2	1983-86	Avg. 1973-82	Avg. 1982-90
Argentina	43.6	83.9	0.22	4.73	0.9	0.1
Bolivia	3.3	114.8	0.71	0.08	2.5	0.7
Brazil	92.9	34.4	(1.32)	4.06	5.1	3.5
Chile	17.3	76.7	(5.52)	2.19	3.6	5.3
Colombia	10.3	26.9	(1.60)	1.09	4.9	0.3
Côte d’Ivoire	7.9	111.4	(5.20)	8.28	4.5	4.2
Ecuador	7.7	66.9	(0.27)	4.45	5.9	2.1
Mexico	86.0	53.4	(0.75)	7.18	5.5	4.1
Morocco	12.5	84.8	(13.45)	(8.93)	6.3	1.0
Peru	12.3	49.7	(0.40)	2.09	3.0	−0.1
Philippines	24.6	62.5	(4.79)	(0.59)	5.4	1.2
Venezuela	32.2	41.4	2.59	7.24	2.0	1.7
All developing countries	883.3	33.81	(0.63)	(0.61)	4.2	3.5

Sources; World Debt Tables 1991-92: World Tables 1992.

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Trade deficits turn to surpluses, but economic growth turns down

	External debt		Trade balance
		(As percent	(As percent of GNP)		Real GDP growth rate
	$ billion	of GNP) 1982	1979-B2	1983-86	Avg. 1973-82	Avg. 1982-90
Argentina	43.6	83.9	0.22	4.73	0.9	0.1
Bolivia	3.3	114.8	0.71	0.08	2.5	0.7
Brazil	92.9	34.4	(1.32)	4.06	5.1	3.5
Chile	17.3	76.7	(5.52)	2.19	3.6	5.3
Colombia	10.3	26.9	(1.60)	1.09	4.9	0.3
Côte d’Ivoire	7.9	111.4	(5.20)	8.28	4.5	4.2
Ecuador	7.7	66.9	(0.27)	4.45	5.9	2.1
Mexico	86.0	53.4	(0.75)	7.18	5.5	4.1
Morocco	12.5	84.8	(13.45)	(8.93)	6.3	1.0
Peru	12.3	49.7	(0.40)	2.09	3.0	−0.1
Philippines	24.6	62.5	(4.79)	(0.59)	5.4	1.2
Venezuela	32.2	41.4	2.59	7.24	2.0	1.7
All developing countries	883.3	33.81	(0.63)	(0.61)	4.2	3.5

Sources; World Debt Tables 1991-92: World Tables 1992.

(6) There is a compelling need for official action to overcome free rider problems that complicate debt reschedulings and reductions. The problems of free-riding and holdouts among the banks have exacerbated coordination difficulties that would have resulted simply from the number and diversity of lenders. In purely domestic contexts, bankruptcy laws exist because of the recognized problem of dealing with conflicts among creditors, and between creditors and debtors. Without such laws regulating sovereign lending, there is a clear case for government action to overcome free-rider problems. This critical point was recognized when the crisis broke and the world financial system seemed to be at risk. But during the heyday of laissez faire enthusiasm during the mid-1980s, at least some officials lost sight of it.

The free rider issue is well recognized in the structure of the Brady Plan, which has provided the framework for commercial debt reduction agreements since 1989. The “menu” approach enables creditor banks with different preferences to choose the debt reduction option most suited to their needs, while the comprehensive nature of these deals minimizes the possibility of free riding by a small group of creditors at the expense of the other participants (see accompanying article by John Clark and Eliot Kalter).

This comprehensive approach is based on the recognition that market buybacks (the repurchase for cash of debt) of only a small part of the outstanding debt stock, even at a discount to face value, generate few benefits for the debtor country, because they raise the probability that the country will repay its debt, and thus the market value of the country’s remaining outstanding debt. Confronted with a steadily increasing price for their debt obligations, countries that are already financially strained will soon reach a point where further buybacks are economically unviable, rendering this mechanism unsuited for large-scale reductions in debt stock. In the same way, there is a real danger that partial debt-equity swaps may benefit creditors who hold on to their debt, without doing a great deal for debtor countries.

(7) Treating the debt crisis purely as a liquidity problem delayed the search for a stable and real solution. In the early years of the debt crisis, many observers felt that the indebted countries were suffering from a liquidity—rather than a solvency—problem, and thus the official work-out strategy relied on providing new funds to overcome the temporary shortage of finance. But in many instances, commercial lenders were unwilling to provide these new funds, essentially because they were uncertain about the prospects of recovering this money even •in the medium term. It was only the debt reduction deals under the Brady Plan that finally helped to reduce this uncertainty by removing one part of the contingent claims on future public finances. More generally, this experience has demonstrated the weakness of the basic liquidity-solvency distinction as applied to the debt crisis. This lesson is well learned now, but the cost of delay has been to put development on hold for a decade in many of these countries (see table). A lesson for the future is the importance of acknowledging reality sooner.

(8) Debt reduction is sometimes necessary but only works well when accompanied by good economic policies. The main benefit of a Brady-type debt reduction deal for a debtor country is that it eliminates the contingent liability represented by the unserviced part of the old debt. The debt reduction thus reduces uncertainty about the returns to any new investment and helps to create the climate of confidence for the private sector to undertake new investments. These benefits are best captured in countries where an established track record of sound policies and prudent economic management have already lifted the other impediments to renewed private sector confidence. Such an established record does not yet exist in some of the severely indebted middle-income developing countries that have not concluded a Brady-type deal with their commercial creditors. Waiting until it does will maximize the potential benefits of the deal to the country and ensure the productive use of the resources needed to finance the transaction.

(9) Building risk-sharing contingencies into financial contracts is much less costly than renegotiating contracts when things go wrong. The essence of the workout process during the 1980s was to agree on the terms for the ex-post rewriting of loan contracts to share the losses associated with an outcome that had turned out to be worse than either lender or borrower had envisaged. The process was made more difficult by the fact that virtually none of the original loan contracts had such “downside” contingency clauses, meaning that all the contracts had to be renegotiated ex.-post and without a frame of reference that such a clause would have provided. Moreover, the predominance of syndicated lending to sovereign borrowers in the 1970s meant that the risk-sharing features of other forms of international finance, notably foreign direct investment and other equity flows, had been largely foregone.

The recent boom in portfolio flows to emerging stock markets in these countries shows that at least one set of international investors has learned from this experience. It is not clear, however, that many developing countries have fully realized either the potential for, or the implications of, using a more diversified set of financial instruments.

(10) External finance for investment in low-income countries must come largely from official sources. A key lesson of the debt crisis is that commercial banks are an inefficient instrument for channeling long-term investment finance to the poorest countries. During the next decade, their role in these countries is likely to focus on the provision of trade and short-term credit, and correspondent banking relationships to facilitate international trade arrangements, as well as limited-recourse project finance, where the repayments on the loan are linked to the success of the investment project financed by the money. Other commercial sources will also run up against internal, or externally imposed, regulatory or creditworthiness constraints.

Yet the financing needs of these countries continue to be pressing. During the past decade, per capita incomes in the severely indebted low-income countries have fallen by a fifth to well short of a dollar a day in 1991. Raising incomes from these pitiful levels will require both better economic management and an injection of foreign capital for investment in economic development. Because many of these countries are not likely to be creditworthy for a long time, the real need is to increase concessional financing. A doubling of all the net resource flows to developing countries last year would add a little over $16 billion to the aid bill of the industrialized world—just 1 percent of what the world spends on defense each year. It is also a small price to pay for reversing the decline in health, nutrition, and educational standards that has characterized so many of these countries during the 1980s.

Is the debt crisis over?

The preceding lessons are vital not only to avoid future debt crises but also to tackle the substantial unfinished agenda from the 1980s. Certainly, considerable progress has been made. National and international actions have helped avert any serious damage to the international financial system, which was a real concern in the early aftermath of the crisis. With the recently announced commercial debt reduction agreements for Argentina and Brazil, the normalization of external creditor relations is now well advanced for the middle-income developing countries. And sustained official financial support on concessional terms has complemented the very limited domestic savings of the poorest countries, ensuring that their basic import needs have continued to be met.

But the debt crisis is far from over for more than 40 developing countries, which continue to have difficulties in servicing their debt as originally contracted. In particular, much remains to be done for the poorest developing countries, 26 of which are classified as severely indebted. For these countries—mostly in Sub-Saharan Africa—official support has been strong through the 1980s, in terms of the provision of both new money and progressively more concessional debt relief. But external viability has remained elusive. On average, these countries have been allocating a quarter of their exports to debt servicing, although this still only enables them to pay half the scheduled amount.

Under any plausible future scenario, many of these countries will regain external viability only if some portion of their existing—largely official bilateral—debt is written down, reflecting the creditors’ acceptance of a reduction in the stock of debt outstanding. Bringing scheduled debt-service payments to a level that can reasonably be expected to be paid would help reduce uncertainty and make new creditors feel more confident that their contractual arrangements were likely to be honored. Debt relief for these countries is thus a high-priority item. But the actual amounts required will have to be determined on a case-by-case basis and assessed within the context of the overall economic and structural adjustment program. It is clear, however, that in many countries, this relief will need to go beyond the 50 percent reduction in the present value of debt service that has characterized some of the most recent agreements reached with official bilateral creditors under the auspices of the Paris Club.

As for the remaining severely indebted middle-income countries, the objective remains to restore access to private international capital markets. The recent experience of a number of major Latin American countries, including Argentina, Brazil, Chile, and Mexico, has shown that private capital can flow back in substantial amounts under the right national and international conditions. Foremost among these is a sustained track record of economic and structural reform. Investor confidence has also been helped by the successful completion—or imminent conclusion—of Brady-type agreements for reducing part of the existing commercial bank debt. A similar sustained track record of sound national policies, complemented, in some cases, by an agreement on commercial debt reduction, should facilitate the return to market access for the dozen or so middle-income countries still classified as severely indebted. The same considerations also apply to some of the states of the former USSR, whose current debt-servicing problems have sharply curtailed access to private international capital markets.

In sum, the debt crisis may no longer be the principal preoccupation of the international commercial banks, but it is far from over for many of the countries involved, among them, some of the poorest. For a number of these countries, a combination of growth and cash flow relief through rescheduling should result in a resumption of normal creditor relations by the mid-1990s. For others, however, a return to external viability can only be achieved in conjunction with some reduction of their existing debt obligations. For all of them, the key to both improved economic performance and continued support from the international financial community will be sound economic policies. And the importance of these policies will increase in the 1990s, as international capital markets remain tight and the competition for concessional finance becomes stronger. Moreover, the tolerance for wrong policies will be sharply reduced in a world where capital account liberalization and financial market integration make large sudden outflows of capital a real constraint on government action.

Sound policies need to be nurtured by a supportive international economic environment. This means that the developing world’s recovery and growth prospects would be helped by reducing protectionism in the OECD countries. Cutting current levels of industrial country protection in half would lead to a $50 billion increase in developing country exports—not including the sizable benefits to consumers in the developed world. It also means that developing countries, as price takers in the international capital markets, would benefit from industrial country policies that would bring down real interest rates from their current high levels. As long as real interest rates are above the growth rates for some developing countries, any net borrowing must necessarily worsen their debt indicators. Thus, actions by the industrial countries to raise their own level of saving, thereby reducing pressure on international markets, would do much to improve the creditworthiness and financing prospects of the developing countries in the decade ahead.