Debt and the Banks: Are the LDCs in Over Their Heads?

Since 1974 - when the oil crisis hit and the world recession began - a number of developing countries that do not export oil (non-oil LDCs) have been borrowing heavily in the international credit markets. Surprisingly, private banks, not international agencies like the International Monetary Fund (IMF) and the World Bank, have underwritten most of this massive debt buildup, as the table on page 734 shows. And this shift from traditional to non-traditional sources of financing, along with the sheer magnitude of the borrowing, has led to criticism of private banks for their handling of the situation.

Banks, it is said, have overextended themselves in lending to LDCs. They have made bad loan decisions and are now being forced to absorb still more LDC debt in the hope of salvaging earlier credits. Major U.S. and European banks will therefore experience large losses on LDC loans, which would lead to a general financial crisis. To forestall that danger, official agencies should intervene to help reschedule loans. Henceforth, private bank lending abroad should be subject to closer official supervision and, in many cases, public lending should supplant private lending.

These criticisms and proposals raise two basic questions. The first is whether banks have acted prudently in lending to developing countries, evaluating risks reasonably and taking steps to protect shareholders and depositors from loss. The second question is what caused the explosive rise in demand for foreign loans by LDCs during the last three years. If the causes are persistent and LDCs continue to incur debt as rapidly as in the last three years, many of them may eventually have trouble servicing their debts. But if the causes are temporary, borrowing by LDCs will decline from present levels and most LDCs should be able to meet their obligations without difficulty.

This essay sketches the broad outlines of the debate on these issues and gives our reasons for believing that the extraordinary surge of demand by LDCs for foreign loans is a temporary phenomenon and that private banks have behaved rationally and prudently in responding to it.

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