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

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

Washington, February 26, 1988

SUBJECT

• Next Steps Under the Debt Strategy

Summary

This memo provides an appraisal of the debt strategy, in light of recent developments and evolving debtor and commercial bank attitudes. In particular, it explores options for encouraging new bank financing, as well as various debt reduction proposals that do not involve a direct and substantial shift of the debt burden to taxpayers of creditor countries.

While the debt strategy has been successful in a number of respects, and remains valid for our general approach, I believe we need to consider whether additional measures are needed to help assure continued new financial flows for the major debtors, and whether we should develop new mechanisms to help reduce the stock of debt.

My conclusion is that we need to make progress on both fronts, but with solutions only to be applied on a case-by-case basis. It is inevitable, however, that as we approach individual cases certain elements of our approach, particularly those related to attempts to reduce the stock of debt, will in practice be perceived as having a general applicability. We need, therefore, to bear in mind these general implications and make certain that we can live with them as they are adapted and perhaps generalized to some extent among debtor countries.

Argentina is clearly a special case and one that will need immediate attention. The GOA received a large commercial bank financing package in 1987 (completed in August), but is now so short of reserves that new financing for 1988 is imperative to meet a very high debt service burden. The problem is complicated by the fact that negotiations with Brazil and the marketing of Brazil’s new money package to the banks will overlap with Argentina’s negotiations with the IMF and the commercial banks. A proposal for Argentina is included on page 7 of this memo.

Current Assessment

The basic strategy has been successful in:

(1) Buying time for both the debtor nations and the international financial community to continue confronting this deeply intractable problem. (The fact that no financial market “crisis” has occurred is itself an achievement.)

(2) Convincing debtors to begin making fundamental economic reforms aimed at strengthening growth (e.g., Mexico finally is beginning to reform its trade regime).

(3) Enhancing the World Bank’s emphasis on policy-based structural reforms and encouraging a more growth-oriented, longer-term focus for IMF programs.

(4) Providing time for the commercial banks to increase both capital and reserves, reducing their vulnerability on LDC exposure, while maintaining their support for new debtor reforms.

(5) Achieving more flexible regulatory mechanisms in support of new financing and exit instruments.

(6) Providing political support to debtors which have had to accept the reduced availability of financing. As a result the growth in the stock of debt has been greatly reduced so that in many countries GNP is growing faster than debt.

(7) Convincing debtor nations that the feared instrument of a debt moratorium is not an attractive tool for long-term use.

(8) Forcing banks to recognize that losses are inevitable and encouraging them to position themselves to take losses. (Debtor conversions and other menu options are being actively embraced.)

On the negative side, the stock of debt remains too large and in some cases is still growing too fast; debtor nations and commercial banks are experiencing “fatigue” in their respective efforts; debtor governments are under domestic political pressure to demonstrate more rapid progress; and commercial banks are increasingly reluctant to extend new loans. Perhaps most important, there is widespread political perception that we are not making progress with the debt strategy and that some global solution involving the transfer of the problem to taxpayers in creditor countries will have to be found.² There is a lack of hope for ultimately resolving this problem without a major crisis. In short, as our ability to resolve the debt problem through market solutions has improved, the prospects for our avoiding a political solution with major creditor government involvement appear to be diminishing.

In my view, the key to reversing this trend is to find ways to accelerate the menu of options approach, including the provision of new money, and at the same time to find market-based solutions for reducing the stock of debt for those debtors with the largest debt burdens in relation to their GNP and their capacity to service debt. In addition, we must be prepared for our banks to face a painful show-down with one or more debtor countries if that possibility emerges at some point in the next few months.

Although we are presently making good progress with Brazil and Argentina,³ the period ahead may prove to be very difficult. Adverse developments on the debt front could seriously affect a small number of U.S. banks and pose difficult problems for financial markets. We should not, however, let our policy response be driven by concerns about the financial weakness of two or three sizeable U.S. banks. The ultimate cost to our strategy of such a course appears to me to far exceed that of facing up to the implications of serious problems for one or two banks.

A. Enhancing Capital Flows

The “menu” approach proposed last spring is evolving to help meet the need for greater flexibility in new money packages, but there is reason for concern that it is not evolving rapidly enough to induce stronger bank lending. Both the Ecuador and the Colombia new money packages saw large numbers of banks refuse to participate, and the bank advisory committee for Cote d’Ivoire has adopted a plan (probably subject to legal challenge) that would penalize banks that refuse to participate.

We should continue to encourage the menu approach (e.g., debt/ equity swaps, trade credits, new money bonds) and seek additional options or refinements that provide a basis for continued participation by banks. For example, the recent OCC statement in connection with the Mexican debt/bond exchange offer that national banks may hold LDC bonds as either loans or as Type III investment securities helps to clarify the general question of whether and how banks can hold LDC bonds. It may also help in the development of a market for LDC bonds as a new money instrument which is viewed as a preferred, non-reschedulable obligation.

We should also continue to press both the IMF and the World Bank to focus on reforms in debtors’ investment climates as an alternative to new debt flows. However, the development of new corporate investment flows will take time, will depend upon a restoration of confidence, and cannot substitute in the short term for continued commercial bank financial support.

As the banks exit from existing exposure, the base for new lending will shrink, making the provision of new funds more difficult to assure. The major money center banks will be reluctant to pick up this slack without added sweeteners. In cases where banks are extremely reluctant to increase their exposure, we probably will need to consider various forms of support from the international financial institutions. These could include the following general approaches:

(1) Parallel IBRD cofinancing.
This program has only been used in a few instances for debtors with a significant rescheduling risk. It fails to meet the banks’ objective to obtain full preferred creditor status and a cross-default provision.

(2) IBRD cofinancing with formal preferred creditor status.
The banks would welcome this approach, but its use is limited by the fact that among major debtors the proportion of the stock of debt that already enjoys preferred status is relatively high. Its heavy use therefore could jeopardize the preferred status of both the World Bank and the IMF.

(3) IBRD guarantees or insurance.
Increased use, on a selected basis, of guarantees of the later maturities of commercial bank loans (as done for Mexico and Chile) are probably the most effective means of enhancing commercial bank flows. They can be used to clearly differentiate new loans from outstanding loans that may be candidates for writing down. As a cosmetic device to help avoid perceptions of a bank bailout, it might be possible for the IBRD to offer “insurance” for higher fees instead of guarantees.

B. Possible Measures for Reducing the Stock of Debt Without a Direct and Substantial Shift of Debt Burdens to Taxpayers of Creditor Countries

Some reasonable reduction in the stock of debt of several major debtor countries would do more to breathe new hope and political credibility into the debt strategy than any other development. The greatest benefits in all respects would be derived from mechanisms that reduce the stock of debt without engaging in conventional debt forgiveness. The greatest weakness of all “grand design” proposals, such as the debt facility proposed by Jim Robinson and some Members of Congress, is that the proposals all visualize large creditor government involvement and negotiated forgiveness of debt,⁴ Our search for solutions in this area should be based on the following principles:

— The primary focus should be on market-based instruments to reduce debt and debt service burdens.

— Official support should avoid shifting the risk on existing private sector debt to the public sector. (Collateralization techniques are preferable to outright purchases of debt. The reduction of regulatory or tax impediments or clarification of regulatory/tax treatment can also be useful.)

— If official funds are involved, they should be carefully conditioned on policy reforms on a case-by-case basis and they should be strictly limited both as to size and to their precedential implications for other countries.

Finally, we should remember that debt reduction can be composed of many facets and that while some may produce small results, the total impact may be significant. In any case, some small measure of debt reduction is far superior to the creation of more debt. A number of positive steps have been taken recently to support techniques that reduce the stock of debt and/or debt service burdens:

— The Fed has liberalized Regulation K provisions to permit bank holding companies (and in limited cases, banks) to own, through debt/equity swaps, up to 40 percent of any private sector company and up to 100 percent of the voting shares of nonfinancial institutions which are being privatized. The permissible holding period for such equity holdings has been lengthened to the shorter of 15 years or 2 years beyond the period of the debtor country’s restrictions on repatriation of the investment.

— Treasury has issued a revenue ruling on the valuation for tax purposes of debt/equity swaps and debt/charity swaps.

— Treasury has supported the Mexican debt/bond exchange offer through the issue of zero-coupon bonds to collateralize the principal of the Mexican bonds.

— Treasury will prepare a report to Congress (due April 1) on possible initiatives to encourage the development of debt-conservation swaps, including potential IMF or World Bank measures.⁵

The Mexican exchange offer provides an alternative route to reduce more rapidly the stock of debt, and by larger amounts. If it is successful, we may want to consider whether it could be developed further for other key debtors. Since Venezuela is the only major debtor with adequate reserves to collateralize securitized debt from its own resources, the following options offer alternative ways of collateralizing or buying back debt for other countries:

1. World Bank/IMF Debt Reduction Program. To assist debtors with low reserve levels, the World Bank and/or the IMF could provide funds to debtors to boost their reserves specifically for the purpose of enabling them to purchase zero-coupon bonds to back the debt/bond swap. The loans should be linked to commercial bank loans for this purpose, and/or could be designated as “debt reduction loans”.⁶ Conditionality would apply to such IMF and World Bank sector loans. As an alternative to lending, the World Bank itself could possibly issue the zero coupon bonds directly to collateralize the bond issue on behalf of the country. (The World Bank could also simply guarantee the principal repayment of the debtor’s own bond issue to avoid altogether the need to buy zeroes.)

Implications. While the debt exchange would occur through the market, some level of official finance would be involved.⁷ Funds for this purpose would have to be additional to other loans to meet the debtors’ financing gap. While the international financial institutions would be assuming additional risk, this would be spread to the full membership of the Bank and Fund, and could be shared with the commercial banks.

2. Debt Exchange Using IMF or World Bank “Window”. Surplus countries (i.e., Japan, Germany, Taiwan, etc.) would fund a newly created IMF or World Bank window similar to the IMF’s Witteveen Facility in the 1970s. The new window would provide finance to debtor countries to collateralize bond issues to retire commercial bank debt. The finance would be used by the debtor country to purchase the zeroes.

Implications. Additional funds for the collateralization would come from surplus countries, so that present IMF or World Bank resources would not be drawn upon.⁸ However, because the IMF or World Bank would be responsible for repaying the surplus countries for funds provided, the World Bank and IMF would still bear the risk.⁹ Creation of such a window, like the previous proposal, would involve the spreading of risk onto all members of the Bank and IMF, but the window would involve the surplus countries directly in recycling their surpluses to the debtor countries. This would take a lot of time to negotiate. There would also be pressure for the U.S. to contribute.

3. Bolivian-Type Debt Buyback. Under this approach debt would be retired directly by providing concessional finance to allow the debtor to buy back its debt at a substantial discount. This approach could be used for countries with exceptionally poor payments capacity such that their ability to even service interest on a reduced stock of debt is suspect.

Implications. This approach is only feasible for countries which expect that their future balance of payments financing needs will be met exclusively by official creditors. As such, it has limited applicability among major debtors. It could be used, though, to retire commercial bank debt in recognized “basket cases”, i.e., Sudan and Zaire.¹⁰ In addition to problems posed using official finance to support a debt buyback (i.e., Congressional charges of “bailing out the banks”), it would also raise questions of comparability for official creditors, who could be asked to forgive their own credits owed by the affected debtor country.

[Omitted here is the proposal for Argentina.]

1. Source: National Archives, RG 56, Records of the Office of the Secretary of the Treasury, Congressional Correspondence, 1988, UD–10, 56–10–1, Box 43, Classified Memos to the Secretary, February ’88. Secret. Baker placed a checkmark at the top of the memorandum.
2. Baker underlined “global solution involving the transfer of the problem to taxpayers in creditor countries.”
3. Baker underlined “we are presently making good progress with Brazil and Argentina.”
4. Baker underlined “visualize large creditor government involvement” and “negotiated forgiveness of debt.”
5. A copy of the report, “U.S. Treasury Department Report to Congress on Debt-for-Nature Swaps,” is in the National Archives, RG 56, Records of the Office of the Secretary of the Treasury, Congressional Correspondence, 1988, UD–10, 56–10–1, Box 46, [no folder title].
6. Baker underlined “‘debt reduction loans’.”
7. Baker underlined “some level of official finance would be involved.”
8. Baker underlined “would come from surplus countries.”
9. Baker underlined “World Bank and IMF would still bear the risk.”
10. Baker underlined “Sudan and Zaire.”