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

252. Paper Prepared in the Department of State¹

Washington, undated

THE U.S. DEBT STRATEGY

Substantial Progress to Date.

○ A key accomplishment is the increasing recognition among developing countries that long-term growth requires a strong commitment to market-oriented policies.

○ For the 15 major debtors specified in the Baker Plan as a group, GDP growth averaged a positive 3 percent in 1986–87 versus negative growth of 3 percent in 1983; export earnings rose 13 percent and imports 9 percent in 1987; imports in 1988 are expected to be at their highest levels since 1982; the aggregate current account deficit fell from $50 billion in 1982 to $15 billion in 1986 and $9 billion in 1987; debt interest/export ratios declined by nearly one-third between 1982 and 1987; aggregate reserves in 1987 were $38 billion, 46 percent above the 1982 level; and capital flight is being turned around, with several countries having net inflows of non-debt-creating finance in 1987.

○ To accelerate this progress, the U.S. has encouraged the further development of a “menu” of alternative, market-driven financial instruments to help meet the diverse interests of both debtor nations and the banking community in devising new financing packages. The thrust among commercial creditors, as well as among the debtors, is for packages that include a variety of options to reduce debt.

— Negotiated, market-oriented mechanisms can, in the aggregate, make a dramatic difference in the debt burden of countries.

— About $10–11 billion in debt/equity swaps and other debt conversions have helped to reduce debt and debt service burdens and to stimulate new investment flows in various countries.

— Chile converted $5.2 billion from debt to equity through September 1988—a third of its commercial debt stock. In early November, Chile bought back about $300 million of its debt at 56 cents on the dollar.

— Mexico eliminated 2% of its debt stock through an innovative securitization scheme with long-term, principal-secured bonds, and variants of this program are planned for the future.

— Bolivia repurchased half its commercial debt stock at a cost of 11¢/$1 with a voluntarily-funded debt-buyback plan.

— Brazil negotiated a package with the banks in 1988 that offers six variations of debt/equity swaps. Brazil can potentially reduce its external debt to commercial banks by a net of $18 billion by 1993, or about one-fourth of outstanding debt, with corresponding savings of $5 billion on future interest payments.

○ Commercial banks have played a major role.

— Total exposure of U.S. banks in the Baker Plan countries, plus two other highly indebted countries, has dropped by 10.5 percent since 1982. The exposure of nine money center banks relative to primary capital declined from 192.4 percent in 1982 to 106.6 percent in 1987. For all other banks, the exposure relative to capital dropped from 85.2 percent in 1982 to 35.2 percent in 1987.

— The decline in exposure relative to capital came about due to lower absolute loans outstanding and a large increase in banks’ capital. Banks want to step up debt reduction now because the provisions they have taken to date place them in a better position to do so, and because depressed bank stock prices tend to rise when high-risk LDC debt is converted, even at a discount.

— Banks have made significant loan loss reserves and have taken some write offs. Although exact figures are not readily available, U.S. banks have taken reserves equal to about 15–20 percent of their LDC exposure.

— They have committed some $17 billion in new finance since October of 1985, while rescheduling approximately $207 billion on outstanding debt, reducing interest rate spreads and providing longer grace periods and maturities.

○ The IMF and World Bank provided strong support for the debtors’ efforts through general economic advice and assistance in the development of growth-oriented programs. Together the two institutions provided $25 billion in new loan commitments during the last three years.

○ Official creditors in the Paris Club have rescheduled approximately $25 billion in outstanding debt and interest since October 1985. In addition to its Paris Club participation, the U.S. supported a $74.8 billion World Bank General Capital Increase to assure that capital is not a constraint on the ability of the World Bank to fulfill its key role in the debt strategy. The U.S. also advocated the creation or strengthening of several IMF facilities to promote growth-oriented structural reform programs.

Despite the Progress, Problems Remain.

○ Total LDC indebtedness has increased from $720 billion at the end of 1982 to $983 billion at the end of 1987. Latin debt grew from $336 billion to $416 billion in the same period, while Sub-Saharan debt grew from $65 billion to $124 billion.

○ The ratio of total debt to exports of goods and services went from 125 percent in 1982 to 157 percent in 1987. This worrisome trend may be shifting, however, as LDC export earnings have increased faster than LDC debt in the last two years.

○ Despite new money packages and increased official lending, the 15 countries specified in the Baker Plan experienced net outward resource transfers of $138 billion during 1983–1987; flight capital was not the primary cause of outward resource flow in this period; most capital flight took place before 1983.

○ Concerted Balance of Payment (BOP) lending is increasingly difficult; even the few Latin countries that have not rescheduled commercial debt have increasing difficulty in borrowing. In a sense, commercial bank creditors have abandoned any pretense of a case-by-case approach, and now rate all middle-income Latin debtors (and the Philippines, Nigeria and perhaps Indonesia) as not very creditworthy.

○ Per capita GDP declined by 6 percent in Sub-Saharan Africa over 1981–1987, and by 7 percent in Latin America.

○ International financial institutions are assuming an increasing share of the burden of lending. Commercial banks are clamoring for IFI guarantees to cover new bank lending. Arrearages to the IFIs are growing, and could become a serious problem in the 1990s.

○ The rate at which countries seek rescheduling from their official creditors via the Paris Club is increasing. From 1983–1987, the frequency of rescheduling quadrupled, with two-thirds of the countries which requested rescheduling doing so on previously rescheduled debt.

○ As debt loads increase and per capita incomes decline, debtor fatigue increasingly leads to a search for a politicized means to solve the debt problem.

○ Political change in Latin America may lead to more radical approaches on external debt. New presidents in Mexico and Ecuador may take harder stances. The possible victors in presidential elections to be held before 1990 in Venezuela, Brazil, Peru, Argentina, Bolivia and Chile may also take a more confrontational approach.

Present Situation.

○ Our approach has been flexible and innovative, but perceptions have altered even faster than the debt strategy could be modified. Increasingly the debt workout is perceived by debtors and many creditors as stalled.

○ Debt has become increasingly politicized, both in debtor and creditor countries. As a result, the search for a “political” solution has accelerated, and the foreign policy challenges have become more acute. In effect, third world debt is now as much a foreign policy issue, with a short-term focus, as a financial issue, with a medium-term focus.

○ In the debtor countries, governments important to us politically are under great pressure to reduce the burden of their debt. The issue has taken on heavy symbolic importance.

○ In creditor countries, the issue is also growing in political importance.

○ A growing segment of the U.S. Congress supports debt relief, again a political sentiment based on the feeling in some sectors of U.S. society (e.g. exporters and farmers) that the banks have been saved at their expense.

Issues for New Administration.

○ The Administration needs to find a concept that defuses the debt issue politically yet incorporates all the elements needed to continue and validate the progress that has occurred since 1982.

○ The debt strategy evolution to date offers us the opportunity to construct a modified framework that could depoliticize debt and lay the foundation for sustained economic growth in indebted LDCs.

○ A sharp departure from the present debt strategy is not necessary. It is increasingly clear, however, that any new design must facilitate debt reduction by encouraging banks to differentiate between debt that would continue to be serviced, and debt that would not be serviced, with banks accepting their losses and settling for less than full value.

○ We have the opportunity to foster even greater movement on the debt reduction front. The USG should articulate a concept or way of thinking about the debt problem which puts much greater reliance on debtors and creditors working out debt reduction without government intervention.

○ In addition, the Administration might consider whether to enhance the role of the World Bank in facilitating the exit of smaller creditors and debt reduction by larger banks. World Bank guarantees for exit bonds and voluntary debt reduction may be useful, although World Bank guarantees for new commercial bank lending should be discouraged.

○ This new design must maintain incentives for short-term trade lines and medium-term project financing even as creditors write off other assets in an orderly fashion.

○ Settlements under a newly evolved debt strategy must be voluntary, country specific (i.e. case-by-case) between the commercial creditors and the debtors, with the USG resolutely on the sidelines. IMF and World Bank lending would be based strictly on the extent of debtor reform, and separate from debtor/commercial bank negotiations.

1. Source: Department of State, Executive Secretariat, S/S Files, 1988–1989 Official Office Files for (E) Economic Affairs Allen Wallis, Lot 89D154: Through Memoranda November 1988. Drafted by John Moran (EB/IFD/OMA) on November 16; cleared in EB/IFD/OMA by Milam. Sent under a November 17 covering memorandum from McAllister to Shultz which provided briefing material for a November 18 IEP breakfast meeting.