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

233. Memorandum From the Assistant Secretary of the Treasury for International Affairs (Mulford) to Secretary of the Treasury Baker¹

Washington, December 17, 1987

SUBJECT

• DEBT SITUATION—NEAR-TERM OUTLOOK AND OPTIONS

Summary. Commercial banks’ willingness to provide new money to LDC debtors will be seriously compromised if the recent decision by the Bank of Boston to increase substantially its reserves forces other U.S. banks to take similar action.² At the same time, Brazil, Argentina and other key debtors face strong political pressures to reduce debt service and minimize adjustment efforts. This may lead one or more debtors to consider unilateral action in early 1988 to reduce its debt service burden. Both Brazil and Argentina confront key deadlines/decisions in the next 30–60 days.

Continued resistance by major debtors to take necessary economic reform measures, unwillingness by banks to provide new money, and a potentially steep drop in oil prices may require us to consider a fundamental departure from the present debt strategy.

It may be possible, however, to contain the situation over the next three months through increased support for troubled but adjusting debtors such as Argentina and possibly Mexico. This would require a more active role for Treasury and official creditors, particularly the World Bank, and would go a long way towards isolating the Brazil problem.

Commercial Bank Environment. The decision by Bank of Boston to write off $200 million in its LDC exposure; add an additional $200 million to its reserves for LDC loan losses; and to place on nonperforming basis an additional $470 million (on top of $330 million already on a non-performing basis) is indicative of a more general hardening of commercial banks’ attitudes towards debt problems. Through this action Bank of Boston’s reserves and write offs are now equal to 63% of its non-trade LDC exposure.

Bank of Boston’s action will increase pressure on other U.S. banks to follow suit. To date, only Mellon Bank has followed suit and Security Pacific is considering doing the same. While many of the regionals can match the Bank of Boston’s move, some money center banks cannot. If the latest reserve action is generally followed by the U.S. banking system (even if at a lower level), it will reduce further the already low appetite of commercial banks for new money packages.

Debtor Country Environment. This latest reserve move comes against a backdrop of continued deterioration in the economies of several major debtors. In particular, Brazil and Argentina face serious political constraints which limit their margin for maneuver and which could give rise to unilateral actions to limit debt service. Such actions by these two major debtors would necessarily set the tone for other debtor countries. Both these nations and the Philippines, Ivory Coast, Nigeria, and Ecuador are expected to seek new money and/or additional debt relief from banks during the first half of 1988.

Brazil. Under the interim agreement, Brazil and commercial banks have until January 15 to agree on a term sheet. The two sides remain apart on many difficult issues: the link between commercial bank disbursements and the IMF; interest cap and interest capitalization; securitization (with an element of debt forgiveness); and the spread.

Brazil’s political situation has paralyzed economic policy making and is the major cause of the present rapid degeneration in the domestic economy. Brazilian inflation is over 350% for 1987, is accelerating, and will exceed 20% per month by early 1988.

The operational deficit is 6–7% of GDP and the overall public sector borrowing requirement is 35–40% of GDP. The only bright spot is the trade balance; a surplus of $11 billion in 1987 that could easily grow to $12 billion in 1988. Daily exchange rate devaluations and depressed domestic demand are the key factors. There is little chance of an adequate economic adjustment program before mid-1988. This makes an IMF program and renewed official financing to Brazil before second-half 1988 remote.

Lack of political leadership in Brazil raises serious questions as to whether even the immediate negotiations with commercial banks can be concluded in a timely fashion. There is a real danger that, if agreement on a term sheet is not at hand by January 15, the GOB will reinstate its moratorium on payment of bank interest. This would probably prompt ICERC to downgrade some Brazilian obligations to “value-impaired” as early as end-January. New non-trade related lending to Brazil is unlikely if this occurs.

A breakdown in negotiations could also trigger a broadening of the moratorium to include interest to official creditors as well as payments to the World Bank and IMF. This risk increases if Brazil proves unable to get its domestic house in order during the first half of 1988 and no official flows occur.

Accelerating deterioration of Brazil’s relations with creditors would be a singularly negative development for the debt strategy. It would come at a time when Argentina is having difficulty with its own economic program and faces a potential cash squeeze.

Argentina. The GOA has been unable to implement the fiscal measures required under its IMF program. With the inauguration of the new opposition-controlled Congress on December 10, a compromise tax package may be in the offing. However, we fear that this compromise will be insufficient to stabilize the fiscal situation and satisfy the Fund.

If Argentina fails its early January performance review, the IMF would withhold its next disbursement. This would, in turn, occasion a suspension of the next $500 million in commercial bank money. Given Argentina’s low level of disposable reserves (about $500 million at year-end), Alfonsin would be forced to suspend some debt service payments. Such an action will be more likely if Brazil has again suspended payments. Simultaneous moratoriums by both nations would magnify the overall impact and could precipitate other direct challenges to the debt strategy.

Other major debtors. A number of other major debtors pose problems for the debt strategy. However, these countries are driven by different forces and timeframes than Argentina and Brazil. Although we do not envision near term actions by these countries which would have systemic impacts, several of them would be susceptible to political pressures in the event of a significant and roughly simultaneous deterioration in the Brazilian and Argentine debt situations (see Tab A).³

Implications for Debt Strategy. The convergence of increased willingness on the part of commercial banks to reserve and eventually write off LDC exposure, in combination with increased pressures for debt relief by key debtors points to a considerably more contentious negotiating environment in 1988 with sharply poorer prospects for concerted new money packages. Many commercial banks will strongly resist providing new money while debtor countries will press harder for greater concessions.

Increased commercial bank reserves, which banks and the market see as more accurately reflecting the value of LDC debt and as providing protection against further adverse debtor actions, may encourage some debtors to default or seek to “capture” unilaterally part or all of the secondary market discount reflected in the banks’ write off.

While the situation may be manageable in the near term by isolating Brazil, continued debtor resistance to reform, bank unwillingness to lend, and a potential steep drop in oil prices may require a fundamental departure from the present strategy.

Possible Approaches.

A. “Steady as She Goes”. We would continue to pursue the present strategy as outlined in your Annual Meetings speech.⁴ We would give greater emphasis on developing and implementing menu options, but with no major shift in the relative official/commercial bank burdens. This would involve the following elements:

— More activist Treasury role in negotiations between banks and LDCs, including offering specific solutions to expedite negotiations.

— New money efforts, exit/conversion bonds and debt/equity swaps. Greater use and enhanced implementation of these instruments would be encouraged by regulatory agencies’ actions. Interagency staff work on this has progressed and we have prepared letters from you to Greenspan and Clarke on these points. In addition, debtors would be urged to allow greater amounts of debt/equity conversions to take place, including by domestic residents to stimulate capital repatriation.

— Delinking of commercial bank disbursements from IMF programs. Encourage banks to reduce, phase, or eliminate the link between disbursements and IMF targets. They would instead accept indirect links to Paris Club reschedulings and World Bank sector loans and de minimis links or no links for disbursements earmarked for elimination of external arrears.

— Early implementation of IMF External Contingency Facility.

— Early conclusion of negotiations on a significant IBRD GCI.

B. Greater Official Participation in Debt Strategy. Official creditors would indirectly assume a greater share of the burden. This could involve the following elements:

— Increased use of official (e.g., IBRD) guarantees for new bank lending.

— Selective granting of preferred creditor status for new money.

— Official support for proposals involving securitization of outstanding bank-held debt that incorporate some form of official guarantees or assumption of risk.

C. New Departures from Existing Strategy. Debtors’ outstanding debt service burden would be reduced to enhance repayment prospects on remaining debt. Implementation of this approach could involve the following elements either individually or in combination:

— Creation of a Debt Facility. Official creditors, in a joint venture with commercial banks, could establish and provide limited financial support for a new facility to purchase bank-held debt at a discount. This discount could be passed on to the debtors in exchange for economic policy commitments. Official participation could be structured in such a way as to minimize the charge of a bank bail-out, which is a serious disadvantage of all present debt facility proposals.

— Chapter 11 partial bankruptcy for debtors. A mechanism, analogous to the domestic bankruptcy mechanism, could be established (perhaps through the IMF) to facilitate a negotiated forgiveness of a significant portion of LDC debt.

— More aggressive use of ICERC. Regulators could more aggressively require write offs by banks. This would give banks a tax deduction and would have no negative impact on earnings unless a bank chooses to rebuild reserves following the write off. But, this action would likely discourage new lending. For non-adjusting LDCs, more aggressive use of ICERC would be a “seal of disapproval.”

— Urge banks to provide partial debt forgiveness. Regulators in industrial countries could encourage banks to pass on to adjusting debtors part or all of the write offs and associated tax benefits derived from a more aggressive use of mandatory writedowns.

1. Source: Washington National Records Center, RG 56, Executive Secretariat, Congressional Files, 1987, 56–90–29, Box 45, Classified Memos to the Secretary (December) ’87. Confidential. Sent for information. Baker wrote in the top left-hand corner of the memorandum: “1/3/88 CJ: Back to me pls. Thanx. JAB III.” Copies were sent to McPherson and George Gould (Treasury).
2. See Document 232.
3. Tab A, an undated paper entitled “Implications of a Deepening Brazil—Argentine Debt Crisis for Other Major Debtor Nations During Early 1988,” is attached but not printed.
4. See Document 228.