Foreign Affairs: 100 Years
A New Americanism
Why a Nation Needs a National Story
THE decade 1920-1930 saw New York become the financial center of the world. At the time we took considerable satisfaction in supplanting London in its time-honored rôle. Today the use which we made of that opportunity is looked back upon as one of the less creditable incidents of a now discredited period.
Five years ago foreign bond issues were a matter of almost daily occurrence. Now, for about three years, practically no foreign loans, except Canadian, have been made in the United States and there is no immediate prospect of any being made. Neither 1928 nor 1933 can be viewed as normal. Judging by British precedents, we some day will again resume foreign financing, just as England has continued to lend money abroad despite periods of widespread default incident to previous economic crises. But the present lull in foreign financing does afford a useful occasion for us to take stock of the advantages and risks of foreign loans and, particularly, to appraise the bearing on such loans of the new Securities Act.
That Act was primarily designed to compel an adequate disclosure of facts with reference to securities offered to the public. It requires, as a precedent to the offering of any security, the filing of detailed information; and it imposes heavy financial liabilities upon those associated with the offering if the information filed proves incorrect in any material respect. As to the desirability of the Act's objective there can be no question. The Act embodies many excellent features. It is, indeed, a most creditable piece of legislative draftsmanship if account be taken of the speed with which it was enacted and the extremely complicated and little understood nature of the subject with which it deals. In the limited time available the special session of Congress found it impracticable to consider all of the manifold forms which financial transactions assume, with a view to assuring in advance that the law might not inadvertently embarrass certain desirable operations. Inevitably, then, the Act has certain unintended, undesirable and harsh consequences. These will gradually come to light, and we can expect them to lead to amendment of the Act in the light of its practical workings.
Some of the effects of the Securities Act on foreign bonds fall in this category of presumably unintended results. This is particularly true as regards the Act's bearing on adjustments of existing bond service in cases where some modification proves necessary.
In recent years the most usual cause of default on foreign bonds has not been the debtor's insolvency but the difficulty -- often approaching impossibility -- of his securing adequate amounts of the particular external currency (e.g., dollars) called for by the bonds he has issued. When such an exchange crisis arises, it is usual for the government of the debtor to enact some form of general transfer moratorium law under which the debtor is required to make full payment, in his own currency, into his own central bank. The central bank then assumes the responsibility of converting this currency into dollars, to the extent that this proves feasible, as a part payment on the debt. The unconverted portion remains, in local currency, with the central bank or similar agency of the debtor country to the credit of the coupon holder, but "blocked" so that only a restricted and approved use can be made thereof by the creditor.
As a practical matter it is very important for the creditor that there be devised some machinery for putting to use the local money thus set aside for him. Unless some occupation can be found for the money within the economy of the debtor country, there is grave risk that even this form of payment will be abandoned, since no country can long stand the strain of having increasingly large percentages of its money immobilized in the form of a demand deposit with its central bank. If the debtor once wholly ceases to pay, even in his own money, and adjusts his affairs accordingly, resumption of debt service becomes immeasurably more difficult. The problem is further complicated by psychological considerations. Once a debtor definitely ends all paying relationship to his creditor, he is apt to lose the will to pay, a will which continues to exist so long as he can still maintain a creditable record for the future. A complete default once having been recorded against him, the debtor is apt to feel that prolongation of default is not a matter of vital consequence. Thus, where default has been due to exchange problems, it is important that the creditor should coöperate to make it feasible to have payments continued at least in local currency. This, in turn, implies that the creditor put his holdings of local currency to work, otherwise even this modified system may not indefinitely continue.
In the case of Hungary, after pengo payments had been accumulated in the National Bank for upwards of a year and the system showed signs of collapse for reasons such as those just mentioned, it was suggested that the creditors be given an option to place their pengos with a Hungarian company to be formed for the purpose under semi-official auspices. This company would put the pengos to work within Hungary in ways presumably advantageous, on their own merits, to the foreign bondholder. Moreover, the very fact that the money was being used in the economy of Hungary would have promoted a continuance of pengo payments as future interest became due. This plan is now in suspense, however, because of the difficulty of qualifying the transaction under the Securities Act, and in view of the financial responsibilities which the Act would place upon those sponsoring the plan, who would be acting primarily to help out the American bondholders and without any possibility of gain commensurate with the risk imposed by the Act.
A somewhat similar situation has arisen as regards Germany. Under the German transfer law of June 9, 1933, German obligors on dollar bonds pay in marks to the Reichsbank (Konversionskasse). The Reichsbank has indicated its intention to transfer 50 percent of these moneys into the currency of the bonds and to issue to the coupon holders mark certificates of deposit for the balance. These certificates of deposit may be subject to the Securities Act. The risk of this is so real that it is difficult to find American institutions willing to handle them. The reluctance exists even though the certificates be registered under the Act, for fear of the financial consequences that might ensue from some inadvertent error in the complicated registration certificate. The German authorities, on their side, are reluctant to assume the responsibility and expense incident to registration of the Konversionskasse certificates. What the outcome will be is not yet evident. One certain consequence is that American investors owning approximately $1,000,000,000 of German bonds are not even receiving the available 50 percent of their interest payable in dollars pending the finding of some solution for handling the Reichsmark certificates representing the balance,
It is fair to assume that such consequences were not intended by Congress. This seems apparent from the fact that the Act exempts transactions where a financially embarrassed corporation offers a composition to its creditors. This exemption is not available in the most usual cases of foreign default for, as already noted, such defaults are not normally attributable to a debtor's insolvency but rather to a national shortage of foreign exchange. In such a case it is usually the central bank or similar agency which deals with the foreign creditors and such dealings by other than the debtor himself are not exempted. In other words, the Act was apparently designed to facilitate processes of adjustment usual when domestic bonds go into default; it does not cover the typical situation where a foreign bond goes into default. The Federal Trade Commission has indicated the desire to interpret the provision of the Act liberally in these respects. However, the Federal Trade Commission is, by law, given very little discretion or power to interpret the Act. The result is that the Act may operate to deprive American holders of defaulted foreign bonds of many useful facilities which would otherwise be made available to them, and even actually to accentuate and prolong the default.
In an entirely different category are the conditions which the Securities Act attaches to new foreign financing. Here three features deserve particular comment. The first is the provision, applicable to issues of foreign governments, that the foreign government must furnish as part of its registration statement "the receipts, classified by source, and the expenditures classified by purpose, in such detail and form as the Commission shall prescribe for the last fiscal year for which such information is available, and the two preceding fiscal years, year by year." Now there is no subject more controversial and less standardized than the preparation of public budgets and the classification of income and expenditures. Whether or not a government's budget is "balanced" is almost always a matter of opinion. It is to be surmised that foreign governments, and especially those to whom we would most prefer to lend, will be very reluctant to submit to the jurisdiction of some foreign commission as regards the classification of their receipts and disbursements.
A second point of major importance is the delay which the Act makes necessary between the decision to borrow in the American market and the date when the bonds can actually be offered. This delay is incident to preparing the very complicated registration certificate, assuring that it satisfies the Commission, and then permitting the lapse of the statutory period between the date of filing and the date of offering. As a result, a foreign government which would sell its bonds in the United States cannot secure as good terms as it would if the whole negotiation could be executed promptly. Under ordinary circumstances a government can pick its date for financing and its bankers can quote a firm price based upon the existing conditions. But in view of the delay which the Act makes necessary the borrower who would be sure of his money will have to pay the underwriting bankers an added amount which, in effect, represents insurance against the risk of unfavorable developments during the period of delay.
The extent and degree of financial responsibility which the Securities Act places upon the representatives and underwriters of a borrower, whether foreign or domestic, may also be expected to act as a serious deterrent to foreign financing. This responsibility goes far beyond that known to the common law or created by statute in other countries. If the highly complicated registration statement contains any material error, even though inadvertent, the officials of the borrower and the bankers who handle the issue may be held responsible for the entire issue. This is true even though the decline in the price of the bonds in question may have been due in no way to the error itself but to totally different causes. Nevertheless, those still holding the security are entitled to recovery and those who have sold at a loss are entitled to damages.
Of course it is only fair to point out that these elements of delay and of financial risk exist to a comparable extent in the case of domestic securities. Indeed, the mandatory delay between the filing of the registration statement and the issue of bonds is shorter where the issuer is a foreign public authority than where the issuer is a domestic borrower. The consequences, however, are not the same. When a domestic corporation wishes to raise money by issuing securities it may have difficulty, because of the provisions of the Act, in finding underwriters, and it may have to pay more for the financing than would otherwise be the case. Its officials, directors and bankers may incur serious risks. But the domestic corporation generally has no practical alternative. Foreign borrowers, on the other hand, certainly those which enjoy the best credit, frequently have an alternative market to which they can turn. England and France, as well as the United States, afford markets for foreign securities. In some cases, too, internal financing is a possible alternative to external financing. The better the credit of the borrower, the greater is his choice of a market and the greater the probability of his using the market where he can get the best price and incur the least statutory risks and embarrassments.
The English Companies Act simply permits a buyer of securities to undo the transaction, that is to rescind, against the person who was responsible for making the public offering, and then only if the buyer bought on the faith of the prospectus and it failed to comply with the law. This right, apart from the disclosure required by the Act, exists at common law. That Act limits the financial responsibility of others to damages actually attributable to a mistake or to monetary fines for violation of the law, but does not subject foreign government borrowers even to this modest risk. Foreign government borrowings are exempted from the provisions of the Act. It is safe to assume that our Securities Act, as it now stands, with the inconveniences which it imposes and its drastic penalties, and with no exemption of foreign government borrowings, will deter the best type of foreign borrowers from using our market. If this result is not desired we should consider the alternative of amending the Act, in line with the English Companies Act.
Since the deterrent effect of the Securities Act upon future foreign financing in this market must have been foreseen, and hence presumably was intended, it is worth while to consider whether, after all, it is or is not desirable to curtail foreign borrowing in the United States.
The prevailing popular prejudice against foreign bonds is due to the impression, firstly, that they are more apt to "go bad" than domestic bonds, and secondly, that money loaned to foreigners goes abroad and, in an economic sense, is lost to the lending country. The latter impression is clearly erroneous. When a foreigner borrows dollars, those dollars are spent in the United States, directly or through triangular operations, precisely as though the dollars had been borrowed by a domestic corporation. The only exception of possible importance is where the dollars are used to buy gold from our monetary stocks and the gold is then "earmarked" or exported. That type of transaction is so rare, however, that it can be ignored. When it has occurred it generally has taken place with the approval of the Federal Reserve Banks and often as part of a deliberate policy to bring about an improved international distribution of gold which would lead to better stabilization of currencies. In all other cases the dollars are and must be spent in this country, as this is the only place where they have spending value. Once the money has been spent, a different economic result is apt to follow than that which follows the purchase of goods by a domestic concern: the goods purchased with the borrowed dollars (farm, mining and manufactured products) are normally taken abroad and so are withdrawn from the stocks which must be consumed in our own country. It is interesting in this connection to note Dr. Schacht's recent criticism of Germany's foreign borrowing: "The foreign money which we borrowed, in so far as it was not directly spent in foreign countries, could only come to us in the form of commodities. The excessive use of foreign credits was therefore the reason for which very large imports came into Germany and gave us an import surplus throughout the period from 1924 to the middle of 1930."
It is sometimes asserted that foreign lending tends to dry up the reservoirs of capital which are needed for domestic development. This might be true if lending were made out of a fund of limited proportions so that any part made available to foreigners reduced by so much the portion available for domestic needs. Actually, loan transactions involve an extension of credit which is susceptible of almost indefinite expansion where there is confidence in the future, including the future of the monetary unit in which the loan transactions are expressed. It was, indeed, at a time when funds were most readily obtainable by domestic enterprises that our foreign lending reached its peak, and foreign lending had virtually ceased well before domestic financing fell into its present phase of stagnation.
From the investor's standpoint we must recognize that foreign bonds carry a certain risk which domestic bonds do not. This is due to the fact that, just as the proceeds of foreign lending normally express themselves in exports, so the extinguishment of a foreign debt can take place, broadly speaking, only through imports to the creditor country. And just as foreign lending withdraws goods from stocks otherwise pressing for domestic consumption, so repayment adds, through imports, to the domestic stocks. To the extent that these compete with domestic production they evoke political control by the government of the creditor nation, which is generally more alert to protect domestic producers than domestic investors. By means of tariffs, quotas, and embargoes creditor countries can and do make it difficult for debtor countries to pay. Experience shows us that against this political hazard we may set the fact that as a class foreign bonds are largely immune from the risk of the borrower's becoming insolvent. This is not surprising, since foreign borrowing is generally confined to governments, important political subdivisions thereof, and a very limited group of foreign companies which have attained sufficient importance and demonstrated sufficient stability to become internationally known.
The American investor's experience as between foreign and domestic loans during the post-war decade indicates that the greater risk of a foreign bond not being paid due to currency and transfer problems is measurably offset by the lesser risk which the holder of a foreign bond runs that his debt will be made less valuable by the debtor's insolvency. This is so despite the fact that the period in question embraced several years during which unprecedented measures have been adopted to curtail imports. A calculation covering all recent domestic and foreign bond issues of over $10,000,000 made on the basis of July 1932 prices, when both domestic and foreign bonds approximated their "lows," showed that approximately $7,000,000,000 of foreign bonds offered in the post-war decade at an average price of 95.17 had then an average market value of 48.61, a decline of 49 percent. Approximately $10,000,000,000 of domestic bonds offered during practically the same period at an average price of 97.41 had retained an average market value of 53.48, a decline of about 45 percent. The average interest rate on the foreign bonds was 6.36 percent and on the domestic bonds 5.3 percent. Since July 1932 both domestic and foreign bonds have substantially appreciated in value, but the percentage appreciation has been approximately the same for both classes.
The plight of the American investor in foreign bonds is not so bad as is generally supposed. The bonds of certain South American countries have fallen to grotesquely low quotations, due primarily to the fact that these countries have no accumulated reserves of foreign exchange or foreign securities with which to tide over an emergency, but are wholly dependent upon being able uninterruptedly to sell abroad, at fair prices, the raw materials which they produce. Their export markets have now largely disappeared or only exist at values which represent a small fraction of those which prevailed when the borrowing occurred. Thinking of the losses taken in such bonds, we are apt to forget the satisfactory lot of the American investor who bought public bonds of Canada, Great Britain, France, Italy, Belgium, Switzerland, Holland, Sweden, Norway, Denmark, etc. There has never been any question of the full payment of interest on these bonds, at a very attractive rate; and among them have occurred substantial appreciations in market values. Many other foreign bonds (e.g., those of Japan, Poland, Czechoslovakia, Finland, Australia, the Argentine Government, etc.) have been kept good, often in the face of difficulties which have served to emphasize the debtors' high sense of financial responsibility. In the case of Germany, full service at high interest rates had been paid on upwards of a billion dollars of bonds throughout the depression up to July 1 last; and a substantial part of the principal has been repaid. Even with the cut in interest consequent upon the recent transfer restriction, the holders of Dawes and Young bonds continue to receive their interest in full and the Dawes bonds receive their sinking fund as well. The holders of other German bonds will still be receiving an appreciable return. Therefore, although it must be conceded that foreign bonds contain a certain element of risk to the investor not inherent in domestic bonds, it must also be recognized that the generally higher standard of internal solvency and the usually higher interest rate provide a measure of compensation.
Diversification, a fundamental rule for the sound investor, affords added protection. For example, take the actual case of an investor who in 1928 acquired $100,000 principal amount of foreign government bonds, distributed as follows: 20 percent in Canadian bonds, 25 percent in bonds of Northern and Western European countries, 20 percent in bonds of South and Central European countries, 25 percent in bonds of South and Central American republics, and 10 percent in bonds of Far Eastern and Australasian countries. His investment on August 14, 1928, had an actual value of $99,804, and was then returning an income at the rate of $5,992 per annum. The value of the same investment list on August 14, 1933, was $73,079, and the actual income in dollars was at the rate of $4,746 per annum. This list of investments, which is based on an actual case, not on hindsight, included obligations of 19 different countries, of which 5 are at present in default, although in some of these cases local currency deposits are being made.
Whatever one's individual views as to the investment merit of foreign bonds, no one can shut his eyes to the fact that the volume of foreign financing we have already done strongly commits us to doing more. Refunding operations are essential if we are to avoid unnecessary defaults and widespread losses to American investors who already hold foreign bonds. It is a natural and normal procedure for a solvent debtor to meet large maturing capital obligations by selling new obligations. The process is accepted without question in the domestic field. If the United States Government for any reason had to pay off its obligations as they matured, without resorting to new financing, its credit would be destroyed forthwith. The same is equally true of our railroads, our public utilities, in fact most of our domestic borrowers. The principles operating with our foreign borrowers are the same. If the billions of dollars of foreign bonds already held by American investors are to retain a value, they must to a substantial extent be refunded, and we should refrain from embarrassing responsible foreign borrowers in their plans to meet maturities by new financing.
In the absence of refunding in this market, the only alternatives of the debtor are to send us more goods or to refund elsewhere. Neither alternative is adequate to meet the problem and avoid widespread default. Nor does either alternative conform to our immediate national program of making our goods more valuable in terms of the dollar. Imports, if expanded to abnormal proportions by the efforts of foreign debtors to pay in goods, force down the domestic price level. Refunding operations through other currencies have the same effect. For example, if the debtor borrows sterling or francs with which to buy dollars to meet his bond maturities here the result will be an artificial appreciation of the dollar in terms of other currencies and of world prices. The July appreciation of the dollar in terms of sterling and the concurrent decline in our commodity values in terms of the dollar were not entirely unrelated to the English Government's scheme for converting its dollar bonds into sterling bonds.
Quite apart from the fact that new foreign financing is necessitated by our existing loans, it is desirable from a broad national viewpoint that the American market should be available to foreign borrowers. That our exports are largely promoted thereby must be conceded. Indeed at this juncture, when foreign bonds cannot be sold to the public, our Government has apparently contemplated stepping into the breach by loaning abroad many millions of public money so that foreigners will have dollars wherewith to buy and consume our agricultural products. Here the risk would be placed upon the taxpayers as a whole rather than upon individual investors, but the economic effect is much the same as if foreign bonds were publicly sold -- namely, dollars are used by foreigners to acquire goods for which domestic consumers would otherwise have to be found.
In addition to the bearing of foreign lending upon our exports, we must bear in mind that there are many and important, even though intangible, advantages in being an owner and potential future buyer of foreign securities. For example, it probably is not to our advantage that Canada, after doing its financing for the past twenty years exclusively in the United States, returned last August to the English market, where its 4 percent bonds were enthusiastically oversubscribed. The event is hailed by the English press as inaugurating closer political and economic relations between England and Canada and a probable tie of the Canadian dollar to sterling rather than to the American dollar. When one nation develops close financial relations with another and realizes that it may have occasion to go to it for financing, it shapes its commercial and fiscal policy with a view to maintaining the lender's good will. England has long derived advantages from such a relationship. It is equally possible for us to do so.
Finally, the ownership of foreign securities may prove of inestimable value in case of some national emergency, such as war, particularly where the creditor country has continued access to the world market. It was of inestimable value to the Allies that they, particularly Great Britain, were able to mobilize hundreds of millions of dollars of American securities for resale to the American investor and use the proceeds to finance the importation of munitions. Foreign securities represent a "call" on the productive capacity of the obligor country. Any nation, no matter how powerful or self-sufficient, is still stronger and safer if it enjoys this additional asset.
It is so clearly our destiny to play an international rôle, and we are already so far committed, that we must assume that foreign loans will again be made. That certain of such loans have in the past been hazardous to our investors cannot justify their prohibition or discouragement as a class. It does justify educating the public to discriminate. Such education will, however, not be accomplished through the information required to be filed under the Securities Act. Although a large part of this information is desirable, it is so voluminous that it will be read by but a few and so complicated that it will be understood by still fewer.
The simplest and most effective way to educate potential investors is to bring them to understand that the rate of interest, or rather the yield, is an excellent criterion of the measure of risk. A very large part, about half, of the foreign bonds which were offered in the post-war decade were priced to yield from 5 to 6¼ percent. There have been practically no defaults in this category. The defaults have been almost exclusively confined to the bonds sold to yield more than 6¼ percent and up to 8 percent. If a bond is sold to yield 8 percent, then it is risky, however laudatory the prospectus and however conservative the reputation of the issuing bankers. This principle is generally recognized as applicable to domestic bonds. There appears, however, to have been an impression that its validity did not extend to foreign bonds, but that in this category high yield could be obtained without risk. It should be implanted in the investor's mind -- so firmly that it cannot be eradicated by the highest of high pressure salesmanship -- that as with domestic bonds, foreign bonds bear their own label. High interest yield means that in the judgment of the financial community there is risk. This simple principle alone, were it understood and acted upon, would largely prevent the imprudent purchase of speculative foreign bonds by banks, trusts and investors of small means who should not place their principal in jeopardy.
Speculative bonds will still be bought, and it is not undesirable that this should be so. Progress and development in every field are largely the fruit of risk. Had there not in the past been many, both at home and abroad, willing to risk the purchase of American bonds when they were highly speculative, the creation of our arteries of transport and the development of our great natural resources would have been long delayed. We in turn have now become a creditor nation. This development, inevitable in the long run, was precipitated by the World War. It found our bankers and our investing public less experienced than if the shift from debtor to creditor position had been a gradual one. The remedy for this immaturity is not to be found in legislative restraints upon our normal creditor nation rôle. Rather it calls for our education in financial matters, to the end that foreign risks will be recognized and appraised and assumed deliberately only by those who can afford them. The practical schooling of the past four years has already done much to qualify us for a wiser use of our opportunities and a better discharge of our responsibilities.