Foreign Relations of the United States, 1981–1988, Volume XXXVIII, International Economic Development; International Debt; Foreign Assistance

123. Memorandum From Consultant to the Department of State Michael Ledeen and the Director of the Policy Planning Staff (Wolfowitz) to Secretary of State Haig¹

Washington, May 25, 1982

SUBJECT

• Possible World Banking Crisis

Let us begin with a quotation from The Economist (March 20):

“. . . if Brazil, Mexico and South Korea all decided in the same year not to pay back their loans to western banks (a not totally inconceivable event) then 100% of the capital and reserves of America’s nine biggest banks would be wiped out. They would be technically bust and that would be the end of the international financial system as it is now known.”

The argument of this paper is that we have failed to seriously address the prospect of a major international banking catastrophe; that such a catastrophe could well come about in the next year (triggered by the default of one or more East European countries, of Argentina, or of Brazil); that measures exist to prepare for this eventuality,² and that we should take those measures forthwith. If we do so, it will not only protect us against the effects of a banking catastrophe, but it will give us greater flexibility in planning our international economic policies (including the use of default or the threat of default as a policy weapon).

Summary of the Problem

— Yugoslavia,³ Poland, and Romania are all in de facto default;

— There is now an acknowledged failure of the “umbrella theory” according to which the Russians would pay debts for their Warsaw Pact allies. The result has been to close lines of credit from Western banks to Warsaw Pact countries;

— State Secretary Schalk of the GDR has called his country’s current trade deficit “catastrophic,” thus raising the possibility of East German “default;”

— Brazil holds at least 1.5 billion dollars’ worth of Polish debt, and owes roughly 80 billion dollars to Western banks and governments. Furthermore, Brazil’s debt is spread around some dubious credits (Liberia, for example, with whom Brazil is attempting to work out a bizarre three-way deal involving Poland). To make matters worse, since Brazil is the leading coffee exporter in the world, it may well have major debt relationships with the GDR, Romania and Yugoslavia.

Consequently, any default involving the above countries could result in a Brazilian default or moratorium, etc.

— Argentina is in parlous economic shape, and may soon find itself compelled to call in its notes (involving some Polish paper). Thus one spin-off from the Falklands crisis may be to provoke a series of defaults.

Thus, several countries are involved in an intricately interlocked network of dubious debt. There is therefore a real possibility that default of one country could produce default in others,⁴ Brazil being the main candidate for “secondary victim” of an East European default, and East Europe being the “secondary victim” of a Brazilian default.

It is not automatic that default of an Eastern European country would result either in a Brazilian default, or in a widespread financial crisis, but the risks are growing alarmingly:

— Brazil needs new loans to service its current debt (its import earnings being insufficient for this purpose);

— Brazil’s new loans are for shorter terms and are more expensive than in the past, thus increasing cost and risk;

— Many banks have reached their legal limits on loans to Brazil, thus making it harder to find new creditors;

— If an East European country defaults, the whole Brazilian house of cards may come down.

The Brazilian case is one among many, and for all these cases the existing international financial mechanisms seem unprepared to handle a large-scale emergency.

— Traditional “swap” arrangements were designed to deal with exchange rate crises, not for channelling multi-currency liquidity to affected banks in the Euromarket (the most directly affected by the scenarios discussed above).

— Many major international banks are now overexposed to countries experiencing debt-service problems;

— European banks have no reserve requirements for Euro deposits and loans in the Euro banks;

— There is no formal agreement concerning which Central Bank has responsibility for what Euro bank;

— The sums involved are very large indeed. The Euromarkets now add up to some 900 billion dollars, of which some 50–180 billion is highly liquid.

— By 1981, some 25 countries were in arrears and the amount involved was at least 6.5 billion dollars.

Conclusions

The international banking system is on the edge of a potential catastrophe for which it is unprepared and which would gravely damage the American economy. Most analyses have downplayed the effects of the default of one or another country primarily because they do not investigate the interlocking structure of international debt, and do not calculate the psychological effect of one country’s default on the domino structure of the banking system.

Moreover, the failure of Western central banks to prepare for such scenarios makes us hostage to the debtors, since the effects of default become unpredictable and there is no game plan in place. If we were prepared for likely scenarios, we could calmly address future threats of default.

At a minimum, we should design an early-warning system among the major Western countries that would enable us to get in front of the crisis before it takes on dimensions we would fear.⁵ We should also reach agreement on how certain scenarios would be resolved (for example, there is no general agreement on who is the “bank of last resort” in certain default scenarios).

Eagleburger comment

There is, I believe, a potentially very serious problem facing us. This paper only touches the edges of the problem, but points out the parameters of the concern I have. Perhaps I’m overly concerned, but I doubt it. If things are as bad as I suspect, then the question becomes how to alert the rest of the USG.

At my request, EB has produced a preliminary, broad look at the problem (attached).⁶ EB and S/P should now join forces to produce a more finished analysis and a more far-reaching look at institutional innovations and other broad policy courses, including the ideas of early-warning and safety-net that S/P and Ledeen have flagged. I have tasked this work. Once it’s completed, we should address the issue and our ideas in the interagency community.

LSE

1. Source: Department of State, Executive Secretariat S/S, Special Handling Restrictions Memos 1979–1983, Lot 96D262: 1982 ES Sensitive. Secret; Sensitive. Sent through Eagleburger. Wolfowitz did not initial the memorandum. Bremer initialed and wrote “5/27” on the memorandum.
2. An unknown hand highlighted “we have failed to seriously address the prospect of a major international banking catastrophe; that such a catastrophe could well come about in the next year,” “East European countries, of Argentina, or of Brazil); that measures exist to prepare for this eventuality,” and “we should take those measures forthwith.”
3. Eagleburger drew an asterisk after Yugoslavia and wrote at the bottom of the page: “*Not true, but will be by the end of the year if things go badly.”
4. A hand, presumably Haig’s, highlighted “There is therefore a real possibility that default of one country could produce default in others.”
5. A hand, presumably Haig’s, highlighted this sentence.
6. The information memorandum from Johnson to Haig, drafted May 14, is attached but not printed.