The attached paper provides our conclusions on how our debt strategy
should be extended in the next phase. It parallels Rimmer de Vries’
paper in many respects but argues, unlike Rimmer’s, that no government
or IMF money is needed to deal with
escalated interest rates on floating rate debt—although regulatory
changes may be.2
We need your reactions before a version of this and Rimmer’s paper go to
Treasury. We recommend a discussion of both papers with you, Ken
Dam, Allen Wallis, Mike Armacost and ourselves.
Attachment
Paper Prepared in the Department of State3
BUILDING ON THE DEBT STRATEGY: AN AUGMENTED ADJUSTMENT
FRAMEWORK
Overview
This paper recaps the debt strategy, reviews in detail the
assumptions which determine its viability and suggests areas where
the basic
[Page 428]
approach could
productively be supplemented to strengthen the adjustment process in
the medium term. In particular, we recommend a strengthening and
modification of the World Bank role, closer coordination between the
Bank and the IMF in a medium-term
context and a proposal on interest capitalization designed primarily
to improve the politics of debt management.
The Strategy
The debt strategy consists of the following main elements: (a)
adjustment by debtor countries; (b) Recovery, sustained expansion
and open markets in the industrialized countries; (c) Adequate
amounts of commercial bank financing; (d) Support of the IMF, the key institution for
encouraging and in lubricating the adjustment process; (e) Readiness
of creditor governments to provide emergency liquidity when
essential to give debtors time to implement adjustment programs.
As pointed out in our earlier paper,4 many elements
of the strategy are not directly under the control of governments.
The strategy is therefore primarily a set of assumptions which
define the conditions under which the debt management process should
be viable. We define viability as a state in which debtor countries
are able to achieve current account positions consistent with
available public/private financing over the medium term and
simultaneously maintain politically acceptable rates of GDP growth, again in a medium term
time horizon.
A Strategic Checklist
Since the strategy rests on a set of assumptions, its viability can
be assessed by comparing the actual evolution of events with initial
expectations.
LDC
Adjustment. The aggregate current account deficit of the
non-oil LDCs shrank from $76 billion in 1981 to $43 billion last
year. This was largely the result of a sharp drop in imports in this
period, reflecting the implementation of austerity measures and the
paucity of finance. Excess demand was a critical part of the problem
and its suppression must figure importantly in the solution.
Eighty-five IMF adjustment programs
were implemented in this period. Net IMF disbursements in 1981–83 totalled 9.5% of current
account financing, compared with 2% in the 1978–1980 period. These
programs included austerity, but also stressed measures which
stimulated production and redirected resources toward the external
sector.
[Page 429]
The politics of adjustment have been mixed. Implementation of IMF programs has occasionally sparked
violence (Morocco, Dominican Republic), but in most cases has met
with grudging acceptance (including tough cases such as Peru). Among
the major debtors: Mexico and Brazil are adjusting relatively
smoothly; Argentina and Venezuela and Nigeria are wild cards. Most
of the rest of the world is either struggling feebly against the
weight of enormous development problems of which debt is only one
aspect (much of Africa), or is managing well (most of South East
Asia, East Asia, and yesterday’s basket case, Turkey).
OECD Growth and
Open Markets. The USG debt
strategy assumed that the OECD
countries would grow at an average annual rate of 3–4% over the next
five years. Other analysts (IMF, Morgan Guaranty, the Institute for
International Economic Policy) set a 3% growth rate as an essential
structural support for an orderly debt work-out. The most recent
OECD forecasts put OECD real GNP growth at 4.1% in 1984, following a 2.4% expansion
last year. Growth should decelerate, on OECD estimates, to about 2.8% in early 1985. IMF forecasts are consistent with the
OECD’s.
The growth assumptions are critical—a 1% percentage point decline in
real GNP growth in the OECD would slash LDC exports by at least $4 billion
annually. Thus, uncertainties in the growth outlook are cause for
concern. Moreover, interest rates are rising as the strengthening
US private credit demand presses
against the budget deficit and inflation expectations stir. Higher
interest rates inject a new and difficult factor into both the
economics and the politics of debt management. Each one percentage
point increase in rates increases the LDC debt service burden by $1.9 billion (net).
Politically, the LDC perception is
that the hard won fruits of the adjustment effort may go up in
interest rate smoke. This could affect negatively their resolve to
stay the economic policy course and their willingness to play by the
rules.
Open markets among the industrialized countries are equally critical.
Increased protectionism reduces LDC
shares in our markets and is thus equivalent to a shortfall in
OECD growth. Preserving
relatively open markets will continue to be difficult. The future
course of events depends on the balance between domestic political
pressure and the Administration’s resolve to fight it, which in turn
depends on where our policy priorities lie.
Commercial Bank Finance. The USG strategy, as originally
formulated, exhorted banks to hang in there, but did not specify
“adequate” amounts. A consensus has developed among analysts that
$20–25 billion per year in net new private financing is necessary to
provide adequate financial support for adjustment. The IMF and OECD estimate that net new private lending to [LDCs?]
reached about $20 billion in 1983. While much of this lending has
been characterized as “involuntary” because it was encouraged by
governments and by the IMF,
“voluntary” lending to protect existing bank exposure was probably
of equal importance.
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The IMF expects bank lending to
continue at just over $20 billion per year over the next few years.
However, commercial bank financing is likely to reflect a balance of
considerations (reluctant regionals, defensive lending, improved
LDC creditworthiness, public
pressure). While the net result of such conflicting forces is
uncertain, there is little reason to expect an early return to
market determined relations between LDCs and their creditor
banks.
Support of the IMF. Some say that this job was accomplished with
the quota increase and expansion of the GAB. Other are less sanguine and point out that the
constraint on IMF’s role is no
longer the quota limits, but the funds available to fill them. The
issue of IMF financing is
inseparable from that of the role of the Fund in the adjustment
process. This is discussed below.
Official Bridge Financing. Bilaterally and
with other OECD countries through
the BIS, the US has reacted quickly to provide very
short term liquidity support to countries in dire need. Some targets
were of systemic importance (Mexico, Brazil); others were not, but
mattered politically (Yugoslavia, Jamaica, the Philippines where we
have a commitment, but no expenditure as yet). Judicious use of
bridge financing, using primarily the Treasury’s ESF, is just as important politically
(we are there in time of great need) as it is economically.
Accordingly, this aspect of the strategy is going well, although
there is a tendency to use the ESP facility more sparingly.
Augmenting the Basic Approach
While fundamentally sound, the debt strategy could be usefully
augmented through:
- —
- A moderate expansion of conditional finance to support the
adjustment process. Because we are operating at the low end
of the viable range, the LDCs have less flexibility than
earlier assumed. The tough cases will probably continue to
experience substantial strain. Thus, the probability of
political instability is higher than expected.
- —
- Giving more concrete institutional recognition to the fact
that the adjustment process must (1) unfold over several
years and (2) extend well beyond austerity in order to
attack the roots of deep-seated structural imbalances and to
effect the redirection of LDC productive resources toward the external
sector. Such a shift in productive effort is necessary to
support existing levels of debt as well as expected future
increases in indebtedness. (There is no question of the LDCs
“paying-off” their debt. The development process requires a
continuing net inflow of capital. This implies that the LDCs
should continue to run current account deficits, which
further implies an increase in net indebtedness over
time.)
- —
- Voicing official support for measures, such as certain
forms of interest capitalization, which could improve the
politics of debt management. A paper outlining a
capitalization mechanism we could support together with a
brief sketch of the costs and benefits of such a mechanism
[Page 431]
is attached at
Tab A.5 (Such a limited proposal would
capitalize the difference between initial lending rates and
higher rates resulting from expectations of increased
inflation.) We would only stress here that floating interest
rates are a private sector phenomenon and should be managed
without the direct involvement of the public sector,
including of the IMF (the
Venezuelans strongly support a Compensatory Financing
Facility for interest rate changes). The USG role should be confined to
supporting economically sound capitalization
proposals.
The above conclusions concerning the sustainability of the debt
strategy and the desirability of strengthening its medium term
aspects and adjustment focus point toward an expanded role for the
World Bank and the IMF, and for
closer coordination between the Bank and the Fund in promoting
economic adjustment over the next several years. Concerning the
World Bank per
se, its effectiveness in supporting
adjustment would require an increased emphasis on program (balance
of payment support through Structural Adjustment Loans or sector
loans) as opposed to project lending, more active use of
IBRD/Commercial bank cofinancing and an enhanced role in promoting.
equity investment. Specific proposals and a more detailed analytical
rationale for them are at Tab B.6
More intensive coordination between the Bank and the Fund should
underpin medium term adjustment. The IMF has neither the resources nor the mandate to
support adjustment in a multi-year frame. The IBRD has both, but has a predominant
focus on project lending and lacks expertise in the stabilization
area. Thus, there is a need for programs with a multi-year time span
to be designed jointly by the Fund and the Bank. Such programs would
emphasize a large stabilization component and a heavy IMF role in the early phase of the
programs. In the latter phases the relative emphasis would shift
toward structural change and IBRD
finance as the program proceeded. Overall consistency would be
provided by an investment program agreed between the IBRD, IMF and financing countries to help ensure that the
Bank’s project lending would “fit”. This approach should feature
maximum IMF funding early in the
program to support vigorous adjustment—a cold bath with a commitment
to medium term financial support. This would require scrapping the
present policy of “catalytic” Fund programs (skimpy IMF financing—50% of quota) in
countries where the necessary profound changes are likely to require
several years. We doubt that such an attenuated process is likely to
succeed and strongly favor a relatively short but financially
important IMF role to be backed
over time by the IBRD. Again a
larger, more program-oriented, World Bank would be necessary to mesh
with the Fund in such an effort.
