Can Putin Survive?
The Lessons of the Soviet Collapse
The music has stopped. In August, Mexico, the largest single recipient of Eurocurrency bank credits in recent years, announced that it could not for the time being meet its scheduled repayments of principal on the external debt of the public sector. Service on the Mexican private sector and banking system debt is sporadic or interrupted because of the shortage of foreign exchange. Argentina has in effect been unable to meet its scheduled debt service since the time of the South Atlantic conflict. And, since mid-1982, international bank lending to Latin American countries has all but ground to a halt. As a result, Brazil may find it very difficult to meet its scheduled debt service, since, like the other countries in the area, it needs a constant inflow of funds to pay off old debt.
The problem for such countries is in a sense as if the U.S. Treasury suddenly found itself unable to borrow. And, at the same time, most countries of the area, both large and small, with a few notable exceptions, face extremely difficult economic problems. These stem in most cases from the combined effects of the international recession and domestic fiscal deficits, which in turn originate in part from overly optimistic projections two years ago of what would happen to the international economy. Since the Latin American economies have been the largest borrowers in the Eurocurrency market, from a wide array of international banks, their balance of payment and debt problems are not just regional questions, but raise issues of great international economic significance.
In the last ten years, the growth of the Euromarket-consisting in large measure of dollars outside of the U.S. monetary system-has been one of the major developments of the international economic scene. World inflation and the need to "recycle" OPEC surpluses have greatly stimulated international lending, mostly from the Euromarket. Lending to developing countries, particularly the resource-rich and economically more advanced ones, absorbed roughly half of this lending-and in turn two-thirds of that went to Latin American and Caribbean countries, so that about one-third of all Euromarket bank lending has been to Latin American countries. Brazil and Mexico have by themselves accounted for close to one-quarter of all the internationally syndicated Euroloans made in the last ten years.
As of mid-1982, according to my estimates described later, Latin American and Caribbean countries owed international commercial banks at least US$200 billion in medium-term loans and short-term borrowing to finance trade and the maintenance of foreign exchange reserves. At the interest rates prevailing in the first half of 1982, the annual interest due on this sum alone-without counting principal or the service on the remaining US$95 billion or so of debt owed to governments, international institutions and others-was in the range of US$30 billion. This sum should be set against export earnings in 1982 of about US$110 billion: it is then easy to see that the region as a whole has a serious financing problem. Some Asian countries have a similar problem, but it is less widespread since few of those countries have been able to borrow commercially and their fiscal management has in general been more conservative.
In Latin America, the size of the debt has meant that the adverse impact of the run-up in international interest rates in 1981-82 has been particularly painful, especially when combined with the drop of close to one-third in the purchasing power of commodity exports in the same period. This scissors effect-higher interest payments and lower export earnings-has been the major cause of the recent problems. It is clear that governments cannot adjust to this new environment without both extremely tough and unpopular economic measures-already being taken in some countries-on the one hand, and a more favorable international environment and continued capital inflows on the other. Even with all these favorable developments and measures, the task will be very difficult. Without all of these elements, several countries in the region could become the scene of social upheavals and political instability which would threaten hemispheric security, and will extend far beyond the region.
The escalation of the problems which the large international banks have had to face in the last two years, both at home and abroad, has spawned a sometimes alarmist debate on the solidity of the international banking system. Unlike the 1930s, however, in recent years the central banks of the major financial centers have made clear that they will step in with special support to avoid catastrophes. Still, the events in Mexico and Argentina, and jitters among the lenders themselves about Brazil, have now put the banks somewhat in the position of a mountain climber on the icy slope of a sharp peak. Having-perhaps rashly-undertaken the adventure, the climber, instead of continuing upward, looks down at the abyss and starts to wobble, increasing his chances of falling.
In any event, the present sharp cutback in lending to major developing countries, if sustained, will-not "could"-hasten the day when those countries are no longer able to meet their scheduled debt service obligations. The adjustment required to a situation of negative capital inflows, in which erstwhile borrowers would have to become exporters of capital, is simply too large and too sudden for most countries to absorb. Mechanisms have to be found, which we review at the end of this article, to avoid these serious problems, which would greatly hamper not only the borrowers but also the creditors.
But, before we address these critical action issues, we need a more detailed analysis of the crisis. How did it reach its present pitch-with such apparent suddenness-and what is its scale and nature? Why did borrowers and lenders interact as they did, and what were their shares of responsibility, as well as those of the governments of the major industrialized countries in which the lending banks are located? Is the crisis simply a short-term debt service problem, stemming from readily reversible policies, or does it have deeper roots in the basic situation of the major Latin American countries at this stage of their development? Does the crisis endanger individual exposed banks (or even the banking structure as a whole), and how are they reacting and likely to react to meet it?
Each of these questions has already been under intense discussion, in stated or unstated form, among the participants in these events; they are of equal concern to those who now have to understand the crisis and who may be asked, in political terms, to support efforts at controlling and eventually resolving it.
There is an obvious risk of overgeneralizing about "Latin America." It is clear, however, that the majority of countries in the region have had better access to external commercial borrowing than those in other areas, that their external debts have in most cases grown much faster than their export earnings, and that the double impact of high interest rates and declining export prices has therefore been particularly burdensome in Latin America. According to data estimated by the Morgan Guaranty Trust Company,1 several Latin American countries in 1982 will have to make interest payments on their external total debt equivalent to 30 percent or more of their exports of goods and services: Ecuador (30 percent), Mexico (37 percent), Chile (40 percent), Argentina (44 percent), and Brazil (45 percent), in ascending order. No developing countries in other regions, even among those facing balance of payments problems-such as Korea, the Philippines and Yugoslavia-have had ratios approaching these.
A key ingredient in the buildup of external debt in the last two years has been short-term debt. The large difference between the outstanding, external public medium- and long-term total debt of Latin American countries, as reported by the World Bank for the end of 1980 (US$159 billion), and the above estimate of about US$290 billion for mid-1982, is of course partly explained by the passage of time and the fact that the latter figure includes the external debt of the private sector, which is particularly important in the case of Brazil and Mexico (a total of at least US$50 billion). The main difference, however, is short-term debt, the precise amount of which is not publicly available.
Short-term debt by itself need not be a matter of concern, since it is normally tied to trade. For example, the production and processing of a crop for export is often financed through external bank loans which are automatically repaid some months later as the product is exported and payment is received. The security for the loan is the crop itself. The same happens in reverse on import transactions. These "self-liquidating" debts, which represent advances against future sales, are the essence of commercial lending and are normal as long as the proportion of future earnings or payments devoted to repaying the advance financing does not rise to the point of being excessive.
Unfortunately, it appears that this point may have been reached in the last year in a number of Latin American borrowing countries. I estimate very roughly that the amount of trade credit outstanding at any one point should be no more than one quarter-year (or 90 days) of exports and imports, after deducting the capital goods which are financed in part with medium- and long-term loans. On this basis, the "normal" outstanding short-term debt of Latin American countries should be in the range of US$30 billion to $40 billion. It is probably twice that amount.
The excess has largely been built up in the last two years as a result of the gradual tightening of terms, in the Euromarket, for developing country borrowers, especially Latin American ones. Countries were able to get both lower interest margins and larger sums from the lenders by "temporarily" borrowing for short terms, of one year or less. This phenomenon explains why, even though the amount of new syndicated loans announced in each of the years 1979-81 for Latin American borrowers stayed almost constant at around an average of US$27 billion to $28 billion of commitments annually, the outstanding debt to banks of the major borrowers from the region was actually expanding at an average annual rate of more than 30 percent, well above the growth rate of their exports. The one exception was Brazil, where the growth of outstanding debt to the banks was held down to about 17 percent each year.
It is this buildup of short-term debt, well above the amounts normally associated with trade, that explains the apparent suddenness with which the problems of Argentina and Mexico have burst upon the international financial market. Both borrowers and lenders were in effect attempting to buy time, in the hope that interest rates would come down, and export earnings revive, in the wake of an often announced but, until now, not yet begun recovery of the business cycle in the United States and Western Europe. Unfortunately, the lenders apparently did not tally what each one was doing until, partly because of the delay in the expected improvement, and also because of the lagged availability of statistics, it became apparent that even more net short-term lending would be required. At that point, sometime in mid-1982, a major retraction of lending took place. It had in fact already begun at the time of the South Atlantic conflict, when the banks sharply held back new loan commitments to Latin America as a whole, irrespective of country.
Another important factor was the misperception, both among lenders and borrowers, of the likely lag between the expected international improvement and its effects on the finances of borrowing countries. For example, the interest rate decline which has occurred since August will not reduce interest payments until next spring, six months after the event, when the next interest payments come due. Commodity prices, if past experience is any guide, will initially strengthen somewhat as a result of the interest rate decline, but sustained improvement, especially for industrial raw materials and minerals, will only occur once the recovery is well underway and the investment climate turns around. Finally, the depth of the industrial recession in the United States and Europe was only realized in 1982: as the lenders began to grapple with major domestic credit problems and bankruptcies, the realization of the large impact of the recession and high interest rates on the rest of the world helped to stimulate a more conservative approach to lending.
It is not easy to put together consistent data on the external debt of developing countries, including debt of both the public and private sectors, and both short-term and longer-term debt. The estimates below, as of mid-1982, are therefore subject to a margin of error, but the broad numbers show that Latin America has a rather high indebtedness, especially when related to merchandise export earnings.
EXTERNAL DEBT: LATIN AMERICA VS. OTHER DEVELOPING COUNTRIES
(US$ BILLION EQUIVALENT)
Estimated total outstanding external debt, mid-
1982 2953 340
a. held by:
financial institutions 200 105
official agencies and
bondholders 95 235
b. of which:
short-term 75 60
medium and long-term 220 280
private sector (80) -
public sector (140) -
Merchandise Export Earnings 1981 113 290
Total GNP 1981 650 730
Debt as percentage of exports 261% 117%
of GNP 45% 47%
1 Including Cuba.
2 Excluding China, major high-income oil exporters (Kuwait, Libya, Saudi Arabia and the United Arab Emirates), Iran and Iraq. Includes other major oil exporters (Algeria, Indonesia and Nigeria), which in 1981 had exports of US$55 billion and a combined GNP of about US$200 billion, with an estimated external debt of about US$75 billion.
3 Of this total, about US$90 billion corresponds to Mexico, US$75 billion to Brazil, US$30 billion each to Argentina and Venezuela (in the latter case largely offset by international reserves), and US$15 billion to Chile, with the remaining US$55 billion among the remaining countries of the region, including the Caribbean. Note that these are rough estimates.
SOURCES: Author's estimates derived from the World Bank Annual Report 1982, and external positions of reporting banks according to the Bank for International Settlements. Data on short-term and private sector debt are the author's approximations from other sources and should be interpreted carefully.
It is of course true that the ability to service debt depends not only on current foreign exchange earnings-mainly merchandise exports-but also on the level of international reserves and on new capital inflows from loans and foreign investment. In short, it is the whole balance of payments that counts, though the ratio of debt service to export earnings does provide a good first approximation.
The burden of debt should also be compared to gross national product (GNP). On that score, the group of Latin American countries does better, a phenomenon which reflects the fact that income levels (an average of about US$1,800 per capita in 1981) are much higher than in the rest of the world (about US$460 in 1981, excluding China and the capital-exporting Arab oil exporters), which is heavily weighted by India. In other words, in very simplified terms, Latin America, compared to the rest of the developing world, is a high income area with a low proportion of export income in relation to its external indebtedness, features which in turn reflect rapid industrialization oriented to the relatively large domestic markets of the principal economies of the region, Argentina, Brazil, Mexico and, to a lesser extent, Venezuela.
Why did the principal actors behave as they did? Here the first point to note is that international commercial bank lending, particularly to the more advanced and large developing economies, has played a vital role in helping these countries adjust to the post-1973 environment.
Commercial bank lending out of the Eurocurrency market has accounted for roughly one-quarter to one-third of the net capital inflows into the non-OPEC developing countries in the period 1974-81. Without this "recycling," the middle and higher income countries that were the recipients of these loans would have had to face much lower growth rates: this applies both to oil importers such as Brazil and to countries such as Mexico which have become major oil exporters. If the capital inflow had not been obtained from the Euromarket, or from another source, about one percent a year would have been cut from the growth of GNP of the developing world, which averaged 5.5 percent over the last decade; given the population growth rate of 2.2 percent per year in the same period, this would have been a reduction of about one-third in the average growth of per capita income.
Second, while the first oil shock of 1973-74 affected the external accounts of both developed and developing oil-importing countries to a high degree, and the admittedly modest recovery in the industrial countries came relatively soon, the second shock of 1979-80 fell particularly heavily on the developing countries, and the recession in the industrial countries has been long and deep. At the same time, the oil-producing country of special concern today, Mexico, along with other oil producers, embarked on ambitious development programs, predicated on rising prices for oil. Both the oil exporters and the oil-importing developing countries thus found themselves in difficulty.
Because of concern about those problems and the impact of increasing debt amortization, net loan disbursements to the Latin-American countries tended to peak in the period 1979-81, at about US$20 billion annually. The total current account deficits of non-OPEC developing countries averaged about US$75 billion in the same period.
In general, as a larger debt amortization burden fell due, it became more difficult to make new loans in increasing amounts: in 1980, there was a sharp drop in new commitments to Brazil and Mexico, as most banks tried to cut back the growth of their exposure to these very large borrowers. In 1981, however, lending resumed on a larger scale, but much of the increase went to pay for debt amortization. In the first half of 1982, gross loan commitments to Mexico rose, largely as a result of short-term loans, to double the annual rate of syndicated loan commitments in 1981, which had been about US$8 billion. Then in July, as we have noted, lending there stopped dead, and slowed down to a trickle in the rest of Latin America, irrespective of country.
A third point to note is that the contribution of the Euromarket would probably not have been possible, or at least would have been much more difficult, without the special nature of that market. Bank lending in Eurodollars, mostly in the form of "syndicates" or pooled risk loans among many banks, has accounted for more than 90 percent of the direct flow from capital markets to developing countries in the last decade. All of this lending has been on a floating rate basis, with only the most creditworthy countries having access to the bond markets, which maintain much stricter creditworthiness standards.
Let me digress for a moment here to comment on the widespread lay view of the Eurocurrency market as a large pool of funds "sloshing around" outside the control of monetary authorities, and feeding exchange speculation. It is of course true that the Eurocurrency market is not formally regulated in the sense that monetary authorities do not influence the reserves which the banks have to keep, and do not set interest rates in the way that they do at home. However, the market, dominated by the U.S. dollar, is virtually an extension of the U.S. monetary system and tends to feel quite quickly the effects of U.S. monetary policy. Effective regulation of the Euromarket would probably help to create a new market, a sort of "Euromarket II," as funds sought to avoid interest rate and profit constraints. The real need is not so much for regulation as for readily available credit information-a point to which we shall return at the close.
In any case, the fact that the Euromarket is a wholesale one, without retail preoccupations, has kept costs down and made the funding of lending easier than in domestic markets, where the mix of funds and loans is far more complex. In the Euromarket, the problem of mismatched assets and liabilities, when banks obtain short-term funds from deposits and take the risk of lending them at longer term, has been substantially reduced: loans are, in fact, simply short-term obligations to lend, which are rolled over periodically-when the interbank deposits which fund the loan mature-at the cost of funds plus a margin at the time of the rollover. The fact that there is little risk of adverse interest rate movements or of mismatched maturities between deposits and loans, together with the wholesale, and therefore low overhead, cost of the operations, explains much of the dynamism of Euromarket lending in the last decade.
Finally, why did lending to the more prosperous developing countries expand so rapidly? Quite simply, because it was profitable in an expanding world economy. In general, the interest rate margins over the cost of funds paid by developing country governments were substantially higher than those paid by first class corporate borrowers-although there were periodic exceptions-and the amount of legal and financial work for a loan to a government or a government-guaranteed borrower was much less than for a corporation. As to the risk factor, it was the dominant view that, as a number of leading bankers said publicly, in the last analysis, countries could not go bankrupt, whereas corporations could and did. What these bankers meant, of course, was that countries did not disappear into the limbo of Chapter XI of the Bankruptcy Act, the way some corporations do-although past history shows that countries can indeed go broke.
Moreover, the relatively rapid adjustment of the world economy to the first oil shock encouraged optimism. The expansion of world trade, of which the more advanced developing countries were important beneficiaries, and the relatively high commodity prices of the second half of the 1970s (when the Club of Rome was predicting major raw material shortages) encouraged an upbeat attitude. The economic departments of major banks saw that borrowing countries were able to support a level of debt service much higher than would have been considered prudent in the past.
In fact, some major money-center banks discarded the idea of the ratio of debt service to export earnings, laboriously built up over the years by the World Bank, as a simplistic measurement of the ability of countries to pay: the indicator to look at was the level of reserves of the central bank-forgetting that most if not all of these reserves might themselves be the result of government external borrowing. The pseudo-science of "country risk analysis" flourished. Some of its practitioners, trumpeting their mathematical matrixes and models in the international money magazines, seemed to think that it was as feasible to predict the fortunes of a country as the number of victims of accidents for an insurance company.
Why is it that much of this optimism has turned out to be misplaced in the setting of the early 1980s? The key reason has undoubtedly been the depth of the recession in the industrialized countries, and its far-reaching effects on the rest of the world. The scissors effect of depressed commodity exports and high interest rates has already been mentioned. In the case of Brazil, for example, each increase of one percent in Eurodollar interest rates in 1981 led to a $500 million annual increase in external debt service, or the equivalent of a reduction in export earnings of about 2.2 percent. This meant that the increase in interest rates which occurred in 1980-81, on top of the deterioration in the terms of trade, was the same as if the purchasing power of exports had been cut by about 40 percent in a little over a year, a crushing burden to bear.
The governments of major industrialized countries, including the United States, did not forecast the duration and severity of the domestic recession. Very few foresaw its international impact, and fewer still are fully aware of its tremendous effect on the emerging industrial developing countries, which are in the middle of a delicate economic transition that still requires high levels of external capital.
It is also true that the governments of most of these emerging industrial powers did not foresee the depth of the recession either. In 1978, Mexico based its public spending plans on a permanently rising international oil price, which appeared to be a correct forecast until the end of 1980, but afterward turned out to be unrealistic. The Brazilian authorities, on the other hand, slammed on the brakes at the end of 1980; a major economic adjustment program was undertaken at that time but, given the unfavorable international setting, it was not possible to reduce external borrowing, only at most to hold back its growth.
To come at the question whether the crisis is a short-term one or much more basic, we need to look at a number of features of the development of the major Latin American economies which have helped to increase external indebtedness rapidly. Three in particular stand out: the sometimes excessive push to industrialize at relatively high cost; extensive, not to say bloated, public sectors; and often erratic exchange rate and interest rate policies.
To some extent, of course, the push to industrialize reflects the stage of development at which the larger Latin American economies find themselves, with relatively large internal markets in comparison with other developing countries, and a level of per capita income-especially among upper income groups-which creates a demand for high income goods found in the industrialized countries, such as cars and appliances. The industries associated with this type of consumption generally require large amounts of capital, and create a need for equipment imports and the loans to finance them.
The pattern of industrialization of the large Latin American economies has thus been different in emphasis from that of the Far East developing countries, which has been export-oriented-reflecting the relatively small size of their domestic markets-and has relied on relatively low wages. In Latin America, at least in the larger countries, export orientation, although growing in importance, has been a secondary consideration. New industries have no particular internal comparative advantage, since they rely largely on imported capital-intensive equipment and a relatively highly paid, elite industrial labor force; indeed they require protection from imports in order to survive.
These features of industrialization in the region, very broadly and perhaps unfairly generalized, have been accentuated by the importance of state enterprises. Functioning under the umbrella of implicit or formal government guarantees, and often lacking sufficient capital, state enterprises in industry and related productive activities have tended to finance a very high proportion of investment with borrowing, largely external.
In fairness, it should be said that politicians naturally use state enterprises to push through particular projects, often highly capital intensive and not necessarily efficient. State industry is a happy hunting ground for equipment salesmen, the cleverest of whom thrive under the cover of international tenders, which are sometimes maneuvered by underpaid public officials. Public service activities, such as grain importation and distribution, fuel distribution, and public utilities, are often used by governments as ways to subsidize the cost of living for volatile and underemployed urban masses.
The losses of government-controlled industrial and public service enterprises, fostered by these various problems, have been the major factor in the recurrent fiscal problems of a number of countries in the region. In the case of Mexico, for example, the public enterprise deficit in 1982 will be on the order of ten percent of GNP, larger than the central government deficit. The bloated public sectors of a number of Latin American economies, as a proportion of GNP, and even more in relation to their ability to manage themselves, are undoubtedly a major contributor to the present debt problems.
The public enterprise issue cannot be easily removed or resolved. Some governments have in recent years faced the problem of subsidies squarely-Brazil, Chile and Peru, for example-and, sometimes at considerable political cost, have eliminated or reduced subsidies and substantially raised the price of basic services and staples. Such moves inevitably cause noticeable increases in the cost-of-living index, since it is heavily weighted by these items of basic popular consumption. In other cases, adjustments have been delayed, at substantial fiscal cost, and perhaps even greater political cost when large increases eventually have to be made. Even where the political conviction and courage exist, selling off the enterprises is not easy, given their size, and may not solve the problem in the case of activities properly considered public services, where the basic issue is price regulation.
A third area of concern has been the perennial conflict between populism and orthodoxy in monetary and exchange policy. It is understandable that chiefs of state, and many others too, should dislike high interest rates and devaluations, which are seen to raise domestic prices and the cost of living. Clearly they have this effect, especially when large-scale adjustments have to be made in the midst of inflationary expectations, and after periods of substantial overvaluation of the currency and negative interest rates. The recent economic history of Argentina, Chile and Mexico has illustrated once again the proclivity, even under very sophisticated economic managements, to repeat past history.
In the Southern Cone countries in the late 1970s, an economic theory took root that was peculiar in the inflationary setting of those countries. At least it had the unusual merit of reconciling economic technocrats with their rulers. The economy was to be made to adjust so as to maintain a fixed exchange rate. In other words, employment rather than the exchange rate would vary.
In the case of Chile, where the public sector had no deficit and inflation was falling rapidly, this policy came close to succeeding. However, the momentum of prior inflation, after the exchange rate was fixed in 1979, rapidly made the exchange rate overvalued: with a cheap dollar and an apparently guaranteed exchange rate, the private sector, and especially the commercial banks, borrowed large amounts abroad (about US$10 billion), while production for the domestic market and for export languished as imports flooded the domestic economy-artificially holding down the cost of living-and the profitability of exports eroded. The collapse of copper prices in 1981-82 completed the deterioration of the balance of payments, and in mid-1982 the authorities devalued the currency by about 60 percent. According to official estimates, GNP in 1982 will fall by over 10 percent, and the unemployment rate is above 20 percent.
In Argentina, where the public sector deficit continued at high, albeit reduced, levels, the policy of a slow devaluation in the face of still very rapid inflation never had a chance, and contributed to the buildup of both private and public sector debt.
The case of Mexico, where economic theory was not the main driving force, was a more classical one of increasing public sector deficits, augmented in 1981-82 by the fall in the price of oil to a level well below what had been expected. It too resulted in large-scale borrowing by the private and public sectors, and eventually in the large devaluations of 1982 and the introduction of exchange controls in September-a difficult undertaking in a country with no recent experience in the management of controls, and with a long border and a very large trade with the United States.
Finally, the political legacy in Latin America of "banana plantation" types of foreign investment dies hard. Few countries have encouraged investment from the outside in an economically meaningful way. In the last five years, foreign direct investment in Latin America has accounted for less than one-fifth of capital inflows, and has been heavily concentrated in Brazil and Mexico. The idea has arisen among politicians of various tendencies that loans create less "dependency" on the outside than investment. In fact, the attitude of foreign investors has become much more flexible and accommodating than it was 20 or even 10 years ago, and the recent debt difficulties highlight the fact that profit remittance payments-which require the availability of profits and do not carry the same level of international obligation as the service on debts of a government-are actually a less problematic burden than debt service.
Are these traits endemic to Latin America? The outlook is mixed. On the one hand, a new generation of well-educated economic managers is arising, in a political climate where understanding of economic problems is making progress, although there is still much ground to be covered. On the other hand, the present stage of development of the more advanced Latin American economies naturally creates some of these features. A growing middle class wants to enjoy the good things of life. It desires long-term mortgages to buy a home and cheap exchange rates in order to travel abroad and own an automobile, the cost of which is heavily influenced by imported materials. A substantial proportion of this middle class works in the public sector. The emerging middle class is a potent political force, and its evolution will take a long time.
Thus, the emerging industrial economies of Latin America are in some ways at the same stage as the United States in the period from the 1840s to the 1880s: rapid expansion of infrastructure and basic industry for the domestic market, based in part on a large inflow of foreign loans. The high rate of growth of population in the United States then, augmented by migration, was comparable to that of Brazil and Mexico today. Bankruptcies, financial panics and balance of payments crises were periodic as late as the 1890s. Today, however, we live in a more orderly world, with clear rules of international financial behavior, which had not yet been firmed up then.
The economic development of the large Latin American economies will become less dependent on foreign capital, but this will take much longer than the present horizon of international bank lending. The debt profiles of several debtor countries, both large and small, suggest that even after the present liquidity crunch is overcome-one hopes in the next couple of years or so-service payments will continue to be relatively heavy on the medium and long-term external debt which exists today, without counting necessary new borrowing. Beyond the immediate liquidity issue, there is no quick fix for the longer-term debt problem, which essentially relates to development. As population growth rates decline as a result of economic advance, and savings rates move up, while the need for public investment declines, the problem will begin to go away. That, however, is a long-term horizon.
Brazil perhaps best illustrates the difference between the immediate and the longer-term problem. To avoid further losses of international reserves, Brazil needs to be able to continue borrowing in the Euromarket. At present, its access, along with that of most Latin American and developing countries, has been very sharply cut back. Unless it is restored, or alternate funds become available, Brazil will in effect have to force a minimum capital inflow by rescheduling a part of its repayments of principal. Further cuts in imports are extremely difficult, and would impinge upon basic inputs needed for exports. Fairly drastic fiscal and monetary action was already taken at the end of 1980 and GNP has actually declined in 1981 and 1982, after 15 years of continuous high rates of growth. The liquidity problem is thus a pressing one, where the borrowing country has very limited room for maneuver.
The longer-term debt problem, on the other hand, should be more manageable. Brazil has succeeded, from 1979 to 1982, in raising its merchandise exports from US$15 billion to US$25 billion in an inhospitable international economic environment. Barring more trade barriers, this performance should be even better when the world economy revives. Population growth is declining, and a transition in the next 20 years or so to a pattern of development less dependent on large-scale financing from abroad is certainly a reasonable expectation.
It is perhaps natural that the existing and possible debt problems of the major Latin American economies, coming on top of well-publicized domestic bankruptcies and problems in the United States, Canada and Europe, have spawned a debate on the solidity of the major banks engaged in international lending. This has been particularly the case in the United States, where accounting rules prohibit the accumulation of "hidden reserves," a form of back-up, non-taxed capital, and where the large money-center banks obtain a substantial part of their earnings from international operations.
The debate has ranged widely. Some sections of the press and outside commentators have said that banks should be "punished" for their past lending-as if their present problems were not enough: for most of the large banks, the lowest stock prices in years in relation to earnings; a higher relative cost in obtaining funds from traditional sources, such as the sale of certificates of deposit; regulators in all major countries breathing down their necks; and boards of directors in a state of alert.
Other discussions have focused on the adequacy of the capital of banks. Simple arithmetic will show that in the case of the largest U.S. banks, their exposure in the major Latin American debtor countries is larger than their capital. But to go on from there to say that banks will have to write off such loans is unrealistic, although in several cases the loans, particularly in Mexico, will have to be significantly stretched out. The key point is the payment of interest. For example, on the unlikely hypothetical assumption that no interest on the debt of the three largest Latin American economies was paid for a year, the gross earnings of the five largest U.S. banks would decline by about seventy-five percent, but the net after-tax effect would be considerably less.
It is thus likely that the present debt problems-both of some major Latin American countries and of other borrowers as well-will affect the borrowers more than the lenders, as credit flows are reduced. A number of recent market developments buttress this conclusion. First, the interbank Euromarket is changing and its growth is shrinking: major banks are finding that it is too risky in relation to likely profits to deposit their surpluses in the interbank deposit market. They are reducing deposits with secondary banks. (Incidentally, the approximately US$6 billion of interbank deposits, outstanding in October 1982 with the Eurocurrency branches of Mexican banks, are being called on their due dates rather than being renewed, as in the past, so that they are in effect becoming a liability of the Mexican government, in the wake of the Mexican bank nationalization of September 1.) Deposits with consortium banks are also being reduced. The revival of the U.S. capital market is keeping funds at home and the disappearance, for the time being, of the surplus of the major Arab oil producers has removed an important inflow into the Euromarket.
Secondly, the recent credit problems have led banks in Europe, North America and Japan to be more aware of the inadequacy of their capital and to cut back new lending accordingly. In the last three years, lending by these banks to the developing world grew at an annual rate of more than 20 percent, about twice the rate of growth of bank capital.
Third, regulators are bearing down on the banks, particularly in Germany, Japan and the United States. Germany has introduced strict limits on the ratio of assets to capital which may be loaned out to any one borrowing country. And guidelines issued in October 1982 by the U.S. Securities and Exchange Commission in effect require banks to disclose, by mid-1983, their outstanding loans by country. Obviously, with nervous boards of directors, lending officers will do their utmost, before that date, to reduce the exposure of their banks to countries and borrowers considered risky.
Given these trends and actions, the danger to individual banks or to the banking structure looks controllable. But, by the same token, it would be quite unrealistic to expect the major banks active in international lending to continue international lending to developing countries at anything like the pace of recent years. The main question is the extent of the reduction.
Will it be a reduction in net exposure, the corollary of which would be that borrowers would become net repayers of debt or exporters of capital? That is where a conflict would probably come, since major debtors, at least in Latin America, are unlikely to be in a position to do that-even with major domestic adjustments, which are politically very difficult, and more favorable markets for their exports. It is very difficult to contemplate an overall reduction in banks' exposure in Latin America, since that would require developing countries to become exporters of capital, virtually an impossibility on a sustained basis. What is required is a slower growth of net indebtedness, but even that is not easy to achieve without a recovery in the world economy and international trade on the one hand and, on the other, the application of needed, and in some cases severe, domestic fiscal and monetary adjustments.
So far, but this is only a distant gleam, it looks as if the major banks are seeking to avoid such a confrontation and have prevailed on smaller banks to slow down the reduction of their exposures. Clearly, such a maintenance of lending would be helpful to the bigger banks, which would hardly be in a position to offset major reductions in exposure by the new entrants into the Euromarket in recent years, including regional and smaller-sized banks.
However, if one more major debtor has to renegotiate its debt, the thread of remaining confidence could snap and a major confrontation between lenders and borrowers could ensue. In order to avoid such an occurrence, it is essential that, at a minimum, there be a continued flow of commitments-from all sources as necessary-which has the effect of renewing maturities as they fall due. And, for some countries, even that will clearly not be enough, so that additional sources of financing are urgently needed.
At the last annual meeting of the International Monetary Fund (IMF) and the World Bank, held in Toronto in early September, bankers and government officials were able to agree, at least implicitly, on some important points, which are not new: that developing countries, particularly the larger Latin American borrowers, were no longer able to continue the rapid growth in external commercial borrowing; that more orderly processes for renegotiation of debt were necessary; and that better credit information was urgently needed. However, there was not much analysis of how a transition to lower levels of commercial financing can be achieved without some special form of alternate financing.
A number of special schemes have been discussed in order to confront the financing problem of major developing countries. It has been suggested, for example, that the Bank for International Settlements provide the additional resources needed in emergencies, as it has done in the case of Mexico-but subject in part to approval by the IMF of the Mexican stabilization program. The BIS gets its funds from central banks and is thus able to move faster than a scheme through the IMF, which would probably require budgetary appropriations and parliamentary approvals. While the BIS could thus be of major immediate importance, in the longer run it suffers from not being a worldwide multilateral institution-nor was it ever intended that it would be one-and does not have the staff or the historic expertise in developing countries of the IMF. In the end, therefore, a scheme which would avoid undue confrontation between lenders and borrowers has to revolve around the institution created specifically for that purpose, namely the IMF itself.
Discussions at Toronto with regard to the future funding of the IMF lacked broad consensus and urgency. Part of the problem is the difficulty of quantifying what the needs might be, which in turn depend on the rate of recovery of the world economy and world trade, and their impact on developing country exports and the ability of these countries to import and to meet debt service. Serious balance of payments problems in the larger Latin American economies would have serious effects on European and Japanese exports, and, to a lesser degree (except in the case of Mexico), on U.S. exports. Another element of the problem is defining whether the IMF will continue to be an institution whose main role is to put the stamp of good housekeeping on the financial management of countries, relying only to a limited extent on its own resources to support these programs. In the last ten years, major commercial bank lending has accompanied IMF-supported stabilization programs in Latin America. This may no longer be the case, at least on a similar scale, in the next few years. The IMF would then have to marshal far larger resources in the future, in effect substituting for part of the market lending of the past.
In reaching a judgment on this last issue, we must take into account the powerful forces working to reduce the net exposure of commercial banks in major Latin American and developing countries. There does not appear to be full awareness of the immediacy of the need. No one can challenge the desirability of increasing the quotas of IMF members substantially-although there are differences between the developing and the industrialized countries on how much-but there is also no doubt that it would be several years before such a move would actually put more usable resources in the coffers of the IMF.
After the first large-scale oil price increases, the IMF established an oil facility, a special window for extra credit for countries especially hard hit by these events. This facility was not only useful in itself, particularly to the poorest countries with no significant access to Euroloans, but its presence was also an element of reassurance to lenders and to developing country governments. Even if the present need turns out to be smaller than some expect, there is an urgent need to establish a special temporary facility within the IMF, which could make available a substantially larger proportion of support funds for stabilization programs than has previously been the case. A new temporary facility, of at least US$25 billion for the time being, is required.
While there may be the possibility of obtaining some of these resources from the capital markets, in the end the bulk of them will have to come from central banks or governments. Even if the facility takes several months to put together-there are several previous IMF special funds to serve as precedents-the fact that serious work had begun, and that there was basic agreement on the establishment of the facility, would probably be sufficient to inject necessary confidence in the system and avoid major defaults.
In contemplating such a facility, it is well to remember that there are extraordinary circumstances at present: a clear retraction of international commercial bank lending to developing countries, after close to a decade during which it was the largest single source of external finance for the larger Latin American economies; a deep international recession combined with high positive real interest rates; and serious balance of payments problems in a number of major borrowing countries. Business as usual is unlikely to come to grips with such problems. Fortunately, there is a growing awareness of the problems, the first essential step toward their mitigation and eventual solution.
There are no doubt critics who see such a scheme as a "bail-out" for the banks or for the borrowers, depending on their point of view. No doubt it is a bail-out. On the other hand, what are the alternatives? Politicians of a radical stripe in Latin America have suggested an "OPEC" of borrowers, who would stop servicing their debts on the theory that it is the creditor who has the problem, not the debtor. As we have seen, that is not true. But major balance of payments crises, with the ensuing economic and political turmoil, could give political credence to such extreme views.
A balanced but swift approach to these problems, including a continued inflow of capital, is needed in order to prevent false solutions from becoming popular. Unilateral defaults would of course trigger the immediate suspension of all lending by official agencies, and would cause the immediate default of all trade financing, leading to economic paralysis. This type of cocktail-party idea has even less intrinsic merit than the search for scapegoats which has characterized some of the discussion on Latin American debt.
A scheme through the IMF has the merit that the institution has shown over the years that it does not support unilateral bail-outs, but requires a genuine recovery program. The IMF is not popular among developing countries. Neither are emergency rooms among patients. The basic adjustment measures have to be taken when the money runs out, although it is much better to avoid some of the pain by taking the measures earlier.
For such early action, up-to-date economic information is vital, especially on short-term borrowing. A number of worthy proposals have recently been made by banks to set up an in-house system of shared information. The borrowers need to use the information also, however, and are a logical official source for it. A review of the role of the IMF should include the establishment of an official, comprehensive and internally consistent body of reasonably prompt information on short-term debt: official statistics are the only ones which can provide such data in a consistent and comprehensive way.
A large expansion in the role of the IMF should also lead to more discussion of whether its basic prescriptions are universally correct. A few cents worth of tax adjustments, in the enthusiasm for fiscal balance, can sometimes jeopardize important development decisions, and can, in some instances, lead to much larger losses in opportunities for fiscal revenues and export income. Careful evaluation of development programs is necessary. An expanded IMF role, even if only temporary, requires even closer coordination with development institutions, especially the World Bank, the regional development banks and the export credit agencies.
As has been often repeated, we live in an interdependent world: a cutback in the trade of developing countries is not only politically counterproductive, but would affect the prospects for the recovery of the world economy.2 The inevitable retraction in commercial bank lending highlights the importance of supporting the efforts of the development banks to expand their capacity to lend for well-conceived development projects.3 Only an integrated balanced effort can prevent the present serious, but so far manageable, problems from turning into a major crisis.
1 World Financial Markets, October 1982.
2 See again World Financial Markets, October 1982.