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

163. Information Memorandum From the Acting Assistant Secretary of State for Economic and Business Affairs (Constable) to Acting Secretary of State Dam¹

Washington, April 27, 1984

SUBJECT

• LDC Debt Problem: Analytical Framework; Issues for Discussion

Introduction

The economic and political pressures accompanying LDC adjustment to the burden of external debt remain strong, despite our large measure of success in dealing with the “debt crisis”. LDC debt will for the foreseeable future retain its prominence among US foreign policy concerns. This memo attempts to develop a common understanding of the nature and origins of the debt problem. It does not offer specific recommendations on debt management. Rather it provides an analytical framework for further consideration of LDC debt by a task force and in discussions [with] a panel of outside economists (S/P has sent you a memo on this).² Finally, we suggest approaches to issues which should be addressed in evaluating our debt management options.

The Problem

The debt problem is this: a number of developing countries have accumulated a level of external debt which exceeds their servicing capacity. The evolution of those factors critical to the orderly resolution of the debt problem (e.g. OECD growth, interest rates, availability of financing) has been such that for some countries the necessary economic adjustment has occurred more sharply than expected and has therefore become difficult to manage politically. The risks are (1) that the adjustment process will abort in these countries, blocking fundamental economic reform without tempering austerity for more than the very short run, (2) the political fallout will adversely affect US foreign policy interests, including our bilateral relationship with important debtors and (3) the probability of a destabilizing financial event, such as repudiation, will rise. The problem is not universal, and the economic pressure on many debtor countries should abate this year as their growth rates improve. Nonetheless, the stress is sufficiently widespread to warrant careful consideration of several key issues relevant to our debt strategy.

How We Got Here

Today’s debt problem is unique in its breadth and severity. It results importantly from the policy decision to blunt the recessionary impact of the income transfer to OPEC resulting from the oil shocks of the 1970’s. Monetary policies in the reserve currency countries were accommodating; real interest rates turned negative. Internationally, such accommodation created the conditions leading to excessive lending to the non-oil LDCs. Total LDC debt thus climbed sharply. In addition, the bulk of the recycling effort was left to the private sector. As the private share of external debt rose, shorter maturities and floating interest rates became more prevalent; debtors became increasingly vulnerable to changes in lender confidence and less creditworthy.

The incentives for rapid accumulation of debt were powerful. On the supply side, there was competitive pressure to move surplus funds, reducing the weight attached to prudential concerns. International lending was profitable, and the loan-loss track record internationally compared favorably with banks’ domestic scorecards. On the demand side, borrowing at negative real interest rates seemed preferable to trimming consumption to fit reduced real incomes. LDC economic policies (bloated public sectors, subsidies to consumption, over valued exchange rates) not only boosted consumption and imports. They also discouraged production of tradeable goods, (exports, import substitutes), thereby reducing the capacity to service debt.

Governments encouraged the process. Moreover, with negative real interest rates and buoyant LDC export growth expected to continue, the accommodation/recycling strategy appeared successful. When the disinflation—which in retrospect seems inevitable—occurred, and bank lending virtually dried up, the accumulated debt became unsustainable. One can conclude that countries, banks and governments guessed wrong about the future and failed to prudently hedge their bets. But bad forecasting and misguided policies are not necessarily the same as irresponsible behavior. Thus, assignment of “blame” for the crisis is a pointless and unhelpful exercise.

Debt Management Strategy

The present strategy rests on the premise that all parties, OECD governments, banks, debtor countries—must participate in resolving the debt problem. The five point approach is as follows (per NSDD #96):

— Economic adjustment by borrowing countries designed to stabilize their economies and restore sustainable external positions.

— An International Monetary Fund adequately equipped to help borrowers design adjustment programs and provide balance of payments financing on a temporary basis while adjustment programs take effect.

— Readiness of monetary authorities in creditor countries to provide short-term liquidity support, when essential to assist selected borrowers that are formulating adjustment programs with the IMF.

— Encouragement to private markets (e.g. commercial banks) to provide prudent levels of financing to borrowing countries in the process of implementing IMF-supported adjustment programs.

— Resumption of sustainable, non-inflationary economic expansion and maintenance of open markets, both in the industrial countries and in developing countries facing debt problems.

Several comments on the above strategy are in order: (1) many elements of the strategy (e.g. growth, bank lending) are not directly within USG control. Accordingly, the approach is a set of assumptions under which the adjustment process should be manageable in political and economic terms, not a set of levers we can manipulate to obtain optimal results; (2) the strategy recognizes that the solution will probably require several years, that the objectives of economic development and adjustment are complementary rather than antithetical, and that for the reform to succeed in the medium term, the effort must begin in the short run—thus, the strategy has an important medium-term as well as short run dimension; (3) Adjustment and austerity are not synonymous. While excess demand is part of the problem and its elimination is necessary, many adjustment measures (devaluation, restoration of market-related producer prices) are designed to stimulate production in export and import-substitution industries. Such redeployment of productive resources increases the debtor countries’ ability to support external debt and thus increases both actual and potential growth over the medium term; (4) The medium-term, adjustment-oriented aspect of the strategy could be strengthened with measures to improve economic efficiency and stimulate trade (e.g. reciprocal trade liberalization), to encourage increased flows of equity investment to the LDCs, and to improve IMF/IBRD coordination.

Problem Areas; Issues for Further Study

The evolution of important elements—OECD growth, private financing, interest rates—has been such as to put the strategy within, but near the edge of the viable range. As a result, countries with “weaker-than-average” economic and social structures are experiencing increased difficulty in managing the adjustment process politically. This syndrome has been most evident in the so-called “second-tier” countries of Latin America, but has also shown up elsewhere (Morocco, Tunisia). It also means that all the non-OPEC LDC’s have somewhat less flexibility at this stage than we had assumed would exist. While most of them can operate within the narrower margins, there are important downside risks: (1) premature termination of the adjustment process; (2) political instability in some countries; (3) destabilizing financial events.

Further adjustment in the external positions of the debtor countries is necessary. The political sustainability of the process and our economic and foreign policy interests require that such adjustment, beyond the very short run, take place in an expansive environment of rising imports and positive GDP growth in the non-oil LDCs. Consequently, LDC exports will need to rise more rapidly than their imports (including interest payments). OECD-area economic policies and performance will therefore remain central to the debt management effort. The IMF and OECD see things working out this way. Nonetheless, uncertainties on growth and in other assumptions which underpin our approach suggest the issues for further consideration:

Adjustment. As noted earlier, adjustment and austerity are not the same thing. However, austerity is often a necessary (if not sufficient) response to external problems, and IMF programs generally feature substantial (some say excessive) doses. As IMF programs are driven by external financing constraints, the appropriate degree of IMF austerity cannot be considered separately from the level of external financing. The adjustment/finance tradeoff notwithstanding, most Fund programs contain measures to spur production as well as to cut consumption. Accordingly, we might also consider further whether IMF programs could be designed to produce more growth and less austerity within given financing limitations. In general, however, less “conditionality” means that more financing will be required.³

Finally, we may not have considered adequately the institutional implications of the fact that the adjustment process is a medium term endeavor, and as such, is partly outside of the financial reach and mandate of the IMF. Thus, it may well be that a modified and possibly enlarged World Bank should figure more importantly in the debt managerial process. We are preparing a separate memo on this subject.⁴

Financing. The issues include the following: (1) Is private bank lending presently adequate to allow adjustment to proceed at a politically acceptable rate? If so, are sufficient flows likely to continue? Are the terms of private lending (maturity, interest rates spreads) consistent with the objective of resolving the debt problem? (2) If not, should we change the relationship between governments and banks so as to obtain more influence over the level, terms and allocation of bank lending internationally? How would this affect banks’ domestic operations? How would we handle foreign banks? How sensitive to interest rate spreads is the level of private lending? Would more active “jawboning” of the banks without fundamental changes in the public sector role be appropriate? Or, would this be an undesirable half-way house where governments influence private lending decisions without accepting financial responsibility for the outcome? (3) Do we have the appropriate “mix” of official and private participation? It has been argued that the recent instability of private flows and their harsher terms (relative to public lending) call for an enhanced public sector role. The main possibilities would be to ease the burden of existing debt by acquiring from the banks a portion of their LDC assets (and then rescheduling on concessional terms); and/or to increase the level of official lending. A large public sector role might also include an expanded IMF (which could obtain funds in private markets, sell gold or emit SDRs) and World Bank.

— Political Dimension. As expected, political friction has accompanied the adjustment process. (The Dominican Republic is a recent example) The issue is whether such friction is likely to reach the point where serious damage to our international political or economic interests indicate a necessity to relieve the pressure across the board. Of course, the political aspects of debt are inseparable from the financing/adjustment issue, since easing the pressure implies (absent faster OECD growth, lower interest rates) more generous debt rescheduling, more official lending, and in general, an enhanced role for the public sector relative to private sector. For the reasons cited above, a relaxation of IMF “conditionality” does not solve the political problem. Finally, we need to consider whether delaying adjustment for short run political motives exacerbates longer run economic and political problems or creates dependency relationships we could not support over time. Would our political strategy therefore be too short run?

It could also be argued that our bilateral financial resources, while adequate to safeguard the financial system, are not sufficiently large or flexible to protect our foreign policy interests. Options for correcting such a deficiency could include a one-time (but multi-year) expansion of the Economic Support Fund, or creation of a temporary Economic Adjustment Fund. Country allocations would be determined on the basis of balance of payments need, willingness to pursue economic reform and foreign policy considerations.

The budgetary costs and other domestic political implications of many of the above actions (compared with the potential gains to the LDCs) would obviously require extensive consideration.

Two further political aspects of the problem deserve mention. One is whether and under what conditions LDC (especially Latin) governments would see it in their interest to continue to play by the economic rules. Another is how the LDCs could improve their own ability to manage the politics of adjustment. The Overseas Development Council has done some interesting work in this area which could be used and/or expanded.

— Growth/Protectionism. A key issue is where our economic and foreign policy interests fit the larger scale of US priorities. It is clear that lower (or not rising) interest rates, continued strong growth and open markets are critical to successful debt management. The central policy question is the degree to which such considerations should influence domestic monetary/fiscal policies and the Administration’s response to protectionist pressures. These interrelationships are crucial: higher interest rates, “yes” to protectionism, slower growth would imply that we either provide more finance to the LDCs (preferably on concessional terms) or push austerity harder with the resultant risks to US foreign policy interests.

We are ready to supplement this conceptual discussion with a quantitative analysis of important debt management issues and relationships.

1. 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: May 1–15, 1984. Confidential. Drafted by McGonagle on April 25; cleared in EB/IFD. Sent, along with a May 2 memorandum from Rodman to Dam, under a May 4 covering memorandum from Dam to Shultz. A stamped notation on the memorandum reads: “Mr. Dam Has Seen Apr 30 1984.” McKinley initialed the memorandum on April 28. Shultz accompanied Reagan on a State visit to Beijing, Xian, and Shanghai from April 26 to May 1.
2. Reference is to the May 2 Rodman memorandum. See footnote 1, above.
3. Dam placed a brace in the right-hand margin next to this and the previous sentence.
4. Dam placed two parallel, vertical lines in the right-hand margin next to this and the previous sentence.