THE IMPLICATIONS OF SEVERE LDC FINANCIAL PROBLEMS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP84B00049R001102630002-2
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 12
• Document Creation Date: December 20, 2016
• Document Release Date: March 15, 2007
• Sequence Number: 2
• Publication Date: May 5, 1982
• Content Type: MEMO

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THE DIRECTOR OF CENTRAL INTELLIGENCE
National Intelligence Council
SECRET
DDI #3744-82
5 May 1982
MEMORANDUM FOR: Director of Central Intelligence
Director, Office of African and Latin American Analysis
Director, Office of East Asian Analysis
Director, Office of European Analysis
Director, Office of Global Issues
Director, Office of Near Eastern and South Asian Analysis
Director, Office of Soviet Analysis
Director, Office of Current Production and Analytic
Support
Chief, Product Evaluation Staff
VIA: Chairman, National Intelligence kzj-
FROM: Maurice C. Ernst
National Intelligence Officer for Economics
SUBJECT: The Implications of Severe LDC Financial Problems
Attached is a preliminary look at what I consider to be the growing
difficulties LDCs will face in financing large current account deficits and
the increased risks to the stability of the international monetary
system. I believe these issues need to be carefully examined and that CIA
needs to do more work on some important aspects.
Maurice C. Ernst
Attachment,
As stated
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DDI #3744-82
5 May 1982
SUBJECT: The Implications of Severe LDC Financial Problems
NIC/NI0/Econ
Distribution:
1 - each addressee
1 - DDCI
1 - ExDir
1 - Executive Registry
1 - DDI Registry
1 - each NIO
2 - NI0/Econ
1 - NIC/AG -
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The Implications of Severe LDC Financial Problems
Argentina's conflict with the U.K. and Mexico's severe difficulties in
making the necessary shift from expansionary to restrictive economic
policies, in addition to broad negative world economic trends, could bring
the financial problems of LDCs to a crisis phase during the next few
months. There appears to be a substantial risk of.a large contraction of
bank lending to Latin American and African countries. There is also a much
smaller, but still worrisome risk that LDC debt problems, on top of those
already experienced in Eastern Europe, will trigger a banking crisis which
could have adverse repercussions throughout the international economy. The
next six months or so will be a period of exceptionally high risk of both
kinds.
There is no question that the LDC's international financial position
has been deteriorating. The debt service ratio rose sharply last year and
will rise again this year as a result of rising interest rates and falling
exports. The Western economic recession has caused prices of most LDC
primary exports to fall sharply during the past year or so, with
detrimental effects on both export earnings and domestic incomes. Many
LDCs have had to curtail imports, which, for the Third World as a whole,
have not grown for more than 12 months. In spite of these painful steps,
current account deficits have not fallen because the impact of higher
interest rates offset any reductions in trade deficits (see attached
tables).
Unfavorable World Economic Trends
Most projections of LDC economic trends have assumed that current
account deficits as large as or larger than last year could be financed.
Although there have been signs of growing difficulties in meeting debt
service obligations, until recently all of the LDCs who were in arrears on
debt payments were small countries--mainly in Central America and Africa.
The consensus view was that the big debtors--e.g., Brazil, Mexico and
Argentina--would be able to finance large deficits. This assumption has
become highly questionable because of both a worsening of some general
economic and financial trends and some unexpected developments in key
countries.
The international economy has been weaker than formerly expected.
Recovery from the U.S. recession, once expected to begin early this year
has been delayed for at least 6 months, and maybe longer. Western Europe's
economic recovery also has been delayed. Consequently, demand for LDC
exports is weaker than had been expected. This unfavorable trend more than
compensates for the impact of declining world inflation on LDC import
costs.
The dramatic turnaround in the oil market, from shortage to glut, and
the resulting disappearance of the OPEC surplus, is having a mixed impact
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on the LDC econom-es, but many of the favorable effects will probably be
delayed while the unfavorable effects are already being felt. Lower oil
prices are beginning to reduce directly LDC import costs, are an indirect
factor in lowering the prices of non-oil imports, and will eventually help
to stimulate Western economic recovery. On the other hand, the
disappearance of the overall OPEC surplus and the .entrance of most OPEC
countries into the financial markets as borrowers is increasing the
competition for loanable funds while reducing their volume. This is
clearly a factor in the tightening of the Eurodollar market, taking the
form of both reduced lending and more stringent terms. Finally, a
retrenchment is underway in official financing of LDC developmental and
balance of payments needs, which places even greater pressure on private
capital markets.
Besides these broad economic trends, events in Argentina, Brazil and
Eastern Europe threaten to shake bankers' confidence in lending to LDCs.
The Argentine Crisis
The Falkland Islands conflict comes at a time when a recently
installed Argentine military leadership was in the process of introducing a
promising, but very painful economic stabilization program. Under the
previous leadership, the economy had suffered at the same time rapidly
declining production, accelerating inflation and a massive increase in
foreign debt, the results of extraordinary mismanagement, even for
Argentina. Even if the military conflict with Britain ends quickly,
without major financial effects, any successor Argentine government will
have great difficulty coping with debt service obligations, which exceed $6
billion this year. To meet these obligations would require both severe
belt-tightening at home, which may not be politically possible, and
enhanced lenders' confidence. Although formal default on Argentina's debt
is unlikely, a great deal of rescheduling is a strong possibility.
Argentina is the third largest LDC debtor, with over $20 billion in medium-
and long-term debt and over $10 billion in short-term debt.
The Mexican Problem
Mexico is beginning to undergo a difficult economic transition during
the interregnum between a lame duck Presidency and a new one. Soft oil
markets are reducing both current and projected export earnings and the
massive Mexican debt (over $70 billion), accumulated in a period of
euphoria over surging oil earnings, no longer looks secure. The overdue,
floating devaluation of the peso has been mismanaged. An attempt to
insulate domestic real wages from the impact of the devaluation has kept
the peso floating downward and has undermined confidence in the seriousness
of government's intention to return to a stable situation. Although the
government has announced a several-point stabilization program, there are
questions both about its willingness to take unpopular measures and about
the possible squeeze on private enterprises between overall credit ceilings
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and the continuing large demilnds of the public sector. At least one major
private enterprise (Group Alpha) has fallen behind on its foreign
obligations and is trying to negotiate ..a rescheduling. Bankers are
extremely worried about Mexico and are--reluctant to provide new money.
Eastern Europe
Far from Latin America, but with possible implications for LDC access
to credit, are the severe debt service problems of Eastern Europe. The
continued worsening of Poland's financial crisis; the growing crisis in
Romania; and the spread of bankers' concerns to Hungary, East Germany, and
the rest of the Soviet Bloc, are causing an overall contraction of private
credit to that area. Apart from the fact that this credit contraction will
force a reduction in imports, the experience in Eastern Europe may color
bankers' attitudes about lending to LDCs.
A Possible Contraction of Credit to LDC's
These developing problems could give rise to either or both of two
kinds of financial crises: a severe curtailment of lending to LDCs; and an
international banking crisis. The first of these crises is far more likely
than the second, but the possibility of both has increased greatly and will
probably peak during the next few months. Beyond that period, economic
recovery in the West should be underway, LDC export prices should be
risinq, and consequently the debt problems should begin to ease.
It would not be surprising if Argentina were unable to finance any
balance of payments deficit for at least several months, although lenders
will have little choice but to roll over existing credits. Mexico is not
yet so badly off, but its creditworthiness has been severely eroded and
strong stabilization measures are needed soon to reestablish bankers'
confidence. It is highly unlikely that Mexico can finance a projected
current account deficit of the order of $8 billion. Major difficulties in
Argentina and Mexico, reinforced by the indirect effects of the problems in
Eastern Europe, will almost certainly make funding of a large deficit more
difficult for Brazil. Brazil has already substantially reduced its imports
over the past three years. Further cuts are bound to adversely affect on
economic activity. Most other Latin American countries are also in
financial trouble, and not only those of Central America and the
Caribbean. Venezuela faces a probably lengthy period of declining oil
earnings, its dominant source of income. Negative bankers' attitudes may
spread to the entire continent, as well as to Africa, where a substantial
number of countries are already in arrears on their obligations. There are
no signs, however, that the Far Eastern or South Asian countries are
encountering any major difficulties in obtaining loans. So far, they may
even be benefiting from the increased risk of bank lending to other parts
of the world and from their comparatively strong economic position.
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A substantial contraction of credi': to LDCs would force severe
additional economic adjustments in countries which are already depressed,
and in some of them this could be highly destabilizing politically.
Moreover, a sharp contraction of imports in both the LDCs and the Communist
countries would act as a further drag on economic recovery in the West. In
contrast, Western recovery from the 1975 recession. was substantially aided
by the continued growth of import demand in LDCs and the Soviet Bloc.
The Risks of A Systemic Crisis
The risk that a reduction in bankers' confidence in lending to LDCs
will trigger a major banking crisis is difficult to assess. Concern about
the vulnerability of the international financial system to events which
could trigger major bank failures, and the spreading of the crisis
throughout the international financial system has increased greatly.
Although national and international financial authorities have addressed
this issue and taken some steps to cope with crisis situations should they
arise, substantial sources of concern remain. These are based on the
following kinds of considerations:
o The enormous volume of interbank deposits in the Euro currency
system (nearly a trillion dollars);
o The lack of transparency in the system and the speed at which money
can move;
o Ambiguities concerning acceptance of responsibility for Lender of
Last Resort functions by central banks--for example, who is
responsible for the branches and subsidiaries of foreign banks in a
particular country?
o Ambiguities concerning criteria for providing central bank support
to private banks which are in trouble--which banks should be helped,
why, and under what circumstances?
o Possible shortages of the particular foreign currencies in which
intervention is necessary.
o Possible legal constraints on private or central bank support.
There is concern that a major bankruptcy among the LDCs or in Eastern
Europe will trigger a liquidity crisis in banks which are particularly
exposed, or in the extreme may wipe out some banks' capital. This process
could begin with the direct effects of bad debts on a bank's balance sheet
and quickly lead to cash flow problems when other banks withdraw their
deposits from or at least refrain from making new deposits in the troubled
banks. A chain reaction could then set in, involving an increasing number
of banks in an increasing number of countries as confidence ebbs and
bankers try to retrench to protect themselves. The retrenchment process
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could be stopped by central bank action but there is a question as to how
prompt and effective this action would be. The problem is complicated by
the great uncertainty as to what form initial stages of the crisis might
take and by the concerns of financial authorities that too much prior
discussion of this problem would become public knowledge and would itself
undermine market confidence. The financial authorities also want to avoid
promising so much support that private banks will feel free to take undue
risks.
Even those who worry the most about the risks of an international
banking crisis do not regard such a crisis as probable. The consensus view
is that the chances of such a crisis are fairly small, but have been
increasing and may be at a postwar peak during the next few months. A
curtailment of credit to the LDCs seems far more likely than a banking
crisis for several reasons:
o Where LDCs are unable to meet obligations, creditors rarely have an
interest in a formal declaration of default--the growing arrears
accumulated by Poland are a good example.
o Even if default is declared by some creditors, and forced on others
through cross-default clauses, the debts are not necessarily wiped
off the lending banks' balance sheets quickly--the impact is likely
to be phased over a period of time so that the banks are more likely
to suffer an erosion of their rating and liquidity position than a
dramatic fall into insolvency.
o Central bank action is likely to contain the impact of an incipient
banking crisis and prevent its spread.
Even so, the situation is worrisome. The aggregate debt of Mexico,
Argentina, and Poland exceeds $120 billion, and U.S. exposure to these
countries is about $30 billion, equal to nearly 80 percent of the equity
capital of the 40 largest U.S. banks. If rescheduling of Poland's 1982
debt service obligations is long delayed, the risk of creditors declaring
formal default will be high. If the war over the Falklands is not resolved
quickly, the Argentine military regime could force formal default by
declaring a moratorium on its debt service payments, even though Argentina
would be hurt more than anyone else in the long run. Large scale defaults
of Mexican debt are less likely but the stakes are enormous. The point is
that any number of circumstances could trigger a major problem, the impact
of which would probably be contained, but no one can be quite certain.
What Needs to Be Done
This worrisome situation will require close monitoring and analysis
throughout the U.S. government and in CIA. While CIA has little uni ue
in evaluating risks to the international banking system
and I have been familiarizing ourselves with the literature on
is subject and discussing it with officials at Treasury, the Federal
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Reserve, the NSC and the State Department, as well as with private sector
experts. Some steps are being taken to examine contingency plans and new
forms of international cooperation through the Working Group on LDC
Financial Problems of the Cabinet Council on Economic Affairs. I had
considered sponsoring, although not managing, a kind of financial war game
as an aid to learning more about the problem, but.I suspect that this would
take too long to be helpful during the high risk period of the next few
months. In any event, the CIA role in this area has to be primarily to
spur the financial authorities to look even harder at the problems they may
face.
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SELDCPFD IJC DEKC S: ECXN IC PERFCIE ;E
(billion US$ except where noted)
1979
1)80
1981e
1E82e
ATTINA
Imports
6.0
9.4
9.2
7.3
Exports
7.8
8.0
9.1
10.3
Trade Balance
1.8
-1.4
-.1
3.0
Debt
15.1
19.,0
24.0
30.0
Debt Service
3.3
5.0
6.1
6.5
Current Account Balance
-.5
-4.7
-3.9
-1.0
Growth (percent)
12.0
1.0
-3.0
0.3
Inflation (percent)
160
100
105
120
BRAZIL
Imports
17.9
23.0
22.1
24.8
Exports
15.2
20.1
23.3
26.8
Trade Balance
-2.7
-2.9
1.2
2.0
Debt
49.9
54.0
62.0
70.0
Debt Service
11.8
12.9
16.8
17.0
Current Account Balance
-10.5
-12.9
-10.6
-11.0
Growth (percent)
6.4
8.0
1.0
4.0
Inflation (percent)
50
80
95
80
CHILE
Imports
4.2
5.3
7.1
8.5
Exports
3.8
4.7
4.4
5.0
Trade Balance
-.4
-.6
-2.7
-3.5
Debt
8.5
9.5
10.6
12.0
Debt Service
1.8
2.4
2.7
3.0
Current Account Balance
-1.2
-1.8
-4.1
-5.2
Growth (percent)
8.3
6.5
5.0
3.0
Inflation (percent)
35
35
20
NA
COSTA RICA
Imports
1.4
1.4
1.2
1.2
Exports
.9
1.0
1.0
1.1
Trade Balance
-.5
-.4
-.2
-.1
Debt
1.4
1.9
2.5
2.7
Debt Service
.3
.3
.4
.6
Current Account Balance
-.6
-.6
-.4
-.5
Growth (percent)
4.9
1.2
-5.0
-3.0
Inflation (percent)
9
20
60
NA
EGYPT
Imports
7.0
8.3
8.7
10.0
Exports
3.2
4.4
4.4
5.0
Trade Balance
-3.8
-3.9
-4.3
-5.0
Debt
11.4
13.5
15.2
17.6
Debt Service
1.0
1.7
2.1
2.5
Current Account Balance
-1.3
-.5
-1.5
-2.0
Growth (percent)
8.7
8.0
8.0
8.0
20
10
10
Inflation (percent)
10
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SELB= IDC DEffltX S :
BCfl 7yIIC PERFCEdV1ANCE (cont . )
(billion IS$ except where noted)
1979
1980
1981e
1982e
I WHY (AAST
Imports
2.2
2.5
2.7
2.8
Exports
2.7
3.0
3.2
3.2
Trade Balance
.5
.5
.5
.4
Debt
4.0
4.7
6.0
7.0
Debt Service
.7
1.1
1.3
1.5
Current Account Balance
-1.4
-1.5
-1.8
-2.0
Growth (percent)
5.2
6.9
1.5
4.7
Inflation (percent)
15
15
12
NA
MEM CA
Imports
12.0
18.6
25.0
24.0
Exports
10.0
17.0
22.0
26.0
Trade Balance
-2.0
-1.6
-3.0
2.0
Debt
39.2
48.8
67.5
78.0
Debt Service
12.4
11.4
14.5
16.2
Current Account Balance
-4.9
-6.6
-11.7
-8.0
Growth (percent)
9.2
8.3
7.0
5.0
Inflation (percent)
20
25
30
45
MDROCCD
Imports
3.3
3.8
4.4
4.5
Exports
2.0
2.4
2.5
2.8
Trade Balance
-1.3
-1.4
-1.9
-1.7
Debt
6.6
7.4
8.0
8.6
Debt Service
.9
1.3
1.3
1.4
Current Account Balance
-1.6
-1.5
-2.2
-2.0
Growth (percent)
4.5
4.0
1.5
3.5
Inflation (percent)
8
9
15
15
PAKI STAN
Imports
4.2
4.8
5.5
6.7
Exports
1.9
2.6
3.3
3.4
Trade Balance
-2.3
-2.2
-2.2
-3.3
Debt
8.0
8.8
9.5
10.3
Debt Service
.5
.7
.8
1.0
Current Account Balance
-1.3
-1.0
-1.0
-1.3
Growth (percent)
3.5
7.5
5.5
7.0
Inflation (percent)
10
12
15
NA
PERU
Imports
2.1
3.1
3.8
4.0
Exports
3.5
3.9
3.3
3.1
Trade Balance
1.4
.8
-.5
-.9
Debt
7.3
7.8
8.3
8.8
Debt Service
1.3
2.1
2.5
3.0
Current Account Balance
-.7
.01
-1.7
-2.2
Growth (percent)
3.8
3.1
4.0
5.5
Inflation (percent)
65
60
70
55
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*
SELB FED LDC DEBTC S:
BOOR IIC PERF RV NM
(cont)
(billion ZS$ except where noted)
1979
1980
1981e
1982e
PHILIPPINES
Imports
6-1
7.7
8.5
8.8
Exports
4.6
5.8
5.9
6.0
Trade Balance
-1.5
-1,9
-2.6
-2.8
Debt
8.2
9.6
11.0
13.0
Debt Service
1.1
1.5
1.8
2.1
Current Account Balance
-1.7
-2.1
-2.5
-2.7
Growth (percent)
5.7
5.4
5.0
6.0
Inflation (percent)
20
20
12
NA
SOUTH K(RFA
Imports
19.4
21.6
24.4
27.5
Exports
14.7
17.2
20.9
24.5
Trade Balance
-4.7
-4.4
-3.5
-3.0
Debt
15.1
17.3
20.0
23.0
Debt Service
2.8
3.4
3.6
4.0
Current Account Balance
-4.2
-5.4
-5.1
-4.2
Growth (percent)
7.1
-3.5
7.1
6.0
Inflation (percent)
20
30
25
12
ZAIRE
Imports
1.1
1.2
1.4
1.5
Exports
1.8
1.9
1.8
2.0
Trade Balance
.7
.7
.4
.5
Debt
4.3
4.2
4.3
4.4
Debt Service
.2
.4
.3
.9
Current Account Balance
-.03
.04
-.3
-.5
Growth (percent)
-3.3
2.5
1.0
1.5
Inflation (percent)
110
40
50
50
* Source: Third WorldB':01h,Economics Division, OGI.
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Aggregate LDC Economic Data*
(percent)
1979
1980
1981
1982
Change in GNP
OPEC
2.9
-2.8
-4.5
negl
Non-OPEC
4.7
4.4
2.5
3.9
Net oil exporters
7.2
7.3
6.6
5.1
Net oil importers
4.2
3.9
1.7
3.7
Major Manufactures Exporters
Africa
2.6
4.6
2.6
2.0
Asia
3.1
3.4
5.7
5.6
Middle East
5.0
6.1
4.7
6.8
Latin America
6.7
6.0
-0.1
3.5
Change in Export Volume
OPEC
3.0
-12.8
-16.3
-7.0
Non-OPEC
9.4
5.6
3.1
7.0
Change in Import Volume
OPEC
-12.3
14.9
19.8
7.0
Non-OPEC
11.2
3.5
2.5
3.0
Change in Terms of Trade
Industrial Countries
-2.7
-7.6
-0.7
1.5
OPEC
28.7
41.7
12.2
-5.5
Non-OPEC
-0.2
-4.4
-1.7
-1.0
* Source: IMF preliminary figures, March 1982.