OUTLOOK FOR THE INTERNATIONAL DEBT STRATEGY

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June 1, 1984
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Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Directorate of Confidential Outlook for the International Debt Strategy An Intelligence Assessment Confidential GI 84-10104 June 1984 copy 4 4 9 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Directorate of Confidential n ) Intelligence Outlook for the International Debt Strategy This paper was prepared by Office of Global Issues. Comments and queries are welcome and may be directed to the Chief, International Finance Branch, OGI, on Confidential G/ 84-10104 June 1984 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential Outlook for the International Debt Strategy Key Judgments Over the last two years, rescue packages coordinated by the IMF have Information available forestalled default by debt-troubled less developed countries (LDCs) and as of 1I June 1984 East European countries and averted a major disruption in the internation- was used in this report. al financial community. Debtors and creditors have negotiated these packages on a country-by-country basis. In return for complying with an IMF economic adjustment program, debtors have obtained debt restruc- turings, new commercial bank and IMF loans, and official emergency short-term loans and export credits. This strategy has assumed that as world economic recovery proceeds and LDC adjustments are undertaken, the financially troubled countries would regain normal market access to new loans and be able to service their debt on time.n Although Western economic recovery is under way and debtor country external accounts are steadily improving, we believe that serious problems still could arise under the present debt strategy: ? Some US regional and European banks are becoming increasingly reluctant to participate in new loan packages for these financially troubled countries. This implies an increased burden on the larger banks; the financial community is already concerned about high loan exposures to troubled debtors. ? Governments of many financially troubled countries face intense political and social pressure to abandon or weaken austerity measures. Reduced subsidies, wage restraints, and sharp import cuts are provoking wide- spread discontent and in some cases, such as the Dominican Republic and Bolivia, are directly responsible for recent political turmoil. ? Global economic conditions may not improve enough for these countries to attract sufficient capital to service their debt and to finance develop- ment needs.F_~ Many observers are concerned that Western economic recovery may falter and interest rates rise further, and they believe new proposals should be considered for dealing with the international debt problem. Already a number of proposals have been put forward-including capitalization of interest, multiyear restructuring, and a new SDR allocation. While these Confidential GI 84-10104 June 1984 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential proposals conceptually would make more foreign exchange available for imports and help spur economic growth in the LDCs, there are several disadvantages: ? Some would require legislation that would be time consuming and perhaps not feasible. ? Some would treat all debtors identically and fail to recognize the uniqueness of each debtor's situation. ? They may reduce the incentive of debtor countries to continue imple- menting austerity measures. ? They could reduce the willingness of commercial banks to extend new credits to the debtors in the future. Debtor countries are also calling for new proposals that would share responsibility for solving the debt problem and assuming losses with creditors. As a result, we expect tougher stances in negotiating with creditors this'year. Moreover, recent reaction to the rise in interest rates suggests closer coordination of debt policies by the debtors. We believe demands for alternative solutions to the debt problem increas- ingly will be heard from LDC debtors, academics, and some Western allies. The political strains on the debtor governments are growing, and we cannot rule out more hardline demands or radical actions. While in some cases calls for action may simply be rhetoric, Washington, could be forced to find a way to respond to creditor and debtor concerns in the months ahead. Moreover, pressure could build rapidly if a major roadblock were hit in financial dealings with a major debtor. In this regard, the Argentine situation probably bears the closest watching; Argentine negotiations with the IMF and commercial banks could be difficult and prolonged. Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential Outlook for the International Debt Strategy F Prelude to the Current Problem The debt burden of the less developed countries (LDCs) and the East European countries has become extremely large. Spurred by grand development plans and the easy availability of foreign bank credit, these countries boosted their combined medium- and long- term debt from only $55 billion in 1970 to over $600 billion at yearend 1983 (see figure 1). By the late 1970s, the LDCs and East European countries were adding nearly $50 billion a year to their medium- and long-term debt burden. In addition, they have at least $165 billion in short-term debt.n The structure of these countries' external debt shifted dramatically in the past decade. In the early 1970s, these countries borrowed mostly from multilateral institutions on concessionary terms; only 40 percent of their borrowing was from commercial banks. By the late 1970s, the ratio had reversed with private sources providing nearly two-thirds of these countries' exter- nal loans; the Latin American countries rely on private sources for almost all of their financing needs. This shift has made the cost of financing more onerous for the debtor countries, because the majority of commercial bank loans are tied to market interest rates, whereas official credits carry lower, fixed inter- est rates. In addition, bank loans have to be repaid more quickly than official credits.n While these trends set the stage for the debt problem, the crisis actually came when countries such as Poland, Mexico, and Brazil were no longer able to repay their debt as scheduled. We and other financial observers believe several factors were responsible: Figure 1 LDC and East European Medium- and Long-Term Debt, 1970-83 ? Concurrently, recession in the industrial countries and low commodity prices weakened debtor coun- tries' exports so that the LDCs had less income with which to service their debt. As a result, several key Latin American countries-Argentina, Brazil, and Chile-saw interest payments alone as a share of export earnings rise to more than 40 percent in 1982. ? The size of the annual interest and principal pay- ments owed by the LDCs and East European coun- tries mushroomed, growing from only $9 billion in 1970 to $140 billion by late 1983 (see figure 2). Much of the increased burden resulted from a dramatic rise in interest rates as industrial countries fought inflation with tight monetary policies. ? Finally, given world economic conditions, interna- tional lenders perceived growing risks in the LDCs; as a result, they cut back new lending and refused to refinance maturing debts, especially short-term credits. 7-1 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential Figure 2 LDC and East European Debt Service, 1970-83' ? Medium- and long-term principal repayments and all interest payments. Source CIA estimate based on IMF, World Bank, BIS, and OECD data. Current Strategy for Coping With the Debt Problem A review of country rescue programs shows that over the last two years creditors have dealt with LDC debt servicing problems on a case-by-case basis. Generally, when a country has fallen behind in payments, credi- tors have agreed to temporary delays of payment while the debtor country began discussions with the IMF. Within a month or two, the debtor country has adopted an IMF-supported economic adjustment pro- gram that is monitored quarterly. In return, the debtor country has obtained new financial assistance from creditors and a restructuring of its debts. The strategy assumed that, as world economic recovery proceeds and LDC adjustments are undertaken, the financially troubled countries would regain normal market access to new loans and be able to return to servicing their debt on time.n This case-by-case approach has been publicly articu- lated by the United States and other industrialized countries as a five-point debt strategy, which includes: ? Encouragement of continued bank lending. ? Continued willingness of Western governments and institutions to provide bridge financing when necessary. Figure 3 Real GDP Growth: Selected Debtor Countries, 1979-83 ? Strengthening of international financial institutions such as the IMF. ? Adoption of policies by industrialized governments to promote sustained noninflationary growth. ? Encoura ement of sound economic policies within LDCs. So far under this strategy, no countries have repudiat- ed their debt, and there has been no major interna- tional liquidity crisis. Most of the financially troubled countries have implemented IMF-supported austerity measures. In addition, the resources of the IMF have been increased. Finally, Western governments and commercial banks have restructured a large portion of maturing debt and have agreed to lend additional funds to several countries as part of their debt-relief packages.n Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential Figure 4 Import Trends in Key Debt-Troubled Countries, 1981 and 1983 Economic Impact on the Debt-Troubled Countries and the United States While cooperative efforts have prevented major dis- ruptions to the international financial system, the impact of adjustment programs on the debt-troubled countries has been severe. Austerity measures, such as restraints on wages, government spending, and domes- tic credit, as well as foreign exchange constraints, have led to steady declines in the debtor economies. According to official government and IMF statistics and our estimates, the largest debt-troubled LDCs have seen their real GDP actually fall during the past two years, a sharp turnaround from the 4- to 5- percent growth of 1979-80 (see figure 3). Imports have even fallen below levels originally targeted in IMF- supported adjustment programs. The imports of Ar- gentina, Chile, and Mexico have fallen by at least half in the last two years (see figure 4).n Moreover, it is not only the major debtors who are having financial difficulties and undertaking econom- ic austerity measures. Close to 40 countries currently have or are seeking IMF-supported programs. Last Figure 5 LDC and East European Debt Restructurings, Selected Years, 1976-84 Source: CIA estimates based on OECD and IMF data. a Estimated. year 25 countries obtained debt relief totaling about $55 billion (see figure 5). We expect that 35 countries will ask for debt relief this year in the amount of $70 billion.) The US economy has not been immune from the fallout of the LDC debt problem. The sharp drop in imports by the debtor LDCs has aggravated the US trade deficit. Trade statistics show, for example, that US exports to Latin America declined from roughly $42 billion in 1981 to $22 billion in 1983. In addition, US banks are highly exposed to debt-troubled coun- tries. LDCs and East European countries owe US banks nearly $150 billion, with the nine largest US banks accounting for roughly $90 billion. Moreover, the exposure of large US banks is highly concentrated in a few large debt-troubled countries; Argentina, Brazil, Mexico, and Venezuela together owe the nine Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential largest US banks over $40 billion, which substantially exceeds these banks' net worth. This vulnerability of the large US banks to the debt problem is reflected in the decline in their stock prices relative to the overall market. press reporting indicate that many investors fear that these banks may have to write off a large portion of their foreign loans, which would depress bank earnings and could raise deposi- tors' concerns over the solvency of these institutions. Potential Problems Under the Current Debt Strategy Although Western economic recovery is under way and LDC external accounts are steadily improving, we believe that serious problems still could arise. In the past six months, there have been signs that many commercial banks have become increasingly reluctant to lend new money to debt-troubled countries. For example, about 30 smaller US and foreign banks, according to press reporting, refused to participate in the recent $3.8 billion loan to Mexico. While most of the large, heavily exposed US banks are willing to make new loans to get back their interest payments on existing loans, a growing number of US regional and European banks are refusing to go along. Financial observers state that US regional bank reluctance is part of a strategy to limit exposure to troubled debtors. European banks operate under less stringent accounting rules and do not feel compelled to lend new money to keep interest payments current on existing debt. Under current US regulations, when interest payments are past due by more than 90 days, US banks-unlike their European counterparts-gen- erally must place their loans in a nonperforming category and deduct interest not received from in- come. As the foreign and smaller US banks drop out, the large US banks are forced to take on even more of the burden of new lending. In the four big Latin Ameri- can countries, the nine largest US banks already account for 60 percent of total loans made by US banks, according to Federal Reserve Board statistics (see figure 6). Concern about regulatory and stock- holder reactions to increased LDC loan exposure hinders these banks' ability to assume this greater burden.F___1 Figure 6 US Bank Exposure in Latin America, by Size of Bank, as of June 1983 -Next 15 largest banks Nine largest banks For this reason, we believe there could be shortfalls in meeting new money requests later this year. Accord- ing to press reporting, Argentina will need over $2 billion to keep interest payments current, and we believe raising that amount could be difficult. The Philippines is already seeking over $1.6 billion in new money from banks, and some banks are indicating reluctance to participate, according to press reporting. We believe Brazil could require more than $3 billion in new loans from banks to meet 1985 financing needs, but many European and smaller US banks have already said that they will not participate in a third packag A second problem area under the five-point strategy is that the governments of many financially troubled countries are having an increasingly difficult time 25X1 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential 25X1 maintaining austerity programs. As wages and subsi- dies have been cut in response to IMF conditionality requirements, political resistance to austerity pro- grams has grown. Such resistance has caused several key debtors to fall out of compliance with their IMF- supported programs, leading to interruptions of new money disbursements and the buildup of arrearages. Once such a disruption occurs, renegotiation of new IMF terms becomes even more politically difficult for the incumbent governments. Argentina, the Philip- pines, and Bolivia have all been declared out of compliance with IMF agreements, and relations with creditors are fragile. Efforts to negotiate new agree- ments have dragged on for months largely because of political constraints these governments face in imple- menting measures to satisfy the IMF. The Bolivian Government's decision last month to devalue its cur- rency and to increase food prices as preconditions for an IMF agreement spurred widespread labor strikes, including disruption of the banking system. In Argen- tina, continued sporadic strikes make it increasingly difficult for President Alfonsin to move forward on economic issues. In the Philippines, creditors are concerned that new opposition strength in the Assem- bly will make it more difficult to implement austerity measures and conclude IMF negotiations.F_~ ? A $5 per barrel oil price increase raises import costs for an oil-importing debtor such as Brazil by at least $2 billion; while an increase would improve the financial situation of oil-exporting debtors such as Mexico, Egypt, and Peru, on balance we believe a runup in oil prices would be destabilizing for those banking centers and countries with high loan expo- sure to non-oil-exporting LDCs.F----] Smaller amounts of official assistance could also hamper the present debt strategy. The capability and willingness of Western nations to provide emergency bridge financing is uncertain. US Government re- sources are constrained; available Commodity Credits Corporation and Eximbank credits are relatively small. Western governments helped to bolster the IMF's pool of funds last year. The IMF, however, provides only temporary and generally limited bal- ance-of-payments relief to financially troubled coun- tries. Many of these debtors require longer-term- investment-related capital to spur economic activity. New Proposals Concerned that Western economic recovery may fal- ter and interest rates remain high, many observers believe new proposals should be considered for dealing with the LDC debt problem. Even with a sustained recovery, debt restructuring and new bank credit are likely to continue to be necessary for many LDC debtors over the next two years. Moreover, consensus is growing among debtors and some Western govern- ments that LDC economic adjustments have been rigorous and that new policies are needed to enable debtor countries to finance growth and investment. There is also the concern that, as IMF assistance nears the debtors' quota limits over the next 18 months, these debtors will not be sufficiently cre- ditworthy to attract needed capital in the market- place. F__-] Over the last year, favorable economic trends have helped improve debt-troubled countries' external fi- nancial positions; since mid-1983 OECD real GNP has risen 4.5 percent annually. In addition, oil prices and, until recently, interest rates have remained steady. It is not clear, however, that the coming months will be as favorable. According to a number of forecasters, economic growth is expected to slow- perhaps as soon as fourth quarter this year-and interest rates could rise further. Moreover, if the situation in the Persian Gulf worsens, oil prices could rise. These economic trends would have the following kinds of impacts: ? Each one-percentage-point drop in OECD real growth cuts more than $2 billion from non-OPEC LDC export earnings. ? Each one-percentage-point rise in US dollar interest rates boosts non-OPEC LDC's annual interest pay- ments by about $2 billion; such a rise costs Brazil and Mexico over $500 million each. New proposals under discussion-including capital- ization of interest, multiyear restructuring, and a new SDR allocation-vary widely in the amounts of debt relief they would provide and who would bear the Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential Lower bank interest rates: Reduces future borrowing requirements Interest losses must be assumed by banks or banks reduce interest rates charged on Frees up money for LDC imports to spur Western governments loans to LDCs below their cost of funding economic growth Requires changes in banking regulations Could reduce banks' desire to lend new money Capitalization of interest: Burden is distributed more evenly among Requires changes in banking regulations banks add all or part of interest payments banks Effects willingness of banks to lend new to the principal amounts owed by debtors Frees up money for LDC imports to spur money economic growth Increases overall level of debt Multiyear restructuring: Spreads bunching of maturities over many Reduces creditor influence over LDC econom- a debt-relief package that restructures years is policies principal for more than one year Could improve the creditworthiness of Provides no relief from high interest charges debtors Reduces costs of restructuring SDR allocation: Helps to rebuild LDC creditworthiness Could be inflationary the IMF creates new money to build up New money for imports to spur economic Across-the-board relief to all IMF members: debtors' foreign exchange reserves growth does not distinguish debtor economic perform- ance and reduces debtor's incentive to adjust One-year grace period: Frees money for imports to spur economic Disincentive to take economic adjustments immediate hiatus of all debt payments for growth Requires changes in banking regulations one year, with the amount being resched- Increases overall level of debt uled Exchange participation notes: debtor governments service debt on the basis of a set share of export earnings Debt discounting corporation: new institution issues bonds to banks in exchange for banks' loans, and the institu- tion reschedules loans on softer terms Debt corporation: new institution purchases problem loans from banks, sells loans to private investors, and guarantee debt servicing Debt repayment linked to ability to pay Difficult accurately to measure export earn- Encourages creditors to invest in export ings in LDCs industries Hinders LDCs' ability to plan and adjust for future changes in economies and world markets Reduces risk to the banking system Requires funding from the United States and its allies Reduces bank responsibility to debt problem Does not provide substantial interest payment relief to debtors Reduces risk to the banking system Requires funding from the United States and its allies Reduces bank responsibility to debt problem costs (see the table). Some would require banks to take larger losses, while others would require substantially more aid from Western governments. According to financial observers, these proposals present other difficulties: ? Some would require legislation that would be time consuming and perhaps not feasible given current Western political environments. ? By providing across-the-board relief, some would treat all debtors identically and fail to recognize the uniqueness of each debtor's situation and economic adjustment performance to date. ? A new initiative will require the approval and cooperation of commercial bank and official credi- tors, which have divergent views between and among themselves. ? They could reduce the willingness of commercial banks to extend new credits to the debtors in the future. ? By shifting the responsibility for the debt problem to commercial creditors and Western governments, debtor countries will have less incentive to under- take needed economic adjustment measures. Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Major banks and official creditors have announced that they will consider a multiyear restructuring package with extended grace periods for those debtors who have adjusted their economies. This restructur- ing, however, does not address the problem of higher interest costs, and presumably would exclude debtors, such as Argentina and Bolivia, who h ve not taken sufficient adjustment measures. The debtor countries are also calling for ways that would share responsibility for solving the debt prob- lem and assuming losses. The Latin American debt- ors' conference on 21-22 June may provide a forum for debtors' views. the major debtors are unlikely to establish a formal cartel or repudiate their debt, largely because of concern that they would jeopardize access to trade credits and world money markets. Nonetheless, collective action will press creditors for debt servicing concessions and the IMF for easing austerity measures. Even if specif- ic proposals or more hardline positions do not surface from the debtors' conference in June, the sponsors- Argentina, Mexico, Brazil, and Colombia-will have generated political pressure for a stronger stand in bilateral negotiations with creditors.F_~ radical demands or actions by debtors. For example, a major debtor such as Argentina could refuse to cooperate with the IMF; Argentina or Mexico could call for a global debt conference; or a major debtor could insist on substantially easier terms from com- mercial banks, resulting in deadlocked negotiations. Implications for the United States We believe calls for new initiatives to the debt problem increasingly will be heard from LDC debtors, academics, and some Western allies. If not responsive, the United States could be criticized for being insensi- tive to lo lon er term growth and development needs of LDCs. Despite new creditor flexibility on multiyear restruc- turings, any further increase in US interest rates will probably continue to provoke LDC political opposition to US economic policies and strengthen collective calls for easier repa ment terms or a new solution to the debt problem. Moreover, the political strains on the debtor govern- ments are growing, and there is much uncertainty over debtor-creditor positions in upcoming debt nego- tiations. In this environment, we cannot rule out more While calls for action may simply be rhetoric, Wash- ington could be forced to find a way to respond to creditor and debtor concerns. The Argentine situation bears close watching. US banks again may face another nonaccrual loan problem at the end of June. Bankers are insisting that a letter of intent be ap- proved by the IMF before an agreement can be reached on interest arrearages. Meanwhile, negotia- tions between Argentina and the IMF are dragging. And even when an Argentine letter of intent is accepted by the IMF's managing director, we believe negotiations between Argentina and commercial banks for the restructuring of 1982-84 maturities and new money will be difficult and prolonged.F__1 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8 Confidential Confidential Sanitized Copy Approved for Release 2009/12/22 : CIA-RDP85T00283R000600080006-8