IMPLICATIONS OF THE LDC DEBT PROBLEM

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 national
Intelligence
Council
Implications of the
LDC Debt Problem
National Intelligence Council
Memorandum
NIC M 82-10013
October 1982
Copy 273
 National
Intelligence
Council
Implications of the
LDC Debt Problem
Information available as of 22 October 1982
has been used in the preparation of this report.
This Memorandum was discussed with experts in
the Central Intelligence Agency, the Treasury
Department, and other government agencies. It
reflects many of their suggestions as well as private-
sector perspectives. The opinions, however, are
solely the responsibility of the National Intelligence
Council. Comments are welcome and may be
addressed to its authors, Maurice C. Ernst, National
Intelligence Officer for Economics (telephone
National Intelligence Council
Memorandum
Confidential
N[C M 82-10013
October 1982
25X1
 Implications of the
LDC Debt Problem
Scope Note This paper focuses on the LDC debt problem and its implications for the
health and stability of the LDCs themselves, the world economy, and the
international financial system. The debt problems of Communist countries
are also dealt with as a contributing factor to international financial
concerns, but the consequences of these problems for the Communist
countries and East-West relations are not developed.
Key Judgments A crisis of confidence in international lending is curtailing the flow of
capital to less developed countries (LDCs). At a minimum many LDCs will
have to make strenuous economic adjustments. At worst these required
adjustments may be so severe as to disrupt economic activity and spur a po-
litical backlash against Western governments and financial institutions.
For the first time, most of the handful of LDCs that account for the bulk of
the group's borrowing from foreign banks either cannot or are in the
imminent danger of being unable to meet their debt service obligations.
LDCs have been hit hard by the lengthy industrial country economic
recession and high real interest rates. Some oil exporters-Mexico,
Venezuela, Nigeria, and Ecuador-face serious financial difficulties be-
cause of inability to adjust their profligate spending habits to the new oil
market realities. The plight of others, especially Argentina, has been made
worse by political instability and economic mismanagement. Under the
best of circumstances, it will take many LDCs at least two years, and in the
case of Mexico and Argentina probably longer, to regain a strong enough
foreign financial position to allow sustained economic growth.
Events in Argentina and Mexico have transformed the debt problem from
one that could be treated purely as reflecting deficiencies of policies and
management in a few countries to one that involves the health of the entire
international financial system and the performance of the world economy.
Bankers are curtailing loans to countries like Brazil not just because their
assessment of Brazil's domestic policies has turned negative, but also
because they are extremely nervous about a high degree of exposure in the
present world environment. They are carefully watching their exposure not
only to problem countries, but to all of Latin America, and even to LDCs
as a group.
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Communist countries have been virtually cut off from new Western bank
credit, except that under government guarantees. Gross economic misman-
agement forced debt rescheduling in Romania and virtual default in
Poland. The near absence of Soviet support for these countries destroyed
confidence in the so-called Soviet "umbrella" over Eastern Europe, while
the souring of East-West political relations greatly increased the perceived
political risk of lending to Soviet Bloc countries. All East European
countries are being forced to cut imports sharply. Even so, Yugoslavia,
East Germany, and Hungary may have to reschedule their debts.
LDC financial problems could become much worse, especially if the
economic recession persists. In any event, financial markets are so nervous
that bad news, such as a continuation of the present uncertainty of
economic policy in Mexico, or the immediate prospect of rescheduling in
Brazil, could bring net new lending to most LDCs to a halt. The
consequences would include:
? A further sharp cut in LDC imports, leading to a dramatic decline in
LDC economic activity and having a significant impact on the economies
of the industrial nations.
? A turn to protection and bilateralism in LDCs that could do lasting
damage to world trade.
Either in reaction to the curtailed loans or to its own financial difficulties, a
major LDC borrower, such as Argentina or Brazil, might declare a
moratorium on its debt service payments and the move could be widely
imitated.
Such a drastic debtors' reaction would greatly increase the chances of an
international financial panic, although these are still small. In spite of
ambiguities and uncertainties in the support system, central banks, if faced
with a major threat to the financial system, would almost certainly provide
massive funding to their private banks to maintain their liquidity because
the economic consequences of not doing so would be too severe. Even so,
some banks without clear parents or nationality would be vulnerable; the
Eurodollar market could sharply contract; and trade could be disrupted,
not only in the LDCs but also in industrial nations.
Politically, severe LDC economic difficulties would probably trigger
nationalistic, often anti-US, reactions, especially in Latin America. These
reactions are unlikely by themselves to bring to power a Marxist or Soviet-
leaning government in any major country, although they would probably
include flirtations with the USSR and anti-US stands on international
issues. Pressures on Mexico's ruling Institutional Revolutionary Party
(PRI) would increase. In the unlikely event of breakup of the party,
widespread turmoil and damage to US interests could follow.
 The chances are that major economic or political disasters will be avoided.
Even so, US and Western policymakers will have to deal with troublesome
trends resulting from the large-scale rescheduling of existing debt and the
contraction of new credit:
? Foreign bank credit will become a much smaller source of capital inflow
for LDCs than in recent years.
? LDC pressure for debt relief will build as more major countries face two
or more years of little or no growth.
? The North-South dialogue will be acrimonious; pressure for increased
bilateral and multilateral economic assistance will be strong.
? The financial position of major banks would be weakened by extensive
and sometimes repeated reschedulings.
? The banks will seek reassurance from central banks as to likely support in
emergencies and help from governments to deal with the more basic
financial difficulties.
Emergency financial measures, such as creation of a special International
Monetary Fund (IMF) facility, are unlikely to solve the problem by
themselves. Coherent programs to facilitate long-term adjustment in many
LDCs will be needed, with the IMF probably playing a key role. Longer
term, confidence-building measures, such as expansion of multilateral
financial facilities and steps to assure market access for LDC products in
industrial countries, are also important. Beyond specific steps such as
these, a steady recovery of the economies of industrial countries, together
with lower real interest rates, is indispensable if LDC economic and
financial health is to be restored in a reasonable period of time. If it is not,
not even a combination of measures is likely to prevent recurrent crises.
 Implications of the
LDC Debt Problem
The Developing Crisis
A crisis of confidence in international lending is
drastically curtailing the flow of capital to less devel-
oped countries (LDCs). The inability of Mexico and
Argentina to meet their debt service obligations has
made it extremely difficult for any Latin American
country, including Brazil and Venezuela, to obtain
new credit. Those few countries in Africa which have
relied heavily on bank borrowing also are in trouble,
as is the Philippines, although most Far Eastern
countries are doing relatively well. East European
countries have been virtually shut out of the medium-
term market for nonguaranteed loans since early
1981, and this year have been experiencing a contrac-
tion of short-term bank credit.
The nervousness of financial markets is being reflect-
ed in:
? A virtual withdrawal from the LDC market by
medium-size US banks and some large foreign,
especially Japanese, banks.
? An increase in the charges (spreads and front-end
costs) on loans to LDCs to take account of the
increase in perceived risks.
? A flight of short-term capital to the United States,
which is widely viewed abroad as the most secure
place.
Importance of Commercial Bank Debt for LDCs
Non-OPEC LDC debt climbed 19 percent a year
between 1973 and 1981. The private portion of that
debt rose most dramatically-22 percent a year-
mainly reflecting the expansion of funds borrowed
from commercial banks (see table 1). In fact, such
private borrowing provided nearly 80 percent of new
non-OPEC foreign debt. The debt is highly concen-
trated. Seven countries (Argentina, Brazil, Chile,
South Korea, Mexico, Peru, and the Philippines), each
of whose private debt exceeds $5 billion, have 75
percent of the total private non-OPEC debt, and
two-Mexico and Brazil-account for about 45 per-
cent (see table 2).
Table I
Gross Foreign Debt of LDCs
and Eastern Europe
1973
1981
1973
1981
1973
1981
Total LDC
55
160
75
360
130
520
Non-OPEC
40
130
60
280
100
410
OPEC
15
30
15
80
30
110
Eastern Europe
(including
Yugoslavia)
5
25
10
55
15
80
. Includes both medium- and short-term loans from commercial
banks and other financial institutions, bonds, and supplier credits.
Banks and other financial institutions account for 80 to 85 percent of
total private lending.
In some 20 percent of 84 non-OPEC LDCs, private
debt constituted more than three-fifths of total debt
(table 3). Although a few dynamic Asian countries
have managed their finances well despite the troubled
times-notably Hong Kong, Malaysia, Singapore,
South Korea, Taiwan, and Thailand-other LDCs
have encountered severe financial difficulties-nota-
bly Argentina, Brazil, Chile, Mexico, Peru, and the
Philippines.
About 40 percent of 84 non-OPEC LDCs obtain less
than 20 percent of their foreign capital inflows from
private sources and have an outstanding private debt
of less than $2 billion. Most of these countries, which
 Table 2
Foreign Debt of Selected LDCs
Mexico
10
8
68
63
Argentina
5
4
34
31
South Korea
5
3
31
21
Philippines
3
2
18
IS
Chile
5
3
14
12
are located in Africa and Southeast Asia, are among
the poorest and slowest growing LDCs. Their develop-
ment problems have little to do with debt servicing
constraints, since most of the foreign financial assist-
ance they receive is in the form of grants or highly
concessional loans. Their interest payments have re-
mained low.
Another 40 percent rely on private credit for 20 to 60
percent of their financial inflows, and almost all have
outstanding private debt of less than $2 billion.
Within this group, many have borrowed a sharply
increasing share of their capital inflows from commer-
cial banks in recent years and now find themselves
facing severe difficulties servicing debt. These strains
often arise from economic mismanagement (some-
times political turmoil). Many in these groups were
particularly hard hit by the decline in foreign sales, as
they depend heavily on products whose prices have
plummeted-copper, sugar, and so forth. About one-
third of the countries in this group have asked for and
received debt rescheduling in the past three years.
They include perennial reschedulers like Zaire and
OPEC countries also have been large borrowers on
foreign private markets. Most, however, have foreign
assets far larger than liabilities-for OPEC as a
whole, liabilities are less than half of assets. The
exceptions are Ecuador, Nigeria, and Venezuela,
whose foreign debt substantially exceeds their foreign
assets and who are in a difficult financial position.
Major Forces at Work
The strained financial situation is partly an outgrowth
of the dramatic shift from inflation to disinflation in
economic policy. Inflationary trends in the 1970s
made large-scale borrowing highly profitable for both
the recipient and the lender while disguising potential
risks. The sharp turnaround in the inflation trends,
accompanied by a prolonged economic recession, has
brought high real interest rates, low demand for LDC
raw materials since the great depression. Political
problems, especially in East-West relations and in
Argentina, and political indecision in Mexico also
precipitated and exacerbated the financial problems.
The rapid increase in bank debt, combined with low
or negative real interest rates and expanding world
trade, greatly assisted many LDCs in adjusting to the
two OPEC oil shocks. Only a handful of small LDCs,
which suffered from severe political and economic
mismanagement, encountered debt problems. Until
1982 the amount of rescheduled loans by commercial
banks to those smaller chronic problem countries
accounted for less than 2 percent of total bank loans
to LDCs and Communist countries.
Commercial banks found lending to LDCs and Com-
munist countries to be more profitable and less risky
than their domestic operations. The so-called sover-
eign risk was virtually ignored, as commercial bank
officials felt governments would husband foreign ex-
change if necessary to maintain access to credit.
 Table 3
Non-OPEC LDCs: Relative Importance of Private Debt
(Outstanding Loans From Private Institutions
as a Share of Total Loans, 1981)
Bahrain
Barbados
Argentina
Bangladesh
Bolivia Is
Brazil
Benin
Cameroon
Chile
Botswana
Colombia
Costa Rica =
Burma
Congo
Hong Kong
Burundi
Dominican Republic Is
Ivory Coast
Central African Republic Is =
Fiji
Malaysia
Chad
Guinea b
Mexico =
Comoros
Guyana Is =
Panama
Egypt
Hondurasc
Peru
El Salvador
Jamaica b
Philippines
Ethiopia
Jordan
Singapore
Gambia
Kenya
South Korea
Ghana
Lebanon
Taiwan
Guatemala
Lesotho
Thailand
Haiti
Liberia b
Trinidad and Tobago
India
Madagascar Is
Uruguay
Maldives
Malawi =
Zimbabwe
Mali
Mauritania Is
Nepal
Mauritius
Pakistan b
Morocco
Rwanda
Nicaragua b C
Seychelles
Niger
Somalia
Oman
Sri Lanka
Papua New Guinea
Swaziland
Paraguay
Syria
Senegalb
Tanzania =
Sierra Leone b
Upper Volta
Solomon Islands
Western Somoa
Sudan b
Yemen AR
Togo b =
Yemen PDR
Tunisia
Uganda Is =
Zaire b
? Boldfaced countries have a private debt in excess of $2 billion at the
end of 1981.
b Rescheduled since 1979.
= Rescheduling likely in near future.
I
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 Market attitudes began to change in 1981, and
pessimism has deepened since then as a result of:
? De facto default in Poland, which shook the com-
fortable bankers' views of sovereign risk and rever-
berated throughout Eastern Europe.
? The collapse of commodity prices.
? A shift to a soft oil market and a major downward
revision in expected oil prices, which hurt some
LDCs badly even though most others benefited to
some extent.
? Continuing high interest rates.
? The length and depth of the global economic
recession.
As the depression of commodity markets deepened
while real interest rates remained stubbornly high, the
LDCs were caught in a severe and persistent econom-
is squeeze. Major LDC borrowers paid 12- to 14-
percent interest on their total outstanding debt in
1981 compared with 6 to 8 percent in 1973-79. For
some borrowers, the cost of new funds rose to near 20
percent. Real interest rates were over 10 percent.
With exports stagnant or falling, the burden of inter-
est payments rose to over one-third of total foreign
earnings and over one-half of merchandise exports for
countries like Mexico, Brazil, and Argentina (see
table 4).
As the financial markets became more wary of lend-
ing to LDCs, a far greater share of new loans was
extended on a short-term basis. Between 1979 and
1981, the short-term debt of 10 major LDCs nearly
doubled, while their total debt increased less than 50
percent. Although short-term debts are normally re-
newed automatically and have traditionally been ig-
nored in assessments of debt service capability, they
are vulnerable to sudden changes in market confi-
dence. Refusal to renew short-term lines of credit, as
well as capital flight, quickly transformed a funda-
mental debt problem in Argentina and Mexico into an
immediate liquidity crisis. To cover interest obliga-
tions and both long- and short-term debt falling due in
1982 would take 1.2 to 1.6 times the total earnings
from exports of goods and services of Mexico, Argen-
tina, and Brazil-obviously an impossible task.
Table 4
Foreign Debt Burden in Selected LDCs
(as a Percent of Exports of Goods and Services)
14 12 29
47
19 29 38
47
Chile
17 17 31
31
South Korea
7 7 13
14
Mexico
17 23 27
37
Peru
12 15 19
26
Philippines
6 11 18
23
Ecuador
NEGL 12 27
34
Nigeria
NEGL 3 4
8
Venezuela
1 6 Il
18
Repayments on Medium-
and Long-Term Debt
Argentina
25 20 32
39
Brazil
21 38 29
34
Chile
27 28 30
27
South Korea
8 9 7
8
Mexico
17 54 29
23
Peru
35 17 38
34
Philippines
10 13 11
13
Ecuador
9 24 10
14
Nigeria
2 NEGL 1
4
Short-Term Debt
Argentina
78 53 89
126
Brazil
20 28 32
40
Chile
56 43 48
56
South Korea
41 36 40
40
Mexico
44 31 50
77
Peru
59 29 36
35
Philippines
25 63 82
90
Ecuador
9 32 47
55
Nigeria
8 7 8
21
Venezuela
5 55 49
64
Although the LDC debt problems were already a
source of growing concern, it was not until the crises
 in Argentina and Mexico occurred that general confi-
dence in lending to LDCs was shaken. Mexico, with a
debt exceeding $80 billion, was the critical factor.
In Argentina, which was in the throes of a severe
austerity program, the Falklands fiasco forced out the
Galtieri government and greatly undermined the
credibility of the broader military leadership, which
led to an easing of austerity to reduce popular opposi-
tion. Current Argentine economic policies are vacil-
lating and inconsistent, reflecting the government's
fundamental lack of confidence and political weak-
ness. A rescheduling of debt is being negotiated.
For Mexico, a severe adjustment to a soft oil market
was inevitable, following four years of headlong eco-
nomic expansion and the mortgaging through debt
accumulation of projected future oil earnings that did
not and are unlikely to materialize. Although stabili-
zation steps were taken earlier this year, including a
large devaluation, the Lopez Portillo government has
lacked the political will to carry out the adjustment in
a systematic way. Wage increases offset the impact of
devaluation, and announced budget cuts were not
implemented. Reacting to political drift and economic
mismanagement in Mexico, foreign lenders and Mexi-
can citizens pulled out their capital and thereby
triggered the crisis, which is still far from being
resolved.
The East European Problem
The Polish near default, which occasioned little Soviet
assistance to Poland, punctured the widely accepted
theory about a Soviet umbrella over Eastern Europe.
At the same time, the end of East-West detente
greatly increased the element of perceived political
risk in lending to both the USSR and Eastern Europe.
The growth of outstanding Western credits to the
Soviet Bloc, which had already greatly slowed during
1977-80 following a fourfold increase in the earlier
part of the decade, came to a virtual halt. And in the
first quarter of 1982, East European bank debt
declined as short-term lines of credit were not re-
newed. Hungary, East Germany, and Yugoslavia, as
well as Poland and Romania, which have already
rescheduled their debt, are having serious financial
difficulties (see table 5).
Table 5
Eastern Europe:
Hard Currency Debt, 1981
Source of Funds
Debt Service
Ratio
Poland
25
14
146 n
Yugoslavia
19
13
25
East Germany
15
12
58
Romania
10
7
27
Hungary
9
8
37
Czechoslovakia
5
4
21
Bulgaria
3
2
33
Total
86
60
a Percent of exports of goods and services.
n Represents debt service owed. Amount actually paid equaled 80
percent of exports.
Future Concerns
The loss of confidence in LDC and East European
lending is contributing greatly to the general unease
in financial markets which also reflects questions
raised by the failures of such financial institutions as
Penn Square, Dreyfus Government Securities, Banco
Ambrosiano, and Lombard Wall. These failures cre-
ated uncertainties about the quality of loans, the
management of banks, and the circumstances in
which financial authorities are willing to provide
support.
The nervousness of the financial markets makes the
situation volatile and projections hazardous. Even if
bankers' confidence returns, outstanding loans to
LDCs are unlikely to increase as rapidly in the next
several years as in the past decade. An annual rate of
growth of 5 to 10 percent-or less than the rate of
growth of total bank assets-can reasonably be ex-
pected. This would mean an annual net capital inflow
of some $15-30 billion to the non-OPEC LDCs. In
comparison with 1981, when the net inflow of private
loans was about $45 billion, there would be an overall
loss of 5 to 10 percent in import capacity.
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International financial problems could quickly wors-
en, especially if industrial country economic activity
stagnates well into 1983. There is also a serious risk
that bad news will trigger a collapse of market
confidence in major LDCs, leading to a drying up of
credit. Smaller banks and some large foreign banks
are trying to reduce their exposure by not renewing
loans when they come due. A continuation of the
present political uncertainty in Mexico, or an immi-
nent prospect of rescheduling in Brazil, could hasten
this withdrawal. It would be difficult for large banks
to offset such a withdrawal without weakening their
own position in financial markets. Most LDCs would
then be faced with little or no increase in net bank
lending, and some would experience a net outflow of
bank funds.
LDC Adjustment Problems
Many LDCs will have to make severe economic
adjustments to meet their debt service obligations.
Table 6 illustrates the magnitude of the adjustment
problem for major selected LDCs. In 1981, net bor-
rowing from private sources covered three-fourths of
imports in Mexico, two-thirds in Argentina, 45 per-
cent in Brazil, and about one-third in Chile, Ecuador,
Peru, and Venezuela. (Venezuela, however, had a
current account surplus.)
Many LDCs have already substantially cut imports in
response to the economic recession as well as to
reduced lending (table 7). The volume of imports of
the non-OPEC LDCs as a group will fall in 1982.
Additional import cuts are likely in 1983 in many of
the countries:
? Mexico and Argentina have been hit by capital
flight as well as reduced net lending. Imports will be
down about one-third for 1982, and the current
account deficits will be substantially reduced. In
recent months, import cuts in Mexico have been
even steeper. Output also has fallen. Both countries
are trying to reschedule their debt. With some
growth of exports likely, especially in Mexico, and,
if the financial situation is stabilized to allow some
Table 6
Selected LDCs:
Importance of Net Private Loans
Net Borrowing From Private Sources
As a Percentage of Imports, 1981
Mexico 75
new net lending, additional import cuts should not
be necessary in 1983.
Brazil, which had planned a moderate economic
recovery this year, following a recession in 1981, is
beginning to put the brakes back on in order to curb
imports, as exports have fallen. New credit has
nearly dried up in recent weeks, and severe austerity
will be required if bankers' confidence does not
return. In any event, the current account deficit
probably will have to be reduced by several billion
dollars in 1983, requiring a large reduction in
imports.
? Chile has made large import cuts; Ecuador, the
Philippines, and Peru, however, have only just be-
gun their economic adjustment. In addition, Ecua-
dor has asked for a rescheduling.
 Table 7
Payments Trends in Key LDCs, 1981-82
Current Account Percent Change
Balance from 1981 to 1982 ?
(billion US $)
1981
1982' Exports Imports
Mexico -12.9
-7.5 8 -34
Argentina -4.1
-3.0 -22 -39
Brazil -11.7
-13.8 -10 -9
Ecuador -1.1
-1.4 -4 0
Peru -1.6
-1.8 0 0
Venezuela 4.0
-1.3 -18 10
Chile -4.9
-3.0 15 -21
Philippines -2.6
-3.1 -6 5
South Korea -4.2
-2.9 5 -2
Nigeria -5.0
-5.3 -13 -6
? South Korea has been able to reduce its current
account deficit without significantly cutting imports
because of continued, though slower, export growth,
and should be able to continue this process. Rela-
tively good export prospects in turn are likely to
allow continued net borrowing.
? Venezuela's main problem is one of debt manage-
ment because almost half its debt is short term.
Even if it is successful in rescheduling its short-term
debt, some austerity will be required.
? Nigeria does not yet have a large debt burden, but
its debt has been increasing at a rapid rate because
of large current account deficits due to uncontrolled
spending. Imports are beginning to be curtailed, and
further reductions will be needed.
The magnitude of the economic adjustments LDCs
will have to make in the next year or so and the
duration of the period of austerity will be strongly
affected by major international economic trends, es-
pecially the timing and speed of economic recovery in
industrial countries and the changes in interest rates.
If the economies of industrial countries begin to grow
at a moderate rate (2 to 3 percent) early next year, as
is now generally expected, LDC export earnings also
will begin to recover. But imports in most LDCs are
unlikely to begin to rise until 1984 at the earliest,
because increases in export earnings will probably be
used first to reduce current account deficits and to
rebuild depleted foreign exchange reserves. A contin-
ued economic recession would further depress LDC
exports and postpone their recovery. By the same
token, a more rapid upswing of the business cycle
would push up both the volume and probably the
prices of LDC exports.
A substantial further reduction in interest rates also
could help to speed up LDC recovery. Every 1-percent
decline in interest rates would free up funds equal to 3
to 4 percent of the imports of the 10 major LDC
debtors. Declining interest rates will be reflected in
new loan agreements, however, only after a lag of
several months. Moreover, much of the interest rate
decline in recent months has been offset by increased
bank charges (spreads and front-end costs) to take
account of the higher perceived risks.
Country-specific factors, such as the export mix, the
quality of economic management, and the political
strength and will of the government, also are impor-
tant to LDC economic prospects:
? Exporters of manufactures, such as South Korea,
will be in a good position to take advantage of a
revival in industrial country demand.
? LDCs dependent on exports of raw materials other
than oil will take longer to recover. Commodity
prices usually do not move up significantly until
excess production capacity is sharply reduced-a
process that could take two years or more. Near-
term prospects for most agricultural exports also are
not bright, although the picture could change quick-
ly if weather conditions turned poor.
? LDC exporters of petroleum (for example, Mexico,
Venezuela, Ecuador, and Nigeria) must make fun-
damental changes in economic development policies
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i.onrwennal
to take account of stagnating or falling oil prices.
They will probably have to constrain imports for at
least several years.
? Should there be a substantial absolute fall in oil
prices-a reasonable possibility-many of these
countries would face a disastrous situation, requir-
ing deep additional cuts in imports. For example, a
$5 a barrel drop in oil prices would require a further
import cut of 15 to 20 percent for Mexico, Venezue-
la, Nigeria, and Ecuador. LDC oil importers would
receive compensating benefits, but those benefits
would be spread among many countries, while losses
would be concentrated in a few countries.
? Countries that are mismanaged economically, such
as Argentina, or that must contend with domestic
political upheavals will probably not achieve a man-
ageable foreign payments position in the foreseeable
future.
? Communist countries are unlikely to take full ad-
vantage of a Western economic recovery because of
their rigid form of economic management. More-
over, the East European countries are being
squeezed both by the near cessation of Western
lending and by imposed cuts in imports of Soviet oil.
Their economic prospects are poor.
The Repercussions of Excessive Adjustment
Although substantial economic adjustment by LDCs
is inevitable and, for some countries, is desirable, the
process will create economic problems for the West-
ern countries themselves, political resistance in the
LDCs, and possibly policy shifts damaging to US and
Western interests. There is also a risk of debtors'
reactions so strong as to threaten the stability of the
international financial system. These problems and
risks already exist; they would be substantially in-
creased if the flow of net private credit to LDCs
should cease.
Industrial countries will be hurt by the economic
problems of the LDCs. A $15-25 billion decline in
LDC imports would reduce OECD GNP by about 0.5
percent. In addition, there is a high risk that, faced
with a drying up of international lending and a severe
economic contraction, LDCs will turn increasingly to
bilateral trade and payments relationships and to
internally oriented economic policies, such as heavy
protection of domestic producers. Such a trend would
severely damage the long-established US policies of
fostering an open, multilateral world economy.
Many LDCs will try to reduce the necessary import
cuts through debt rescheduling. In some countries,
there may be a succession of reschedulings. Some
countries, moreover, may be tempted to stop payment
of interest as well as capital.
A drying up of or a major reduction in bank credit
would also bring a strong political response from
LDCs, especially a loud and insistent chorus of LDC
demands for a general restructuring of debt. Although
such demands have been expressed before, they had
little political impact on countries borrowing heavily
from banks, in part because real interest rates were
low or negative. The response is likely to be far more
positive and vehement under present circumstances.
There is a possibility, especially if the financial situa-
tion deteriorates, that this rhetoric will stimulate
specific actions by LDCs that amount to some form of
debtors' revolt. The debtors realize that formal de-
fault would cut them off from bank capital in the
future and force them to finance trade on a strictly
cash basis. On the other hand, the prospect of continu-
ing interest payments at the cost of lower income and
employment in the near term and lack of economic
growth for several years is difficult to accept, particu-
larly for large debtors who are aware that their
actions can also do great harm to their creditors.
Moreover, most of the big debtors, including Mexico,
Argentina, and Brazil, are running surpluses on their
current account transactions, excluding interest, so
that they could see the prospect of increasing import
capacity if interest were not paid.
A debtors' revolt would most likely begin with an-
nouncement of a debt moratorium by a major coun-
try, which could trigger a chain reaction. Brazil's role
 is probably crucial. Brazil has followed responsible
economic adjustment policies. It can legitimately
blame its recent, increasingly serious funding difficul-
ties to a substantial extent on the spillover effect of
other countries' financial problems. Although not
under severe domestic political constraints, the Brazil-
ian Government could choose to respond to nationalis-
tic, populist currents, and to a desire to play a
leadership role internationally. Mexico, Argentina,
and other Latin American countries would almost
certainly follow a Brazilian lead. Brazil is more likely,
however, to try if necessary to meet its obligations
through rescheduling.
Argentina also could be the instigator, given the
country's political history. The widespread political
appeal of Peronism, coupled with the discrediting of
the military leadership, make it likely that some
populist policies will be adopted. There is, moreover, a
significant possibility that a radical populist regime
will come to power. Such a regime would be tempted
to declare a moratorium on debt service payments as a
means of freeing up foreign exchange for economic
development. The regime could argue that Argentina
normally has a surplus on its trade account and,
therefore, would be in good shape, if it were not for
the enormous debt burden.
There is little doubt in any case that severe and
prolonged economic disruptions and unemployment,
which could be attributed to the actions of foreign
bankers, would spur strong nationalistic reactions in
many countries, notably in Latin America, possibly
including restrictions on US firms, and anti-US posi-
tions in foreign affairs.
It is highly unlikely that hard times would lead to the
coming to power of Communist or extreme Marxist
governments in any major LDC in the near term,
although leftwing insurgencies, such as those in Cen-
tral America, would become even more difficult to
contain. In most LDCs, the military is the final
arbiter of power and would take the responsibility to
either impose or reestablish order. Although in most
countries the military would not promote social revo-
lution, it would be at times inclined toward narrow,
inward-looking nationalism and flirtations with Mos-
cow on such matters as arms purchases. In the longer
term tough military rule, coupled with the likely
failure of nationalist economic policies, might become
a breeding ground for the growth of revolutionary
movements.
An extended economic downturn would put great
strain on the political system in Mexico, in the
continued stability of which the United States has an
enormous stake. Although the Mexican political sys-
tem has been stable, strong, and resilient, there is a
risk that bad times will so polarize the left and right
wings of the PRI as to eventually cause a breakup of
that dominant political institution. There are few
signs that such a trend is in progress but the possibili-
ty cannot be wholly discounted, and in any event
cannot be ignored because the consequences would be
too serious. Widespread violence, threats to US per-
sons and property, massive border crossings, and the
potential for eventual radical leftwing takeover all
would be within the realm of possibility.
Potential for a Panic
The LDC and Soviet Bloc debt problems are likely to
weaken the position of many Western banks. Massive
reschedulings, such as those in Mexico and Argentina
at a minimum, will reduce bank flexibility, hamper
individual bank financing, and force adjustments in
other parts of their asset portfolio. The total external
debt of the LDCs and Communist countries that have
rescheduled or will soon do so is about $200 billion,
and countries with another $100 billion or more of
external debt are having difficulties. The amount of
this debt that is held by major banks probably exceeds
their capital and constitutes nearly 5 percent of their
assets. Should LDC problems prove so difficult as to
require repeated reschedulings in major countries,
rates of return on assets would decline because of the
need to increase loan loss reserves and the likely
deferment of some interest income. The weakest and
most exposed banks would have to pay higher interest
rates for deposits.
With their financial position weakened by both inter-
national and domestic developments-many domestic
firms are in poor shape-and, with the intense nerv-
ousness in financial markets, the risks of a major
financial panic have greatly increased, although they
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Confidential ,
are probably still small. There is great concern that a
major shock-such as default by a large international
borrower-could trigger a large-scale withdrawal of
deposits from exposed banks, placing these institu-
tions in jeopardy and threatening a chain reaction.
How effectively such a crisis would be contained
would depend on the actions of central banks. There
are potential gaps in the coverage of the central bank
support net and ambiguities as to the circumstances in
which support would be provided.
Central banks are prepared to provide support in a
liquidity crisis, not to bail out insolvent banks. In a
crisis, when action must be taken immediately, it is
not always possible to determine whether a bank is
solvent or not. The chances are, however, that a clear-
cut threat to the international financial system, such
as default by a major borrower, would trigger imme-
diate action by the central banks. They would provide
enough funds to keep the banks operating. Solvency,
legal, and bank management issues would be tackled
later.
Even so, some banks would not be covered and would
probably fail:
? LDC central banks may lack sufficient foreign
exchange to support their commercial banks in case
of trouble.
? Responsibility for supporting jointly owned banks
and subsidiaries is often unclear.
? Although the central banks of the major industrial
nations have accepted fairly clear-cut responsibility
for supporting the foreign branches of their national
banks, there is still uncertainty for some central
banks about whether they or the central bank of the
host country are responsible for supporting
subsidiaries.
The major dangers to the stability of the international
financial system would come from the following types
of developments:
Group of Ten to act in unison in the face of a major
threat to the international financial system is the
least plausible of these dangers, although the most
serious. Such a division would almost certainly
require a profound divergence of policies among the
governments of the Group of Ten countries, espe-
cially the United States, West Germany, France,
and the United Kingdom. Moreover, political splits
in all but the most extreme cases would sooner or
later give way to a common desire to avoid a global
economic calamity.
? If central banks were unable to prevent a panic from
starting. For example, the sudden impact of some
massive triggering event may not give central banks
adequate time to sort out the problems of national
responsibility for overseas banks, thereby making a
rescue operation more difficult. Central banks
might also delay in providing sufficient liquidity to
commercial banks because of their concern that the
increased money supply would spark inflationary
tendencies.
? An undercutting of the informal codes of conduct
that sustain confidence in the international finan-
cial system-for example, an indeterminate mora-
torium on debt and interest payments, such as was
discussed above.
? A confluence of a number of major events. Most
likely such a situation would involve the inability of
several major countries to meet foreign exchange
obligations and some large-scale bankruptcies of
companies within the industrial world.
A financial panic would do considerable damage to
the world economy; it probably would not lead to a
1930s-type depression. The consequences would
include:
? A drastic shrinking of the Eurodollar market and
the failure of a number of Eurobanks.
? A near halting of credit to LDCs, forcing even more
severe import cuts.
? A serious disruption of trade, especially if debt
default were involved.
? If central banks were unwilling to act quickly and
in unison in an emergency. The unwillingness of the
 ? A sharp increase in the demand for liquid assets in
Western countries, which would result in reductions
in credit and economic activity.
Implications for Policy
US and Western policies designed to deal with the
LDC and Soviet Bloc debt problem will have to take
into consideration the following likely developments:
Bank credit will probably be a much smaller source
of foreign capital inflow to LDCs than in the past
decade. Since official aid is unlikely to grow much,
if at all, the total capital inflow to LDCs is likely to
shrink substantially. For most countries, economic
growth will tend to be slower. Soviet Bloc countries
will be able to get bank credit only under govern-
ment guarantees.
Western banks and governments will be under
strong political pressure from LDCs to reschedule
debt on a massive scale and on easy terms. The
North-South dialogue will be acrimonious and debt-
ors' threats more believable than in the past. Al-
though case-by-case solutions are essential if rea-
sonable discipline is to be imposed on borrowers,
some slippage of discipline may occur. Reschedul-
ings are likely to be messy, and some will not stick.
Large Western banks will have no choice but to
hold, and even to increase, outstanding LDC loans
which the financial markets consider to be of low
quality. Banks will try to reduce this undesirable
exposure and, failing this, will seek assistance from
governments, arguing that their problems are due
partly to having been used as instruments of public
policy.
The three key parties coping with LDC debt issues-
industrial country governments, LDC governments,
and commercial banks-have a common stake in
resolving the debt problem. They all want the debtor
countries' financial health to be restored in a way that
avoids excessive austerity measures while allowing
payment of interest. But although this coincidence of
general goals provides the glue for agreement, the
negotiations as to how the parties will split the
burdens involved will be fierce and prolonged.
The LDC debtors realize that, if they fail to take
sufficient belt-tightening actions, foreign banks and
other financial institutions will be reluctant to provide
fresh funds or significant debt service relief. In that
case, the debtor countries would have to cut imports
anyhow. On the other hand, if the debtor countries
become convinced that they would receive little or no
increase in funds no matter how much austerity is
imposed, they would have less to lose by imposing a
debt moratorium.
Major commercial banks want to reduce their expo-
sure to most LDCs but are generally unable to do so.
When necessary to avoid formal default, they have
provided new funds which, in effect, have capitalized
interest payments. In some cases, they also have little
choice but to offset the withdrawal of funds from
smaller banks which have much less to lose in the
event of default. Formal rescheduling of LDC debt
can be advantageous to the major banks, as well as to
the LDC governments, because it locks in the smaller
banks.
Industrial country governments have two key goals in
regard to the debt issues. They want to prevent
financial strains in debtor countries from causing
political-economic turmoil and they want to retain
confidence in the financial system. In doing so they
have two lines of defense. The first involves propping
up the LDC financial position by supplying fresh
funds through official sources-for example, through
a special IMF emergency fund-thereby allowing
debtor countries to service their foreign bank debt
without excessive austerity measures. That effort
would be successful only if (1) the debtors did not
loosen their belt-tightening policies too much and (2)
the banks did not use the opportunity to reduce their
exposure. The second line of defense involves provid-
ing the banks with sufficient liquidity to retain the
confidence of depositors in the safety of financial
assets in the face of substantial LDC moves to reduce
their debt burden. Although ambiguities and uncer-
tainties in the lender-of-last-resort function are inev-
itable, some clarification of responsibilities may be
feasible in order to build market confidence.
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connaenual
Emergency financial measures could be reinforced by
longer term, confidence-building measures, such as
expansion of multilateral financial facilities and even
more explicit policy commitments to maintaining
market access for LDC products in industrial coun-
tries. Beyond specific steps such as these, a steady
recovery of the economies of industrial countries,
together with lower real interest rates, is indispensable
if LDC economic and financial health is to be restored
in a reasonable period of time. If it is not, not even a
combination of measures is likely to prevent recurrent
crises.