LDC EXTERNAL DEBT: SIGNIFICANT TRENDS AND RISKS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP97R00694R000600380001-3
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 25
• Document Creation Date: December 22, 2016
• Document Release Date: March 24, 2011
• Sequence Number: 1
• Publication Date: September 1, 1986
• Content Type: REPORT

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Directorate of Sccrr~-
2
LDC External Debt:
Significant Trends and Risks
GI 86-10063
September 1986
Copy 2 2 9
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Directorate of Secret
Intelligence
LDC External Debt:
Significant Trends and Risks
Office of Global Issues. Comments
Reverse Blank Secret
GI 86-10063
September 1986
and queries are welcome and may be directed to
the Chief, International Finance Branch, OGI, on
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LDC External Debt:
Significant Trends and Risks
Key Judgments Falling prices for oil and other commodities are causing a major resurgence
Information available in LDC economic strains and, in turn, LDC demands for external
as of 15 August 1986 financing and debt relief:
was used in this report.
? Mexico-facing dwindling reserves, negative growth, and rising infla-
tion-may request that a $12 billion international rescue package be
assembled that includes $6 billion in new commercial bank loans for
1986 and 1987 and a contingency fund to cover earnings losses from a
further oil price decline.
? Argentina's economic program is faltering and Buenos Aires is likely to
ask for as much as $1.5 billion a year for 1986 and 1987-or it might
seek interest rate concessions-coupled with a program to reschedule
about $14 billion of debt due during those years.
? According to Embassy reporting, Venezuela may request $600 million in
new money, ask for postponement of $3.4 billion in principal repayments
due during 1987-89, and seek further unspecified concessions on interest
rates.
? Peru has serious problems with its relations with creditors, and there is a
danger that it may be the first debtor in recent years to be formally de-
clared in default. Already, the International Monetary Fund (IMF) has
declared Peru ineligible to draw on Fund resources.
Although its trade prospects are improving, Chile continues to struggle
with low copper prices and is now expected to seek at least $450 million in
new money for 1987 to 1988. Santiago also plans to ask for postponement
of commercial bank principal repayments for 1988 to 1990, according to
Embassy reporting.
Bank creditors expect Egypt will need a debt rescheduling soon-its first-
to help offset sharply lower oil export revenues and worker remittances.
Nigeria will need as much as $1 billion in new loans annually over the next
few years, according to World Bank estimates, even with maximum debt
rescheduling. Lagos still must request an IMF standby arrangement to
obtain commercial bank new money and a Paris Club rescheduling.
Secret
Secret
GI 86-10063
September 1986
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Raising new money or obtaining debt relief will be difficult for these
heavily indebted countries, even with IMF-supported economic programs
in place. Doing so will put the biggest US and foreign banks in riskier posi-
tions. These banks remain a diverse group whose interests, commitments,
and financial strength vary between and within countries, making it
difficult for them to organize and lead efforts to boost lending to LDCs.
Commercial banks with small LDC exposure, for example, increasingly are
opting to write off troubled LDC loans and take a loss rather than
contribute to fresh loans they believe would not be repaid. As a result,
forced bank lending over the next few years is likely to be concentrated
even more among the world's largest banks-increasing both the burden
and the risk of new LDC exposure for these banks.
In our view, debtor-commercial bank negotiations during the next 18
months probably will result in some middle ground between the extremes
of large sums of forced new lending and partial debt forgiveness by
commercial banks on one hand and unilateral debtor action on the other
hand. The costs of a complete breakdown in relations-earnings losses for
banks and curtailment of loans for debtors-are too high. Potential actions
by debtors and creditors alike will produce many situations in which the
US Government may be called upon to intercede:
? Washington will have to stay involved in the Mexican negotiations with
commercial banks, where the short-term risks are that foreign creditors
will be unwilling to supply new money in the amount requested because
of disagreement over Mexican proposals, thereby dragging out financial
negotiations.
? If a major debtor country chooses not to play by the current rules of the
debt game, Washington will be called upon by international banks to use
its leverage to bring the debtor around or to provide new regulatory
changes to help cushion the resulting bank losses.
? If the United States were to go into a recession, if dollar interest rates
were to rise, or if US trade protection were to grow, the LDC debt service
problem would increase and debtors would demand countering actions
from Washington.
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? As economic troubles continue in the major debt-troubled countries,
further calls for Washington's leadership in providing an orderly way to
write down LDC debt can be expected.
Finally, despite recent modest improvements in US banks' financial
positions, debt repudiation or a long-term interest payment delay by a
major debtor still would present a serious problem. The greatest danger to
the solvency of the US banking system would be if other countries joined
that debtor's action. Although the likelihood of an outright repudiation is
small, there is substantial risk of a debt-troubled country acting unilateral-
ly to curtail its debt payments if it cannot find further orderly ways to re-
duce them.
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Key Judgments
The Debtors' Perspective: Increased Relief Needed
1
Individual Country Situations
2
Calls for Alternate Approaches
5
Outlook: Compromise Likely but Risks Remain
7
Individual Country Risks
9
Spillover Risks
10
Implications for the United States
11
LDC Debt Analysis
13
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LDC External Debt:
Significant Trends and Risks
The Debtor's Perspective: Increased Relief Needed
In an atmosphere of continued reduced bank lending
and dubious prospects for other sources of financing-
such as foreign aid or direct investment-the major
debt-troubled countries continue to face an economic
development crisis. The high rates of economic growth
obtained during the 1970s and early 1980s with big
government spending and massive external borrow-
ings are no longer possible. Moreover, many LDC
government officials believe that the classical ap-
proach to balance-of-payments adjustments taken by
some since mid-1982-to improve export performance
and cut imports with monetary and fiscal measures,
including realistic interest and exchange rate poli-
cies-has not worked. Indeed, after four years, the
debtor countries appear no closer to gaining access to
voluntary, substantial medium-term loans from com-
mercial banks. Also, living standards have fallen,
unemployment has risen, inflation remains a worry, a
rising share of domestic savings goes into interest
payments, and domestic investment has slowed dra-
matically. In effect, economic development for many
LDCs has been deferred to preserve limited cre-
ditworthiness in the international financial markets.
The net outflow of resources from these countries to
commercial banks and creditor countries totaled some
$22 billion in 1985 and is continuing to a similar
extent in 1986.
Debt service payments will remain onerous for the
next several years. For some major debtors, past
restructurings have created new repayment schedules
that cause scheduled principal repayments to peak
during the second half of the 1980s (table 1). There-
fore, many LDCs will need to restructure their debt
during the next several years to keep payments man-
ageable if large sources of new financing are not
available.
LDC debt probably will reach about $855 billion by
yearend 1986-up some $21 billion from yearend
1985. We project that LDC debt service payments
will be about $115-120 billion in 1986, about the
Table 1
The 10 Major Debtors:
Projected Future Principal Repayments, a
1986-91
Argentina
9.3
6.2
5.0
4.5
3.5
3.0
Brazil
13.5
13.9
13.2
13.9
12.0
7.6
Chile
0.5
0.4
3.1
2.7
2.2
1.6
2.6
2.9
3.4
3.6
3.4
2.9
0.9
1.0
1.5
1.6
1.6
1.5
6.2
7.1
6.5
8.0
8.1
8.5
South Korea
4.0
4.3
4.1
3.7
2.8
2.3
Venezuela
3.9
3.9
2.9
2.5
2.0
1.2
a For medium- and long-term debt contracted as of December
1985. Includes 1985 reschedulings. Future prepayment, restructur-
ing, or cancellation of principal would alter this schedule.
same as last year.' Continued debt reschedulings and
lower interest payments would help offset the overall
growth of the debt stock, keeping debt service pay-
ments from rising rapidly and providing some relief to
the overall LDC payments position. Given the stagna- 25X1
tion of LDC exports, however, the aggregate LDC
debt service ratio will remain high and constrain
improvements in their debt situations. In this environ-
ment, we expect a major resurgence in LDC demands
for external financing and debt relief and increased
deterioration in their economic performance.F 25X1
' For further information on quantitative debt trends, see ap endix,
"LDC Debt Analysis."
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Figure 1
Aggregate LDC External Debt,
1979-85
Individual Country Situations. Despite the similar
financial problems experienced by debt-troubled
countries, we believe the debtor countries are begin-
ning to diverge into two distinct groups. Favorable
global economic conditions-such as falling oil
prices-and the results of a greater commitment by
some countries-Brazil and Colombia-to economic
adjustment are primary factors leading toward an
improving economic performance. On the other hand,
in debtor countries such as Mexico, Venezuela, and
Peru, the prospects are for unsteady economic growth
and continuing financial problems because they are
unwilling or unable to undertake the necessary eco-
nomic reforms that will build confidence and attract
foreign capital. In our judgment, the differences
among debtor countries probably will become more
distinct in the coming years.
Brazil and possibly Argentina are the only
major debtors who can undertake substantial struc-
tural economic reforms at this time, given the political
Mexico may request $6 billion in new loans from
banks as part of an overall $12 billion, 18-month new
money package. It also may ask for a contingency
fund to cover earnings losses from a further oil price
decline or to boost economic growth if current actions
and lending are insufficient. These negotiations with
banks are likely to be arduous, however, lasting at
least two to as long as six months, and it is not certain
that banks will be willing to provide all Mexico wants.
Meanwhile, Mexico continues to face difficult prob-
lems, despite its recent signing of an International
Monetary Fund (IMF) letter of intent. Gross domestic
product (GDP) is projected to fall 4 to 5 percent this
year-and inflation may reach 100 percent; we expect
the inflation level to reach as much as 120 percent by
the end of next year. More important, many of the
policies that are at the root of Mexico's economic
problems have not been changed-for example, the
lack of privatization and foreign investment-and
President de la Madrid is likely to resist adopting
difficult economic reforms.
Argentina is likely to begin negotiations with the IMF
soon on a new standby agreement. Buenos Aires is
likely to ask for $1.5 billion a year for 1986 and 1987,
but international banks would prefer to lend no more
than $1 billion. Alternatively, Buenos Aires might
seek interest rate concessions. In addition, Argentina
is expected to ask the banks to reschedule about $14
billion of debt due during 1986 and 1987. On the
economic front, the Austral Plan to lower inflation is
faltering, despite its early success. GDP growth has
been slow, inflation is on the upswing again, and this
year's fiscal deficit is running above the targeted 3
percent of GDP. Investment continues to stagnate as a
forced savings plan funnels capital to the government
and discourages foreign investors from making new
commitments. Over the longer term, major obstacles
facing Argentina include a bloated public sector, an
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Table 2
The 15 Largest LDC Debtors,
Yearend 1985
? The oil collapse will cause the public-sector fiscal
accounts to post huge deficits.
? A recently announced economic package is likely to
have a depressing effect on the domestic economy.
50.2
35.7
Philippines 26.3
Chile 21:0
Nigeria 20.5
20.0
19.3
16.6
15.8
inefficient and protected industrial sector, and an
overdependence on agricultural exports. Meanwhile,
difficult external trading conditions-notably falling
grain prices-are likely to prevent any improvement
soon in the balance of payments.
As a result of the lower oil prices, Venezuela has
indicated it wants to revise its February debt resched-
uling agreement. According to press reporting, Cara-
cas is considering requesting $600 million in new
money from its 75 largest bank creditors, asking to
postpone $3.4 billion in principal repayments due
during the period 1987-89, and seeking further un-
specified concessions on interest rates. None of these
actions deal directly with Venezuela's fundamental
economic problems, including dependency on oil; a
highly restricted, controlled economy; and a need to
devalue its currency and unify its exchange rate to
become more competitive. Moreover, Caracas's rela-
tively strong position of 1985 has been dramatically
worsened by the collapse in oil prices:
? Petroleum export revenue will drop by at least $5
billion from last year.
Chile also remains in dire financial straits, suffering
from a heavy dependence on depressed copper export
receipts; a high external debt load-its debt-to-GDP
ratio is 120 percent, among the highest in Latin
America; high but declining unemployment; and large
internal debts. Santiago is now expected to seek at
least $450 million in new money from international
banks for 1987 to 1988 and to ask for postponement
of commercial bank principal repayments for 1988 to
1990, according to Embassy reporting.
Ecuador's prospects have been dampened by low
export prices. Negative economic growth and a cur-
rent account deficit of $750 million is expected this
year. Bankers apparently have been made nervous by
the unexpected depth of the oil price plunge and
initially were reluctant to commit to a $200 million
syndicated loan secured by oil receipts. The loan is a
key component of efforts by Quito to cover its exter-
nal financing gap. Meanwhile, the IMF postponed a
decision for two weeks in early August to approve a
new arrangement because Ecuador had not imple-
mented economic adjustment measures, particularly
devaluing the sucre. We believe a continuation of low
oil prices will necessitate the implementation of se-
vere-and highly unpopular-austerity measures and
could force the government to request additional relief
from debt payments to assure minimum import levels.
Peru is heading toward a severe economic crisis, in
our judgment. Large real wage increases and big tax
cuts have temporarily spurred economic growth, but
inflation-currently 70 percent-is running far above
the government's annual target of 40 percent. Because
the government's budget deficit is growing-it could
exceed 10 percent of GDP this year-we expect Peru
will have to print more money, and inflation could
exceed 100 percent later this year. Export revenues
are lower this year not only because of falling oil and
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mineral prices but also because of the overvalued
exchange rate. In addition, Peru has serious problems
with its relations with creditors, and there is a danger
that it may be the first debtor in recent years to be
formally declared in default. In mid-August, the IMF
declared Peru ineligible to draw on Fund resources
when Lima failed to clear its arrearages to the Fund.
In Central America, the Core Four countries-Costa
Rica, El Salvador, Guatemala, and Honduras-may
become increasingly restive concerning their financial
squeeze. Their $11 billion collective external debt is
small compared with most other LDCs, but weighs
heavily on their equally small, cash-starved econo-
mies. For each of the four countries, relations with
creditors are strained, and the region's political lead-
ers perceive their problems as receiving short shrift
from an international financial community that pays
greater attention to the largest debtors. US Embassy
reports indicate Core Four leaders reason that credi-
tor concessions are more important for their new
democracies than for the rest of Latin America
because the risk of political instability is greater. IMF
and World Bank data indicate debt service for the
Core Four will remain high at least through 1987, and
the region's leaders can be expected to increase
pressure for debt relief, possibly focusing on the US
Government-creditor for about 14 percent of the
four nations' debt.
Alone among the major Latin debtors, Brazil and
Colombia have achieved some modest success in their
external adjustment efforts. Brazil-resource rich and
with strong export performance-is continuing its
drive toward sustained growth despite its large debt
load. In Colombia, a recent coffee bonanza and
President Barco's Liberal Party's majority in Con-
gress probably will enable it to sustain economic
growth, reduce unemployment and inflation, and
strengthen external accounts.
In Africa, foreign bank creditors expect Egypt will
soon need its first debt rescheduling to help offset
sharply lower oil export revenues and worker remit-
tances, Recent state-
ments by President Mubarak and other high-level
Egyptian officials suggest Cairo has accepted the
inevitability of an IMF-supported adjustment pro-
gram, but Egyptian attempts to extract a lenient
economic adjustment program from the Fund might
well complicate progress toward an agreement and
subsequent debt rescheduling. Cairo's latest reform
measures, proposed in July, still fall short of require-
ments for IMF and World Bank assistance, particu-
larly concerning the budget deficit, domestic credit
expansion, and exchange rate reform. The Fund
reportedly does not expect an agreement with Cairo
for at least several months.
Plunging oil export earnings-97 percent of total
foreign exchange receipts-have created financial
turmoil in Nigeria. Oil earnings were halved from
$24 billion in 1980 to almost $12 billion in 1985, and
probably will drop another 40 percent this year to less
than $7 billion. Against this, Nigeria's scheduled debt
service obligations are about $5 billion this year, on
top of an import bill of at least $6 billion. Even with
the maximum possible debt rescheduling, Lagos
would still need at least $1 billion of fresh loans
annually over the next few years to maintain essential
imports, according to World Bank estimates. Lagos
still must request an IMF standby arrangement-
which it has avoided so far-to obtain commercial
bank new money and a Paris Club rescheduling, and
even then negotiations would be likely to drag on
through the end of this year.
Morocco has asked banks for rescheduling and $200
million in new loans to help cover an expected $500
million financing gap this year. The country's IMF
accord was scuttled in June because of failure to meet
economic adjustment targets, however, and, while
Rabat plans to negotiate a new standby, differences
over such politically sensitive issues as price hikes
probably will delay agreement for several months. In
the meantime, the country's foreign exchange
crunch-which, already has resulted in at least $500
million in trade credit arrearages, according to the
IMF-will worsen, threatening creditors' willingness
to offer future trade finance.
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In Asia, the greatest problem is the Philippines
which, with a $26 billion debt, remains mired in
financial troubles. The most immediate challenge for
President Aquino is to get foreign financial assistance
flowing into the country again. Rampant spending by
the Marcos administration prior to the February 1986
election put the Philippines out of compliance with its
IMF standby program and made it ineligible to draw
on commercial bank lines. Manila's commercial bank
creditors have extended the drawdown deadline on the
$325 million in undisbursed funds remaining in the
new money facility until December 1986. Hopes are
that an IMF program will be in place soon in time for
Manila to draw on these funds. Executing a new
economic plan without considerable new external
financing will be difficult because of the discordant
voices of those President Aquino has appointed to her
Cabinet. One particularly divisive factor will be the
approach the government takes in maintaining control
over an increasing militant labor force.
Elsewhere in that region, oil and commodity exporters
Indonesia, Malaysia, and Thailand have also seen a
worsening of their financial position, although we
would not yet categorize their position as serious as
that of the other countries examined. The sharp
decline in world oil prices is having a serious impact
on Indonesia's ability to service its $34 billion debt
because petroleum products account for about 70
percent of its foreign exchange earnings. In addition,
depressed prices for commodities have cut Malaysia's
and Thailand's export earnings, and economic diffi-
culties are mounting and debt relief could be neces-
sary in the next 18 months.F____1
Calls for Alternative Approaches. Calls by LDC
leaders for more funds and for reduced interest
payments on the debt already incurred result from
frustrations over their continuing economic difficul-
ties and dim prospects for resolving their debt prob-
lems. The Cartagena Group and some debt-troubled
country leaders state that debtor countries require
greater new lending than the Baker initiative pro-
poses. According to a report from the UN Committee
for Development Planning, developing countries will
need to double their rates of financial inflow-to at
least $80 billion annually by 1990-to achieve what
LDC leaders deem as politically acceptable growth
In contrast, other leaders and financial experts in
debt-troubled countries believe that additional lending
would only worsen these countries' financial positions
in the long term and make the present debt more
risky. In their view, the only way the debt problem
will be defused is for banks and creditor countries to
take on more of the burden of adjustment by provid-
ing interest relief or debt forgiveness or both. The
amount of debt that proponents suggest should be
written off ranges from 3 to 33 percent of the total
stock of debt held by debt-troubled countries. These
proponents also believe that debt forgiveness would
help solve the LDC debt problem and, by knocking
the debt level down, move the countries toward
creditworthiness.
In the debtors' eyes, debt servicing remains particu-
larly burdensome. As a result, the debtors are present-
ing new payment schemes to creditors in an attempt
to reduce their debt servicing burden:
? Mexico has proposed tying new loans to the price of
oil-its chief export earner.
? Venezuela recently legislated a below-market-rate
bond payments mechanism to service its private-
sector debt.
? Some financial observers have suggested a zero-
coupon bond issue to assist debtor countries.
The risk is that, if a debt-troubled country cannot find
further orderly ways to reduce its debt payments, it
might unilaterally act to curtail them. F___-]
The Creditors' Side: Financial Positions and
Perspectives
While debtor positions are growing more strained,
some international banks-especially smaller US
regional and West European banks-are in a better
position now to deal with LDC payment difficulties
than they have been since the debt crisis began in
mid-1982. Most of these banks have strengthened
their financial situations by increasing their capital
base while lending little additional money to debt-
troubled LDCs, and thereby have built up reserves
against some of their bad loans. As a result, some of
these banks now feel they can refuse to participate in
new lending if they find the lending arrangements
unacceptable.
rates of about 5 percent a year.
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Figure 2
Commercial Bank Exposure to 15
Troubled Debtors, 19858
Federal
Republic of
Germany-8.1
United States-
32.3
United Kingdom-
16.9
a Data are for December 1985. The 15 countries are
Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador,
Ivory Coast, Mexico, Morocco, Nigeria, Peru,
Philippines, Uruguay, Venezuela, and Yugoslavia.
b Estimated.
The change in the situation of US banks is indicative.
The exposure to debt-troubled LDCs of the top nine
banks, which account for almost two-thirds of loans
by US banks to Latin America, has fallen from nearly
180 percent of primary capital in 1982 to under 130
percent at present, according to financial reporting.
With restrained lending to LDCs and a continued
buildup in banks' capital bases expected over the next
several years, we believe further improvement is likely
in banks' ratios of LDC loans to capital-indicating a
further easing of banks' vulnerability to LDC finan-
cial troubles.
West European, Canadian, and Japanese banks have
been even more aggressive in building loan-loss re-
serves than US banks, thereby strengthening their
balance sheets. the
Swiss Federal Banking Commission has issued guide-
lines suggesting loan-loss reserves ranging from 10 to
50 percent for certain debtor countries. The Dutch
banking supervisory authorities require specific loss
Figure 3
Regional Distribution of Commercial
Bank Loans, 1985 a
North Africa/
Near East/
South Asia-
15.3
a Data are for the Bank for International Settlements
(BIS) reporting area, December 1985.
Latin America-
56.4
provisions ranging from 5 to 100 percent against loans
to more than 20 debtor countries. West German
banks currently keep reserves ranging from 20 to 50
percent of the face value of Latin loans
Moreover, the fall in the
value of the dollar has boosted the value of their
reserves, increasing their capital strength over the
past year and a half.
Commercial banks will remain unwilling to extend
new medium-term loans to most LDCs unless pres-
sured to do so in financial packages in conjunction
with the IMF, De-
spite being more able to extend such loans, the banks
prefer to reduce their exposure further and improve
the integrity of their loan portfolios. Private credi-
tors-primarily commercial banks-probably will
boost their lending by only 3 to 5 percent during the
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next year. Moreover, most of the increase in bank
lending will come in conjunction with debt restructur-
ing packages for a handful of major debtor countries.
Raising new money for heavily indebted countries will
be difficult even when the country has an IMF-
supported program in place.
during current negotiations Mexico will meet
resistance from US regional banks and some smaller
foreign banks, leaving about 150 to 200 international
banks to supply the new loans, in contrast to the 530
banks that participated in Mexico's previous loan
syndication in 1984. US regional banks and other
foreign banks with small exposure would prefer to
write off their Mexican debt and take a loss than to
contribute to a loan they believe would not be repaid.
To avoid the arduous effort needed to try to bring
skittish smaller banks aboard a new money package,
Venezuela may request a $600 million loan from only
its top 75 creditor banks. Thus, the forced bank
lending to LDCs over the medium term is likely to be
concentrated even more among the largest commer-
cial banks in the world-increasing both the burden
and the risk of new LDC exposure for these banks.
In our judgment, a resumption of banks' willingness
to lend voluntarily substantial amounts of new money
to the debt-troubled countries is unlikely this decade.
The greatest hindrance to a revival of voluntary bank
lending is the high-debt levels of many LDCs. 0
a bankers' rule of thumb these
days is that a financially sound country should have a
GDP-debt ratio of no more than 20 to 25 percent. By
comparison, Mexico's ratio is 80, Argentina's is 70,
and Chile's is 120.
even under the best of external
circumstances-continued world growth, lower US
interest rates, and rising commodity prices-debt as a
percentage of export earnings in the major debtor
countries will remain above desirable levels until after
1990.
New lending to LDCs.is also discouraged by other
factors, such as the existence of a secondary market
that trades LDC debt at a deep discount and the rapid
'evolution of financial markets that is changing bank-
lending strategies away from sovereign country lend-
ing. Moreover, banks
complain about what they perceive as conflicting
signals from regulators that penalize them for lending
new money, even within the context of the Baker
initiative. For example, in Japan and several Europe-
an countries, supervisory authorities require sizable
reserves, which apply to both old and new loans. As a
result, these banks must take a charge against earn-
ings when they make new loans, and this charge often
is not tax deductible.
Outlook: Compromise Likely but Risks Remain
In our view, debtor-commercial bank negotiations
during the next 18 months probably will result in
some compromise between the extremes of large sums
of forced new lending or partial debt forgiveness by
commercial banks on one hand and unilateral debtor
action on the other hand, largely because the costs to
both parties of a complete breakdown in debtor-
creditor relations are extremely high. From the credi-
tor point of view, the Baker initiative provides a broad
framework within which bilateral negotiations will be
carried out.
international bankers expect debtor countries to seek
further reductions in spreads, a lengthening of repay-
ment and grace periods, and a rescheduling of previ-
ously rescheduled debt. On the debtor side, while they
will continue to press for concessions, they are also
likely to accept compromise. Nevertheless, a break
with the current debt strategy-by either a major
debtor or creditor- cannot be ruled out.
The prospects for collective action by debtor coun-
tries-such as the Cartagena Group of 11 Latin
American debtors-appear diminished at this time.
The diverse financial situations of the Cartagena
Group members, their continuing disagreement over
how to resolve their debt problems, and the fear of
financial fallout have undercut a hardline approach
by the group. The Cartagena Group has not met since
February and has no meeting scheduled.
However, we do expect debt-troubled countries to
continue to see merit in meeting to discuss their debt
troubles, whether as part of the Cartagena Group
process or some other forum. Philippine officials, for
example, visited Mexico and Peru to discuss debt
problems with their counterparts, according to press
reporting; and Argentine President Alfonsin visited
Philippine President Aquino in July to compare notes
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aMAUL
LDC Debt: A Quietly Emerging Swap Market
Creditors and debtors are increasingly active in a
growing but often secretive swap market for LDC debt
in which banks sell or swap troubled LDC loans at
less than their face value. Some observers believe this
could lighten the LDC debt burden but, in our view,
both creditor and debtor reluctance to use these
techniques will limit the overall impact. F__~
Bankers, frustrated by the current approach to debt
problems, are expanding their use of swaps to limit
risks, reduce exposure to a given country, and
strengthen their balance sheets. For some smaller
banks, swaps have provided an opportunity to elimi-
nate LDC exposure completely. For others, it has
offered a way to concentrate or consolidate loans
within a preferred geographic region. West European
banks and smaller US banks are particularly active
in this market. Larger US banks, however, are con-
strained by accounting standards that require a bank
that sells a portion of its debt at a discount to write
down its remaining loans to that borrower. F__]
Approximately $3 billion in international loans will
be traded at a discount this year
Purchase prices for debt range
from about 10 cents on the dollar for Nicaraguan
debt to 87 cents for Colombian exposure. Other price
examples include 25 cents for Peruvian loans, 58
cents for Mexican loans, and 75 cents for Brazilian
loans.
One of the most significant factors in the expansion of
the swap market has been the debt-to-equity pro-
grams instituted by debtor countries including Brazil,
Chile, and Mexico. In such schemes, a bank sells
debt at a discount to a multinational corporation or
private investor who transfers it to the debtor country
for redemption at near or full face value in local
business. These arrangements benefit the debtor
country by reducing its external debt level and lower-
ing the accompanying interest payments. They may
also serve as a stimulus for additional foreign
investment:
? Chile's schemes for converting debt into equity will
reduce its external debt by more than $500 million
by next year.
? Mexico has just developed a system to handle the
swapping of public-sector debt for equity in private
Mexican companies. For example,
=arranged a debt-to-equity swap worth about
$40 million to finance expansion of Nissan's Mexi-
can operations.
The swap market also is being stimulated by the
increased use of a debt-for-exports scheme. Under
such a plan, a company seeking to import goods from
an LDC would purchase some of the LDC's debt at a
discount and exchange it at the LDC's central bank in
return for specified goods. F__1
Although offering relief to both sides, we believe
swaps and conversions will provide only a marginal
solution, given total LDC debt of roughly $900
billion. Some observers doubt that there would be
enough buyers for large-scale debt purchases unless
the loans are substantially marked down, and they
doubt commercial banks would be willing to take the
resulting losses. Also, debtor countries will have to
limit their use of debt-for-equity conversions because
of their inflationary impact. If a debtor country were
to allow many debt-for-equity conversions at the
same time, too much of its currency would be put into
circulation at once, causing inflation to rise rapidly.
Moreover, if the market for discounted paper contin-
ued to grow, regulators could force the banks to value
their entire loan portfolios at the lower market rate.
a growing recognition that
LDC debts are not worth par value could lead debtor
countries to argue that their obligations to creditors
should be adjusted correspondingly. For example,
Mexico might argue that, with the market price of its
debt only 58 cents on the dollar, its debt obligations
should be only $58 billion, rather than the $100
billion it actually owes. Alternatively, debtor coun-
tries can buy back more of their own debt-through
third parties-at deeply discounted rates. Thus, we
believe bankers will continue to downplay their par-
ticipation in this emerging hidden market.
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The Cartagena Group:
Politicizing the Latin Debt Problem
The rising outspokenness of Latin debtors has be-
come a key development in the Latin American debt
situation over the past three years. The process of
politicizing the debt issue began in February 1983,
when the former President of Ecuador, Osvaldo
Hurtado, sent a proposal to the Economic Commis-
sion for Latin America, the Latin American Econom-
ic Systems, and all Latin American nations seeking a
common response to the region's economic crisis. His
initiative led to formation of the Cartagena Group,
which has held four ministerial-level meetings on the
debt situation and issued several statements. The
Cartagena Group consists of Argentina, Bolivia, Bra-
zil, Chile, Colombia, Dominican Republic, Ecuador,
Mexico, Peru, Uruguay, and Venezuela. 0
The Cartagena Group established a political forum
to voice Latin concerns to industrial country govern-
ments through public declarations. The declarations
are also part of the Latin debtor effort to gain
concessions from their international creditors, an
objective that heretofore has been accomplished
through bilateral negotiations. In addition, the
Group's pronouncements are intended to appease
on debt. In addition, we are watching to see if a Latin
heads-of-state summit is organized later this year to
discuss the debt problem.
such a meeting will take place. We also remain
concerned that the currently dormant Cartagena
Group-or some variation of it-could be revived by
deterioration in external conditions that debtors per-
ceive the United States as having some control over,
such as sharply rising interest rates, spreading OECD
protectionism, or slowing OECD economic growth.
growing domestic popular sentiment-in countries
like Argentina, Mexico, and Venezuela-for a tough-
er stand with creditors. Moreover, Latin leaders want
Washington to view their debt problem as at least as
important as issues in Central America.
So far, no consensus has been reached on radical
alternative proposals, such as a unilateral moratori-
um on interest payments. Indeed, by limiting itself to
the lowest common denominator within the group, the
Cartagena process has reinforced a moderate posi-
tion. Most Latin leaders continue to take a two-track
approach to resolving their financial burden: servicing
their debt to the best of their ability, while concur-
rently seeking more concessions. Nonetheless, the
Cartagena process has encouraged the Latin debtors
to share information on debt negotiations and to use
that information to seek better terms from credi-
tors-the so-called spillover effect. The creation of
the consultative system also has heightened the level
of participation on the part of Latin political leaders
to press for changes in the policies and operations of
official and private international institutions. F__1
Individual Country Risks. Although we believe the
most likely outcome for debt negotiations in the near
future is pressure from the debtors and initial stub-
bornness by the banks but with eventual compromise,
some risks remain. In individual countries:
? Mexico has hinted at a possible suspension of
interest payments in the past. If bankers refuse to
renew substantial lending this fall, Mexico will
reduce payments, possibly opening a special account
in the central bank where interest owed to foreign
banks would be deposited in pesos rather than in
dollars.
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? Argentina could, on its own, take some action to cap
interest payments if the labor situation grows worse
and banks rebuff Buenos Aires' efforts to obtain $3
repayment of some loans arranged under the Mar-
cos administration remains an issue within the
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billion in new money through next year.
? Peru continues to limit debt payments to 10 percent
of export earnings and would welcome similar ac-
tion as support for its position.
? Venezuela had announced that under a new law the
government will issue dollar-demonstrated bonds to
be used to pay off private-sector debts totaling
almost $5 billion. The bonds, which do not mature
for 15 years, carry an interest rate of 5 percent-
below the commercial banks' cost of funds. Sur-
prised by the intensity of bankers' reactions, Vene-
zuela has scrapped the bond scheme.
? Ecuador, because of low oil prices, will need to
implement severe austerity measures and could
request additional relief from debt payments or
unilaterally act to assure minimum import levels.
? Many smaller debtor countries-including Bolivia,
Costa Rica, and Nicaragua-have either restricted
their debt payments and allowed interest arrearages
to build or have arranged with creditors for a
rescheduling of some of their interest payments.
? Philippines' President Aquino plans to ask bankers
for debt relief during her trip to the United States in
September, according to press reports. In addition,
Cabinet.
Spillover Risks. We are also concerned that, with
Mexico apparently obtaining significant concessions
from creditors, other debtors may expect similar
treatment, claiming that they too are constrained by
external economic conditions, that they see no pros
pects for an improvement in export earnings, and that
they cannot make further substantial spending cuts
for domestic political reasons. Furthermore, if a major
debtor is unable to come to terms with its creditors
and takes action to limit its debt payments, other
countries might reevaluate their positions in servicing
their debt, particularly if they perceive that the debtor
is not suffering serious consequences from its actions.
At the very least, other debtors will use concessions
granted to one as a benchmark for their own future
negotiations with creditors.
Several Latin American countries are positioning
themselves to take advantage of the innovative finan-
cial package recently put together by the IMF for
Mexico. Failure by these governments to obtain
Mexican-like repayment terms tied to the prices of
key export commodities or to economic growth could
cause them to adopt confrontational tactics. For some,
the large new money commitment to Mexico will raise
expectations of substantial new credit infusions.
These potential spillover effects pose the greatest
danger for the US banking system. If only Mexico
forces major concessions on interest or defaults, the
magnitudes, while large, need not be catastrophic for
the system. Mexico's interest due for 1986 to the nine
largest US banks, which hold over half of the US
portion of the Mexican debt, is equivalent to roughly
40 percent of their 1985 profits. If major concessions,
such as forgiveness of one-half of interest due, are
applied to other debtors, the consequences become
much more serious. In the case of these nine large US
banks, the lost interest from all LDC debtors would
exceed the total profits for 1985.
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Implications for the United States
In this environment of increased debtor demands for
relief and commercial bank reluctance to lend, we
believe there may be a number of situations involving
debt-troubled countries in which the US Government
would be called upon to intercede:
? Washington will have to stay involved in the Mexi-
can financial negotiations, where the short-term
risks are that foreign creditors will be unwilling to
supply new money in the amount requested because
of disagreement over Mexican proposals. In this
case, financial negotiations would drag out and
Mexico almost certainly would have difficulty meet-
ing interest payments on its external debt.
? If a major debtor country chooses to curtail interest
payments unilaterally, the United States will be
called on by international banks to use its leverage
to bring the debtor around or to provide new
regulatory changes to help cushion the resulting
bank losses.
? Progress toward resolution of LDC debt difficulties
also will be affected by global economic conditions.
If the US economy were to go into a recession, or if
dollar interest rates were to rise, or if US trade
protection were to grow, the LDC debt service
problem would increase and debtors would demand
countering actions from Washington.
? As economic troubles in some major debt-troubled
countries continue, further calls for Washington's
leadership in providing an orderly way to write
down LDC debt can be expected.
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Appendix
LDC Debt Analysis
Volume of Debt
The increase in the level of aggregate LDC external
debt remained small in 1985. We estimate that total
LDC debt-$834 billion-grew by 3.9 percent last
year, following a nearly identical 3.6-percent increase
in 1984. These modest rises contrast with 8-percent
LDC debt growth in 1983, 12 percent in 1982, and 21
percent in 1981. The rate of growth of the non-OPEC
LDCs' debt has continued to taper off since 1981.
Last year the non-OPEC LDC debt-$662 billion at
yearend 1985-rose 3.9 percent, compared with 4.3
percent in 1984 and 8.3 percent in 1983. The growth
of the debt of the OPEC LDCs, however, reversed its
three-year downward trend. OPEC LDC debt grew 4
percent in 1985, up from only 1-percent growth in
1984.
exports, also unchanged from 1984. This ratio is
important because interest payments are considered
essential for LDCs to maintain minimum credit-
worthiness with banks, whereas principal repayments
can be rolled over or delayed.
Major Creditors
Despite attempts to reduce their LDC exposure
through swaps and some small-scale writeoffs, US
banks continue to be major holders of LDC debt
(table 3). According to US Federal Reserve data, US
bank claims on LDCs totaled about $117 billion at
the end of 1985-down from about $127 billion at the
end of 1984-representing 26 percent of total bank
claims on LDCs. Latin America accounted for about
$82 billion in US banks' claims, followed by East Asia
with about $27 billion. Mexico, Brazil, Venezuela,
and South Korea remained the largest individual
The reluctance of creditors-primarily commercial
banks-to increase their lending in view of continuing
LDC economic and financial troubles remained the
major reason behind the slow overall LDC debt
growth, in our view.
in most cases, new bank lending to financially
troubled LDCs was done involuntarily in conjunction
with IMF-supported. economic adjustment programs.
Debt Service Payments
Falling interest rates yielded a substantial dividend
for LDC debtors last year; total debt service payments
dropped 3 percent to $115 billion. Even though
principal repayments were up 7 percent last year to
$52 billion, a 10-percent drop in interest payments to
$62 billion resulted in the net drop in total debt
service. We estimate that close to 60 percent of total
LDC debt is at floating interest rates.
The benefits of the drop in interest rates were offset
by a decline in LDC exports of goods and services and
higher principal repayments, keeping the average
LDC debt service ratio at 21 percent last year-
unchanged from 1984. Interest payments last year
were equivalent to 12 percent of goods and services
debtors to US banks at the end of 1985.
UK bank claims on LDCs totaled about $71 billion at
the end of 1985, or about 16 percent of total Bank for
International Settlements-reported bank claims on
LDCs. Latin American countries owed nearly $36
billion, with Brazil, Mexico, and Argentina the three
largest debtors to UK banks. West German banks
were owed about $37 billion by LDCs at the end of
last year-about 8 percent of total Western bank
claims-with Brazil, Mexico, and Argentina also the
largest individual debtors to FRG banks. Neither UK
nor West German banks posted significant new expo-
sure to LDCs in 1985.1
With the exception of British and West German
banks, debt data for non-US bank creditors are
largely unavailable. Japanese commercial banks are
important LDC creditors, but Tokyo does not official-
ly release bank exposure data.
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Table 3
Selected LDCs: Debt Held by
US, UK, and West German Banks,
Yearend 1985
Million US $ Table 4
LDC Debt Reschedulings, 1982-85
US Banks
UK Banks
West
German
Banks
BIS Total
Algeria
829
1,481
829
9,621
Argentina
8,411
4,409
3,046
28,923
Bolivia
113
118
98
642
Brazil
22,796
13,926
6,097
77,329
Chile
6,569
2,511
1,003
14,272
Colombia
2,625
703
444
6,503
Ecuador
2,143
NA
327
5,167
Indonesia
2,748
1,463
2,192
15,085
Ivory Coast
358
512
498
2,901
Malaysia
1,087
1,529
557
10,507
Mexico
24,934
12,554
3,813
73,368
Morocco
905
NA
577
4,826
Nigeria
1,199
3,828
1,583
9,047
Peru
1,654
642
455
5,683
Philippines
5,418
1,457
552
13,333
South Korea
9,165
3,246
1,084
34,033
Thailand
1,877
617
524
7,527
Uruguay
913
341
84
2,150
Venezuela
10,091
3,454
2,104
26,024
Yugoslavia
2,398
2,981
1,954
10,508
Number of Value
Number of
Value
Countries
(Million US $)
Countries
(Million US $)
1982
6
641
4
1,741
1983
17
10,559
14
41,091
1984
13
3,894
10
8,813
1985
19
5,916
12
86,877
Argentina, Chile, and Yugoslavia, rescheduled both
official and commercial debt. Also, 11 additional
commercial bank reschedulings-including a $21 bil-
lion deal for Venezuela-were agreed to in principle
in 1985 but not signed before the end of the year.
Venezuela's rescheduling still has not been finalized.
Debt Reschedulings
Key rescheduling developments in 1985 included the
first-ever Paris Club multiyear rescheduling agree-
ment (MYRA), for Ecuador, and a commercial bank
MYRA for Mexico covering nearly $49 billion. There
were a total of 31 LDC debt reschedulings in 1985-
up from 23 in 1984-covering a record $93 billion in
debt obligations (table 4). Of these agreements, 19
involved debt owed to official creditors, and 12 cov-
ered commercial loans. Eight countries, including
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