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

218. Memorandum From the Under Secretary of State for Economic Affairs (Wallis) to Secretary of State Shultz¹

Washington, May 8, 1987

SUBJECT

• Debt Strategy Proposals

It is unfortunate that ARA and EB could not provide you with a unified memorandum on this subject as requested. I am afraid that the resulting hodgepodge, while containing valuable elements, still amounts to something less than a coherent analysis of weaknesses in the present strategy and ways in which different proposals would address them.²

EB and ARA agree, and so do I, that our present, basically sound strategy has achieved important progress, but that there is still a hard road ahead for debtor countries and their creditors. (Were quick and easy solutions to be expected?) All agree that further economic policy reforms in the debtor countries are the key to a sustainable long-run solution.

EB and ARA also describe current strains on the debt strategy: difficult and contentious debtor-creditor negotiations and political pressures in debtor countries. ARA fears that these pressures may lead to political upheavals unfavorable to the further reforms needed in these countries, as well as damaging to our foreign policy interests; EB believes that the frustration level is likely to recede, a conclusion buttressed by the table (Tab 4) showing substantially reduced net resource outflows this year and next for the fifteen heavily-indebted countries.³

Neither Bureau clearly identifies major weaknesses in the Baker strategy, the correction of which could avert these strains, but they agree on the desirability of encouraging larger net financial flows to the debtors and improving incentives to economic policy reform. The need to strengthen the current strategy is undisputed, but it seems to me that no case emerges here that it needs to be fundamentally altered.

The Bureaus agree on a number of proposals as promising and potentially supportive of the existing strategy. However, they part company over ARA’s proposal for a government-financed “buy-back” facility (buy-out is more descriptive) which would forgive debt in exchange for policy reforms.

I believe that any plan which seeks reduction of debt by government fiat (Bradley) or at taxpayer expense (ARA) departs radically from our existing strategy. The ARA plan would introduce OECD governments into debt management in a dramatically new way, greatly increasing the politicization of the process. Acceptance of the principle of government-financed debt forgiveness would inevitably encourage future demands for more and more, producing inter-government friction.

The plan would involve a major shift of burdens from the parties that originally contracted the loans—the banks and the LDC agencies—to the taxpayers. (Although banks would need to acknowledge some losses on their books, sales to the facility would be voluntary, and therefore presumably beneficial to them as compared to the present situation—the inevitable charge of bank bail-out would be partly justified.) Essentially the facility would be speculating with taxpayer money that the purchased loans will be serviced and, during the life of the facility, rise to full face value from their purchase price, thus covering the cost of forgiveness. Costs to taxpayers would be highly uncertain but potentially large.

ARA believes these costs are outweighed by potential benefits to the debt strategy. The plan would, it is true, provide some reduction of debt-service payments and thus some respite for the debtor countries, but it would bring no lasting solution to the debt problem unless, as claimed, it were to be an effective spur to economic policy reform.

Support of policy reform in the debtor countries is of course needed (and provided within the existing strategy). But the idea that the offer of this kind of debt relief would produce substantial additional reform is at best naive. The domestic political barriers to reform would still be present—opponents of reform would still have much to lose from the loss of their protected positions. Effective pressure for reform must come from within; outside pressure will produce limited results. Financial support for reform will be most effective when it has a positive relationship to the reforms needed. For example, debt-equity swaps provide both debt reduction and incentives to improve the investment climate.

In my view, then, USG attention should be focused on ways to facilitate the more flexible approaches by banks called for in Baker’s “menu approach” and greater engagement by capital markets in financing LDC private-sector investment. A good many of the ideas briefly described in the ARA/EB paper go in this direction—for example, the IFC debt conversion program and interest payment alternatives. We should direct efforts to be focused on developing such proposals.

Allen Wallis⁴

1. Source: Department of State, Executive Secretariat, S/S Files, 1987 Official Office Files for (E) Economic Affairs Allen Wallis, Lot 89D155: Memoranda for the Secretary April/May/June 1987. Confidential. Quinn initialed the memorandum and wrote “5/11.”
2. A copy of McMinn and Abrams’ undated memorandum to Shultz is in Department of State, Executive Secretariat, S/S–I Records, Files of the Deputy Secretary of State (D), Lot 95D334: Debt. In it, Abrams and McMinn explained that Shultz had requested “a joint examination” from EB and ARA of various possibilities for strengthening the current debt strategy, but that “our two Bureaus have struggled for the past two months on this and still cannot come up with a common view; our approaches differ fundamentally.” The memorandum laid out the two contrasting views. In a May 7 memorandum to Shultz, Abramowitz provided INR’s assessment of how to improve the current debt strategy, writing: “The LDC debt problem is getting worse instead of better in many important respects, raising serious questions concerning the effectiveness of our current debt strategy.” (Reagan Library, George Shultz Papers, Official Memoranda (05/07/1987); NLR–775–58A–40–3–0)
3. Tab 4 is not attached.
4. Wallis initialed “AW” above his typed signature.