LATIN AMERICA AND AN EVOLVING INTERNATIONAL DEBT STRATEGY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP04T01091R000100140001-2
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• Original Classification: C
• Document Page Count: 21
• Document Creation Date: December 27, 2016
• Document Release Date: March 31, 2014
• Sequence Number: 1
• Publication Date: July 1, 1989
• Content Type: REPORT

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Directorate of Uonnaenual
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Latin America and an
Evolving International
Debt Strategy
A Research Paper
Confidential
ALA 89-10024
GI 89-10064
July /9892 7 1
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Latin America and an
Evolving International
Debt Strate0
A Research Paper
This paper was prepared by Office of
African and Latin American Analysis, and
Office of Global Issues. Comments and queries are
welcome and may be directed to the Chief, South
America?Caribbean Division, ALA
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ALA 89-10024
GI 89-10064
July 1989
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Scope Note
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Latin America and an
Evolving International
Debt Strategy
As part of an effort by the Directorate of Intelligence to monitor the Third
World debt situation, this Research Paper examines the complex problem
of Latin American debt for nonexperts. In particular, it discusses the
importance of Latin American debt for the United States, identifies the
reasons why the international debt strategy is undergoing change, describes
the new US initiative on debt, and assesses what is likely to happen next on
the Latin American debt scene.
111
Confidential
ALA 89-10024
GI 89-10064
July 1989
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Summary
Information available
as of I June.1989
was used in this report.
Latin America and an
Evolving International
Debt Strategy
US Treasury Secretary Brady announced a new initiative on Third World
debt in March 1989 that emphasizes the reduction of commercial bank
debt and debt servicing instead of large-scale new bank lending. By May,
governments of other major industrial countries had agreed to the new
approach in principle. The US initiative provides a framework for encour-
aging creditor banks to undertake substantially greater voluntary debt
reduction by drawing upon official resources in the IMF and the World
Bank. Under the plan, the extent of actual debt or interest payment
reductions cannot be dictated by creditor governments or international
financial institutions but must be worked out in negotiations between the
debtors and commercial banks
The US initiative was taken to strengthen a faltering debt strategy. Efforts
made by creditors and debtors to ease the debt crisis since it broke in late
1982 have met with only limited success because of a disappointing global
economic environment, a lackluster push by the Latin Americans for
domestic economic reform, and a strong reluctance by commercial banks to
extend new loans. Accordingly, the region has suffered serious economic
deterioration, with stagnant growth, soaring inflation, and declining living
standards. Economic and debt problems have emerged as a major political
issue in many Latin American countries and are important factors in
numerous national elections. Debt also had created or added to tensions in
Washington's bilateral relations with some Latin American countries.
To become a workable plan of action, the US initiative must gain the
support of other industrial country governments, the international financial
community, and debtor governments. Important differences persist among
these three groups on the desired levels of reduction in debt servicing; the
appropriate means of achieving the reductions; the amount of public funds
that should be used to support the reductions; the effects of debt reduction
on new lending; and the extent to which economic policy reform by debtor
governments should be a condition. For example, many international banks
insist they will have difficulty reducing debt or debt servicing as much as
contemplated by the US initiative?not to speak of the reduction sought by
debtor governments?because of insufficient financial support from indus-
trial country governments. Many of these governments, however, strongly
oppose contributing additional taxpayer money.
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The US initiative could offer debtors significant help in dealing with their
financial and economic problems if it encouraged their governments to
implement more far-reaching economic reforms and if it supplemented,
rather than replaced, new commercial lending. In addition, debt conces-
sions may help to bolster the political standings of the Latin American
administrations involved. If the major debtors in the region, especially
those such as Mexico and Venezuela that have undertaken serious reforms,
fail to gain significant reduction of debt or debt servicing following their
high expectations, they are likely to suspend their commercial debt
payments?despite potential long-term economic and political costs. They
will also resent the failure of Washington and other industrial country
governments to ensure satisfactory debt reductions and may be less
cooperative on other bilateral issues.
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Contents
Page
Scope Note
111
Summary
The Importance of Latin American Debt
1
How Large Is Latin America's External Debt?
1
Which Countries Have the Biggest Debt Problems?
1
Why Did Debt Become a Bigger Problem in Latin America
Than Elsewhere?
2
What Happened to All the Money the Debtors Borrowed?
2
What Risk Does the Latin American Debt Pose to US Interests?
3
How Important Politically Is the Debt Issue to Latin America?
4
The Need for Modifying the Debt Strategy
4
How Have the Latin American Economies Fared Since the
Early 1980s?
4
Why Has Economic Reform Not Come Easy in Latin America?
5
How Has the Global Economic Environment Affected the Debtors?
5
Why Has New Bank Financing Fallen Short of Debtor Needs?
7
What Has Been the Response of Creditor Governments?
8
The Ideas Behind the New US Debt Initiative
8
What Are the Essential Features of the US Initiative on Debt?
8
What Kinds of Debt Reduction Options Are Considered?
8
What Is Required of Industrial Country Governments?
9
What Is Required of the IMF and World Bank?
9
Will the Costs to Industrial Country Taxpayers Rise?
10
What Impact Does the US Initiative Have on International Banks?
10
Implementing the US Debt Initiative
10
Will Creditor Banks Agree to Much Debt Reduction?
10
Will the Banks Be Willing To Lend New Money?
10
What Happens Next in Formulating a Coordinated
Creditor Strategy?
11
Are Latin American Debtors Responding Favorably?
11
What Are the Prospects for Increased Inflows of Foreign
Investment or Repatriation of Capital Flight?
11
How Much Will the US Initiative Help Latin America's Debtors?
12
What Would Happen If Nothing Further Were Done?
12
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Latin America and an
Evolving International
Debt Strategy
The Importance of Latin American Debt
How Large Is Latin America's External Debt?
Latin America's combined foreign debt totals some
$425 billion, nearly half the $1 trillion owed to foreign
creditors by all Third World countries. According to
the World Bank, 12 of the 16 most highly indebted
Third World countries are located in Latin America.
These countries carry extraordinarily heavy debt bur-
dens relative to the size of their economies, and their
debt servicing obligations are large relative to their
capacities for earning foreign exchange. As a share of
regional gross domestic product, Latin America's
overall foreign debt exceeded 60 percent last year.
In 1988, Latin America's debtors paid $35 billion in
interest to service their debt, compared to only about
$12 billion received in net new lending. Their com-
bined ratio of interest payments to exports of goods
and services was about 31 percent. Many financial
analysts view ratios exceeding 25 percent as a threat
to financial stability. Argentina's ratio last year was
42 percent, Brazil's was 39 percent, and Mexico's was
28 percent.
Which Countries Have the Biggest Debt Problems?
US concerns regarding foreign debt in Latin America
inevitably focus on Argentina, Brazil, Mexico, and
Venezuela, even though debt presents serious prob-
lems for many other countries in the region as well.
These four countries account for about three-quarters
of the region's overall debt and are among the Third
World's largest debtors. Accordingly, their foreign
debts pose risks for regional economic and political
stability, the international financial system, and US
relations with the region.
Mexico and Venezuela have been suffering acute
foreign exchange shortages caused by depressed oil
prices and large current account deficits. Both govern-
ments seek sizable financial assistance from their
1
Table 1
Debts of Sixteen Highly Indebted
Countries, End of 1988
Total
Foreign Debt
(billion US $)
Key Debt Ratios
Debt/GNP
(percent)
Interest/Exports
(percent)
Argentina
58
74
42
Bolivia
6
134
44
Brazil
120
39
39
Chile
21
124
27
Colombia
17
50
17
Costa Rica
5
116
18
Ecuador
11
107
33
Ivory Coast
14
144
20
Jamaica
5
176
14
Mexico
104
78
28
Morocco
22
132
17
Nigeria
32
123
23
Peru
19
41
27
Philippines
30
87
19
Uruguay
5
59
18
Venezuela
35
95
22
creditors and have implemented tough reform mea-
sures in cooperation with the IMF to strengthen their
cases. These measures, however, have been taken at
the short-term cost of economic recession and social
restiveness, of which the bloody riots in Caracas in
March 1989 provided stark evidence. Mexico and
Venezuela potentially are important examples of the
international case-by-case debt strategy being applied
successfully.
The economies of Argentina and Brazil are in even
more serious straits, mainly because of government
mismanagement. Their vacillating leaders have shied
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Figure 1
Major Latin American Debtors:
Total Debt, 1988
Billion US $
Brazil
Mexico
I
Argentina
Venezuela
Chile
Peru
r -
Colombia
'
Ecuador
_
0 20 40 60 80 100 120 140
322240 6-89
away from the politically unpopular steps needed to
put their economies on stronger footings and thus
have fallen out of grace with the IMF. Consequently,
inflation is soaring, investment is slumping, and
growth has ceased. Capital flight has surged as a
result of evaporating public confidence in government
and is undermining the countries' foreign exchange
positions. Poor domestic economic conditions in turn
are contributing to political turmoil and opening the
way for new waves of populist policies.
Why Did Debt Become a Bigger Problem in Latin
America Than Elsewhere?
For a variety of political, cultural, and economic
reasons, the Latin American debtors did not adjust to
the changing world economic environment as well as
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some other Third World countries. Many developing
countries in East Asia (including South Korea, Tai-
wan, and Singapore), South Asia (including India),
and Europe (including Turkey) also were hit hard by
the major oil price increases and global recessions of
the mid-1970s and early 1980s, but came to terms
with these external shocks reasonably quickly. While
these countries restructured their economies, most
Latin American countries turned heavily to foreign
borrowing to cushion the external shocks rather than
try to force changes on politically powerful domestic
interest groups
After a brief initial slowdown, a number of the
developing countries in East Asia, South Asia, and
Europe soon returned to sustainable growth. By con-
trast, many Latin American countries continue to
suffer through severe economic hard times. The only
other region that has suffered as long and as much as
Latin America is Africa, largely because of the
structural shortcomings intrinsic to its lower level of
development.
What Happened to All the Money the Debtors
Borrowed?
Most Latin American countries did not use produc-
tively the bulk of the funds they borrowed during the
past 15 years and failed to create needed debt servic-
ing capacity. A large part of the money loaned by
foreign banks in the early and mid-1970s was invested
in large and inefficient state-owned companies or in
showcase projects such as huge dams, luxury hotels,
and sophisticated military weaponry. A substantial
portion of the funds also was used to sustain high?
consumption, including vast subsidization programs.
Brazil probably is the most notable exception, as it
invested parts of its borrowings in productive econom-
ic infrastructure such as transportation, communica-
tions, and the development of domestic energy re-
sources.
In the late 1970s and the 1980s, the largest share of new
borrowed funds was recycled out of the country. Be-
cause these infusions of foreign exchange propped up
overvalued local currency exchange rates, they ended up
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Figure 2
Exposure of US Banks in Latin America
As a Percentage of Bank Capital, 1982-87
Billion US $
End of 1982
Total US banks
Nine major banks
01 All other banks
Mid-1984
End of 1987
0
80 120 160 200
By Size of Bank, as of December 1988
Percent
Brazil
D All other banks
Next. 13 largest banks
Nine, largest banks
Mexico
Argentina
Venezuela
0 5 10 15 20 25
financing large-scale capital flight as public confidence
waned and expectations of large devaluations grew. The
exodus of funds from Mexico, Argentina, and Venezue-
la was especially heavy. Finally, as interest rates surged
beginning in 1983, Latin America's debtors needed
most of the new money they were able to borrow just to
pay their swollen debt servicing bills.
What Risk Does the Latin American Debt Pose
to US Interests?
Although international banks have reduced their vul-
nerability to possible defaults or moratoriums on debt
payments in recent years, they still stand to suffer
3
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major financial setbacks if debtors undertake some
form of coordinated debt action. Simultaneous sus-
pensions of debt payments by several of the region's
largest debtors?especially Mexico, Braiil, and Ar-
gentina?would cause serious liquidity, and in some
cases solvency, problems for a number of US banks.
The most severe difficulties would be faced by the
largest banks, which hold the preponderant share of
Latin American debt. The threat of insolvency for
such large banks might prompt the Federal Reserve
Bank to intervene?at sizable cost to the US Govern-
ment?to stabilize the banking system.
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Because foreign debt contributes to Latin America's
financial difficulties and general economic malaise, it
has numerous other adverse effects on US interests. It
reduces US trade and investment opportunities in the
region. Poor economic conditions impede Latin Amer-
ica's progress in the war against narcotics trafficking,
weakens the resolve of governments in the region not
to sell arms to radical states, and adds impetus to the
heavy flow of Latin American emigrants to the
United States. At the same time, these conditions
breed political and social discontent in the region and
undermine efforts to consolidate democracy.
How Important Politically Is the Debt Issue to Latin
America?
Economic and debt problems have emerged as a
major political issue in many Latin American coun-
tries and are important factors in national elections
throughout the region. Politicians frequently cite the
net outflow of financial resources caused by large debt
payments as a major explanation for their country's
deteriorating economic conditions. They also com-
plain that, as a condition for providing new money,
foreign creditors force them to adopt austere policies
that discourage economic growth. Thus, a number of
the region's leaders argue that the heavy debt burdens
are stirring social unrest and imperiling their democ-
racies. Some leaders, including Brazil's President
Sarney and Peru's Alan Garcia, have used their
countries' debt difficulties as excuses for their own
mediocre performances. Others who have managed
their economies more responsibly are unhappy with
the sparse rewards from creditors.
An ascendancy of new populist or left-of-center
leaders already signals a potential hardening of
policies on debt in the region. Venezuela's new
President Carlos Andres Perez and Argentina's Pres-
ident-elect Carlos Menem have made debt their top
priority and advocate a limitation of debt service
payments. Although President Carlos Salinas of
Mexico is committed to a generally moderate path,
his policies may come under strong leftist attack if
debt payments are not cut. Presidential elections are
scheduled for November in Brazil, and several leftist
candidates are among the frontrunners. By mid-
1990, all major Latin American governments will
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Table 2
Presidential Transitions in Nine
Highly Indebted Latin American
Countries, 1989-90
Country Date of Election Date of Inauguration
Venezuela December 1988
February 1989
Jamaica February 1989
March 1989
Bolivia May 1989
August 1989
Argentina May 1989
July 1989
Brazil November 1989
March 1990
Uruguay November 1989
March 1990
Chile
December 1989
March 1990
Peru
March 1990
July 1990
Colombia
May 1990 August 1990
have new leaders, and continuing economic deteriora-
tion could impel a decisive political shift toward
economic populism and nationalism.
The Need for Modifying the Debt Strategy
How Have the Latin American Economies Fared Since
the Early 1980s?
Following a brief period in 1984 and 1985, when the
major Latin American debtors seemed to have made
significant progress in adjusting to their sharply swol-
len debt burdens, the debtors' financial positions as
well as economic conditions weakened considerably.
During the period 1986-88, exports by major debtors
grew unexpectedly slowly and their current account
deficits?which had been subdued if not eliminated
over the previous two years?once again surged. Most
of the Latin debtors, with the exception of Chile, have
not significantly reduced their debt service ratios
since 1983, the first full year of the Third World debt
crisis.
Domestic economic conditions of the region's debtors
deteriorated because of external accounts difficulties
and economic mismanagement. In nearly all major
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Table 3
Major Latin American Debtors:
Economic Indicators
1982 1984
1986
1988
Gross Domestic Product Growth (percent)
Argentina
-5.4
2.4
5.4
1.0
Brazil
1.4
4.5
8.0
0
Chile
-14.3
6.3
5.7
7.4
Colombia
0.9
3.2
5.1
4.2
Ecuador
1.4
4.1
2.8
3.0
Mexico
-0.5
3.7
-4.0
1.1
Peru
0.7
4.7
8.5
-8.0
Venezuela
0.6
-1.4
6.8
4.2
Consumer Inflation (percent)
Argentina
164.8
626.7
90.1
342.8
Brazil
100.4
188.8
132.9
583.9
Chile
9.9
19.9
17.4
12.7
Colombia
24.0
18.3
20.9
28.1
Ecuador
16.3
31.2
23.0
85.7
Mexico
58.9
65.5
86.2
114.3
Peru
64.5
110.2
77.9
667.8
Venezuela
9.6
12.2
11.5
29.5
Current Account Balance (billion US $)
Argentina
-2.4
-2.5
-2.9
-2.3
Brazil
-16.3
0
-4.5
4.5
Chile
-2.3
-2.1
-1.1
-0.3
Colombia
-3.1
-1.4
0.4
-0.9
Ecuador
-1.2
-0.1
-0.6
-0.6
Mexico
-6.3
4.2
-1.7
-2.7
Peru
-1.6
-0.2
-1.1
-1.2
Venezuela
-4.2
4.5
-2.0
-4.9
debtor countries, decreased imports and slashed in-
vestment spending-often reflecting, in large part,
flagging business confidence in government-have
deterred economic growth. Furthermore, swelling
budget deficits have caused inflation rates in some
countries to soar. Throughout much of the region,
economic growth has been insufficient to absorb new
entrants to the labor force and to meet debt servicing
5
obligations. Real wages have declined and living
standards in many countries are below what they were
at the beginning of the 1980s.
Why Has Economic Reform Not Come Easy in Latin
America?
Many of the inefficient structural underpinnings of
Latin America's economies have deep cultural and
historical roots. State interventionist tendencies in
many countries can be traced back several centuries
to Spanish colonial practices. Moreover, most coun-
tries in the region embraced as their development
model a protectionist, import-substitution path to
industrialization some 50 years ago in reaction to the
collapse in primary product prices during the 1930s.
Implementation of this model also reinforced major
government roles in productive activities because of
the scarcity of private capital, the touted importance
of economies of scale, and the perceived weakness of
the private sectors. These policies continue to have
many powerful adherents despite their failings in
recent years and despite the growing recognition in
Latin America that reform is essential to the region's
future economic vitality.
Moreover, the consolidation of the statist-led, import-
substituting development strategy created a network
of influential interest groups strongly resistant to
reforms. Labor, which has prized the large numbers
of secure and well-paid public-sector jobs, has vigor-
ously opposed cuts in government spending and the
streamlining of state-owned companies. Parts of the
business community have objected to liberalization of
trade and foreign investment controls because of the
advantages that protectionism has accorded them.
Government officials, including retired military offi-
cers, have resisted privatizing state-owned companies
because of the lucrative-and often not demanding-
positions they hold through patronage.
How Has the Global Economic Environment Affected
the Debtors?
Slow growth in world trade and soft commodity prices
have impeded the efforts of many Latin American
governments to export their way out of their debt
difficulties. World trade growth of some 3.5 to 4
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Economic Reforms Recommended for Latin
America's Debtors
Latin America's structural economic inefficiencies
are the cumulative result of years of public-sector
dominance, protectionist import and investment bar-
riers, and nonproductive use of foreign loans. Govern-
ments in the region were not significantly pressed to
change these policies until the early 1980s, when they
suddenly had to cope with mushrooming debt diffi-
culties brought on largely by soaring interest rates,
a deterioration of their terms of trade, and a decline
in new lending.
Against this backdrop, Western commercial creditors
and multilateral lending institutions began to insist
on economic reform programs as conditions for fur-
ther financial assistance. They advised the debtors to
undertake three general types of economic reforms:
? Promotion of exports to strengthen external pay-
ments and to improve prospects for economic
growth.
? Augmentation of other capital sources to replace
borrowed foreign funds and to promote productive
investment.
? Reduction of the role of government in the economy
to promote economic efficiency and to facilitate
internal price stability.
To achieve greater export growth, debtors are urged
to devalue their overvalued currencies and maintain
competitive exchange rates. Because of their contin-
ued dependence on a few export commodities, many
debtors also need to develop and diversify their
export lines of industrial goods. By reducing their
excessive import protectionism and adopting interna-
tionally acceptable export incentives, Latin America's
debtor governments can reduce their policy biases
against exports and help promote competitive manu-
factured exports.
Latin American governments can augment their in-
vestment capital by expanding the levels of savings
available from both domestic and external sources.
Many debtor countries need to undertake financial
reforms, which can range from simply freeing artifi-
cially low deposit interest rates to strengthening
domestic capital markets, to encourage mobilization
of domestic savings. Tax policies that encourage
savings rather than consumption also can help. To
expand inflows of non-debt-creating savings from
abroad, debtor governments should provide policy
incentives?including a stable investment climate?to
attract more foreign investment and to induce repatri-
ation of flight capital.
The privatization, liquidation, or streamlining of
poorly managed and inefficient state-owned corpora-
tions rank high among the measures recommended to
reduce the government's often suffocating effect on
Latin American economies. These state-owned enter-
prises have represented severe drains on limited
government financial resources. The liberalization of
government controls and regulations?including con-
trols and subsidies on prices, trade, and credits?
would boost entrepreneurial initiative and reduce
misallocation of productive resources. Finally, by
trimming their large budget deficits, many Latin
American governments would sharply reduce infla-
tionary pressures and encourage private investment
by limiting the public sector's dominance of credit
and capital markets.
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percent per year during 1982-88 was insufficient to
stimulate major increases in Latin American export
earnings. Moreover, most of the region's debtors rely
heavily on sales of foodstuffs and raw materials and
have been hurt by sluggish prices relative to other
internationally traded goods. The prices of a number
of leading Latin American export commodities?
including coffee, grain, sugar, iron ore, and petro-
leum?remained below 1982 levels at the end of 1988.
Most commodity analysts do not expect a major
resurgence of these prices soon. Finally, trade protec-
tionism has been on the upswing worldwide, according
to the IMF, and may continue to rise, retarding
growth of exports by debtor countries.
Although international dollar-denominated interest
rates declined substantially and provided important
relief to the region's large debt payments for several
years after 1982, rates renewed an upward trend in
1987. The London Interbank Offerred Rate (LIBOR),
the leading measure of international dollar rates, rose
more than three percenta4 points from mid-1987
through early 1988. Many financial analysts are
forecasting a continued rise in LIBOR into 1990.
each percentage point
increase in interest rates raises annual debt service
payments for Brazil and Mexico by $750 million, and
for Argentina by $500 million.
Why Has New Bank Financing Fallen Short of Debtor
Needs?
Foreign commercial bankers generally have remained
reluctant to commit new funds to Latin American
countries over the past two years because of their lack
of confidence in the governments' abilities to manage
their economies and because of the confrontational
stances taken by several debtors. The banks not only
have refused to voluntarily lend new money to debtor
countries in the region, but they have also increasingly
resisted "involuntary" syndicated loans, which have
required the participation of all commercial banks
under pressure from the largest banks and the official
creditor community. Instead, many international
banks have buttressed their financial positions by
boosting their loan-loss reserves, increasing their capi-
tal, and reducing their exposures in the region by
writing off some debt and exchanging some for equity
in Latin American enterprises.
7
Figure 3
Latin America: Long-Term Net Bank Flows
and Transfers, 1980-88
Billion US $
40
Net Flows a
El Net Transfers b
30
20
10
r---
-10
-20
-30
I I I I I I I I
-40
1980 81 82 83 84 85 86 87 88
a Net flows: Commercial bank disbursements minus principal
repayments.
b Net transfers: Net flows minus interest payments.
322242 6-89
Although most large international banks remain will-
ing to provide some new money on a case-by-case
basis, they generally tend to concentrate these funds
in only a few of the largest debtors?Brazil and
Mexico?where their stakes are high. A number of
other banks, especially small- and medium-size banks,
have opted not to participate in new loan packages for
debtors in the region. There is also a growing senti-
ment among banks?large and small?that the debt
problem has evolved into a political issue and that
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creditor governments and international financial insti-
tutions should provide substantially more lending or
participate more fully in debt reduction schemes.
What Has Been the Response of Creditor
Governments?
During the past year, industrial country governments
have begun considering new approaches to the debt
problem. Many became increasingly skeptical that the
economies of major debtor countries could achieve
substantial recoveries and support debt payments
under continuing conditions of modest world econom-
ic growth and limited new external financing. They
also were concerned about a growing potential for
social and political instability and the threat to the
tenuous trend toward democratization in the region.
In the second half of 1988, the governments of Japan,
with the Miyazawa Plan, and France, with the Mit-
terrand Plan, proposed multilateral schemes aimed at
extending debt reduction to highly indebted, middle-
income developing countries. The theme that new
lending must be supplemented by greater voluntary
debt reduction by bank creditors also became the key
element of the new US debt initiative.
The Ideas Behind the New US Debt Initiative
What Are the Essential Features of the US Initiative
on Debt?
The US debt initiative, announced on 10 March 1989
by US Treasury Secretary Brady, does not spell out
definitive proposals, but rather comprises ideas, areas
of emphasis, and suggestions to help strengthen the
international debt strategy. The initiative builds on
the fundamental principles of the past debt strategy
known as the Baker Plan, which were:
? Economic growth is essential to the resolution of
debt problems.
? Debtor countries will not achieve sufficient growth
without credible economic reforms.
? Debtor countries will have a continuing need for
financial support from foreign creditors.
? Solutions must be found on a country-by-country
basis.
Confidential
While the fundamental principles of the Baker Plan
remain valid, the new US debt initiative attempts to
strengthen the strategy in several ways:
? The approach stresses voluntary negotiations be-
tween debtor countries and creditor banks to estab-
lish accelerated reduction of debt and debt servicing
over three years. While the Baker Plan focused on
new bank loans, the new US initiative focuses on
reduced debt payments.
? The US initiative calls for redirecting official re-
sources of the IMF and World Bank to guarantee
debt-for-bond exchanges agreed upon by commer-
cial banks and debtor governments. Both organiza-
tions would have to make special provisions to take
on this additional and unusual function.
? While the approach maintains the IMF's and World
Bank's central role in encouraging debtor policy
reforms, stronger emphasis is placed on efforts by
debtor governments to attract new foreign invest-
ment and repatriate flight capital.
The US Treasury suggests the debt initiative is
potentially available for 39 debtor countries. If all
these countries participate, their combined $340
billion stock of commercial debt would be reduced
by some $70 to $100 billion-20 to 30 percent?
over three years. The 17 Latin American debtors
among the 39 eligible countries owe $265 billion
and would see their combined debt reduced by $53
billion to $80 billion.
What Kinds of Debt Reduction Options Are
Considered?
Debtor countries seeking to reduce their commercial
debt burdens under the new US initiative have
several options from which to choose:
? Discounted debt-for-bond exchange. Debtor govern-
ments can reduce their overall debt by exchanging
existing loans at a significant discount for new long-
term bonds bearing market-determined interest
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rates. The new bonds' principal would be fully
backed by funds administered by the IMF or World
Bank.
? Par restructuring. Debtor governments can ex-
change existing commercial debt for long-term
bonds at par value but with a lower-than-market
interest rate. This option would not reduce a deb-
tor's outstanding debt but would lessen its interest
servicing costs.
? Debt buybacks. A debtor government can directly
purchase its outstanding debt at a substantial dis-
count.
In addition, commercial banks continue to laud the
debt-for-equity swap as an effective mechanism for
reducing debt and will encourage debtor governments
to maintain swap programs. Under this transaction, a
commercial bank typically sells its loans at a discount
to a multinational company, which transfers it to the
debtor country for redemption in domestic currency at
near or fullface value. The company then invests the
proceeds in a business venture in the debtor country.
What Is Required of Industrial Country Governments?
For the new US debt initiative to succeed, it must
have the full support of other key industrial country
governments. The Group of Seven ' industrial coun-
tries already have given their backing in principle to
debt reduction for those Third World debtors that are
committed to substantial economic reforms. These
governments also have approved the use of IMF and
World Bank financial resources to provide support to
the various schemes for reducing debts and debt
servicing to commercial banks, and have left decisions
on implementing details to the two international
organizations. Some creditor governments also would
probably have to review their regulatory, tax, and
accounting practices to determine whether additional
measures are desirable to encourage bank participa-
tion in the new debt initiative.
' The Group of Seven is comprised of Canada, France, Italy, Japan,
the United Kingdom, the United States, and West Germany
9
In addition, the US Treasury has stated that it intends
to look to Japan, and perhaps other wealthy countries
such as West Germany and Taiwan, to provide addi-
tional fresh funds to debtor countries. Japan, for
example, already has pledged at least $4.5 billion in
new loans to developing country debtors, including
some in Latin America, in collaboration with the IMF
and World Bank programs to reduce debt and debt
servicing.
What Is Required of the IMF and World Bank?
The IMF and the World Bank will play a crucial role
in the new US initiative by facilitating debt and debt
service reduction and by continuing to encourage
policy reforms by debtor countries. For this purpose,
the two organizations have agreed to set aside por-
tions?amounting to a total of some $24 billion?of
their loan resources that are conditioned on recipients'
policy performances. The IMF stated it would allow
member countries to allocate about 25 percent of their
standard borrowings from the Fund to support debt-
principal reductions?such as collateralizing the prin-
cipal of discounted debt-for-bond transactions or re-
plenishing reserves following discounted debt
buybacks. The Fund will consider additional loans in
some cases to support reductions in interest rates for
new bonds. Likewise, the World Bank agreed that 25
percent of its structural adjustment lending to a
country could be used for debt reduction over three
years and, when justified, additional resources could
be made available for support of interest payment
reductions.
The steering committees of the IMF and the World
Bank reaffirmed their view in early April that finan-
cial assistance from these two major international
financial institutions should be linked to sound eco-
nomic policy performance on the part of debtor
governments. Accordingly, those governments that
wish to participate in the new US initiative would
have to subscribe to an economic reform program
with the IMF and World Bank, including measures
that improve the foreign investment climate or en-
courage citizens to bring back capital they had sent
abroad.
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Will the Costs to Industrial Country Taxpayers Rise?
The new US debt initiative does not contemplate
additional direct costs to US taxpayers, or those of
most other industrial countries, except Japan. The
initiative does not call for any tax changes to ease the
costs of debt writeoffs?something commercial banks
desperately want. Some creditor governments, such as
Bonn and Tokyo would like to see the IMF's funds
substantially boosted, which would require additional
budgetary outlays for all member governments, but
agreement on such a step probably will not be con-
cluded for at least another year or two. Tokyo is the
only creditor government that has pledged some of its
own funds?at least $4.5 billion?to supplement the
$24 billion so far set aside by the IMF and World
Bank.
Indirectly, the effects of the initiative's debt reduction
schemes on taxpayers will be mixed. On the one hand,
financial losses by commercial banks?and their
shareholders?may result in the banks' paying less in
taxes than they otherwise would. On the other hand,
reduced burdens of debt owed to commercial banks
may make it easier for the Latin American debtors to
meet their obligations to official creditors. Moreover,
improved Latin American financial conditions could
lead to fewer loan "bailouts" by industrial country
governments, less recourse to Paris Club debt relief,
and reduced dependence on large-scale balance-of-
payments assistance from the IMF and World Bank.
What Impact Does the US Initiative Have
on International Banks?
In the short term, the US initiative may hurt interna-
tional banks. Banks participating in reductions of
debt and debt servicing generally will incur financial
losses, although many, including US institutions,
already have taken some steps to prepare for this
contingency?by strengthening their reserve-loss
provisions and reconstructing their capital bases?
and probably have already suffered much of the
expected related decline in their stock prices. Official
support for bond exchange schemes also could soften
the impact of losses for highly exposed large banks.
Confidential
Over the longer haul, banks could derive substantial
benefits. Many banks view some debt reduction deals
as advantageous because they believe the value of
their remaining outstanding debt will be enhanced.
Moreover, if debt reduction contributes to an eventual
strengthening of the Latin American economies and a
more rapid return to creditworthiness, the region
could once again become an attractive investment
outlet for commercial banks. For this to happen, the
new US initiative will also have to encourage debtors
to implement sustained economic reforms.
Implementing the US Debt Initiative
Will Creditor Banks Agree to Much Debt Reduction?
International banks will agree to some reduction of
Latin American debt and debt servicing, but the size
and pace of the reductions remain questionable. The
banks probably will accept at least 20-percent debt
reductions over three years, especially considering
that the secondary market prices?that is, the resale
values?of most of these loans are very low. More-
over, creditor governments appear committed to the
initiative's success and probably will provide the
banks sufficient incentives through the IMF and
World Bank to encourage debt reduction on that
scale
The banks are balking, however, at the much larger
demands for debt reduction of 40 to 50 percent made
by some of the region's major debtor governments.
For example, the committee of creditor banks negoti-
ating with Mexico blamed the government's excessive
demands for obstructing an early agreement on a debt
reduction package. Many bankers maintain the IMF
and World Bank are unlikely to devote sufficient
financial resources to support debt and debt servicing
reductions on the scale sought by Latin American
governments.
Will the Banks Be Willing To Lend New Money?
International banks probably will not be willing to
extend large amounts of new money to Latin Ameri-
can countries under the new initiative, especially
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given current regulatory and tax rules. Many banks
are discouraged by the continued lack of determina-
tion by various Latin governments to implement
economic reforms and are wary of future confronta-
tional debt policies in the region. In addition, most
commercial banks see new loans to Latin American
debtors as costlier as a result of the recent increase in
their loan-loss reserves against debt exposures in the
region.
Commercial bank loans probably will be extended
only to Mexico and Brazil, where bank stakes remain
high, and to a select few small debtors demonstrating
strong commitment to economic reform. Elsewhere,
Latin America's access to commercial funds generally
will be limited to short-term trade credits. Part of the
slack left by reduced commercial bank loans may be
taken up by a rise in lending from international
financial institutions, such as the World Bank and the
InterAmerican Development Bank, although these
organizations are unlikely to become major lenders.
What Happens Next in Formulating a Coordinated
Creditor Strategy?
The US Treasury will continue to work closely with
key creditor and debtor governments, the commercial
banking community, and the international financial
institutions to work out the details of a revised
strategy. Third World debt will be a focus of discus-
sion among the Group of Seven leaders at the Paris
Economic Summit in mid-July?as well as a series of
meetings with both developing and industrialized
countries in the next few months. Because of the
diversity of views, progress on the new strategy is
likely to be slow and take many months. In the short
term, the US Treasury is trying to encourage debtor
countries, such as Mexico, Venezuela, and Uruguay,
to pursue negotiations with commercial banks that
incorporate the ideas of the US initiative.
Are Latin American Debtors Responding Favorably?
Latin American leaders have welcomed the shift in
the debt policies of the industrial countries from
emphasis on new money to outright reduction of debt
and debt servicing. They view the US initiative as a
significant breakthrough, noting that it recognizes
11
t..onnaenuai
that Latin America's debt load is too heavy to be
repaid, that debt reduction is necessary to rekindle
economic growth, that the problem has become more
urgent than earlier believed, and that new debt should
be treated differently from old debt.
The Latin American debtors' optimism for the initia- 25X1
tive has been tempered, however, by several concerns
that are generally oriented around three groups.
Mexico and Venezuela, two countries targeted by the
US Treasury as priority beneficiaries because of their
urgent financial needs and willingness to implement
crucial domestic reforms, have expressed doubts that
debt relief under the initiative will be nearly large
enough or available soon enough. The second group?
comprising Colombia, Chile, and Uruguay?is con-
cerned about the initiative's impact on countries like
themselves that have managed their debt responsibly
and do not need bank relief. They are wary that debt
reduction for several poor performers might discour-
age new lending to the entire region. Peru, Argentina,
and, to a lesser extent, Brazil?representing a third
group?object to the economic policy reforms they are
required to implement as too demanding and fear,
accordingly, that they will be excluded from the
initiative, at least for now.
What Are the Prospects for Increased Inflows of
Foreign Investment or Repatriation of Capital Flight?
Foreign investment flows probably will recover gradu-
ally in the coming years from the low levels of the
mid-1980s but not enough to offer substantial finan-
cial relief to the major Latin American debtors. A
number of governments?such as Mexico and Vene-
zuela?have expressed a desire to attract substantially
more foreign investment and have taken some steps to
improve the investment climate. Nevertheless, signifi-
cant resurgence of investment probably will not occur
until the region's debtors mount sustainable recoveries
from their current recessions and show substantially
improved economic management.
In the past year, capital flight has again become a
serious drain on the financial resources of Latin
America's major debtor countries and probably will
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continue to plague several countries whose govern-
ments will fail to undertake responsible policies. Even
when debtor governments turn their flagging econo-
mies around, they will not be able to count on a timely
and substantial repatriation of capital. Many Latin
American investors will want to see a sustained track
record of sound economic management and political
stability before bringing their funds back into the
region. Some investors will be slow to repatriate
capital for fear of retroactive taxes or penalties for
past violations of currency exchange controls. Some
private studies also indicate that as much as a third of
flight capital has been used to buy less liquid assets?
mostly real estate?that cannot be easily repatriated.
How Much Will the US Initiative Help Latin
America's Debtors?
The initiative would offer significant help if it suc-
ceeded in encouraging debtor governments to imple-
ment stronger economic reforms and if it supplement-
ed, rather than replaced, new commercial lending.
The reforms will be essential for the major debtors to
become more internationally competitive and return
to sustainable development and growth paths over the
long run. In the shorter run, reduced debt servicing
payments could provide financial breathing room for
some economically pressed Latin American govern-
ments. Indeed, debt concessions may help to bolster
the political standings of the administrations involved.
The benefits of debt servicing reduction would be
partially or wholly neutralized, however, if it discour-
aged new lending, as some bankers fear. In 1987 and
1988, Argentina, Brazil, Mexico, and Venezuela paid
out a combined average interest bill of $27 billion.
Accordingly, a 20-percent reduction would trim these
payments by $5.5 billion. In the same two years,
however, these four countries received a combined net
$7.5 billion annually in new loans. It is clear that, at
the extreme, some major debtors could find them-
selves in worse financial positions under the new debt
initiative if commercial banks used it as an excuse to
cease providing new money.
Confidential
Figure 4
Latin America: Capital Flight
Billion US $
Argentina
1
Asset Stock at Yearend a
0 1980
1982
El 1987
ii
1
Brazil
Colombia
Ecuador
Mexico
Venezuela
- 1
1
0 10 20 30 40 50 60 70 80 90
a Compounded values excluding assets built from capital
before 1977. The compounded values assume a pretax return
of six-month dollar LIBOR on the annual flight capital outflow
estimates.
171243 6-89
What Would Happen If Nothing Further Were Done?
If Mexico City gets little or no debt reduction follow-
ing its high expectations, it very likely would declare a
moratorium on its debt payments and probably accuse
Washington of insincerity in its stated wish to help
Mexico. Moreover, many other debtors who closely
monitored the Mexican debt reduction talks as a test
case probably would follow suit in what could become
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Table 4
Selected LDC Debtors: Effects of Commercial Bank
Debt Reduction
Total Official
and Commercial
Debt
Reduction
Implied To
Obtain
Creditworth-
iness a
Total
Commercial
Debt
Billion US $
Alternative Reduction Scenarios
20 Percent
30 Percent 50 Percent
Argentina
? 58
32
35
7.0
10.5
17.5
Brazil
120
40
76
15.2
22.8
38.0
Costa Rica
5
1.3
1
0.2
0.3
0.5
Mexico
104
33
69
13.8
20.7
34.5
Morocco
22
10
5
1.0
1.5
2.5
Uruguay
5
.03
2
0.4
0.6
1.0
Venezuela
35
11
26
5.3
7.8
13.0
Philippines
30
6
12
2.4
3.6
6.0
a The amount of debt reduction needed to bring the debtor within
the desired creditworthiness levels was derived by comparing each
debtor's actual total debt to GDP, total debt to exports of goods and
services, and total interest payments to exports of goods and
services ratios to levels desired by creditors, which are 40 percent,
200 percent, and 20 percent, respectively.
a regionwide movement. If Venezuela fails to gain
significant help?whether or not Mexico did?it too
would almost certainly impose a full suspension of
payments, and President Perez would try to spearhead
a Third World debtors' movement.
If Brazil does not reap benefits from the new debt
initiative this year similar to those expected by Mexi-
co and Venezuela, the Brazilian congress probably
will pass legislation suspending at least some interest
payments. If a leftist wins November's presidential
election, even stronger action may be taken. As time
passes, and if the new debt initiative eventually proves
Reverse Blank
13
to be beneficial to Mexico and Venezuela, Brasilia
may reconsider its options and institute stronger
economic reforms to qualify for similar concessions. If
Argentina does not receive creditor treatment similar
to that accorded Mexico or Venezuela, President
Menem probably would formally suspend interest
payments, withdraw Buenos Aires further from the
international financial community, and try to go it
alone.
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