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

175. Paper Prepared in the Department of State¹

Washington, undated

NEXT STEPS ON DEBT

Most would agree that the initial battle in the debt crisis has been won (e.g., Mexico, Brazil), but the war goes on. While our debt strategy has served us well so far, we need now to consider what additions to the strategy are needed for the next stage. The objective of our debt policy should be to identify and do what we can to support the right mix of financing and adjustment in developing countries which will enable them over time to put their external financial relations back on a normal footing and to achieve an acceptable level of growth and development. The debt crisis is both a liquidity and, over the medium to longer term, a growth problem.

We are at a point in the process where we must give greater attention to the implications of the continuing crisis on the political stability of affected debtor countries and on the U.S. banking system. Debtor countries cannot avoid adjustment and should not be encouraged to do so, but we should seek to manage the crisis in ways that minimize the risks to the stability of fragile democratic regimes in a number of debtor countries. Further, although the threat of a massive default which could undermine the international financial system has receded, the U.S. banking system has undergone some unsettling shocks recently and remains vulnerable to lesser calamities.

Proposals for next steps can be put into two categories: (1) refinancing/rescheduling and (2) new financing/World Bank role.

Refinancing/Rescheduling.

(1) Interest-capping. We should be prepared to support any reasonable plan the private lenders may come up with for capitalizing interest when rates rise over some pre-determined level. While the initiative must be with the bankers, we should provide a regulatory context which would give them confidence that such a move would not lead to a risk of such loans being deemed “non-performing”.

The IMF could, as some bankers recommend, pick up the tab for an interest cap through a system similar to the compensatory financing facility. This or other official financing options are not recommended for two reasons: (1) they would be seen as a direct bank bailout which would threaten already tenuous support for the IMF and (2) they would provide the potential for substantial new and unconditional flows of IMF resources, thus reducing its leverage in the adjustment process.

(2) Repackaging of Debt. A number of proposals are circulating which would consolidate, discount, and reissue existing debt in the form of bonds or other longer term instruments. The common element is that someone, i.e., taxpayers or lenders, have to absorb substantial up-front losses. Aside from the questionable wisdom of setting such a precedent, there is simply no prospect that governments could persuade taxpayers to play this game. Private lenders are of course free to set up a discount market which could restructure LDC debt should they choose to do so. However, any advantages to such a development could be affected by the loss of control that would be entailed in having LDC debt shifted to secondary holders. Those who bought the debt paper at a discount might well be harder to organize and less tractable in their dealings with the LDCs concerned than are the banks.

We should not encourage debtors or creditors to think that governments might consider this approach. At the same time, we could quietly follow the development of these ideas in the private sector and consider whether it might be in our interest to be supportive of such schemes—short of paying the bill.

(3) Multi-year Reschedulings. This is a limited but potentially significant technique. The typical Paris Club rescheduling of official debt currently incorporates a “good-will” clause that assures the debtor country that it can return for a subsequent rescheduling if needed. To go beyond the one-year consolidation period places a great strain on the debtor and creditor countries’ ability to project the key economic variables accurately enough to design an appropriate rescheduling package for the longer term. Nevertheless, it may be appropriate in selected cases to reward successful adjustors (e.g., Mexico, Brazil) with a multi-year rescheduling. The Paris Club is now actively engaged in working out guidelines for such reschedulings.

Bankers are also moving towards multi-year reschedulings, and it is anticipated that the current negotiations with Mexico will result in such an arrangement. We should support the banks in their prudent use of this technique.

New Financing/World Bank.

In order to sustain the painful and extended adjustment period which will be required, high-debt LDCs must be able to look forward to the resumption of new financing flows adequate to their development needs. The prospects for the resumption of substantial flows of voluntary bank lending to the developing countries are uncertain at best. The rebuilding of investor confidence necessary to once again attract substantial flows of private investment will be a long and difficult process. In this context, the role of the development banks, particularly the World Bank, is critical.

(1) We could consider a modest new SDR allocation. While the direct contribution this would make to the ability of debtor countries to service debt would be extremely small, it could be helpful politically. Also, the larger amounts of SDRs that go to creditor countries could be made available under various schemes to selected debtor countries if this seemed advantageous at some point down the road.

(2) World Bank Program Lending. Under the Special Action Program (SAP) instituted in 1982 as a response to the debt crisis, the World Bank has a mandate to lend up to 10% of its portfolio in the form of structural adjustment loans (SALs) which are tied to commitments in the debtor country to undertake broad structural adjustment measures. Under the program, the Bank has also placed more emphasis on sectoral loans conditional on performance criteria as well as co-financing measures designed to encourage more participation by private lenders in the LDCs. The Bank’s experience with these programs has been spotty and somewhat disappointing thus far, although they have had important positive effects in certain situations, e.g., a series of SALs to Turkey played an important part in that country’s recovery.

We should recognize the importance of these programs to the continuing successful management of the debt crisis. The Bank should be encouraged in its review of activities in this area and urged to expand and perfect its techniques in this regard. There are risks, emphasized by the Treasury Department, that the Bank could move too far from its traditional project-lending role and thus undermine its standing as a borrower and/or generate pressures for an unduly large general capital increase (GCI). However, they are currently operating well below their sustainable lending level and the immediate need is to get them more broadly and effectively engaged in contributing to the longer range resolution of the debt crisis. Treasury’s misgivings should not stand in the way of achieving that important goal.

(3) World Bank/IMF Coordination. It is important that in working on different aspects of the debt problem in a particular country the Bank and the Fund coordinate closely and avoid inconsistent actions. Both institutions are aware that this coordination has not always been as close as it should be and are working to improve it. They should be encouraged in this effort. The management of the debt problem leaves plenty of room for full participation of both the Bank and Fund, each operating well within its particular mandate, and would benefit greatly from active coordinated joint participation.

Conclusion.

We need an evolutionary approach which builds on the successes of our debt strategy. The power of the adjustment process has been demonstrated. While seeking to ease the disruptions involved and make the process more sustainable, we must avoid undermining the incentives to adjust. More radical approaches, such as the various proposals for repackaging and restructuring, should be followed closely but treated with caution at this stage. In summary, the following next steps seem to make sense:

— Support any reasonable interest-capping scheme private lenders may come up with and encourage regulators to be accommodating.

— Move forward on multi-year reschedulings of official debt for selected successful adjustors and support move by private lenders toward such multi-year arrangements.

— Encourage expanding World Bank program lending and co-financing aimed at assisting recovery in high-debt LDCs.

— Support closer World Bank/IMF coordination in providing conditional resources to LDC debtors.

— Consider supporting a modest new SDR allocation as a potentially helpful contribution to debt management.

1. Source: Department of State, Executive Secretariat, S/S–I Records, The Executive Secretariat’s Special Caption Documents, Lot 92D630: Not for the System—August 1984. No classification marking. Sent under an August 16 covering note from Constable to James Covey. Covey forwarded the paper to Hill under an August 16 covering note, writing: “CH, This is DEBT discussion paper, for the Secretary’s next talk with Regan. JC.” (Ibid.) Shultz wrote in an August 20 note to Constable: “Thanks for letting me see this memo on your current thinking, which seems most sensible to me, re the debt crisis.” (Ibid.)