The Outlook for Latin American Debt

The debt containment strategy designed in 1982 has run its course. In May Citicorp, the largest international bank lender both worldwide and in Latin America, announced the creation of an additional reserve of $3 billion—equivalent to almost one quarter of its loans to troubled developing country debtors, the bulk of them in Latin America. Other major banks promptly followed its example. These actions confirmed the end of the containment strategy, or at least its first stage. Thus far, no new scheme has taken its place. The question now is not only whether the big debtors in Latin America will pay, but also where the money will come from.

No long-term solution to the debt question is possible without a mixture of economic reform in the debtor countries and additional fresh capital, both of which are needed to revive economic growth. Both were important in the original debt strategy, but neither was forthcoming in sufficient amounts, despite considerable differences among debtor countries.

The coming year is likely to be one of major decisions as several debtor countries face fundamental choices. Brazil, which suspended interest payments on the bulk of its external debt in February, has to decide how to resume service. Mexico has to decide on the shape of basic national policies once a successor to President Miguel de la Madrid is announced in the fall of 1987. Argentina has to decide whether it should further intensify its effort at economic reform after two years of slow economic growth associated with the struggle against inflation and a growing budget deficit.

A scenario of a gradual economic "Albanianization" or autarky is conceivable if more highly indebted countries pursue unilateral defaults as have a few of the smaller debtors in Latin America and elsewhere. Following this path means that their economies would gradually become disconnected from the international financial system; credit would be difficult if not impossible to obtain, and foreign trade would be reduced to bare essentials. While the largest debtors—including Brazil, Mexico, Argentina, Venezuela and the Philippines—are quite unlikely to take this step, the creditors’ financial systems are put under increasing strain with each default, manageable perhaps, but very costly in terms of eventual write-offs of loans and ensuing higher domestic credit costs.

Leadership in the industrialized world is now essential to convince governments and legislatures to support viable new plans and innovative financing mechanisms. Otherwise an opportunity will be lost and the damage to world trade, employment and international finance could be large and lasting.

II

The basic objective of the containment strategy begun in 1982 was for the major debtor countries, notably the larger economies of Latin America plus the Philippines, to continue interest payments on their external debts. In the absence of major capital inflows, the means was to build up large trade surpluses. These surpluses were achieved by tough austerity measures, including those recommended by the International Monetary Fund (IMF), which led to domestic economic recession for the debtors. The average decline in real personal incomes in Latin America exceeded ten percent over the last five years. However, there was no follow-up to the initial success of the containment operation; no new sources of capital flows were developed, export earnings of the debtors stagnated despite significant increases in volume, and sustained growth has not been rekindled.

The weakness of commodity prices, in the wake of a slow-growing world economy, is a key reason the debt problem lingers on. Of the major Latin countries only Colombia has avoided the debt crisis. Although the volume of exports from Latin America has gone up by about one quarter since the early 1980s, their value is lower. Today Latin America owes about $400 billion abroad, against exports last year of about $80 billion and perhaps $90 billion in 1987; before the crisis broke in 1982, Latin America owed $325 billion against average exports in 1981-82 of $94 billion. The relative debt burden has thus not declined, as a number of observers and officials had hoped in 1982. Only the sharp decline in international interest rates until 1986 has made the debt service manageable. As the upturn in interest rates in the first half of 1987 has once again made clear, however, the debtors remain highly vulnerable to these increases, since virtually the whole of their debt to commercial banks—three-quarters of the total—is at floating interest rates.

"Involuntary" or forced lending by the banks, lending carried out in order to finance part of the debtors’ interest payments, was an important element of the original strategy. This lending declined sharply after 1984, however, as market obstacles increased. In most European countries, for example, each dollar of new lending to troubled debtors requires a mandatory reserve against possible future loan losses of part or the whole amount lent—a prescription that obviously constrains lending. In the United States bank stockholders have reacted negatively to significant lending exposure to Latin America. Smaller banks and even some larger ones have therefore done what they could to sell off their loans, if they could do so without too much of a loss. The volume of such sales has been relatively small—perhaps $8 billion worldwide in 1986 out of total international commercial bank exposure in Latin America of about $300 billion (including trade finance), of which about one-third belongs to U.S. banks. This trend to sell loans is accelerating in 1987, and the result is increasing discounts on the loans.

In sum, up to 1987 the commercial bank lenders gained time by making some "involuntary" loans to the debtors to avoid the danger of default, but also by gradually building up reserves against doubtful loans. They also increased their capital from other sources and in general strengthened their balance sheets against another rainy day. That day came on February 20, 1987, when Brazil, the largest debtor among the developing countries, announced it would not pay interest, for an indeterminate period, on the approximately $70 billion medium-term debt that it owed to international commercial banks, including $8 billion owed to Brazilian banks. (Short-term debt was excluded.)

The reaction of the banks was, predictably, one of concern. The 15 largest U.S. banks placed the loans on a nonaccrual basis, so that the income from interest cannot be counted unless actually received. Most major banks registered some first-quarter weakness in net income. Even though a special effort was made to establish a dialogue with Brazil, the collapse of Brazilian foreign exchange reserves made any rapid resolution difficult. Brazil may resume partial interest payments before the end of 1987, but full payment is unlikely for at least a year or two, until its reserves are rebuilt and the domestic economy is stabilized. Brazil is likely to use the resumption of interest payments as a strong bargaining weapon to negotiate easier terms for its bank debt.

Concern over the poor results of the debt strategy was already clearly visible in April 1987 at the regular semiannual meeting of the International Monetary Fund’s Interim Committee, a kind of ministerial super-board. U.S. Treasury Secretary James A. Baker called on the commercial banks to develop a "menu of alternative new money options."

In retrospect, the fact that some lending continued, even though on a declining scale, was the real financial news. In the spring of 1987, after lengthy negotiations, commercial banks agreed to two large new loan packages—$6 billion to Mexico and $1.9 billion to Argentina, plus contingent credits in case outside economic conditions deteriorate. But the large reserve increases by all major commercial banks in the United States and several in Britain and Canada, coming on top of previous gradual increases, in effect puts a damper on further large general-purpose commercial bank loans to sustain the balance of payments of the debtors.

After Citicorp announced its $3 billion one-time increase in reserves against loans to troubled developing country borrowers on May 19, Chase Manhattan followed with $1.6 billion, BankAmerica and Chemical with $1.1 billion, and Manufacturers Hanover with $1.7 billion. These large increases in reserves, which led to record losses that will in time be partially offset by a lower future tax liability, signaled the banks’ decision to take losses in earnings now rather than at a possible future date when actual write-offs of loans might be necessary. Many observers saw the actions as an overdue acknowledgement that the service on the loans is unlikely to be paid in full.

These actions may well improve the banks’ negotiating strength with the debtors—Citicorp’s stock price rose the day after its announcement—but they do not change the basic ingredients of the debt question. The banks’ actions do, however, clarify a number of changes that were already under way. The most important one is the greatly increased reluctance on the part of the banks to provide general-purpose balance-of-payments loans to troubled debtors.

From the point of view of the debtors, life is no easier. The banks’ action does not change their obligation. Lenders may be more willing to consider interest concessions, but not necessarily. For the debtors, the increasing difficulties in obtaining new loans from commercial banks may well revive the temptation to default on interest payments, especially if fresh capital cannot be obtained from other sources. It is too early to judge whether large syndicated loans such as the recent ones for Mexico and Argentina can still be put together, but it is clear that an increasing number of banks with small and medium exposures will not want to participate.

Several results are likely to emerge, with implications both for the debtors and the creditor banks. First, each bank will increasingly look individually at its options, which will make it difficult to hold together the large syndicates of banks of the past. The administration of debt will thus become more complex. Banks will henceforth look to the so-called menu of new options, perhaps including a limited amount of new lending by the largest banks, but also conversions of debt to equity, notes or securities, and so-called exit bonds for lenders that do not want to provide new money. A debt-equity conversion entails sale of a bank’s loan at a discount; the proceeds are converted into the debtors’ currency, usually by the buyer of the loan—such as a multinational corporation—and invested in that country at something approaching the original value of the loan, with the difference made up by the local central bank. The "menu" offers increased flexibility but does not go to the heart of the problem of providing fresh capital.

Second, credit decisions are likely to become even more concentrated in the larger banks, which in any case already hold the bulk of the debt. Therefore, the large banks will be in a position to be firmer in their negotiating positions, both because of their increased reserves and because of the reduced number of players. The reserves may make it possible for U.S. banks to look into new formulas such as partial capitalizations of interest, which would have been too costly for them to contemplate before they created the additional reserves.

The banks’ action could thus lead to more complex negotiations, but with the possibility—as yet untested—of greater flexibility. In my view, most of the options on the "menu" that may be available to banks are likely to result in less fresh money from them than in recent years, when it was already difficult to obtain. It is quite unlikely that the larger banks would be willing to shoulder the additional burden caused by the refusal of smaller lenders to participate.

Creating substantial reserves strengthens the banks’ financial position, but the banks still need to shore up their own finances further. The reserve levels now reached, including the reserves gradually created in the past, are in the range of 25 to 30 percent of the total loans to most of the major debtors, and are comparable to those achieved over several years by most European banks. The publicity given to the one-time action of major U.S. banks, however, is leading many of the smaller U.S. banks to sell their loan positions. As more banks seek to sell their loans, the supply of loans in the secondary market is increasing, but the demand is not. This means the average prices of the loans have fallen in recent months, and banks are forced to take a greater loss when they sell. For example, a typical portfolio of loans to the governments and public sector agencies of the four largest Latin American debtors—Brazil, Mexico, Argentina and Venezuela—had an approximate market value in mid-July 1987 of 58 cents on the dollar, admittedly in a rather thin market, compared to 66 cents in February. Brazil’s partial suspension of interest payments was the trigger that eventually led to the decline in value.

Another key issue for the banks is whether public recognition of problem loans helps their ability to raise capital for themselves in the most economical way, namely through equity. Most banks need to strengthen the quality of their capital. The creation of reserves has shifted capital out of bank shareholders’ equity and put it into reserves. While undoubtedly a prudent move, the resulting decline in common equity now has to be made up in the case of most large banks, especially since the reserves built up in recent months would decline if loans are written off, which occurs if they are sold at a discount. Selling additional bank stock is undoubtedly a challenge; only a few of the largest banks, including Citicorp, have succeeded in recent years. Greater regulatory flexibility may therefore be needed in the definition of what constitutes useful capital in order for the banks to strengthen their capital in the next couple of years.

In the end, of course, what matters is the quality of the banks’ assets. To the extent that the quality of the loans to troubled debtors in Latin America improves, the banks’ position improves. But to improve the quality of these loans, what is needed is a more buoyant international economy, further progress toward economic reform within the debtor countries and, especially important at present, new sources of funds.

III

Unfortunately, among the governments of creditor banks, there appears to be little sense of urgency. The June economic summit of Western and Japanese leaders in Venice brought no new or clear-cut ideas on the subject. Yet the Baker Plan of October 1985 clearly needs to be refurbished; its success was dependent on renewed economic growth, which has not occurred. It also called for $29 billion in lending over three years, $20 billion from commercial banks and $9 billion from multinational financial institutions. These levels have not been met, and the banks’ recent action makes clear that they will not meet these targets any time soon.

The international environment for the recovery of the major developing country debtors, most of them in Latin America, is uncertain. The growth of the world economy in 1983-86, spurred by an unusual combination of forces—namely a Keynesian fiscal stimulus in the United States, financed to a substantial degree by foreign sources—was already running out of steam by the end of 1985. The imbalance between relatively fast U.S. and Japanese growth and virtual recession in Europe was evening out, mostly because of a gradual cyclical downturn in the United States. The most rapidly growing major economy in Europe, that of Spain, has grown at about three percent annually in 1985-86; most European economies are suffering from unusually high, persistent levels of unemployment. The likely prospect is for only modest growth in world trade and continuation of generally high unemployment worldwide.

Such an international setting means that there is little reason to expect a sustained commodity boom for quite some time. Commodity-producing developing countries (including Latin American countries except Brazil, a major industrial exporter) rely on commodities for about 80 percent of their exports. The decade of the 1980s could turn out to be that of the slowest economic growth since the 1930s (see Table I). The combination of sluggish growth worldwide, lagging purchasing power of commodity exports and the high burden of servicing the interest on external debt spells a sobering and perhaps bleak outlook for commodity exporters in general, and for the highly indebted among the developing countries in particular.

The depression in most of Latin America not only bodes ill for the political prospects of the new democracies in the area, but it has also cost the traditional suppliers of Latin America, especially the United States. For example, the United States exported about $42 billion to Latin America in 1981, mostly machinery and farm products. In 1984-86, these sales fell to about $30 billion annually. Even moderate growth in Latin America, instead of depression, might have pushed those sales to perhaps $50 billion today, making a measurable contribution to reducing the U.S. trade deficit and helping some of the distressed areas in the Midwest.

The restructuring of inefficient industries, needed in the advanced industrial economies as well as in the state sectors of many developing countries to improve global economic prospects, is difficult for everyone. The prospects for shifting successfully into new ventures are made even worse by the fact that in the late twentieth century the natural tendency for maturing industrial products to behave increasingly as commodities has accelerated. The easy entry of new competitors—because of increasing access to technology and the large role of developing country governments in industry and mining—has created oversupply in products such as petrochemicals, copper and steel, without effective incentives to correct the imbalance. Everyone loses: the old industries which can no longer compete because of older equipment and high labor costs, and many new industries because of the high cost of amortizing expensive new plants and servicing the debt.

TABLE I

COMPARISON OF ECONOMIC GROWTH AND EXPORTS

(average annual percentage changes)

1950-59 1960-69 1970-79 1980-86

GNP Growth:

O.E.C.D. 6.0 5.1 3.2 2.2

Developing countries 6.0 5.6 4.9 2.7

Latin America 5.9 6.4 6.2 1.8

Terms of Trade of

Developing Countries:

Oil Exporters -0.5 1.5 4.0 -0.1

Oil Importers 5.0 0.5 -2.0 -1.6

Merchandise Export Growth:

(in real terms)

O.E.C.D. 10.3 8.5 5.8 3.6

Developing countries 7.5 7.0 5.0 0.2

Latin America 5.6 3.1 3.5 1.8

Interest as percentage of

annual merchandise exports:

(estimated)

Latin America 5 8 18 40

SOURCE: Derived by author from World Bank, World Development Report, various issues; International Monetary Fund, World Economic Outlook, various issues; plus author’s estimates.

The free trade system is now threatened. It flourished after World War II partly because of bad memories of the 1930s. A key underpinning of free trade was that there were very few important participants in international trade in the two decades after the war. In the last 15 years several new and increasingly important players have emerged. While it is true that the recent decline of the U.S. dollar will, after a lag, reduce protectionist pressures in the United States, the underlying protectionist trend has long-term causes which are not easy to uproot.

In sum, the relatively upbeat and comfortable setting of the world economy has changed. This outlook need not spell doom for economies that have shown flexibility and adaptability, such as those of East Asia, but it is disturbing for countries and industries that are already in trouble.

IV

A new strategy is needed for the debt problem. It includes: (1) economic reforms in debtor countries, (2) a new inflow of capital, and (3), if the first two are inadequate, viable formulas for partial and temporary interest deferral.

Two immediate issues loom on the horizon. First, letting the debtors rely on large trade surpluses and low capital inflows is unlikely to work. Trade surpluses are impermanent; either they will erode as domestic growth and demand for imports resume, or exports could decline if there is a weakening in the world economy. Second, the debtors remain highly vulnerable to increases in international dollar interest rates, as occurred on a massive scale in 1979-82 and to a lesser extent in 1984. Rates looked like they might be rising again in the spring of 1987. A rise in dollar interest rates, induced by the collapse of orderly exchange rates among key currencies, might by itself precipitate the default of both Mexico and Brazil.

Even with the lower interest rates prevailing in 1986, debtor countries were not able to rekindle significant economic growth (except for Brazil, where a price control-induced spending boom stimulated a short-lived growth spurt). Domestic product statistics, often quoted as evidence of some renewed growth, omit the negative effects of declining terms of trade on incomes. It is incomes that matter: their lack of dynamism is reflected in the stagnation of investment, which is the harbinger of growth prospects.

The lesson is clear: substantial capital inflows are needed. If there are no inflows, the international banking system will be dragged into unilateral or possibly negotiated interest relief.

As part of the debt strategy, it is imperative that the debtors put their own houses in order. The problems of domestic economic restructuring in developing economies, however, are at least as complex as those facing older industries in Europe and the United States. These problems are even more difficult in poor countries which lack the resources to absorb change. In addition, while there is a significant private sector in virtually all the economies of Latin America, the Spanish colonial tradition of special concessions and monopolies for particular enterprises, as well as other protected economic privileges, dies hard. There is thus a big difference between what is apparently private business and truly effective entrepreneurship.

The debt crisis has made it clear that the past emphasis in Latin America on state enterprises was excessive. The public in the debtor countries correctly perceives that much of the excess external borrowing was due to the profligacy of state-run companies. In many Latin American countries, "privatization" has become a topic for lively debate. But actual progress in this direction has been slow, except in Mexico, where there has been a reprivatization of the industrial assets of the commercial banks taken over by the state in September 1982, and the subsequent sale of minority interests to the public in the state-owned commercial banks in February 1987.

Privatization is not easy. Moreover, enthusiasts sometimes forget that many developing countries lack the most elementary services, and therefore the governments must assume some responsibility for providing them. If privatization is presented as a panacea, it could become just another fad, such as land reform in the early 1960s or regional economic integration a few years later.

The careful opening-up of economies is another obvious high priority. It would foster entrepreneurship, efficiency and a greater long-term ability to compete with imports and to expand exports on a realistic competitive basis. It would also attract foreign investment and stimulate the reflow of flight capital. This is not disputed, and a number of countries, notably Chile, Colombia and Mexico, have in recent years moved in this direction. The important point is that a more open trading system cannot be pursued unless there is a well-established and consistent policy of realistic exchange rates. The long-term success of Brazil from the mid-1960s onward in expanding its industrial exports almost as rapidly as the East Asian countries is testimony to the benefits of a realistic exchange-rate policy over a long period. Without such a policy, liberalization of trade merely stimulates a speculative import binge. Such an event would imperil the already feeble debt-servicing capacity of the most highly indebted countries.

Reform is difficult in any setting, and in the Latin America of today there are many obstacles. The new democracies are naturally cautious about radical economic changes, especially if they are likely to cause higher unemployment in the short term, even though there would be longer-term gains. Just as there are political pressures against free trade in the United States, so there are in developing countries. In the latter, private sector leadership is often opposed to freer trade and is cozy with state enterprises, which are major buyers of their products and services. Trade unions, which cover the uppermost tier of the labor force, are naturally also the defenders of established patterns of economic behavior.

Nevertheless, there are strong forces for change: a younger generation of managers and entrepreneurs, strong national leaders who believe in change, the example of the outside world—always a powerful force in Latin America—and an increasingly young labor force (although high unemployment could well turn the latter into a volatile political element). The outlook for the region as a whole is uncertain, but there is likely to be significant progress in several countries, notably Mexico, Argentina and in time Brazil.

Liberalization and privatization of economies are urgent priorities for the debtors. The task has to be undertaken in full awareness of the considerable historical, political and economic obstacles. To the extent that their balance-of-payments constraints can be eased, at least partially, the chances of their new economic policies succeeding are greater. But the case for interest relief and for greater capital inflows cannot be made unless the governments of the debtor countries at the same time put their own houses in order. There is a growing consensus in many of these countries on the need to do so.

V

For most Latin American countries the burden of paying interest on their external debt is the major economic issue. There are several reasons for this: the shortage of external capital flows, which has made it necessary to maintain large trade surpluses and to keep imports and thus economic growth down; the lack of growth itself, combined with persistently high inflation in several major economies; the unfavorable outlook for traditional exports as well as the increasing threat of protectionism to more recent manufactured exports; and the very large fiscal burden of servicing the debt, which puts pressure on governments to raise taxes, most of which are indirect and thus inflationary in their initial application.

The interest due to commercial banks by Latin American debtors in 1982-85, virtually all at variable rates, averaged slightly under $30 billion per year, of which about one-tenth was for trade-related credit. That sum was equivalent to about 30 percent of merchandise export earnings, and to it must be added another $10 billion or so for fixed-rate obligations to bondholders and official creditors. Altogether there has been a net outflow of about $20 billion annually, as interest payments regularly exceeded the inflow from loans and investments. Aside from the internal pressures which could erode trade surpluses, there are international developments which might make it necessary for some debtors to delay interest payments: for instance, a slowdown in the world economy and a further drop in international commodity prices (which looks unlikely at present), an increase in international interest rates (a real possibility after the spring 1987 run-up) and increasing protectionism.

It is therefore important to have in place before the next crisis the main points of an acceptable scheme to face the demand for deferral of part of the interest burden. Deferral is not forgiveness, which would encourage profligacy. A relief scheme would not necessarily have to be put into effect, but its outline would at least have to be ready. It was difficult enough for hundreds of banks to defer principal repayments by debtors in 1982-86; it would be far more difficult and complicated to face the sudden deferral of interest—as is happening now in Brazil—even if many banks are in a stronger capital position in 1986 or 1987 to face the ensuing losses.

Under normal accounting and banking regulatory practices, the nonpayment of interest after a time entails, first, charges against the bank’s income (because of the need to create reserves against possible losses) and eventually, if nonpayment continues, writing off loans. Any formula which defers interest partially must therefore as a first step be sufficiently credible economically to be acceptable to the bank regulators. Otherwise it cannot be considered by the lenders. The focal point for thinking about any future arrangements thus has to be within the key three or four central banks in the financial capitals of the world, as well as a few of the very largest international commercial banks. There also needs to be an informal group among debtor nations. Unfortunately, so far there are no clear signs that such a process has begun.

Many types of deferral schemes have been proposed. None has managed the feat of combining in one package three key requirements: political viability in the creditor countries, financial viability for the major bank lenders, and real cash-flow relief for the debtors. The first requires that the need for deferral be generally accepted; regrettably, a crisis may be necessary to bring about this recognition. The second requirement is particularly difficult for the very largest bank lenders, especially in the United States, because a very large proportion of their income still comes from interest on past loans to the troubled debtors.

As for the third requirement, a major deferral in interest payments might be possible if it were selective enough that not all debtors would want to participate. Otherwise, countries that have been cautious and managed to avoid payment problems, such as Colombia, would be penalized for their past careful behavior. For the present, debtors seeking relief would have to agree to an IMF stabilization program and to economic reforms supported by lending from the multilateral development banks. Of course, debtors do not have to accept these conditions, but then creditors do not have to give temporary relief either. Thus, there must be some generally accepted standards of assistance that give lenders confidence in the future of borrowers. Otherwise there would be a legitimate fear that interest relief would be used to finance an expansion of public spending.

A plan to defer interest payments would work only if it were monitored by a widely trusted international agency and subject to reasonably objective standards of application. In this way deferral could be granted to those needing it, thus meeting the fear of creditors that all debtors would demand the same privileges. Those needing relief are the countries with a big debt service—both because of the size of the debt itself and because of depressed commodity export markets—and which are taking measures to put their financial houses in order. The way in which the Oil Facility within the International Monetary Fund worked in the mid-1970s provides a useful precedent.

To illustrate: countries wishing to participate would have to show that interest on their external debt would absorb, for example, at least 30 percent of their current foreign exchange earnings for a period of at least one year. They would have to demonstrate that existing and foreseeable foreign exchange reserves would be inadequate to cover minimum payments of, say, four months of imports and interest payments. It is not necessary for an IMF "Interest Facility" to lend to countries, as has been proposed in the past, because that would simply expand short- and medium-term debt. Rather the facility’s role should be to provide credibility to a deferral or capitalization program, so that banks and bank regulatory agencies can have confidence that deferred interest would not simply fund fiscal profligacy. Plenty of examples exist in the market, such as the adjustable-rate mortgage system in the United States, under which some $300 billion of mortgage loans are outstanding.

Several more advanced interest relief schemes have been suggested. One variety would have an international public authority, under the aegis of the World Bank, offer to buy back debt at a discount and pass on the benefits to the debtors. The obligations would decline and so would the interest payments. For this scheme to function, very substantial guarantees would be required from creditworthy industrial countries, given the likely fluctuation in the underlying debt service from the borrowing countries. Such guarantees would far exceed the contingent capital which the industrial countries have provided over 40 years to the multilateral development banks. As a more economical and practical alternative, George Moore, the former chairman of Citibank, has suggested a facility run by the IMF, which would borrow with the guarantee of the developing country debts themselves, suitably discounted. This scheme would probably require the banks to sell debts at very substantial discounts, at least initially, a step most large banks are understandably reluctant to take.

Such repurchase schemes have a substantial cost, which someone has to bear. In addition, they tend to reward debtors whose debt sells at the biggest discount and to penalize those whose economic performance maintains their debt at high values. Their implementation, an unlikely eventuality, would lead to a significant erosion of international financial discipline.

VI

No single scheme will "solve" the debt problem; there is no alternative, however, to some mix of reform of debtor economies and fresh capital. Unfortunately, the clock is ticking and progress on new action has been limited. Among the debtors the siren song of default is gaining new supporters. There is the example of Peru, which practically ceased debt service in 1985 and in 1986. After several years of depression Peru enjoyed strong economic growth in 1986, and this has encouraged admirers, who do not realize the one-shot nature of the growth spurt, which was encouraged by large salary increases made possible by the temporary buildup of foreign exchange reserves once most debt service was suspended.

Making the interest burden bearable is not enough; there must be more funds for development. If all the elements of the program—a stronger international economy, restructuring of domestic economies and more capital inflows, plus a contingent policy on the interest burden—can come together, then there is a chance of improving an otherwise gloomy trend for debtors. Additional capital may be the hardest element to obtain.

The largest reservoir of funds that is in theory available to the debtor countries is the capital which left these countries during the period of high external borrowing. Much of the money borrowed from commercial banks fled because overvalued exchange rates, themselves made possible by the borrowing, made such flight attractive. The $80 to $100 billion or so which fled Latin America after 1974 is the single largest resource which could help the balance of payments of the region. But the money will not begin to return until there is a period of consistent and realistic economic policies accompanied by visible economic growth.

The repatriation of capital is a necessity; without it, foreign direct investment will be slow to revive from the low levels it has reached. The reason is simple: foreign corporations are understandably reluctant to put money into countries from which their local partners are withdrawing. In net terms, foreign direct investment into Latin America fell to almost nothing in 1986, and inflows in many cases resulted in bargain-hunting purchases rather than additions to productive capacity.

Special insurance arrangements, such as the Multilateral Investment Guarantee Agency approved two years ago by the World Bank, can help speed up the process of changing debt into equity; however, results will not be visible for some years, and they will not be forthcoming unless the overall economic outlook improves. Therefore foreign investment is likely to be a follower rather than a leader in recovery.

One idea that has gained many supporters among banks and Western governments is to exchange part of the debt for equity in enterprises and projects in the debtor countries. The basic concept is sound. The fixed burden of interest would be replaced by the more variable and usually lower outflow of dividends derived from production and profits; this would encourage private investment and the privatization of government enterprises.

In its actual application, however, the debt-equity swap idea has to be treated with care. It does not mean that new funds come into the debtor countries; it is only a substitution of one form of obligation by another. If Japanese investors were to shift their holdings of U.S. Treasury debt into U.S. real estate, as they are doing to some extent at present, the debtor position of the United States vis-à-vis Japan would not change, only the nature of the obligation would be altered: the same is true in the case of Latin America and the Philippines vis-à-vis their creditors. Admittedly, dividend outflows are likely to be less than interest payments, at least initially, but investors fully expect to be able to repatriate their equity and profits.

In order to encourage banks to sell off their debt at a loss and trade it for equity, the debtor countries (such as Chile and Mexico, the most active swappers so far, for a total of about $3.5 billion by mid-1987) have had to make up the loss by giving the investors the equivalent in local currency of full nominal value (or close to it) of the debt. This can lead to excessive domestic money expansion, the assignment of domestic credit for the single purpose of prepaying debt, higher domestic interest rates, and thus the choking-off of domestic investment. Properly managed, debt-equity swapping is one among several ways to make the debt burden more manageable. But it is no panacea.

How much can be realized in debt-equity swaps? At the outside limit, as much as was invested in Latin America from abroad in the boom years of the late 1970s, which at today’s prices means perhaps $8 billion annually. But those were days of burgeoning investment opportunities due to rising incomes. The first task is therefore to provide the setting for economic growth.

Given the current limited outlook, and the fact that commercial banks are unlikely to provide new large general-purpose lending, real capital inflows must thus come initially from public sources. Such a statement no doubt will generate strong ideological reactions in an age of deregulation and privatization; yet, as the case of U.S. aid to Central America demonstrates, creditor governments are likely to put up large amounts of public funds if they perceive an emergency.

The one source of capital flows with so far unrealized potential is multilateral development banks. They must begin to play a significantly larger role than in the past. Does this mean using U.S. and other taxpayers’ money? Not necessarily. First, the multilateral development banks have relatively large cash reserves, particularly in the case of the World Bank, which could support larger disbursements in the short run, as has been the case in 1987. In the last three years, the World Bank and the Inter-American Development Bank have increased their disbursements somewhat, but the overall sum remains relatively modest, a combined total of about $4 billion net of amortization in Latin America in the 1986-87 fiscal year, after falling in the previous year.

Second, the multilateral banks need capital increases to expand their long-term lending for development. But the capital they need to continue expanding their borrowing from private markets can be supplied almost entirely in the form of non-cash guarantees by their shareholding governments. In its 40 years of existence, the World Bank has never had to rely on the guarantees, or "callable capital," supplied by its shareholders and, like the Inter-American Development Bank and the Asian Development Bank, it has never had a significant default. Such callable capital, specifically the portion from highly creditworthy countries such as Japan, the West European countries, Canada and the United States is what gives the multilateral development banks their financial clout, enabling them to borrow funds in the capital markets of the world at the lowest possible costs without the governments of the industrialized countries having to put up more than symbolic amounts of taxpayers’ dollars.

Last, the institutions have the experience and knowledge necessary to play an effective role. Since the Baker initiative of October 1985—which predicated a mix of reform plus official and commercial bank lending—the psychological responsibility for developing some sort of a plan for new capital inflows has been laid squarely at the door of the World Bank. While much useful institutional innovation has taken place, the World Bank responded slowly in 1986 to Baker’s expectations. Part of the problem concerned the discussion over the next increase in callable capital. Without some assurance from the United States, the World Bank has been reluctant to draw down its considerable cash reserves as it gears up lending. In addition, the bank has yet to define what role it can take in a new attack on the debt problem.

The next step in developing a new debt strategy is therefore to build up the capital (and hence the lending) of the multilateral development banks, which has in fact stagnated in recent years. This involves going to parliaments and congresses, always a thorny and politically difficult process. An equally difficult requirement will be improving the multilateral institutions’ operational capacity; streamlining them so they can more effectively foster the economic reforms that debtor countries have to make if the original causes of the debt problem (especially bloated public sectors and state enterprises and the ensuing inflated fiscal deficits) are to be rooted out.

Barber Conable, an experienced former U.S. congressman, who became head of the World Bank in 1986, is now completing a major internal reorganization of the institution. Another reorganization is likely at the Inter-American Development Bank, where the United States, the largest provider of its capital, has felt that greater emphasis should be placed on economic reform within borrowing countries.

Much of the debate about the roles of the World Bank and the Inter-American Development Bank has focused on the need for general-purpose sector loans, as opposed to specific project loans of the type that both institutions have traditionally made. Sector loans, which have existed in various guises for quite a few years, are used to encourage broad policy reforms. There is no doubt that such loans are indeed needed; however, policy problems that have been around for years will not disappear because of one or even two large loans. A long-term persistent effort should therefore be envisaged.

One idea that has been frequently mooted in the United States is for Japan, today the largest capital exporter, to put some of its money into the debtors. While it is likely that Japan will take a special interest in the Philippines, both directly and through the Asian Development Bank, it is unlikely that it would take the leadership in an area such as Latin America, which is not a major trading partner, unless the United States takes the initiative first. If that were to happen, Japan would probably act in part through international institutions; for this to become a practical possibility, Japan would have to be given a larger voice in the capital of these organizations and greater representation in their staffs, both difficult but not unattainable aims. The special loan collection company which Japanese banks organized in early 1987 for some of their Latin American loans was primarily the result of domestic tax considerations and does not so far represent a major international contribution to alleviating the debt problem.

My estimate is that the Latin American countries would need approximately $20 billion per year in the next few years in net capital inflows in order to permit moderate growth. Foreign investment, which declined to almost nothing in 1986, can be expected to recover to perhaps $4 to $6 billion annually with some help from debt-to-equity swaps. The key will be the repatriation of flight capital, which totaled about $3 billion in the case of Mexico in the last year. That represents a real inflow, as does lending from official multilateral institutions, which in net terms could reach $6 to $7 billion per year, if there were a major effort within those institutions and, internationally, at a political level. The multilateral development banks are thus crucial.

Official export credit agencies such as the U.S. Export-Import Bank, the Japan Export-Import Bank and similar agencies in Europe are another important source which has been dormant since 1982. An enhanced role on their part could help commercial banks provide some of the balance, with some form of parallel or joint financing with official institutions. The overall outcome will be quite difficult to achieve, but it is plausible, as long as the political will is there on both the side of the debtors and especially that of the governments of the creditors.

VII

How can the three parts of this new approach—economic reforms, interest policy and new capital inflows—be put together? Unfortunately, there are several complicating factors. First, retrenchment will be the top priority of money-center banks for some time. Bank stock prices are at relatively depressed levels, preventing banks from adding to their capital in the most economical way—through the equity market.

Second, the banks have been the subject of conflicting signals from their regulators, especially in the United States. On the one hand, the Federal Reserve has been telling them to expand lending at concessional terms to those troubled countries that try to get their affairs in order. On the other, the Federal Reserve itself, as well as the Congress, the Securities and Exchange Commission, and the Comptroller of the Currency have imposed disclosure and tighter capital requirements which make it very difficult for banks to ease troubled customers back to health, domestically or abroad. Additional regulatory demands are likely, including calls to expand bank capital. Capital is to a large degree a matter of providing financial confidence, and ways exist to make the expansion of capital more flexible.

Third, the industrialized countries face serious tasks at home. In Europe, stagnation and sick industries and in the United States, the political difficulties of reducing the budget deficit naturally receive priority attention. The debt crisis appears to be a more distant issue, even though it has undercut a major U.S. export market.

It is thus difficult for policymakers in the major creditor countries to focus on preventive action. The Baker initiative fortunately broke this pattern. But it has faced serious difficulties: neither the economic growth nor the credit flows have materialized to the extent envisioned. The clear support of industrialized country governments for an expanded initiative is essential. The major debtors, especially Brazil and Mexico, could play a key role in tilting the balance in the direction of an internationally accepted set of initiatives. It is important to get clear agreement among the principal creditors and debtors—perhaps eight to ten key participants altogether—on a few basic working assumptions, without which the design of further action would not be possible. A large conference could not achieve the consensus of a small group. Among the basic precepts on which agreement is needed are:

—The problems of the heavily indebted countries, most of which are very dependent on commodity exports, are long-term and cannot be alleviated only through financial stabilization programs accompanied by modest lending from abroad.

—Most of the debtor governments have made major efforts to adjust to the new austerity, but external financial support for these efforts has been inadequate. The continuation of financial discipline and the beginning of fundamental economic reform require more external support in the next few years, especially from international public sources.

—This support can be obtained with minimum funds from taxpayers by substantially expanding the disbursement, lending and, in time, the callable capital of the multilateral development banks.

—To the extent that capital inflows can be effectively stimulated, the need for large-scale interest relief will be less; but it is still desirable at least to plan some interest relief, in case major debtors cannot pay interest. Existing market mechanisms provide examples which might be helpful.

Agreement on these working assumptions will not by itself restore the high-debt countries to economic health—a plan has to be fleshed out in detail—but it would provide a ray of hope to alleviate the increasing strains of 1986 and 1987. Certainly, after the Baker initiative of October 1985, there is no turning back. The only question is how to turn general proposals into concrete action and with all deliberate speed.