The Changing Role of International Bank Lending in Development Finance
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

During the past 15 years, the provision of development finance has undergone major institutional changes. The international market for bank loans has replaced the markets for international bonds and direct investment as the major source of private capital for development. In addition, multilateral rescheduling of debt, whether commercial or official, normally in the context of a comprehensive stabilization program, has successfully replaced default by borrowers. This paper argues that the disproportionate increase in bank financing to developing countries in the 1970s was facilitated by the institutional and financial innovations that were set in motion by the global payments imbalances of the early years of the decade. These innovations enabled the international banking markets to absorb large deposits from the surplus oil exporting countries, and enabled them, at the same time, to overcome the traditional problems of monitoring and enforcing loan contracts with borrowers in the developing countries. This paper argues further that the greater role of bank lending in development finance has had important implications for the pricing and for the allocation of development credit, as well as for the sharing of risk among lenders and borrowers.

Abstract

During the past 15 years, the provision of development finance has undergone major institutional changes. The international market for bank loans has replaced the markets for international bonds and direct investment as the major source of private capital for development. In addition, multilateral rescheduling of debt, whether commercial or official, normally in the context of a comprehensive stabilization program, has successfully replaced default by borrowers. This paper argues that the disproportionate increase in bank financing to developing countries in the 1970s was facilitated by the institutional and financial innovations that were set in motion by the global payments imbalances of the early years of the decade. These innovations enabled the international banking markets to absorb large deposits from the surplus oil exporting countries, and enabled them, at the same time, to overcome the traditional problems of monitoring and enforcing loan contracts with borrowers in the developing countries. This paper argues further that the greater role of bank lending in development finance has had important implications for the pricing and for the allocation of development credit, as well as for the sharing of risk among lenders and borrowers.

During the past 15 years, the provision of development finance has undergone major institutional changes. The international market for bank loans has replaced the markets for international bonds and direct investment as the major source of private capital for development. In addition, multilateral rescheduling of debt, whether commercial or official, normally in the context of a comprehensive stabilization program, has successfully replaced default by borrowers. This paper argues that the disproportionate increase in bank financing to developing countries in the 1970s was facilitated by the institutional and financial innovations that were set in motion by the global payments imbalances of the early years of the decade. These innovations enabled the international banking markets to absorb large deposits from the surplus oil exporting countries, and enabled them, at the same time, to overcome the traditional problems of monitoring and enforcing loan contracts with borrowers in the developing countries. This paper argues further that the greater role of bank lending in development finance has had important implications for the pricing and for the allocation of development credit, as well as for the sharing of risk among lenders and borrowers.

Between about 1920 and 1931, when private finance for development purposes was minimal, the primary sources of funds were the foreign bond market and the market for direct investment; a borrower in a developing country unable to service its external debt typically defaulted on its bond issues. As a result, the lending rates that were established in the foreign bond market included risk premia to compensate lenders for the expected losses arising from defaults. A country’s cost of borrowing in the external bond markets tended to rise whenever the market’s evaluation of the risk of a specific project or a particular policy stance in the borrowing country increased, and this mechanism served to direct capital to its most efficient use. In addition, the possibility of defaulting on a given stock of outstanding bonds limited the liability of the borrower, so that the market ensured some sharing of risk between borrowers and lenders.

We attribute the recent growth in the share of development finance flowing through the international banking markets (see Table 1) to comprehensive advantages gained by international bank lenders over the more traditional sources of development finance. First, financial authorities were perceived as being increasingly willing to protect the deposit liabilities of their large money-center banks (an examination of the risk premia paid by such banks on their deposit liabilities offers support for this hypothesis (see Table 2)). The cost of deposit liabilities for banks, therefore, became largely independent of the banks’ choice of assets, which combined with low capital requirements to provide the incentives to expand into new areas of lending. Second, international banking markets generally proved better equipped to deal with the risk of lending to sovereign borrowers than the markets for foreign bonds and direct investment. In particular, international bank lenders were able to form credible coalitions designed to deny delinquent borrowers access to refinancing in the banking markets.1 As a result, outright default has been replaced by the restructuring of debt in the context of a stabilization program. Competition in the international bank loan market then ensures that the risk spread above the banks’ cost of funds reflects only the expected loss that bank lenders would incur should a rescheduling of this country’s bank debt become necessary. It does not reflect fully the risk associated with individual projects or policies financed by international bank loans. A comparison of the cost of borrowing in the international banking markets with the cost of borrowing in the international bond markets, for a selected group of developing countries, demonstrates that bank lending rates are generally low and uniform across borrowers, with delinquent borrowers being denied access to refinancing, while bond rates vary with changes in the ability of borrowers to service their debt as perceived by the bond markets (see Tables 5 and Table 7). This leads to the conclusion that developing countries will borrow excessively in the banking markets unless they add the full expected costs of undertaking periodic stabilization programs to their market cost of borrowing in the banking markets.

Table 1.

Financial Flows to Non-Oil Developing Countries, 1970-83

(In billions of dollars)

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Source: Group of Thirty, Foreign Direct Investment, 1973–81; International Monetary Fund, International Capital Markets, Developments, and Prospects, 1984, Occasional Paper No. 31 (Washington, 1984); World Bank, World Development Report, 1983 (Washington, 1983).
Table 2.

Yields on Deposit Liabilities of U.S. Money-Center Banks, 1976-84

(In percent per annum)

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Source: Board of Governors of the Federal Reserve System, Statistical Release H.15 (Washington), various issues.

Section I comprises a discussion on how the international banking markets gained their competitive advantage over the bond and direct investment markets, and how financial innovations succeeded in reducing the risk of financing development. Section II discusses the effects of these institutional developments on the pricing and allocation of international bank loans. Section III contains an examination of the effects of the institutional innovations on the optimal amount of borrowing by developing countries. An appendix provides theoretical support for some of the hypotheses concerning the pricing and allocation of loans in the international banking markets.

I. The Changing Structure of Development Finance

Until the late 1960s, the largest share of private external financing of economic development took place through the international bond markets; the role of international bank lending was essentially limited to short-term financing of trade flows secured by collateral in the form of traded goods. Two related developments then enabled the major banks in the financial centers to become the largest recipients of international loanable funds and the major suppliers of development finance. First, the perception spread during the early 1970s that the national financial authorities in the major industrial countries had assumed an increasing proportion of the risk on the deposit liabilities of their major banks, enabling them to compete successfully for funds from surplus countries. Second, the risk of default by borrowers was reduced through financial innovations in the banking markets that increased its cost, and through the enhanced ability of international financial institutions to provide assistance to borrowers having difficulties with debt servicing.

The International Bond Market, 1920–70

There was virtually no private debt financing of development from 1931 until bank financing began on a large scale in the early 1970s. During the 1920s, the last decade of extensive private resource transfers to developing countries prior to the 1970s, bank lending for development projects or balance of payments financing was virtually nonexistent. A boom in the underwriting of foreign bonds in the United States began in 1924. Rising commodity prices created prosperous conditions in Latin America and Australia, and the United States itself entered a four-year period of prosperity. More than US$1.2 billion in foreign capital issues were sold in the United States in 1924; a peak was reached in 1927 when total foreign bond issues amounted to US$1.6 billion. In 1929, the collapse of the stock market in the United States, rising interest rates, and falling commodity prices resulted in a sharp decline in foreign bond issues, and after a temporary revival in 1930 the market for new international bond issues essentially disappeared in early 1931. By 1974, bond financing had declined to barely 10 percent of the bank-financed external debt of non-oil developing countries (Table 1).

An important feature of the period of bond dominance was that defaults occurred with some regularity. If the borrower—whether a national government, municipality, or private enterprise— defaulted on a particular bond issue, it was usually able to re-enter the bond market after some partial settlement had been reached with bondholders. However, if default occurred because of an unwillingness to pay—for instance, if the debts contracted by previous governments were repudiated—then the borrower was typically barred until the lenders had obtained redress. International councils of bondholders were the legal means for ensuring, albeit imperfectly, the exclusion of delinquent debtors from the international bond markets (see Borchard and Wynne (1951)).

There was a substantial number of defaults in the early 1930s, but in almost all cases borrowers subsequently offered bondholders readjustment plans providing for partial payment of debt service. By December 1935, debt service had been paid in full on 62 percent of all foreign dollar bonds outstanding, while interest was in default on 37 percent of the total owed, and principal and sinking funds were in default on 1 percent of the total.2

The most remarkable feature of the international bond markets was that during the turbulent period 1920-35, foreign bonds issued in the United States offered coupon rates that were sufficient to compensate bondholders for expected default and, in fact, produced a holding period rate of return of about 3 percent, which was comparable to the average holding period rate of return on U.S. AAA bonds over the same period (see Madden and others (1937); Winkler (1933); and Durand (1942)).

The International Bank Market in the 1970s

The international payments imbalances generated by the oil price increase of 1973 provided an unprecedented opportunity for the international credit markets to expand. The increased supply of loanable funds from low-absorbing oil exporters was met by a sharp rise in the demand for balance of payments financing by non-oil developing countries. These payments imbalances induced two institutional developments that enabled the international banking market to become the main conduit for financial flows from the surplus to the deficit countries.

Reduction in Risks on Deposits

An institutional development with far-reaching consequences for the functioning of financial markets has been the gradual assumption by the central banks and deposit insurance agencies in the industrial countries of a larger portion of the default risk of the deposit and debt liabilities of the main banks. The extent to which this development prevented an increase in asset holders’ assessment of the risks attached to holding the deposit liabilities of the major banks is indicated by Table 2, which compares the interest rates on certificates of deposit of major U.S. banks (with deposit liabilities exceeding US$10 billion) with the interest rates on AAA commercial paper (short-term, fully transferable, high-grade corporate debt), and short-term treasury bill rates. The excess of the rate of return on the certificates of deposit was less than 100 basis points above the yields on six-month treasury bills until the third quarter of 1978, but rose to 240 basis points more by the third quarter of 1981. Thereafter, the spread declined gradually to its historical average of 30 basis points.

The increase in the premium on these certificates of deposit in 1981 and the first half of 1982 can be interpreted as a reflection of heightened concern for the stability of the financial system, which subsided after concerted efforts to restore confidence by national and international financial authorities. The increase in the premium in mid-1984 was largely due to difficulties experienced by some major money-center banks with their domestic portfolios.

This evolution toward a domestic financial system in which the financial authorities bear a significant portion of the risk attached to the deposit liabilities of the major banks was largely completed by the early 1970s in the industrial countries outside the United States, either through direct state control and ownership as in Italy, or via automatic discounting facilities as in France, the United Kingdom, and the Federal Republic of Germany. In the United States, the Federal Deposit Insurance Corporation (FDIC), established in 1934, was gradually transformed from an insurance agency empowered to merge failing banks (under the 1935 Banking Act) and pay individual depositors of failed banks up to US$2,500 each, into a financial stabilization agency guaranteeing the total deposit and debt liabilities of the major banks. While the stockholders of failing banks often lost their equity, the FDIC was always able to structure mergers or to effect a “purchase and assumption”—in which the ailing bank was acquired by another bank with a subsidy from the FDIC—so that depositors in the end recouped their investments.3 Important examples of the effects of this evolving financial policy were the failure of the Franklin National Bank (the twentieth largest bank in the United States) in 1974; the First Pennsylvania Bank (the twenty-first largest U.S. bank), which was rescued in 1980; and finally the Continental Illinois National Bank and Trust Company of Chicago (the eighth largest U.S. bank), which was rescued in July 1984. In all these cases, the full nominal value of foreign as well as domestic deposits was maintained, irrespective of the cause of the bank’s difficulties.4

The need for international cooperation among financial authorities to assume responsibility for the supervision of and assistance for offshore banks arose from concerns about the ability of the international financial markets to cope with the sheer volume of funds that were recycled during the 1970s. The informal encouragement of international banks to lend was backed by implicit understandings about the lender-of-last-resort obligation of the national central banks. The debt crisis that began in August 1982 has tended to validate the previously untested assumption that national financial authorities would assist international bank lenders in coping with a systemic debt crisis in developing countries.

Concerted efforts by central banks, acting through the Bank of International Settlements and the Exchange Stabilization Fund of the U.S. Treasury, led to emergency loans to Mexico and support for the international interbank market in September 1982, enabling Mexico to reschedule its debts and remain current on interest payments. The increased pressure exerted by central banks on the main participating banks to remain active in the interbank market (and, for example, not to withdraw deposits with Latin American banks in London), may have been interpreted as enhancing the obligation of central banks to assume risk (Clarke (1984)). Finally, an emergency loan of US$300 million (guaranteed by the Exchange Stabilization Fund of the U.S. Treasury) coupled with a loan of US$100 million from 11 major banks (guaranteed by the New York Federal Reserve Bank), was extended to Argentina in March 1984 and renewed in June 1984, to permit Argentina to remain less than 90 days in arrears on interest payments to U.S. banks.5

Reduction in Risks of Default

The reduction in the risk that major lending banks would default on their deposit liabilities gave bank credit a competitive advantage over other sources of finance for developing countries during the 1970s, and made it possible for these banks to intermediate a larger share of the financial flows than they might otherwise have handled from countries with payments surpluses. However, there is no legal structure that predetermines the allocation of property rights in the case of default—which introduces the possibility that a borrower may be unwilling to service his debt even though he is able to do so—and this has increased the risks of lending to developing countries. As the international markets were able to overcome some of these difficulties during the decade, private bank lending to developing countries could rise.

The laws that govern the allocation of property rights in conflicts between lenders and borrowers in international credit markets differ significantly from their domestic counterparts. In domestic credit markets, bankruptcy laws limit the claims of lenders to certain types of individual borrowers; thus the future ability of the bankrupt borrower to acquire unencumbered assets is not impaired. Similarly, the liability of the corporate borrower is limited to its current equity, and the lender retains no claim on future output. The bankruptcy law also provides the borrower’s assets with some legal protection from seizure through the possibility of reorganizing a bankrupt corporation (see Chapter XI of the U.S. Bankruptcy Code). Such limitations on the domestic borrower’s liability are balanced by the lender’s right to declare the borrower to be in default if it is delinquent in servicing debt, and to try to attach the assets of the borrower before they are fully depleted. The domestic credit market also allows the lender to place restrictive covenants (such as limitations on the borrower’s debt-equity ratios and amounts of subordinated debt) on its credit, to prevent the risk of the credit from changing after the loan has been made. The institutional structure of the domestic credit market and the bankruptcy code allow borrower and lender to share the risk of a loan.

However, the markets for external credit to developing countries that cover foreign bonds, as well as international bank loans, have a much less developed institutional and legal structure, and in particular no clear definition of the borrower’s liability and the lender’s rights (Rendell (1980)). For example, when the borrower is a sovereign entity, the creditor has no recourse to its external or domestic assets, because of the well-established legal principle of sovereign immunity according to which domestic courts relinquish jurisdiction over a foreign state (Sweeney (1963) and John (1982)). Until 1976, when the Foreign Sovereign Immunities Act became law in the United States, European and U.S. courts generally adhered to the theory of absolute sovereign immunity and acceded to claims of immunity involving all commercial activities of foreign states, including those of state enterprises (Rendell (1980)). If the foreign borrower is a large and nationally recognized private entity in a developing country, then its domestic assets have also proven, in practice, to be immune from seizure by a foreign creditor. In addition, domestic courts in developing countries rarely give foreign lenders equal standing with the borrowers. Foreign lending to developed countries is less hampered by these institutional shortcomings, since the lending entity frequently enjoys full recognition in the courts of the borrowing countries. The absence of a legal framework to limit the borrower’s liability and safeguard the lender’s rights is a fundamental difference between the external and the domestic credit markets, and is probably an important reason for the low levels of private credit extended to developing countries before the early 1970s.

These shortcomings in the institutional structure governing the allocation of property rights given debt-service difficulties have to some extent been overcome through financial innovations designed to raise the cost of default by borrowers in developing countries. In particular, the introduction of cross-default clauses covering publicly guaranteed debt have significantly strengthened the guaranty and have blurred the differences in risk among individual borrowers within a country, since a delinquent borrower is supported by others to avoid triggering the cross-default clause. (A loan encumbered by a cross-default clause is due immediately; the clause is triggered by the default of the associated loan.) This innovation is all the more important because the increase in bank lending to developing countries during the past ten years has tended to be concentrated in loans to governments, their agencies, borrowers with government guarantees, and borrowers whose size or importance to the economy meant that their debt was likely to be publicly guaranteed if necessary.

In practice, most of the external private debt of developing countries has been transformed into publicly guaranteed debt in times of debt-service problems, since debt-servicing difficulties experienced by private borrowers have usually taken the form of liquidity constraints on foreign exchange. This de facto aggregation of external debt that results from public guarantees and cross-default clauses means that bank lenders need not be concerned with the ability of individual borrowers in a country to pay their external debt, but only with the ability of the country itself to pay. And indeed, the differences in lending rates paid by different borrowers within the same country have typically been less than 50 basis points (World Bank (1984)).

A similar aggregation of responsibility has been achieved among lenders in the international bank loan market through syndication, whereby many lenders subscribe to a small portion of a loan. Syndication has involved all major lenders with the major debtor countries. Thus, should a borrower in a developing country become delinquent, cross-default clauses would trigger default on all outstanding loans, and syndication ensures that all bank lenders would be affected.

In addition to the aggregation of responsibility in borrowing and lending, other legal developments have helped lenders protect their assets. The most important of these was the Foreign Sovereign Immunities Act of 1976, mentioned already, which established a more restricted interpretation of sovereign immunity. In particular, immunity will not be recognized if the relevant borrower is a commercial agent of a foreign state or its agencies (Rendell (1980)).

The net effects of these financial and legal innovations have been to raise the cost of defaulting on any loan, by efforts to ensure that a borrower in default will be denied access to the international banking markets and have its external economic relations interrupted. Syndication prevents a borrower from selectively defaulting on loans owed to a subset of lenders, while the cross-default clauses prevent individual public sector borrowers from defaulting without the country being declared in default by most international banking markets. Since regulatory requirements prevent the major banks from extending loans to borrowers that have already defaulted on loans, countries that have defaulted on public sector loans will forfeit access to the bank loan markets.

The relative openness of debtor countries in the developing world, combined with their potentially high marginal productivity of capital, implies that a default on external debt involves substantial costs. So countries with debt difficulties have typically chosen to seek a rescheduling of debt in return for adopting a stabilization program (Table 3).6 This evolution has been encouraged by the international financial institutions (such as the International Monetary Fund), as well as by the domestic financial authorities in the industrial countries. In particular, these institutions, in concert with the international banking markets, have provided the bridging finance necessary to support stabilization programs until the countries with payments difficulties could begin to service their external debt again and return to the international banking markets.

Table 3.

Multilateral Debt Renegotiations, 1975-84

(In millions of U.S. dollars)

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Source: World Bank, World Debt Tables, 1984–85 Edition (Washington, 1985).

The effect of these financial and legal innovations has been to shift some of the risk incurred by international bank lenders as they increase their lending to developing countries onto national financial authorities and to the borrowing country. Simultaneously, the replacement of outright default by debt rescheduling combined with a stabilization program has extended the borrower’s liability into the future.7

II. The Pricing and Allocation of International Bank Loans to Developing Countries

The replacement of foreign bonds and direct investment by international bank credit as the main source of development finance has had significant implications for its pricing and allocation. In particular, even a casual inspection of the difference between the borrowing and lending rates of banks active in the international market suggests that the spread between the interest rate charged to borrowers and the banks’ own cost of funds—the London Interbank Offered Rate, or LIBOR—has come to reflect the market’s assessment of expected loss due to debt rescheduling, rather than the (greater) specific risk of default on individual projects or policies in each borrowing country. These costs include any loss of interest and principal agreed to in the rescheduling, as well as transaction costs and the cost of not being able to adjust loan portfolios. This hypothesis is supported by the observation that these spreads are relatively small and have varied little, either across borrowers or over time.8

For example, Table 4 indicates that despite the debt crisis in developing countries in 1982, the spreads over LIBOR on loans to non-oil borrowers among developing countries remained, on average, less than 50 basis points greater than those paid by borrowers in industrial countries during the entire period from 1974 to 1983. The difference between the average spreads paid by developing countries that were obliged to undergo a rescheduling and those on loans to industrial countries remained below 1 percentage point until 1981, when it rose on average to about 150 basis points.

Table 4.

Average Interest Rate Spreads above LIBOR on Publicly Guaranteed Loans, 1974-83

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Note: LIBOR is London Interbank Offered Rate; LDC is developing country.Source: Data from World Bank, Debtor Reporting System (1984 data).

The variations in spreads around their arithmetical average have been very narrow, normally less than 100 basis points. The spreads for a sample of borrowers among non-oil developing countries are given in Table 5 and are very close to the average spreads in Table 4. Furthermore, Table 6 displays the surprising fact that the average interest rate on loans to non-oil developing countries has consistently remained below that on large corporate loans in the United States. Thus the institutional evolution of the international bank loan market has been a movement away from pricing to offset the expected risk of outright default, to a new system where rates on syndicated international credits reflect only the (lower) expected cost of rescheduling. This, in turn, has led to lower and less variable spreads than those existing even in well-developed domestic financial markets.9

Table 5.

Interest Rate Spreads Above LIBOR on Public and Publicly Guaranteed Loans for Selected LDC Borrowers, 1979–84

(Quarterly averages)

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Source: World Bank, Debtor Reporting System (1984 data).
Table 6.

Comparison of Interest Rates on Foreign and Domestic Bank Loans, 1979–83

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Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, various issues; and World Bank, Debtor Reporting Service (1984 data).

Large long-term U.S. corporate loans with floating interest rates.

Interest rate range that covers the middle 50 percent of total dollar amount of loans made.

A comparison between the pricing and allocation behavior of the international bank loan market and that of the market for the international bonds issued by developing countries provides direct evidence to support the hypothesis that interest rates in the international bank loan market tend to reflect the lower expected loss of a rescheduling, rather than the higher loss that would be incurred in an outright default. In particular, the risk premia paid by borrowers in developing countries in the foreign bond markets are considerably larger (and more variable) in response to changes in the individual borrower’s expected ability to service the debt than the spread above LIBOR paid by developing countries. For example, in January 1982 the yield on deutsche-mark-denominated international bonds issued by the Mexican public sector was 70 basis points above the average yield on deutsche mark international bonds of the same maturity issued by all industrial countries. After increasing slightly to 140 basis points by July 1982, this yield difference widened to 430 basis points in August 1982, following the Mexican moratorium. It generally remained in the range of 400 basis points until the credibility of the Mexican adjustment program became established in mid-1983, after which the yield differential fell to 240 basis points and then to 160 basis points by March 1984.

Table 7 indicates that a very similar pattern of yields also occurred on deutsche mark bonds issued by Brazil and Venezuela over roughly the same period. The yield differential on Argentina’s public sector bonds were the most variable (10.5 percentage points in September 1982) and generally remained in the 8.5 to 9.5 percentage point range until the first quarter of 1984, when the yield difference dropped to 5 percentage points. From this perspective, the rather larger yield differential of 5 percentage points that existed in August 1984 can be interpreted as a reflection of concern over Argentina’s credibility in implementing its adjustment program. Comparison of the differential between the yield on international bonds and that on syndicated credits denominated in the same currency can provide an estimate, albeit a very rough one, of the premium required to compensate bondholders for the expected default risk. This simple measure, of course, tends to underestimate the true risk premium, since the benchmark is the average yield on all industrial country bonds, and not a risk-free bond. These risk premia seem to rise considerably, given the rise during times of increased uncertainty about the ability of the borrower to service bond obligations. Furthermore, while the banking markets have succeeded in barring developing countries that were unable to service their interest obligations by refinancing their debt (rather than raise their interest spreads), the bond markets increased their premia to reflect the increased uncertainty.

Table 7.

Yields on Deutsche-Mark-Denominated International Bonds, 1982-84

(Percent per annum)

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Note: The bonds are public sector deutsche mark bonds issued by nonresidents.Sources: Deutsche Bundesbank, Statistical Supplement No. 2 of Monthly Report Verlag Borsenzeitung, Renditenuber sicht Festverzinslicher Wertpapiere (yield survey of fixed-interest securities).

Average yields of medium-term international deutsche mark bonds.

Bonds issued in 1980 with a 9¼ percent coupon and due in 1988.

Bonds issued in 1978 with an 11 percent coupon and due in 1988.

Bonds issued in 1978 with a 6½ percent coupon and due in 1988.

Bonds issued in 1980 with a 9¾ percent coupon and due in 1990.

A very similar picture emerges from the international market for bonds denominated in dollars (Table 8). The increase in the risk premium on Mexican dollar bonds between January 1982 and March 1983 was approximately 10 percentage points, while the increase in the risk spread on bank loans at those dates was less than 150 basis points. This evidence on the increase in the level and variability of risk premia lends support to the conclusion that interest rates on bank loans to developing countries are less sensitive to default risk than is bond debt. In other words, it provides evidence that the bond market faces different risks and is more responsive to them, thereby providing more accurate information on the real cost of capital. Table 8 also suggests that from August 1982 to the end of 1983 Brazil’s default risk was viewed by the bond market as less thanrthat of Mexico. Brazil’s risk premium increased by 4.5 percentage points from January 1982 to March 1983. In March 1984, the default premium for Mexico was 3 percentage points higher than it had been in January 1982, while for Brazil it was 3.8 percentage points higher, suggesting a market perception that Mexico had, by then, made more progress in reforming economic policy than had Brazil.

Table 8.

Default Risk Premia on Foreign Bonds Denominated in U.S. Dollars, 1981–851

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Note: The bonds are medium-term seasoned bonds, January 1982-March I 1984.Source: International Herald Tribune, various issues.

Call provisions on the World Bank bonds raise rates of return on these relative Mexican or Brazilian bonds of same risk and maturity. Hence, the changes over time of the differences in the rates of return are of interest.

For the World Bank l0¼, June 1987; for Mexico 8½, March 1987; for Brazil 8¼, December 1987.

If the lending rates on international bank loans to developing countries reflect the lender’s expected cost of debt rescheduling— rather than the risk that individual investment projects or policies may not generate sufficient returns to service the loans—then such lending cannot be counted on to allocate credit through a price mechanism that matches risk premia embodied in lending rates with the riskiness of the loan. Instead of allowing the price mechanism to allocate bank loans, bank lenders have denied borrowers access to refinancing when it is expected that, on the basis of current policies, the borrower will experience difficulties in meeting interest payments out of current income. The resulting liquidity crisis has then induced countries to adopt stabilization programs to obtain bridging finance until they can return to the private markets. This mechanism for pricing and allocating credit is to be viewed as a direct outgrowth of the institutional evolution of development finance; an inadequate framework for sharing risk and enforcing contracts led to the replacement of default with rescheduling when debt could not be serviced according to the original maturity schedule.

Considering initially the external bank loan market from the point of view of a single developing country facing the aggregate supply of a large number of bank lenders, the shape and position of its demand for credit are determined by the portfolio behavior of the domestic private and public sector (including the demand for foreign reserves by the public sector). Portfolio behavior is, in turn, influenced by domestic monetary, fiscal, and exchange rate policy, as well as by structural variables, such as the marginal product of domestic capital. At a given set of policies and for a given economic structure, the demand curve is assumed to be a downward-sloping function of the cost of external credit. The channels through which policies and structure can affect the stock of foreign bank debt can be classified according to the fundamental identity obtained by cumulating balance of payments flows over all past periods:

FB=ΣTB+ΣS+OR+GPC,

where FB is the stock of foreign borrowing, ΣTB the cumulative trade deficit, ΣS the cumulative service deficit, OR the stock of gross official reserves, and GPC the stock of gross private claims on nonresidents. There are three major channels through which the stock of foreign debt is affected; namely, the financing of the current account deficit (TB + S), the acquisition of reserves, and an increase in the gross stock of private claims on nonresidents. A larger current deficit or larger reserves can be financed through a reduction in private claims on nonresidents or through an increase in gross (and net) foreign indebtedness. An increase in gross private claims on nonresidents can be accomplished through a current account surplus or through a rise in foreign borrowing by the public sector, leaving net foreign indebtedness unchanged.

Graphically, any policy undertaken by an individual country that raises its demand for the stock of debt shifts the demand curve in Figure 1 rightward. This will happen, for example, when an overvalued exchange rate is combined with high levels of protection on goods, while capital mobility is left unimpaired, creating an incentive for capital flight. Similarly, an overvalued exchange rate combined with impediments on capital flows, but low protection of goods, will result in a deterioration of the current account and an increase in the demand for debt. An increase in the fiscal deficit that is unmatched by a corresponding increase in private saving will also raise the current account deficit and the demand for debt, as would an increase in the marginal productivity of capital, ceteris paribus, by increasing investment. An upward valuation of natural resources, either through an improvement in their relative prices or the discovery of new resources, could also lead to an increase in the desired stock of external debt as a means of monetizing a natural resource.

Figure 1.
Figure 1.

Equilibrium in the External Bank Loan Market Without Credit Rationing

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

Between 1974 and 1982, the causes for higher external indebtedness varied markedly among developing countries (Dooley and Helkie (1983) and Dornbusch (1984)). For example, the rise in private claims on nonresidents, often associated with capital flight, appears to have accounted for about half of the increase in the external debt of Venezuela, Argentina, and Mexico, and for about 20 percent or more of the debt increase of the Philippines, Peru, and Korea. Chile and Brazil, on the other hand, had little or no capital flight. Reserves increased significantly in Chile, Korea, and Venezuela. The cumulative trade deficits of Brazil, Chile, Mexico, and Peru were less than 20 percent of the increase in external debt of these countries: together the six Latin American countries—Argentina, Brazil, Chile, Mexico, Peru, and Venezuela—had a cumulative trade surplus.

Changes in the total supply of the stock of loans to the developing countries by the international banking sector were more important than the behavior of demand for external credit, since many of the pressures on the market originated from the supply side. It was argued above that before the early 1970s, the supply of credit was severely limited by a financial and institutional structure that was insufficiently developed to overcome the incentive and information problems associated with lending to developing countries. The difficulties of monitoring and enforcing contracts, and of assigning property rights in cases of nonperforming debtors, created incentives for borrowers to alter implicitly the terms of loan contracts in their favor after they had been concluded—by altering loan risks, or by limiting their efforts to secure a viable return on loans. This created a situation of what is known as “moral hazard” in the literature on the economics of uncertainty.

After the payments imbalances created by the oil price increases of 1973, financial innovations and institutional developments went a long way toward reducing the problems of monitoring and enforcement inherent in lending to developing countries.10 In particular, public guarantees and cross-default clauses on loans to the same country, together with an almost marketwide participation in the syndication of loans to developing countries, have had the effect of raising the cost of defaulting on external bank loans. At the same time, national and international lending agencies have increased their ability and willingness to arrange stand-by programs and interim financing for countries with difficulties in servicing their external debt.

Both developments have induced countries to reschedule loans rather than default on external bank debt, and have caused the expected loan losses of bank lenders to decline, thus increasing the supply of external bank loans to developing countries. As indicated above, these financial and institutional innovations increased the lenders’ ability to overcome the moral hazard problems associated with external lending. The supply of loanable funds to the banking sector and the level of innovations designed to overcome monitoring and enforcement problems can be thought of as determining the position of the stock supply curve of loans by all banks active in the international credit market.

The shape of the aggregate supply curve of external bank loans faced by an individual country is determined by the relation between the lending rate and the average risk of the projects financed. In cases where the banks’ information about the risk of potential projects undertaken by a borrower is incomplete, the interest rate itself has been used as a device for screening out risky projects. The higher the lending rates, the more risk borrowers will have to take on in order to generate a positive expected return. Hence, lenders have refrained from raising lending rates to clear markets; instead they have excluded some borrowers from the international banking markets. When increases in interest rates induce borrowers to choose projects with higher risk, an “adverse selection” effect is said to be present. In this case, quantity rationing in the loan markets will be an optimal response by bank lenders.

Potential development projects and potential policies to be financed with external credit have different probabilities of yielding a return sufficient to service the credit. Since the expected return to the bank lender depends on the probability of repayment, the lender would like to be able to identify the riskiness of a loan, and charge a rate of interest that reflects it. However, it has generally not been possible for external lenders to identify projects and policies. This is largely due to the borrower’s ability to affect the yield of the project or policy after the loan has been made, by varying his efforts or by changing the nature of the project or policy itself. (In the domestic bank loan market the lender attaches covenants and other legal restrictions to prevent such moral hazard problems.) This inability of the lender to identify risk accurately is directly responsible for the aggregation of risk of different loans through cross-default clauses, as discussed earlier. The lenders’ expected return on loans to an individual developing country then depends on the expected losses on loans incurred by rescheduling. Such losses are, in turn, determined by the average risk of projects and policies undertaken by the borrower. The fundamental insight to be gained from the theory of adverse selection is that the average riskiness of the projects and policies the borrower chooses to finance with external loans rises with the lending rate.11

The borrower’s potential loss in undertaking a project is limited by the value of his equity in it; hence his expected profit would increase with a rise in the risk of the project chosen.12 At any given interest rate there is a level of risk such that development projects and policies with lower risk yield negative expected profits, while projects with higher risk yield positive expected profits and are chosen depending on whether the lender is risk averse or not. Any increase in the lending rate will then cause the lower-risk projects to be abandoned, and the average risk of the remaining projects then rises.13

The banks’ profits from lending to a developing country are the interest payments; hence their expected profit (which is interest income less the loss expected from rescheduling) decreases with a rise in the average riskiness of the loan. The Appendix shows that the increase in the expected profits from raising the lending rate may not be sufficient to make up for a decline of expected profits due to riskier loans. For example, if all loans fell into two risk categories, expected profits per dollar of lending would drop once the lower-risk loans were abandoned. Thus, the expected profits of lenders are a negative function of the lending rate, and since the banks’ deposit costs are independent of their asset portfolio choices and their supply of funds can be assumed to increase with expected profits per dollar of lending, the supply of external bank loans to a developing country is also a backward-bending function of the lending rate. The type of equilibrium that will prevail in the international bank loan market then depends on the position of the demand schedule, as in Figures 1 and Figure 2.

Figure 2.
Figure 2.

Equilibrium in the External Bank Loan Market With Credit Rationing

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

In Figure 1, the demand schedule for the stock of credit intersects the backward-bending supply schedule below the optimal lending rate (r**—the lending rate at which the banks’ expected profits are maximized) at which supply begins to contract, so the market clears at r*.

In Figure 2, the demand schedule intersects the supply schedule for loans above the banks’ optimal interest rate at which there is excess demand for loans. The market will not move to r*, since at that rate the borrower would get less credit than LS at the higher interest rate r*, and the banks’ expected profit would be less than its optimum rate.

This analysis of the external bank loan market has involved a single country facing a large number of bank lenders. Given many borrowers, the bank lenders face for each a backward-bending relation between the lending rate and their expected profit per dollar of claims. Increases in lending rates to a particular country lead to an adverse selection of projects, from among all potential domestic projects, and thus to a decline in the banks’ expected profit from lending more to that country once interest rates have been raised above the level that maximizes expected profits.

In Figure 3, β1(r), β2(r), and β3(r) represent the relations between the interest rate charged and the expected profit to the lender per dollar of loans made for countries 1, 2, and 3, respectively. If the cost of funds to the banks is d2, then country 3 will be rationed out of the international bank loan market because the maximum expected return from loans to this country is less than the banks’ cost of funds. Country 1 will get all the loans it desires at interest rate r4, and country 2 will get some loans, but not necessarily all it demands at r2.14 For example, country 1 might represent some low-income borrower unable to obtain private bank loans when the cost of funds for bank lenders is d2; country 2 might represent a middle-income developing country that is able to get some but not all the bank credit it desires; and country 3 might represent a newly industrialized borrower.

Figure 3.
Figure 3.

Equilibrium in the External Bank Loan Market With Many Risk Classes of Borrowers

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

This adverse selection model of the international bank loan market explains the observed narrowness of the variations in the lending rates on loans to different developing countries. The elimination of loans that occur as lending rates rise makes lenders prefer to limit their supply of credit to some countries, rather than to raise the lending rate whenever the demand for credit exceeds its supply. In addition, if bank lenders believe that the mean return of development finance does not differ much from one country to another (assuming that differences in mean returns will be fully incorporated in lending rates), most of the variation in lending rates will originate with differences in the expected profit-interest rate relation for particular countries.

The analysis of the pricing and allocation of credit in the international bank loan market also serves to isolate lenders’ expected profit-interest rate relation as the main analytical determinant of the type of equilibrium that emerges—whether market-clearing or rationing. Institutional and financial innovations affect the international bank loan market through this relation. In particular, the financial innovations and institutional developments that reduced some of the difficulties in monitoring and enforcing loan terms during the 1970s also shifted the expected profit-interest rate relation and the supply of credit schedule rightward (Figure 4).

Figure 4.
Figure 4.

Increase in the Supply of External Bank Loans to Developing Country Borrowers

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

In Figure 4, the supply curve shifts from L1S to L2S and then to L3S, and the amount of excess demand for external credit is reduced from X1 to X2 and to zero. The lending rate declines from r1 to r3. If the demand schedule LD shifts upward in addition to shifting rightward, then interest may not decline. Figure 4 might be taken as a stylized representation of the international bank loan markets up to 1981. It was possible to increase credit without interest rates rising because the supply curve—the expected profit-interest rate relation—shifted right after institutional and financial innovations. After the end of 1981, innovations can be presumed to have slowed and may have been somewhat reversed, though the good experience with rescheduling over the past two years may have prevented a substantial leftward shift of the supply curve for credit.

III. Implications of Pricing for Allocating Credit

It has been argued that the institutional innovations in the international credit markets during the late 1960s implied a consolidation of individual loans to a developing country and a reduction in the risk of this single liability through the replacement of default with the rescheduling of debt. Hence, the lending rate reflects the lenders’ expected cost of rescheduling the total bank debt of a borrowing country rather than the risk of default on individual loans. The problem that arises with such risk-invariant pricing is that bank lending rates do not fully and immediately reflect the risk of a loan; thus, they understate the true cost of credit.

A developing country borrower that cannot service its external bank debt will seek to avoid default by negotiating a rescheduling and implementing a stabilization policy. Since the aim of stabilization policies is to enable the borrower to resume debt-service payments, and since the proximate cause of the interruption in payments is generally an excess of domestic demand over supply, stabilization policies usually involve a reduction in private and public consumption and real prices and wages. Such an adjustment involves costs which arise from the necessary changes in production techniques, and in consumption, investment, and employment. International financial organizations, such as the Fund, provide “bridging finance” on certain conditions to assist countries in minimizing such costs. Thus, while a rescheduling-cum-stabilization program may involve short-term losses for the lenders, and such losses are anticipated in the spread above LIBOR, it also involves costs for the borrower. If the likelihood of a debt rescheduling—and the implementation of a stabilization program—is assumed to rise with the stock of external debt a country issues, then the borrower’s expected cost of rescheduling accompanied by a stabilization program also increases as its external debt rises. The full economic cost to the borrower of a given stock of external debt thus consists of the market interest rate plus the expected cost of the stabilization program accompanying a debt rescheduling.

In Figure 5, these costs have been added to the market supply curve S0, which becomes S1, that is, the full average cost of credit to a developing country. (This analysis of the cost of credit is valid only for developing country borrowers that are not quantity constrained in the international bank loan market.) The positive slope of S1 reflects the assumption that the borrower’s cost of a debt rescheduling plus stabilization program increases with increases in the stock of external debt; the borrower is a quasi-monopsonist in the bank loan market. (Since the borrower’s demand for external debt does not increase the interest rate paid by other borrowers, but only its own interest cost, it has been termed a quasi-monopsonist.) The curve S2 is marginal to the curve S1; it indicates the marginal cost of an increase in bank loans. Since the schedule of the demand for external debt is the marginal revenue product of capital, the welfare-optimizing borrower would endeavor to equate the marginal cost of borrowing, as given by S2, with the marginal benefits or D. Under these assumptions, the optimal stock of debt would be L2; the developing country would be charged a spread of r4r0 and its marginal economic cost of debt would be r2.15

Figure 5.
Figure 5.

Determination of the Optimal Stock of External Debt

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

If there are many public or private borrowers in a developing country, as there are in many of the large developing country borrowers, the individual borrowing agent must be expected to act in his own best private interest. In so doing, he does not recognize, nor should he be expected to recognize, that a rise in his individual bank debt increases the likelihood that his country’s total debt may become unserviceable. The private borrower recognizes only the private cost, given by the market interest rate, of acquiring more debt, and does not recognize the total economic cost that arises from its negative externality. Thus, a developing country with many borrowers will issue L0 of external debt and thus exceed its optimal stock of debt by L2L0 of debt. The optimal level of debt can be attained in this case by the imposition of a tax (of r2r4) on capital inflows from the international banking market. This tax, r2r4, plays the same role as the optimal tariff on commodity imports, but presumably implies less danger of retaliation by the supplier, which can negate the effects of an optimal tariff on commodity imports. Thus, a country with many public and private sector borrowers that does not tax foreign bank loans may acquire “too large” a stock of external bank debt. Similarly, a country with only a single public borrower that chooses to ignore the social cost of more debt and that takes the market rates as its marginal cost of capital will also acquire “too much” debt.

However, while the overborrowing results in an inefficient allocation of capital in Figure 5, improvements in policy, contract monitoring, and enforcement, may well shift the bank lenders’ expected profit-interest rate relation rightward, and thus increase the supply of loans at each interest rate, thereby increasing the optimal stock of external debt.16

IV. Conclusion

This paper has argued that the international payments imbalances caused by the oil price increases in the early 1970s led to financial and institutional innovations in the international credit markets that substantially affected the supply, demand, and pricing of credit for development purposes. The recent increase in debt rescheduling may be, at least partially, a result of these innovations. Before the 1970s, the main obstacle to the private funding of development had been monitoring and enforcing contracts and the assignment of property rights in the case of non-performing debtors, which were problems of moral hazard, since the circumstances could be changed by the borrower after the contract had been signed. In the 1920s, a limited amount of private finance for development had flowed through the international bond market, where default was common and lending rates tended to reflect this. There was little further private financing of development until the early 1970s, when higher oil prices greatly increased the supply of loanable funds and the need to finance oil imports or monetize newly valued resources led to a higher demand for credit by developing countries.

Institutional developments in the 1970s fostered the perception of an increased tendency of national financial authorities to assume the risk of the deposit liabilities of their major banks. International banking markets were thus able to attract a greatly increased supply of funds. This institutional development was accompanied by financial innovations designed to overcome the moral hazard problems in the development of credit markets. In particular, the risks of individual loans to different borrowers in one developing country were linked through public guarantees and cross-default clauses, while at the same time the lending side of the market was also concentrated through the syndication of loans. Both innovations made it more difficult for borrowers in developing countries with loans in default to obtain further access to international bank credit markets. In turn, this meant that with increasing economic and financial integration, the cost of default had risen. In addition, national and international lending agencies were increasingly willing and able to assist countries with payments difficulties by financing stabilization programs. For these reasons, default was replaced by the rescheduling of loans associated with adjustment. The ability of the international banking market to deny access to countries with debt-service difficulties acted as an incentive that was analogous to the traditional risk premium.

In the current institutional environment, international bank loans are priced to reflect these new institutional features. The relatively low spreads above cost that are charged to borrowers reflect the lower expected loss incurred by bank lenders in rescheduling debt. The relatively small variations in spreads charged to individual borrowers within a country reflect the consolidation of risk achieved through public guarantees and cross-default clauses. The rationing of loan credit to some borrowers can be explained by the need to avoid an adverse selection among potential loans, given the asymmetric information that arises from the banks’ inability to distinguish accurately among the different risks of individual loans to borrowers in a particular country. Public guarantees and cross-default clauses have equalized the lending rates for loans of differing risk in a country, and a higher lending rate tends to result in a higher average loan risk, owing to the phenomenon of adverse selection.

The individual borrower’s liability is limited by his equity, while his returns are not subject to a predetermined limit; hence, a higher risk increases the borrower’s expected return. Thus, higher lending rates require higher risks if expected returns are to be positive. However, since the lenders’ profits are limited by the contractual interest rates, an increase in the average risk of all loans made to a developing country reduces the lender’s expected profit per dollar lent. Thus, an increase in the lending rate has two offsetting effects. The increase in the price of the loan raises expected profits, while the higher average risk reduces them. Hence, the schedule for the supply of credit to a developing country is a backward-bending function of the lending rate, and for each country there is a lending rate and loan amount that maximizes lenders’ expected profits. A country willing to offer a higher lending rate for more credit will be rationed. Lending rates are therefore less variable than they would be if they fully reflected the risk of individual loans. In these circumstances, some countries will be able to satisfy fully their demand for credit, others will not satisfy it fully, while others will be unable to obtain any credit at all.

The failure of the supply of credit to reflect its full cost has been the main consequence of replacing default with rescheduling plus a stabilization program—and of pricing credit so as to represent the expected loss in a rescheduling. At each level of debt, the expected cost incurred by a borrower of a rescheduling and a stabilization program must be added to the market cost of debt. If borrowers take the supply curve to reflect the true cost of credit, they overborrow external funds.

This analysis of the history of development finance over the past decade is based upon the institutional and financial evolution of the international bank loan market. It indicates that the ability to overcome the traditional shortcoming of lending for development represents a fundamental change in development finance. It is an example of how an unexpected disturbance to an established order, in this case large international payments imbalances, can generate institutional innovations with far-reaching consequences.

APPENDIX

This Appendix demonstrates that an “adverse self selection” among borrowers in a developing country, or among the projects or policies it undertakes, may cause the credit supply schedule it faces to be a negative function of lending rates. An equilibrium in which credit is rationed will ensue when the demand for credit exceeds its supply at the lending rate where the supply of credit begins to contract with further rate increases. An equilibrium may result where some countries obtain all credit desired, others obtain only some, while others are altogether excluded.

Assume that foreign lenders are able to recognize differences in the expected potential returns on loans, and that they can sort borrowers into broad risk classes, but that they cannot distinguish the different degree of riskiness of loans within the same class. In principle, a risk class may contain all borrowers in several countries, all borrowers from one country, or only a subset of borrowers from one country; to simplify the exposition, assume that all borrowers from one country are in the same risk class.

An external loan to a borrower in a particular class is L, the gross return on this loan is R, and the distribution of gross returns and its density is F(r, ξ) and f(R, ξ), respectively. The variable ξ is the risk associated with this particular loan; the larger is ξ, the larger is the risk. The measure of increasing risk employed here is that of a mean-preserving spread (Rothschild and Stiglitz (1971)). In particular, let F and G be the two distributions of returns to two different loans. Then G is more risky than F if G can be derived from F by adding an uncorrelated random term. Equivalently, G is more risky than F if G can be derived from F by taking probability mass from the center of the distribution and adding it to the tails, so as to keep the mean constant (Figure 6).17 The advantage of this method of defining risk is that it allows unambiguous comparative-static conclusions about the effects of an increase in lending risk on the banks’ expected profits, and it permits an analysis of the relation between the borrower’s expected benefit from a loan and changes in its risk.18

Figure 6.
Figure 6.

Increasing Risk

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

0tF2(R2,ξ2)dR20tF1(R1,ξ1)dR1 for allt,

and

0R2f2(R2,ξ2)dR2=0R1f1(R1,ξ1)dR1,

where the first condition says that the density of returns on L1 has more weight in the tails, while the second condition implies equality of expected value of returns on L1 and L2.

The individual borrower maximizes his expected returns from the loan. Let R denote the gross return to the borrower of using a bank loan of size L, and let r denote the interest rate charged by the banking market. The net benefit to the borrower of using a loan of size L with return R is given by:

U(R,r)={R(1+r)L whenR>(1+r)L,0 whenR(1+r)L.(1)

Assuming that the lender has first claim on the returns, the borrower will be in default on this loan if:

RL(1+r).(2)

Figure 7 shows that the borrower’s net benefits from the loan are a convex function of gross returns. Hence, any change to a more risky policy or project (an increase in ξ), results in an increase in expected net benefits to the borrower.19 Only policies or projects with risk greater than some risk level ξ* will be undertaken, where ξ* is the risk at which the borrower’s expected net benefits from a loan are zero:

Figure 7.
Figure 7.

Net Returns to Borrowers

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

E[U(R,r)]=0U(R,r)dF(R,ξ*)=0.(3)

An increase in the rate of interest charged by the bank reduces the expected net benefit of loans to the borrower and hence requires an increase in the cutoff level of risk ξ* necessary for loans to have a positive expected net return. To establish this rigorously, differentiate equation (3):

dE[U(R,r)]dr=LzdF(R,ξ*)0 wherez=(1+r)L,

since

dE[U(R,r)]dξ*>0we getdξ*dr>0.

This conclusion establishes the possibility that the interest rate itself can be used by the lender to screen borrowers: the risk of any given amount of lending to a particular risk class will increase with a rise in the interest rate charged, because some of the less risky projects or policies are no longer profitable at the higher interest rate. An increase in the interest rate produces an adverse selection among potential borrowers; that is, the bank’s composition of borrowers becomes more risky.

The concentration of risk within a country, which arises from explicit or implicit public guarantees for private borrowing and cross-default clauses, implies that the total external bank debt of a country is the variable of interest to the bank lenders. Let ΣR be the total return on external bank loans. When total returns fall below (1 + rL then the country will be induced to undertake a stabilization program in order to obtain a rescheduling of its debt. Assume that debt rescheduling is such that the bank lenders’ loss increases proportionately to the shortfall in total return, so the bank’s net return (see Figure 8) is given by:

Figure 8.
Figure 8.

Returns to Bank Lenders

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

ρ(ΣR,r)={(1+r)ΣL whenΣR>(1+r)ΣL,ΣR whenΣR(1+r)ΣL.

The international banking market is taken to be competitive in the sense that there are many noncollusive bank lenders and borrowers. The banks are price-takers in the deposit markets, while they set their lending rates so as to maximize expected profits. Since the national monetary authorities have assumed most of the risk of banks’ deposit liabilities, the banks’ choice of assets does not influence their cost of deposits. The interest rate on deposits is determined by the assumption that banks do not earn excess profit from external lending.

Thus, an increase in the interest rate charged on loans to a particular risk class has two effects on the banks’ expected profits. First, there is the usual direct effect resulting in an increase in expected profits when the composition (and hence the risk) of the borrowers is held constant. Second, an increase in the interest charged by bank lenders has an indirect negative effect on the banks’ expected profits, owing to its adverse selection effect on borrowers. The higher the interest rate, the more likely it is that the latter will dominate the former.

Since the supply of external loans by banks can be assumed to rise with increases in expected profits, the relation between the interest rate charged and the expected profits becomes a relation between the interest rate charged and the supply of loans by the banks. Thus LS in Figure 9 represents the backward-bending relation between the supply of loans and the interest rate charged by international bank lenders for loan financing policies and projects in a particular risk class.

Figure 9.
Figure 9.

Equilibrium in the External Bank Loan Market With a Single Risk Class of Borrower

Citation: IMF Staff Papers 1985, 002; 10.5089/9781451946932.024.A005

The demand curve for bank financing of development policies and projects is assumed to be downward sloping, as discussed earlier. Hence, it is easily seen (Figure 9) that when the aggregate demand curve for loans, LD in this particular risk class intersects the backward-bending aggregate supply of loans, Ls curve, there will exist an excess demand for loans equal to X. Any increase in the interest rate r beyond r** will reduce the banks’ expected profit. Thus, there is no incentive mechanism to clear the external loan market if there exists excess demand for loans at the interest rate r**, and some potential borrowers will be rationed. On the other hand, if the aggregate demand for loans intersects the aggregate supply below r**, the loan market will clear. An increase in the supply of loanable funds to the banking sector will leave the interest rate-expected profit relation unchanged, and will cause the supply curve in Figure 9 to shift rightward. From this figure it is apparent that such an increase in the supply of loans will first reduce X, the size of the rationed portion of the market, and only then reduce the rates charged to borrowers.

Assume now that the bank can sort potential international borrowers into risk. classes, such that borrowers are known to differ across risk classes, but appear identical within each risk class.20 For each risk class there exists a backward-bending relation between the interest rate charged and expected profits from loans to this risk class. Figure 3 in the text shows the interest rate-expected profit (per dollar lent) relation for three different risk classes, β1(r), β2(r), and β3(r). From this figure, it is clear that if the bank’s cost of deposits exceeds d3 then no borrower in risk class β3(r) will obtain loans from this bank. This is so despite their possible willingness to pay interest charges above the cost of deposits to the bank. For example, if the cost of deposits to the bank is d2, then no borrower in risk class β3(r) will obtain loans, while some, but not necessarily all, borrowers in risk class β2(r) will be able to borrow at interest rate r2, and all borrowers in risk class β1(r) can borrow at interest rate r4. Competition among banks assures that the interest rates charged are such as to equate the expected profits per dollar lent to the various risk classes. Furthermore, profit-maximizing behavior of the individual banks implies that loan credit is available to risk class β1(r) only if risk classes (β2(r) and β3(r) are not rationed.

The shape of the interest rate-expected profits relation for a particular risk class of borrowing countries will be determined by the risk and the distribution of risk among the borrowers in a risk class. For example, if there are only two risk classes, one safe and one risky, then the expected profits will decline steeply once the interest rate is such as to drive the safe borrowers out of the loan market. The position of the interest rate-expected profits relation is determined by the expected return on the total of loans to this particular risk class. Banks will always demand to be compensated for any expected shortfall in loan repayment by raising the contractual interest rate charged. While the lender has no information about the differences in risk among borrowers in a particular risk class, he has knowledge of the interest rate-expected profits relation which permits him to make the kind of lending and interest rate decisions described above.

The argument developed above demonstrates that if international bank lenders have sufficient information about their borrowers and their loans to sort these into risk classes, but not enough information to discriminate among borrowers in the same risk class, then:

(i) an entire risk class of borrowers may be denied access to the international bank loan market;

(ii) there may be one risk class containing both borrowers that obtain bank financing and others that do not;

(iii) all other borrowers will obtain loans at rates reflecting their risk class; and

(iv) banks will not accept offers from the rationed borrowers to pay higher interest charges on loans.

SUMMARIES

A Monetary Analysis of a Small Open Economy with a Keynesian Structure— peter montiel (pages 179–210)

It has been argued by some observers that the monetary approach to the balance of payments was tested and found wanting in several prominent stabilization programs undertaken during the late 1970s. The short-run failure of domestic prices and interest rates to converge to those prevailing abroad, and short-run deviations of output from capacity, are viewed as disproving the basic tenets of the monetary approach.

The monetary approach, however, is based on a balance-sheet identity that does not itself yield testable hypotheses. Predictions capable of being disproved can be derived only from a structural model used in conjunction with this approach. Recent experience may cause one to question the usefulness of one class of such models—the “global monetarist” versions of the monetary approach to the balance of payments—for short-run policy analysis. These models rely on continuous purchasing power parity and uncovered interest parity as well as instantaneously flexible nominal wages. This paper analyzes the behavior of a small open economy in an alternative Keynesian framework that is characterized by short-run nominal wage rigidity and in which prices in a nontraded-goods sector are set by way of a mark up equation. This Keynesian variant is capable of generating short-run deviations of output from capacity as well as fluctuations in real exchange rates and real interest rate differentials. Nevertheless, it remains firmly embedded in the monetary approach. If this model represents an accurate description of an economy’s short-run behavior, then framing a stabilization program under “global monetarist” assumptions may well confront policymakers with undesirable consequences for the domestic economy while leaving them short of their balance of payments target.

Exchange Rate Systems and Adjustment in Planned Economies—thomas a. wolf (pages 211–47)

The U.S.S.R., the German Democratic Republic, Poland (in the 1970s), and Hungary represent within the Council for Mutual Economic Assistance (CMEA) a spectrum of the extent to which decisions on foreign trade have been decentralized and the exchange rate has taken on a direct role in determining prices. To the extent that these developments have occurred, the exchange rate has in principle a broader role to play in both economic stabilization and structural adjustment. The paper analyzes this role in the four planned economies.

The authorities of the U.S.S.R. are increasingly relying on more economically meaningful exchange rates, along with other criteria, to plan foreign trade. Exchange rates may have a function in determining prices in some sectors, but not as yet a general function in this regard. As long as foreign trade organizations and industrial enterprises have severely limited autonomy, the use of exchange rates as a planning device will be confined to the highest levels of the planning hierarchy.

Large industrial combines in the German Democratic Republic have somewhat more interest in, and autonomy over, foreign trade than do their industrial counterparts in the U.S.S.R. The exchange rate influences the domestic price of some imports in the German Democratic Republic, and it may also have a limited influence on resource allocation, at the level of the industrial combine, for exports. The function of signalling prices, and therefore the potential use of the exchange rate in structural adjustment, may eventually be enhanced in that economy.

The Polish exchange rate system and policy of exchange rates during the 1970s are instructive. Initially, an economically meaningful though overvalued exchange rate was established, and foreign trade was partially decentralized. Continuing and growing price distortions, however, together with growing excess demand pressures, led to a renewed increase in governmental intervention in foreign trade. This highlights some of the dangers involved in a partially liberalized foreign trade system responding to distorted financial parameters. The Polish experience raises the question whether these distortions may have added to the structural and macroeconomic problems that evolved during the 1970s.

Experimentation with determining domestic prices according to exchange rates and with liberalizing foreign trade has been most striking in Hungary. The potential significance of the exchange rate as a transmitter of signals from the world market and as an instrument of economic stabilization is much enhanced in the present Hungarian context. Past experience raises some doubt about the actual economic impact of exchange rate changes in Hungary, but as yet there has been insufficient theoretical and empirical analysis of the effects of the exchange rate in this economy to establish firm conclusions.

The Choice of Exchange Rate Regime in Developing Countries: A Survey of the Literature—peter wickham (pages 248–88)

In the aftermath of the breakdown of the Bretton Woods system, considerable attention has been paid to the problems faced by developing countries in choosing their exchange rate regimes. In the first instance, the question addressed is whether it is possible or desirable for a developing country to let its currency float independently, with the value of its currency being largely determined by market forces. Among the structural characteristics cited as making independent floating infeasible for most developing countries is the underdeveloped state of their foreign exchange and financial markets. In addition to the requirement of a well-developed financial structure, the “openness” of the economy in its structure of trade and output has also been suggested as a factor making independent floating infeasible for a developing country.

The focus of the paper then shifts from the issue of floating and feasibility to the question of whether some degree of exchange rate flexibility is necessary or desirable for developing countries. This question is discussed with reference to the use of rules or indicators for managing the exchange rate.

The subject of exchange rate management, including flexibility in pegged rates, leads to a review of the considerations that are relevant in determining how a developing country should choose a peg when the currencies of the major industrial countries are floating against one another. The different costs associated with exchange rate volatility and fluctuations are examined, as well as the extent to which the choice of peg can be used to reduce these costs and to maintain an appropriate level of the exchange rate. The paper concludes with an examination of empirical work on the choice of exchange rate arrangements and with suggestions on the areas where further research is warranted.

Food Subsidies: A Multiple Price Model—robert r. schneider (pages 289–316)

In many countries, food subsidies are the most politically and emotionally charged of all government expenditures. To some observers, the fundamental measure of a successful government is its commitment to, and effectiveness in, providing its population with adequate nutrition. To others, food subsidies are a token treatment masking serious structural economic illnesses, ranging from chronic unemployment resulting from the failure of economic policy to hopelessly skewed access to economic opportunity. Whatever the short-run economic, political, or moral justification for food subsidies, however, experience has shown that the long-run consequences are often different from the short-run objectives.

These consequences relate to unforeseen effects on the domestic agricultural sector, the budget, and the balance of payments, as well as distributional effects that are often both disappointing and poorly understood. The paper develops a simple, calculable, partial equilibrium model that explicitly incorporates the often neglected linkages among food subsidies, food imports, domestic producer receipts, local production, and the budget. In addition, the model deals explicitly with the issue of the relative effect of policy changes on different income classes in society. Using the values for relevant supply and demand elasticities typically found in the literature, the model is used to evaluate alternative subsidy policies. These policies vary according to the coverage provided by subsidies to different income classes and the extent to which domestic producer prices are protected from the price-depressing effect of subsidy policy.

One of the most important points demonstrated by this exercise is the extent to which a policy of untargeted subsidized imports is paid for by the agricultural sector rather than by the budget. If subsidized prices are to be maintained, this loss in incentives to the domestic agricultural sector inevitably forces the authorities to raise food imports in the long run to a level much higher than originally anticipated. In addition, increased food imports combine with the government’s commitment to a fixed domestic price of food to create a serious problem of budgetary exposure to vacillations in the price of food imports. These problems can be avoided only if domestic producers can be insulated from the effect of the food subsidy program. This, in turn, requires that the subsidy be confined to the lowest income classes of the society.

The Changing Role of International Bank Lending in Development Finance—david folkerts-landau (pages 317–63)

During the past fifteen years, the international bank-loan market has replaced the international bond and direct investment markets as the major source of private development capital. In addition, rescheduling external debt, normally in the context of a comprehensive stabilization program, has generally taken the place of default by developing country borrowers. This paper examines how innovations in financial institutions over the past decade have facilitated these developments.

During the 1970s, institutional developments in the domestic banking systems of the industrial countries lowered the risk on deposit liabilities of the money-center banks. As a result, these banks gained a competitive advantage over the international bond and direct investment markets in intermediating the flow of loanable funds from surplus to deficit countries. Simultaneously, financial innovations