The subject of short-term indebtedness of developing countries has received little attention in analysis of external debt problems, largely because of the lack of statistical information on debts with original maturity of less than 12 months. The absence of data, coupled with the widespread assumption that short-term credits are mostly trade related and continuously rolled over, has resulted in a certain neglect of the issue from the point of external debt management policies. The object of this paper is to attempt to fill, at least in part, this lacuna by reviewing the modalities and the channels through which short-term banking credits are extended to developing countries, and by raising some of the issues related to this type of financing.

Abstract

The subject of short-term indebtedness of developing countries has received little attention in analysis of external debt problems, largely because of the lack of statistical information on debts with original maturity of less than 12 months. The absence of data, coupled with the widespread assumption that short-term credits are mostly trade related and continuously rolled over, has resulted in a certain neglect of the issue from the point of external debt management policies. The object of this paper is to attempt to fill, at least in part, this lacuna by reviewing the modalities and the channels through which short-term banking credits are extended to developing countries, and by raising some of the issues related to this type of financing.

The subject of short-term indebtedness of developing countries has received little attention in analysis of external debt problems, largely because of the lack of statistical information on debts with original maturity of less than 12 months. The absence of data, coupled with the widespread assumption that short-term credits are mostly trade related and continuously rolled over, has resulted in a certain neglect of the issue from the point of external debt management policies. The object of this paper is to attempt to fill, at least in part, this lacuna by reviewing the modalities and the channels through which short-term banking credits are extended to developing countries, and by raising some of the issues related to this type of financing.

In the description that follows, considerable attention is given to newer credit instrumentalities developed in the Euro-currency market, because there is evidence that the evolution of facilities in this market is leading to marked changes in the modalities of financing. To the extent that developing countries increasingly utilize these facilities, the scope and aims of their external debt management policies are significantly affected. The paper alludes to the risks involved in Euro-currency borrowing resulting in part from certain features of this type of financing. However, no attempt is made to analyze how individual countries in the developing world are affected by extensive reliance on the Eurocurrency market nor does this paper attempt to analyze the impact of the process of evolution that is taking place in the field of nonbank financing. Here again, there are indications that the role of multinational corporations and nonbank financial intermediaries in trade and working capital financing has led to newer kinds of credit facilities becoming available to developing countries.

Traditional Banking Facilities

Short-term lines of credit

The traditional type of short-term facility is the line of credit opened in favor of banks in developing countries by other banks, mostly those located in developed countries. The credit line is usually trade related in the sense that it provides facilities for the opening and confirming of letters of credit or the acceptance of drafts arising out of export/import transactions. The credit line stipulates a maximum amount that can be utilized by the borrowing bank, the repayment of any part restoring the right of the borrower to draw an equivalent sum. In this way, a large number of transactions are accommodated through a coordinated rollover of maturities. While basic features tend to be common to this type of financing throughout the world, terms and conditions are tailored to meet the specific needs of the borrowing bank. The credit term is usually 90 to 180 days, but somewhat longer terms are not uncommon. In certain instances, credit lines allow for large seasonal swings in drawings to accommodate exceptional credit demands such as those for the financing of crops.

In granting short-term lines of credit, banks focus primarily on evaluation of “customer risk.” Experience is gained in the framework of normal correspondent relationships, starting with fairly tight limits that are gradually increased as confidence develops.2 In addition, since bank-to-bank credit lines are usually trade related, the amount of credit is more or less determined by the volume of the trade between the two countries and the share of trade financing that the correspondent bank can normally expect to handle. The lender knows that the transactions underlying the credit line involve the physical movement of commodities and therefore are usually of a self-liquidating nature. The element of risk is further reduced to the extent that the correspondent bank may keep balances with the lending bank.

Bank-to-bank lines of credit have enjoyed a high degree of stability in the face of changing economic conditions in the borrowing country. Once good working relationships have been established, lending banks endeavor to maintain their lines and to adapt them to the changing requirements of the borrower, so that “short-term” credit facilities tend to be, in effect, equivalent to perpetual loans. Often, where arrears accumulate because of export shortfalls or for other reasons, lending banks may intervene with various types of assistance such as new overdraft facilities and lengthened maturities (from 90 to 180 days, or 360 days) for existing credit lines. Similar measures are taken to comply with regulations introduced in the borrowing country, such as the prescribing of minimum credit terms for imports. On the other hand, banks have sometimes reacted to serious economic developments in the borrowing country by withdrawing or curtailing lines of credit. This, however, is always a major decision, taken only after careful evaluation of alternative measures and possibilities.

Other traditional types of borrowing

In addition to bank-to-bank financing, alternative forms of borrowing have increasingly been utilized by many developing countries. Among these, two in particular are worth mentioning: (a) the purchase by banks of commercial paper issued by firms in developing countries and (b) bankers’ acceptances. The first type of instrument is more typical of countries that have already reached a stage of integration with international money markets that enables firms operating in the country to directly approach banks or nonbank financial institutions abroad.

The second type of instrument, bankers’ acceptances, are negotiable time drafts drawn to finance export, import, movement, and storage of goods, and are said to be “accepted” when a bank guarantees payment at maturity. Such acceptances have also been used more recently for purposes other than the financing of foreign trade. “Finance acceptances” are instruments of short-term borrowing for working capital purposes. They can be used in bank-to-bank financing, when the drawer is not a well-known bank, but are primarily drawn by nonbank concerns in developing countries. The most extensive market for bankers’ acceptances is in the United States, where dollar acceptances have been used to finance both U.S. trade and third-country trade (mainly by Japanese banks and large trading companies). They have also been used to alleviate the shortage of dollar exchange for short periods (usually 90 days) in certain developing countries in Latin America (so-called dollar exchange bills).

In addition to these two types, other instruments have sometimes been used by banks to accommodate particular needs of the borrowers. In certain countries, financing from abroad, both from banks and private investors, has been provided in the form of foreign currency deposits with local banks, repayable in foreign exchange both for principal and interest. While this has been done sometimes for “window-dressing” purposes, in other instances tax avoidance considerations were instrumental in denominating financing as a “deposit” rather than as a “loan” transaction. The same considerations are reportedly applied when loans are designated as “repurchase agreements.”

While the traditional credit facilities described earlier are extended by banks in all developed countries, the money market institutions in New York and London have been active in financing not only the trade of the United States and the United Kingdom, respectively, but the trade of third countries as well. A review of statistics on short-term credits extended to developing countries revealed little information in published form. A notable exception is represented by the United States, which collects and publishes statistics on short-term credits granted to foreigners both from banks and nonbanking concerns (see the Appendix). Other countries regularly collect data on banks’ foreign assets and liabilities, mostly in the context of balance of payments statistics. Some countries, such as the United Kingdom, report on these data with a geographical breakdown but with no maturity detail, while most others do not publish a geographical distribution of claims. As to nonbank credits, the U. K. Department of Trade and Industry has conducted regular inquiries on trade credits since 1963.3 The coverage has changed over time in various aspects, and the data are therefore not strictly comparable. A similar investigation, limited to the year 1970, has been conducted in Canada4 on trade credits classified by original credit terms, by industry, by company affiliation, and by trading area.

Euro-Currency Credit Facilities

This section deals with credits that are granted by banks out of funds borrowed in the Euro-currency market rather than financed from domestic currency deposit resources or borrowed in the internal money market. The credit facilities that have been developed in this market differ in a substantial way from more traditional types of financing, both in their technical features and in the policy issues that they raise.5

The raising of funds by banks in the Euro-currency market is not always linked to the extension of Euro-credits. Banks in some of the lending centers have been led by a number of considerations to borrow in the Euro-currency market for financing even their regular lines of credit. For U. S. banks this has been due mainly to interest rate considerations and to the need to comply with the Voluntary Foreign Credit Restraint (VFCR) Program. During 1969–70, when interest rates on treasury bills and commercial paper were higher than the ceiling established by Regulation Q, U. S. banks experienced a run-off in deposits and borrowed on the Euro-dollar market to fund both domestic and international lending. Under the VFCR Program, U. S. banks are obliged, beyond certain limits, to lend abroad only with funds borrowed abroad, with a few exemptions (e.g., export credit extension). Non-U. S. banks are sometimes prevented by national regulation from lending abroad in domestic currency and, therefore, use foreign funds in what are referred to as “foreign-to-foreign” or “offshore” operations. In other instances, banks simply find it more convenient, on interest rate or tax considerations, to fund their lines of credit in the Euro-market.

To a certain extent, therefore, developing countries have had indirect access to Euro-currency finance for a long time. Since 1970 a number of them have acquired direct access and have made intensive use of it, benefiting from the change in the overall situation of the market from a phase of strong demand for funds at high interest rates to a phase of rapidly increasing supply, especially in the period following the large-scale repayment of funds previously borrowed by U. S. banks on the market.6 The intensification of capital controls in major European countries affected the access of their residents to the Euro-currency market. This applied to Japan, Switzerland, and, to a greater extent, Germany after the introduction of the “Bardepot” scheme in March 1972. A large increase also took place in revenues of the oil-producing countries following the negotiations that led to an increase in royalties and the accelerated exploitation of oilfields in the face of an emerging shortage; this in turn resulted in an increased flow of liquidity being channeled to the market, partially through newly created multinational banks in partnership with Arab interests.

Concomitant with these developments, certain factors stimulated demand from developing countries. The relative stagnation in the flow of official development assistance resulted in an increased demand for other means of financing, especially from private banks and other financial institutions. In some countries, reliance on foreign equity capital was reduced as developing countries sought to exploit their resources via contractor or agency arrangements with major foreign companies, raising in the process the demand for borrowed funds. Moreover, in the more advanced developing nations that could utilize domestically produced capital goods in the implementation of projects, Euro-currency borrowing provided funds at a lower cost than would have been paid to raise the resources internally.

In a situation of rising liquidity at a time when traditional “big name” borrowers were withdrawing from the market, banks started offering loans at increasingly more favorable conditions to “new” borrowers, including a number of developing nations. To a certain extent, Euro-currency flows went to countries in the developing world that placed substantial funds in the market through their central monetary institutions to earn a higher rate of return than was available in reserve currency centers or to achieve a degree of diversification of reserve assets. In some cases, however, these institutions were placing in the market the proceeds of the loans contracted on the market itself by enterprises borrowing for financing domestic expenditures or in the interim period before loans could be disbursed for purchases abroad.7

Maturities on Euro-credits began to lengthen from the traditional 3–5 year range to 10 or 12 years.8 In addition, lending rates declined, as well as margins (or spreads) over the interbank rate (which is the yardstick for setting Euro-credit rates—see below). While margins for nonprime borrowers were as high as 3 per cent only a few years ago for credit up to 5 years, more recently loans have been contracted, even by developing country borrowers, at margins of 1 per cent or less for periods of up to 8 years or longer.

Before analyzing the impact of these developments on the borrowing by developing countries, it may be useful to describe the technical features of the Euro-credits and the modalities of Euro-lending.

Technical features of euro-credits

The most typical form of Euro-lending is the revolving credit at a floating interest rate. While generally granted for a variable period of 3–8 years, it is drawn as a short-term advance, renewable at the end of each six-month period (usually called the “renewal period” or “rollover period”) for a designated maturity term (usually called “commitment period”). To start with, most Euro-credits were denominated in U. S. dollars, but more recently have also been expressed in deutsche mark or Swiss francs and less frequently in French or Belgian/Luxembourg francs, depending on the currently prevailing rates of interest.

Euro-credits are granted by one bank and more often by a syndicate of banks that finances them normally by borrowing on the Euro-currency market, although there have been cases in which funds have been obtained by the banks on the Euro-bond market. Since the availability of funds in the Euro-currency market at terms of more than one year is limited (in the sense that interest rates to attract longer-term deposits rise sharply), lending banks tend to use short-term deposits (usually three or six months) to fund the credits. As a measure of protection to the lender, interest rates are kept variable, that is, adjusted at each intermediate renewal date on the basis of the London interbank offer rate (LIBO) in effect at the time of roll-over for advances in the same currency and for the same term.

In addition to the variable interest rate, the borrower pays a margin or “spread” over this rate, which is normally a function of the borrower’s creditworthiness and the commitment period of the loan. Margins over LIBO currently range from ½ to 2½ percentage points. While fixed margins over LIBO are the normal practice, recent loan agreements have allowed for “modulated” margins for split periods, whereby the margins are increased (or, in rare instances, reduced) by stated amounts (usually ¼ of 1 per cent) after a predetermined number of years has elapsed. Increasing margins provide an effective incentive for early repayment or additional compensation to the lender for the protracted use of funds. On the other hand, declining margins may work as an insurance against advance repayment of the loan, which might be undesirable for the lender in a situation of generally weak demand for credit.

The borrower also pays a commitment fee (usually ¼ to ½ of 1 per cent) on the unused portion of the loan, but the borrower cannot postpone the drawdown of funds indefinitely since most loan agreements provide a maximum length of the drawdown period, that is, the time between the signing of the agreement and the last drawing. The drawdown period is normally not longer than 18 months. It gives the lender the assurance that the loan will be drawn in a reasonable period of time and the borrower the possibility of scheduling drawings in accordance with his own financing requirements (especially for project financing). The length of the drawdown period is important in times of high interest rates. If the borrower expects a decline in interest rates, a longer drawdown period allows him to postpone drawings, during which period he pays only the commitment fee. On the other hand, borrowers might draw the loan entirely to avoid the commitment fee and redeposit the unused proceeds of the loan, if the differential between the interest rate on the credit and on the deposit, after adjustment for tax, is less than the commitment fee.

For loans granted by a syndicate of banks, the syndicate manager or co-managers charge a “management fee” as a flat percentage of the loan (usually ¼ to ½ of 1 per cent). However, some banks do not charge management fees on certain Euro-credits. Similar fees are charged by banks or brokers acting as intermediaries between lenders and borrowers by way of “finders.” All rates and charges are quoted net of taxes in the borrowing country and, with the exception of the margin over LIBO, are normally “front-loaded,” that is, paid at the outset.9

Many revolving credit agreements provide an option for the borrower to change the currency of the loan, at the time of renewal, in order to benefit from more favorable interest rates or from exchange rate differentials. In utilizing the multicurrency option, the borrower carries the exchange risk. In some instances, the lender reserves the option to substitute another currency for that borrowed if the latter is not available in the market.

Euro-credits are usually granted against promissory notes of the borrower.10 The promissory notes are usually of a maturing coinciding with the renewal period of the loan, but sometimes the maturity is that of the commitment period. Short-term promissory notes are more common because of the interest variability clause and the currency option. At the end of each renewal period the expired promissory note is withdrawn by issuing a new one for the same amount and with the adjusted interest rate and with another currency package, if the borrower has exercised his option to change the currency (currencies).

Among provisions included in most revolving credit agreements, two deserve mention. One is a clause to the effect that if the roll-over of the loans becomes impossible because one currency or a package of currencies is no longer available, the loan becomes immediately due. This provision applies also where the roll-over is technically possible but at an interest rate that is considered unacceptable by the borrower. As an alternative, some agreements allow the borrower to defer the renewal until interest rates are lower, upon payment of a commitment fee. This means that the loan is reimbursed, but the loan agreement is still valid and the borrower is entitled to draw again when interest rate conditions are more favorable. A second provision relates to the possible imposition of reserve requirements on Euro-currency transactions; loan agreements stipulate that any additional cost accruing to the lender because of the imposition of reserve requirements will be paid by the borrower.

As an aspect of growing competition in the market, little or no use has been made of covenants relating to net worth, borrowing from other sources, and other criteria of performance often found in term-financing loan agreements for domestic corporate customers funded out of resident deposit resources.

Repayment of Euro-credits is frequently done by a single payment at the end of the commitment period (the “balloon”), which means that the loan has in fact a grace period as long as the commitment period itself. In some cases, the repayment is made by progressively reducing the amount committed in each roll-over period at specified dates (designated as the “commitment decrease date”) sometimes starting after one or more years of grace. While the “balloon” technique is commonly used for short-term loans, some bankers consider it as less than satisfactory11 in the context of long-term commitments, where final repayment is not due for several years. Most loan agreements also include provisions for advance repayment by the borrower and early recall by the lender.

Modalities of Euro-currency lending

Most of the lending in Euro-currency is done by syndicates of banks or by consortia banks, that is, banks owned jointly by other banks sometimes from different countries. This has tended to modify banking practices in a significant way. To the extent that consortia banks do participate in loan syndicates, what follows applies to them as well, but consortia banking involves features that are peculiar to that type of institution.

The key element in lending through syndicates is that it affords a much greater distribution of risks than single-bank lending.12 Most syndicates involve a large number of participants, sometimes more than 40 banks, so that, even for a very large loan, the average individual share taken up by one bank is relatively small, as is the risk involved.

There are two usual methods for syndicating a loan. The first is the “broadcast system,” whereby the managing bank solicits, by telex, a large number of banks around the world. The second method is “straight syndication,” whereby the loan is committed from the beginning by a group of banks selected by the managing bank. The second method was more commonly used in the past but recently the “broadcast system” has become frequent, with telephone messages replacing the telexed dispatches and with decisions on participation required in a very short time. The possibility of minimizing risk has been utilized by banks in recent competitive conditions of rapidly rising supply of funds in the market. In the absence of “big name” borrowers to whom large funds would normally be entrusted even by a single lender, banks have been obliged to lend to lesser-known customers, and have done so by reducing the amounts committed in any one transaction.

A comprehensive evaluation of risk is normally done by the bank that leads the syndicate, with participant banks relying almost exclusively on the information provided by the lead bank. However, in this type of lending, banking principles are increasingly supplemented by insurance principles in that the focus is primarily on risk distribution and secondarily on creditworthiness analysis. Being a lead bank does not involve any greater financial risk than being a participant bank if the former does not take up a very substantial amount of the loan.13 However, the reputation of the lead bank as a sound manager is at stake in syndicated operations and there is a strong presumption that the lead bank will make a careful evaluation of risk, to the extent that it can be evaluated, which of course becomes more difficult as the repayment term of the loan is stretched longer. In such instances, banks rely heavily on personal contacts and on ad hoc criteria peculiar to each bank. Wherever possible, guarantees are secured from governments, central banks, or other official entities. The existence of natural resources is considered generally as sufficient evidence of creditworthiness. When a loan is used to finance a project, many banks tend to rely on the feasibility and the profitability studies carried out by the contractors (this is especially so for projects related to the exploitation of oil or natural gas) or suppliers of equipment.

In addition to spreading risks over a large number of loans for smaller amounts, banks also seek a wide geographical distribution of risks, which has resulted in a search for “new” borrowers in developing countries. In doing this, banks again appear to resort to the application of an insurance principle by focusing on financing the same sector in a number of countries. A typical example of this approach is the financing of energy projects. In the face of an energy shortage, countries with natural resources such as oil or gas are automatically considered to be creditworthy over the next several years. Some bankers are in favor of financing oil-related projects in different countries on the assumption that if a project turns out to be nonprofitable in one country or the country runs into a political risk situation, the chances of success in the same sector in other countries are consequently better.

The absence of exchange or interest risks, the lack of reserve requirements, and the level of efficiency achieved in handling large volumes of funds enable Euro-banks to operate on small margins and still obtain a good return on capital. This is particularly true for consortia banks, which tend to have a fairly minor equity base relative to their borrowing capability in the market; when large commercial banks form a consortium bank, the latter institution can attract deposits to an extent that bears little relationship to the capital base of the bank. This means that a bank with a very low capital/deposit ratio can still earn a substantial rate of return on capital even if the average margin applied to its lending operations is small.14

A situation in which profit margins are squeezed and banks are eager to increase their turnover has led to the entry of “brokers” acting as trait d’union between banks and potential borrowers in arranging the extension of credit facilities, but without bearing any financial risk. As brokers’ profits are based on a commission that is reckoned as a flat percentage of the loan, profits are maximized by offering large loans to potential borrowers. The activities of some brokers have been characterized as high-pressure “salesmanship,” with the broker rather than the borrower taking the initiative in the loan arrangement in some instances.

Preliminary statistical information on Euro-borrowing by developing countries

Some statistical information on the use of Euro-credits by developing countries can be derived from announcements that appear in the press indicating that a loan of a stated amount has been contracted by a borrower in a developing country. These announcements, usually referred to as “tombstones,” contain the names of the banks that have arranged the loans and of the institutions that have subscribed to them (but with no details of the amounts subscribed by individual banks).

Before analyzing the published data, it is necessary to indicate their limitations. The practice of advertising loans in tombstones does not follow any precise rules, and there have been occasions when loans for substantial amounts have not been publicized for undisclosed reasons; there is some indication that the trend is toward less publicity than in the more recent past. There appear, nevertheless, to be certain considerations bearing on the decision to publicize a loan. Tombstones are issued only for loans granted by a syndicate of banks. Loans extended by a single bank are considered “in-house” operations. Loans of smaller amounts, for example, up to US$3 million or less, are not publicized because they do not necessarily advertise the strength of the lending institutions in a market where the unit of transaction is a million U. S. dollars. Loans with a commitment period of less than three years also are not usually advertised. In many cases banks do not like to see their names publicly associated with new or untested borrowers, while in others, the borrower does not like to publicize loans that are related to defense purposes or simply does not wish to show that its foreign indebtedness is increasing. Exceptions occur when some lenders, especially newer institutions, insist that a loan not otherwise of minimum size or maturity be publicized, as also do some borrowers because it advertises their acceptability to the international banking community. These considerations make it difficult to estimate correctly the coverage provided by tombstones; the consensus appears to be that tombstones understate by 50 per cent or more the actual volume of credit extended by Eurobanks to the developing countries.

Data on publicized loans have been collected by the World Bank for 1971, 1972, and the first half of 1973 and are summarized in Table 1. While reported gross Euro-borrowing rose by 87 per cent between 1971 and 1972, gross borrowing by developing countries rose by 162 per cent and their share rose from 36 per cent to 50 per cent of the total of publicized loans. The total of newly contracted Euro-credits has been estimated at between US$8 billion and US$10 billion in 1971 15 and between US$10 billion and US$11.4 billion in 1972.16 If the ratio that derives from the total of tombstones and the estimated total of Euro-credits were applied to tombstones on developing countries, the estimate of Euro-credits extended to them would be in the range of US$3–4 billion in 1971 and US$5–6 billion in 1972.

Table 1.

Euro-Currency Credits by Nationality of Borrowers, 1971-June 1973 1

article image
Source: Data collected by the World Bank from published loan announcements.

Amount of newly contracted loans during each period.

Mostly countries that are members of the Council for Mutual Economic Assistance (CMEA).

This conclusion appears to be supported by statistics collected by the Bank of England on “external liabilities and claims of banks in the United Kingdom in overseas currencies.” In its March 1973 review of the Euro-currency business of banks in London, the Bank states that “business continued to expand as banks widened the field of their lending, especially to the less developed countries in Latin America, Africa, and the Middle and Far East. In fact, lending to these countries increased by about £.2,500 million during the twelve months [ended in October 1972].”17 It is to be noted that the above figures refer to banks in the United Kingdom only.

Data for the first half of 1973 indicate that gross Euro-currency borrowing by developing countries rose by 65 per cent compared with the same period of 1972, but declined by 11 per cent compared with the second half of 1972. This decline can be explained by the sharp increase in Euro-currency rates recorded during the first six months of 1973 (Chart 1). There are reasons to doubt, however, that such a decline took place at all. There is some evidence that, as a result of rising costs, profit margins for lending banks are being squeezed and this has led to economies on expenses such as those (often substantial) incurred for publication of tombstones. For this reason the data for the first half of 1973 may understate actual gross borrowing to an extent larger than for previous years.

Chart 1.
Chart 1.

Euro-Dollar Deposit Rates in London, 1970-September 1973

Citation: IMF Staff Papers 1973, 003; 10.5089/9781451969313.024.A003

Source: Board of Governors of the Federal Reserve System, Selected Interest and Exchange Rates for Major Countries and the U.S. (Washington), various issues.

From available data it appears that a surge in gross Euro-currency borrowing by developing countries is under way. An evaluation of the extent to which this surge was reported to international institutions cannot be made satisfactorily at this stage for a number of reasons. The maturity of loans is often indeterminate because the definition of “medium-term” is not specified. Information on the interest rate charged is normally not included in tombstones and the date of the agreement is often missing. Sometimes, a loan advertised in tombstones is the sum of several loans that would be individually reported to the World Bank. Under these circumstances, a comparison between the information available in tombstones and that of the Debtor Reporting System (DRS) of the World Bank is apt to be misleading. This is especially true for the year 1972.

Data collected by the DRS (Table 2) indicate that over the period 1967–71 borrowing from banks by developing countries rose considerably. While total debt outstanding of 80 developing countries rose by 64 per cent, debt owed to banks rose by 147 per cent over the same period. However, a sample survey for 1971 indicates that only about one third of banking loans contracted in that year were Euro-currency loans, and that borrowing from the Euro-market was generally reported to the DRS only to a limited extent. There are several reasons that might explain this phenomenon. Some of the loans, especially those to the more advanced developing nations, are contracted by private concerns without public guarantee and, therefore, do not have to be reported to the DRS. Other loans may have financed military purchases for which there is no obligation to report to the DRS. For loans contracted by government agencies or guaranteed by them, it is surmised that these may not be reported because they are considered to be short-term revolving lines of credit (which, strictly speaking, they are) rather than medium-term obligations. Another possibility is that some of the unreported loans are in fact refinancing operations of previous debts that were reported.

Table 2.

Total Outstanding Debt and Debt Owed to Banks by 80 Developing Countries, 1967–711

(In millions of U.S. dollars)

article image
Source: International Bank for Reconstruction and Development, Annual Report, 1973 (Washington).

Totals may not add up because of rounding.

At December 31, 1971 exchange rates.

Main Issues Related to Short-Term Bank Financing

Traditional types of borrowing

Bank financing in the domestic currency of the lender within the framework of traditional types of financing does not ordinarily create problems from the point of view of external debt management, except when the normal roll-over process is interrupted. There are, however, difficulties in determining the magnitudes of such flows to developing countries. The complexities of international financing make it difficult to assess the volume of short-term flows to a given country.

The major international banks are increasingly active, not only in the traditional sphere of trade financing (either directly or through their own branches) but also in other fields of financial intermediation, such as leasing, factoring, and mutual funds. These activities, which are complementary to traditional banking services, are often handled through wholly owned subsidiaries that act quite independently of their banking parents. At any given moment, therefore, the level of a bank’s exposure in one country may be difficult to determine, especially when account is taken of contingent commitments related, for example, to the unused portion of lines of credit, or when the bank has given confirmation to letters of credit.

In addition, the traditional financing instrumentalities appear to be undergoing a rather significant transformation. While the largest share of total short-term indebtedness is normally owed to banks, there are indications that this is no longer true for the relatively more advanced countries in the developing world or those whose money markets are more closely integrated with markets in lending countries. Short-term credit in these countries is increasingly granted by nonbanking concerns, typically in the way of trade financing, and sometimes by purchases of commercial paper issued by established corporations.

Use of open account financing for transactions in developing countries is an illustration of this diversification process, which assumes major proportions for multinational corporations carrying out transactions with their branches or affiliates. These corporations dispose of large financial resources and have easy access to bank credit both at home and abroad. They are in a position to extend credit directly to customers without bank intermediation. Once good working relationships have been established, transactions are handled through open account, unless regulations in the debtor country impede foreign exchange remittances abroad when there is no bank documentation.

This substitution process among short-term types of financing is increasingly providing credit not only for trade but also for capital transactions, as for the financing of equipment leasing or working capital. For these reasons, it is difficult for the authorities in the borrowing countries to ascertain the total volume and the nature of short-term indebtedness. While information on foreign liabilities of the banking system is normally available to the authorities of the borrowing country, short-term debts contracted by nonbanking institutions are more difficult to monitor. To the extent that foreign exchange obligations arising from borrowing from banks or nonbanking concerns and intermediaries are not recognized by the authorities in the borrowing country, their ability to pursue appropriate external policies may be affected.

Euro-currency borrowing

In the following analysis of the issues relating to Euro-currency borrowing, the advantages of this type of financing are set against the risks it involves for developing countries.

The Euro-currency market has provided a certain number of developing countries the opportunity in the past two years or so to borrow large sums on relatively favorable terms in situations where alternative flows of financing might not have been available or would only have been available on more onerous terms and conditions. This has also been so because the Euro-currency market is free from the limitations and regulations that sometimes render access to national capital markets more difficult. Euro-credits are not tied to the exports of any particular country and the borrower can allocate his purchases in the most efficient way. Since the cost of Euro-financing is related to short-term interest rates, the borrower in fact obtains medium-term loans at the cost of short-term funds. The borrower frequently has the option to switch from one currency to another and this gives him the possibility to switch from the currency where interest rates are high to a currency where rates are lower. He may also exercise an option, as the repayment date approaches for loans repayable in a single lump sum (the “balloon”), to shift from a currency likely to appreciate into one likely to depreciate, provided that the latter is available. The attractiveness of Euro-credits is also explained by their flexibility and simplicity of administration. Borrowers might prefer a Euro-credit at a floating interest charge to an insured export credit in order to obtain the most competitive rate by paying off the supplier in cash and also to avoid the complex process of assembling separately the finance for downpayments, for local expenditure, and for supplies from sources other than those covered by the prime supplier’s export credit insurer.18 In evaluating these positive aspects of Euro-currency credits, it is to be noted that not all credits permit the exercise of various options and not all borrowers in developing countries have the opportunity to take advantage of such options as do exist.

The risks involved in Euro-currency borrowing relate partly to their commercial character and are partly associated with their technical features. Whenever foreign financing of a commercial nature is abundant, there are attendant dangers of overborrowing and of misallocating resources. Scrutiny of the feasibility of projects, on the part of both lenders and borrowers, tends to be weakened by the interplay of competitive pressures. Under these circumstances, a debt-servicing problem similar to that associated in the past with overreliance on supplier and other types of commercial credits may well emerge. In addition, if one takes into account the peculiar repayment techniques adopted for most Euro-credits, there may arise a problem of reserve management as well. A “balloon” repayment schedule implies that large outflows of funds will take place when the loans become due, with attendant pressures on the country’s official reserves, if equally large loans cannot be contracted to refinance the expired ones. If one considers that most of the Euro-borrowing by developing countries has in fact taken place in the last two years or so, such a situation may well arise when most of the loans begin to fall due in the next several years.

Where foreign credit provides financing for domestic expenditures, the borrowing country subjects itself to foreign exchange risks that could have been avoided if internal sources of financing had been mobilized; these risks are intensified in a regime of fluctuating exchange rates.19 In a more fundamental sense, the influx of foreign funds raises complex problems of domestic monetary management and might impede the achievement of higher rates for domestic savings.

A second category of risk relates to the typical characteristics of the credit instrumentalities involved. A major problem is represented by the interest rate adjustment clause typical of Euro-credits. The floating interest rate makes it difficult for the borrower to evaluate what the cost of the loan will be over its life. To the extent to which the ability of the borrower to repay is not fully analyzed by the lender, for reasons already mentioned, little is known of the effects that a sudden increase in Euro-currency rates may have on the debt-serving ability of the borrower.

Three-month and six-month Euro-rates are highly sensitive to changing market conditions and to uncertainties in the international monetary scene (Chart 1). During the 1969–70 period of monetary restraint in the United States, the six-month Euro-dollar rate was constantly above 8 per cent, with peaks of 11 per cent and over. At the end of 1970, the six-month Euro-dollar rate in London was at 6.75 per cent. It rose to 7.75 per cent in September 1971 and then declined to a low level of 5.69 per cent in June 1972. Since then the rate has been steadily increasing. At the end of December 1972, it was 6.19 per cent and jumped to 8.63 per cent at the end of March 1973 in the aftermath of the monetary crisis of the previous month. At the end of September 1973, it was as high as 11.38 per cent.

Some borrowers have reportedly been successful in obtaining Euro-credits at fixed interest rates. However, this has been possible for a very limited number of borrowers of exceptionally good standing. For the time being, in addition to the foreign exchange risk involved in any type of foreign financing, Euro-credits entail interest rate risks that are absent from traditional loans. This is particularly important, because if the borrower does not accept the interest rate at which the loan is to be rolled over, there is no other choice but to repay the loan immediately. The same applies, although rather improbably, should a particular currency or package of currencies not be available in the market at any interest rate and the roll-over could not be completed. Another element of risk is represented by the provision included in many loan agreements that the borrower will bear the cost of the imposition of reserve requirements on Euro-currency deposits.

The special risks of Euro-borrowing are accentuated by the fact that a number of these loans are reportedly utilized to finance large industrial or infrastructure projects. Despite the fact that maturities are lengthening for some borrowers in selected countries, the average maturity of Euro-credits is still predominantly in the range of five to eight years, raising the presumption that for such use the payout period of the investment may well be longer than the repayment period. If, in addition, there is also the risk that the cost of capital might increase beyond the profitability of the investment, or that the loan may have to be repaid quickly, the use of Euro-credits becomes unsuitable for project financing.

It is from this point of view that the presence in the market of brokers applying sales pressure is a rather disturbing element. While the projects to be financed could be sound and profitable, one cannot disregard the possibility that the wrong type of financing may be applied. To the extent that basic Euro-currency rates are low and stable and that banks are willing to reduce margins over the London-interbank-offered rate to low levels, Euro-credits may be more attractive and convenient than alternative financing, but no assurance exists that these conditions will prevail throughout the life of the loan, as they reflect an interlude of large supply of funds in the market that may well pass away.

This latter consideration brings to the fore another important question: the continuity of Euro-currency flows to developing countries. Changes in the situation of abundant supply in the market may lead not only to higher interest rates but also to a reallocation of financial resources in favor of traditional and established borrowers in the developed countries at the expense of new borrowers from the developing countries. The possibility of such changes is not wholly remote. Recent experience in the United States suggests that, as monetary policy becomes more restrictive domestically, U. S. banks may again have recourse to the Euro-dollar market, both to ease the domestic restraint and to accelerate the dollar reflux into the United States.20 An increase in the demand for Euro-currencies by traditional borrowers might not negatively affect some of the developing countries, which are already well established in the market, but might have unforeseen consequences on marginal borrowers in the remaining countries that have only recently gained access to it. In addition, in a market highly sensitive to shifts in confidence, such as the Euro-market, any major development that might cloud the “image” of the borrowing country is likely to trigger reactions on the part of lenders that might have far-reaching repercussions on its ability to manage its balance of payments.

As for traditional banking credits, there also exists a recognition problem in the field of Euro-currency financing. Comprehensive information is lacking on the amounts and direction of Euro-currency lending to the developing countries. The inadequacy of information at the level of the lending banks has already been mentioned; it affects their ability to make a comprehensive evaluation of the risks involved and of the borrowers’ ability to repay in the short and medium term. At the level of the monetary authorities in the lending countries, the situation is not much clearer. A review of available statistical sources in major industrial countries has revealed little information on the volume and geographical distribution of Euro-lending. In some countries, the authorities appear to assume that banks “know what they are doing” and are concerned with only one aspect of risk, viz., the possibility of an imbalance of maturities arising in the market. In a sense, this is partly the consequence of the new lending modalities introduced in the market. As the “broadcast system” of loan syndication becomes more frequently used, it becomes more difficult to trace all the participants in a given loan. The authorities might be informed of the share of a given operation that has been taken up by banks operating in their jurisdiction, but this might well represent only a minor part of the total. As an outcome of the increasing internationalization of capital and money markets, data collected at a national level thus tend to become deficient.

There are reasons to believe that a substantial amount of Eurocurrency borrowing will be identified at the level of the borrowing countries. However, the extent to which that takes place may vary greatly from country to country. Where borrowing is done by government agencies or has their guarantee, Euro-credits are most likely recorded. In countries where the private sector or independent state enterprises have succeeded in operating directly in international capital and money markets, recording of Euro-borrowing may be less complete. Where this is so, Euro-borrowing escapes the reporting systems of international organizations, as the information gathered by them is predominantly based on the reporting of the debtor countries.

APPENDIX: U. S. Statistics on Short-Term Credits

Statistics on short-term claims and liabilities to foreigners are collected by the U. S. Treasury and the Federal Reserve Board from banks 21 and nonbanking concerns. The data are reported with a breakdown by type of credit and by recipient country. While the country breakdown is similar for bank and nonbank claims, the breakdown by type is different for the two categories. For bank claims the breakdown is as follows: loans made to and acceptances made for foreigners; drafts drawn against foreigners where collection is being made by banks for their own account or for account of their customers in the United States; and foreign currency balances held abroad by banks and their customers in the United States. For nonbank claims, the breakdown is less detailed: total short-term claims are broken down into claims payable in dollars and payable in foreign currencies. This latter category is further divided into deposits with banks abroad and other short-term claims. Both series exclude amounts outstanding for less than US$500,000, but these represent a small percentage of total transactions.

Statistics on banks’ claims and liabilities do not separate the operations of foreign branches of U. S. banks from total claims on and liabilities to foreigners. Since foreign branches might in some cases act as on-lenders to countries other than those where they are located, the recipient country breakdown may not be a correct indicator of the U. S. exposure in individual countries. Statistics on the foreign assets and liabilities of foreign branches have been collected by the Federal Reserve from its member banks only beginning from September 1969 and published in its Bulletin for the first time in February 1972. The published data provide no geographical breakdown beyond separating the United Kingdom and the Bahamas. As, however, these two are to a large extent “on-lending centers” the breakdown does not permit any conclusions to be drawn as to the residence of the ultimate credit user. The reason for this limitation is that the purpose of the reporting is to determine to what extent foreign branches of U. S. banks (which are heavily concentrated in London and Nassau) lend to and borrow from U. S. residents in general and their own parent banks in particular. In addition to the absence of a geographical breakdown, the statistics do not have a breakdown by maturity of assets and liabilities, with two exceptions. For claims on other banks outside the United States (excluding other foreign branches of a parent) the Federal Reserve asks reporting banks to indicate whether the claims have a maturity of less or more than one year, but this information is normally not published in the Bulletin. The Bulletin does publish data on the maturity of Euro-dollar deposits in foreign branches of U.S. banks.

As to the data on credits extended by nonbanking concerns, transactions between U. S. corporations and their affiliates abroad are again not included. According to U. S. definition, any foreign corporation with at least 10 per cent U. S. ownership is considered an “allied organization.” Transactions on open account or otherwise between allied organizations are classified as direct investment and are reported to the Office for Foreign Direct Investment of the U. S. Department of Commerce.

In addition to the above statistics, the Federal Reserve Bank of New York collects information on bankers’ acceptances outstanding in the United States. The data are published monthly and acceptances outstanding are classified as financing imports, exports, third-country trade, domestic shipments, domestic storage, and dollar exchange. Country breakdown is available only for the “dollar exchange acceptances.” The statistics distinguish between acceptances outstanding in the market and acceptances held in banks’ portfolios, and the latter represent about one third of the total outstanding. Banks report the recipient country breakdown of their acceptances’ holdings in the statistics already mentioned. Among acceptances outstanding in the market are not included the “finance acceptances,” that is, acceptances that do not originate from trade transations but are used to finance working capital. Since these acceptances are not eligible for rediscount at the Federal Reserve, data on them are not available.

Data on claims on foreigners reported by U. S. banks are summarized in Table 3. They show a general trend toward moderate increase in U. S. exposure vis-à-vis most developing countries, with no appreciable fluctuations. For some countries—Brazil, Spain, and Mexico—U. S. credit rose sharply over the period, while in others, such as the Philippines and Chile, it showed a marked general decline. The increase in the exposure vis-à-vis the Bahamas and Bermuda reflects the increasing use of these as “on-lending” centers by U. S. banks.

Table 3.

U.S. Banks’ Short-Term Claims on Foreigners, 1969–721

(In millions of current U.S. dollars)

article image
Source: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin (Washington), various issues.

Amounts outstanding at end of period.

Provisional.

*

Mr. Azizali F. Mohammed, Assistant Director in the Exchange and Trade Relations Department, obtained his doctorate from George Washington University and has been a member of the faculty of the University of Karachi and George Washington University. He has been the co-author of two books on the economy of Pakistan and has contributed articles to economic journals.

Mr. Fabrizio Saccomanni, an economist in the Exchange and Trade Relations Department when this paper was written, is now Technical Assistant to the Executive Director for Italy in the Fund. A graduate of Bocconi University, Milan, Italy, he studied also at Princeton University. During 1967–69 he was an economist in the Bank of Italy, from which he is presently on leave.

1

For collecting information, discussions were held with over 30 commercial banks based in New York, London, Paris, Rome, and Milan. Discussions were also held with monetary authorities in the countries visited and with institutions such as the Export-Import Bank of the United States, the Export Credit Guarantee Department of the Department of Trade and Industry in the United Kingdom, and the Compagnie Française d’Assurance pour le Commerce Extérieur in France.

2

In recent years, competition has led international banks wishing to expand their foreign activity to offer lines of credit to banks in developing countries without being solicited to do so and without an active correspondent relationship preceding the offer.

3

The results of the inquiries were published in Board of Trade Journal, Vol. 190 (June 17, 1966) and Vol. 193 (July 21, 1967), and in Trade and Industry, Vol. 3 (April 14, 1971) and Vol. 7 (April 13, 1972).

4

Stella Gianetto, “Terms of Credit Extended on 1970 Export Sales by Canadian Corporations,” Canadian Statistical Review, Vol. 47 (October 1972).

5

Euro-currency credits with the special characteristics described later will hereafter be referred to as “Euro-credits.” The prefix “Euro” will be used also in expressions such as “Euro-funds” and “Euro-financing” to mean Euro-currency funds or financing.

6

The net creditor position vis-à-vis the United States of European banks reporting to the Bank for International Settlements (BIS), “which had amounted to about US$12.5 milliard at the end of 1969, was reduced to US$2 milliard at the end of 1971,” BIS, Forty-Second Annual Report, Basle (June 12, 1972), p. 155.

7

“… a substantial part of the funds lent to the developing countries tended to flow back to the market through official reserve placements. Many of the loans seem to have been made for the financing of fairly long-term projects and to have been rather long-dated,” BIS, Forty-Third Annual Report, Basle (June 18, 1973), pp. 155–56.

8

The lengthening of loan maturities in response to competitive pressures is probably less than indicated by nominal maturity periods. While the latter have risen to 10 or 12 years, if not longer, banks attach significance to the concept of “average maturity” which depends on the repayment schedule adopted, that is, the average of the number of years to maturity weighted by the amounts outstanding at the end of each repayment period. Only when repayment is made in one installment at the end of the commitment period does the average maturity coincide with the nominal maturity, while a repayment schedule renders the average maturity shorter than the nominal maturity. By adopting a repayment schedule with diminishing instead of equal installments banks can reduce the average maturity further.

9

Where a withholding tax applies, which the lending bank can recoup against its own tax liability in its home country, the period for which the lender’s funds are locked up by the tax withheld is explicitly provided for in the rate quotation.

10

A secondary market for promissory notes is small at present and it is restricted to banks. There are proposals to reduce the nominal value of each promissory note so as to make them attractive for individual investors.

11

For example, T. H. Donaldson, “A Shot at the Five Year Balloon,” Euromoney (August 1971), p. 6: “It is possible to predict heavy losses if these unsound lending practices persist.”

12

However, single-bank loans may be sold via “participation certificates” issued by the original lender, which often maintains a secondary market in its certificates.

13

The following quotations may illustrate some typical concerns of the banking community: “Among charges made by operators in the market are: standards of credit analysis are low; sometimes basic principles are ignored. (This, of course, does not necessarily apply only to managing banks.) There are too many banks, paying high rents in the City of London, who are prepared to lend almost anything to earn their keep. Rates are being dangerously pared under the influence of competition; furthermore, in the case of floating rate loans, the fixing of rates is done wrongly. The typical loan agreement, while going to some lengths to secure the interests of the lenders, is a masterpiece of evasion concerning the responsibilities of the lead bank. The service of the loan, once made, ranges from the mediocre to the non-existent” (Philip Howard, “Medium-Term Lending, Lead Managers and Medium-Term Loans,” Euromoney (January 1972), p. 18), or “Much, if not most, lending is done on a ‘name’ or ‘near name’ basis, which is to say that minimal financial analysis is performed by the individual participants in a lending syndicate—indeed, even the syndicate manager’s financial analysis of the borrower is often slight when the loan is made on a ‘name’ basis” (Michael von Clemm, “The Rise of Consortium Banking,” Harvard Business Review (May-June 1971), p. 129).

14

If, for example, the capital/deposit ratio is 0.05, the bank will have a rate of return, before tax, of 20 per cent, if the margin over LIBO is 1 per cent.

15

Jean L. Blondeel, “Revolving Credits in Eurocurrencies,” The Banker, Vol. 122 (September 1972), pp. 1153–56.

16

William F. Low, Eurostudy [Amsterdam], 1973.

17

Bank of England, Quarterly Bulletin, Vol. 13 (March 1973), p. 44. Previous reviews of the market were published in the Bulletin’s issues of March and December 1970, June 1971, and March 1972.

18

The national export credit guarantee agency in one country felt that the advantage of a fixed subsidized rate of interest more than offset the merits of a Euro-currency credit at a higher and fluctuating interest rate.

19

However, in countries that use the U. S. dollar as an intervention currency, a borrower of Euro-dollars carries only a risk of a change in the home currency/ dollar rate. A borrower in a non-dollar currency carries an additional dimension of risk, as there is also the possibility of a change in the dollar rate vis-à-vis the other foreign currency which would affect repayment liability via the fixed home currency/dollar rate. Moreover, hedging facilities are generally available at moderate cost in relation to the intervention currency, while forward cover in non-dollar currencies becomes more expensive and in periods of acute strain in exchange markets might not even be available to a small borrower.

20

During May 1973, the Federal Reserve Board modified Regulation M by reducing the reserve requirements on Euro-dollars from 20 per cent to 8 per cent, making it equal to the reserve requirement on large domestic deposits.

21

Both members and nonmembers of the Federal Reserve System.

IMF Staff papers: Volume 20 No. 3
Author: International Monetary Fund. Research Dept.