125. Information Memorandum From the Director of the Policy Planning Staff (Wolfowitz) to Secretary of State Shultz1
SUBJECT
- The International Financial System—Heightened Risks
INTRODUCTION
The international financial system is more vulnerable to sudden shocks today than any time since 1945. Strains on a system that so far has demonstrated great resilience have intensified enormously. Some banks have failed, and more individual institution crises are anticipated. Most observers grant that the probability of a chain reaction set off by a large default or debt repudiation is positive. How large it is, however, is itself highly uncertain. A breakdown would be so grievous for the world economy and vital U.S. and allied governments’ interests that we would be foolish to be too complacent about the situation.
THE SITUATION
The system’s increased vulnerability results in large measure from the concentration of high levels of external debt among a few countries. The number of lenders involved is also comparatively few. Faced with highly disappointing export earnings and high (mostly floating) interest rates, major borrowers—e.g., Poland, Mexico, Brazil, Argentina—are [Page 327] confronting extreme difficult-to-manage debt-service problems. The following illustrates the conditions they are in:
| 1973 | 1981 | |
| Poland | 19 | 157 |
| Brazil | 35 | 72 |
| Mexico | 36 | 48 |
| Argentina | 27 | 50 |
Among lenders, Western European banks are heavily exposed in Eastern Europe (their average exposure is 25 percent vis-a-vis 4.5 percent for U.S. banks). Our banks, in turn are deeply committed in Latin America (exposure to Mexico, Brazil and Argentina by the nine largest U.S. banks equal 100 percent of their capital and reserves).
The environment for borrowers, lenders, and governments has become far from compatible with maintenance of a highly sound financial system. The global recession, making things difficult for everyone, is spurring intense pressures for protectionist policies, and is contributing very significantly to growing corporate (including bank) failures and to the contraction of Western public and commercial credit to Eastern Europe and the LDCs. Adding to the problems of the major borrowers, some 45 percent of all international long-term debt must be repaid or rolled over this year. Vulnerability, of course, will largely lessen or increase as international economic conditions improve or worsen.
MAKING THINGS WORSE
Potential Achilles’ heel: The Eurocurrency market, functioning quite well at present, has built-in high risks. Some 70 percent of its operations involves “wholesale” lending bank to bank. A large default or repudiation affecting just one of them (it probably would affect many from the beginning) could stimulate deposit withdrawals and lines of credit suspensions. As the affected bank(s) failed to meet obligations to others there could be set in motion a situation of falling dominos and a consequential contraction of a highly important financial market. The implications, of course, would be global.
Less productive financing: Credit quality deteriorated during the 1970s on a massive, global scale. The switch has been toward non-self-liquidating loans, and as a result less production capacity is being generated by the loans to provide the basis for repayments.
Early warning problem: Two of the four Euromarkets are on the opposite side of the globe. It is possible that a serious problem of [Page 328] confidence affecting international banks in Singapore or Hong Kong would find markets and authorities in London and Luxembourg out of action for what could be quite critical hours.
Risk premium burden: Heavily indebted countries are paying higher risk premiums—Mexico is now up to the very high Brazil level. Other countries, such as Hungary and Yugoslavia, are experiencing extreme difficulties obtaining private sector loans at more conventional terms.
Overexposure limits: For a considerable period of time lenders can be induced to increase their exposures in high-debt countries to avoid default/repudiation losses. There are risk limits individual lenders can accept, however, for reasons of prudency, law or (as has happened) credit rating deterioration associated with overexposure.
SAFEGUARDS IN PLACE?
Are there mechanisms in place to avoid a falling dominos scenario? The central banks of the G–10 plus Switzerland are parties to a 1974 gentlemen’s agreement which pledges them to provide funds to solvent banks in crisis. Large segments of the Euromarket are not covered by this loose arrangement, however, and there is no deposit insurance system or reserve requirements. To avoid contagious failures, central bank funds would have to be moved efficiently and rapidly. This situation almost certainly has been a topic of discussion among central bankers but we are unaware of any reliable, all-encompassing arrangement having been even informally agreed upon. Because central bankers legitimately wish to avoid any revelation of rescue mechanisms that might lead private banks to become less careful in their lending policies, they hold such information very tightly. You may know more about these informal mechanisms than I do. If, however, you share our uneasiness, I would recommend that you discuss this matter with Regan and Volcker. For your reference there is a table attached showing the extent of Eastern European/LDC debt burdens and the exposure of U.S. and European banks in these areas.2
- Source: Department of State, Executive Secretariat, S/P Records, Memoranda/Correspondence From the Director of the Policy Planning Staff to the Secretary and Other Seventh Floor Principals, Lot 89D149: PW—August 1–10, 1982. Confidential. Drafted by David Luft (S/P) and Joseph O’Mahony on August 4. Sent under an August 5 covering memorandum from Wolfowitz to Dam.↩
- The World Debt Burden Table is attached but not printed.↩