Strategy for an LDC debt workout: a U.S. perspective - William B. Milam address - transcript

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Address before the Western Economic Association International in Los Angeles on July 3, 1988. Mr. Milam is Deputy Assistant Secretary for Economic and Business Affairs.

There are two debt problems, and they are quite different. I will address, first, the debt workout for the middle-income developing countries; second, I will discuss the debt situation of the very poor countries, most of which are in Africa.

How the State Department Fits In

The State Department bas two distinct but interdependent roles in the formulation and implementation of debt policy as it relates to both the middleincome and the poorest countries.

First, we have a direct role as tbe agency which leads on official debt rescheduling negotiations. (As you know, these negotiations take place in tbe mysterious Paris Club.)

Second, we participate in formulation of debt policy and try to ensure that it is compatible with-even supportive of-our foreign policy and national security interests.

If I may speak personally for a minute, my own experience and role in debt policy stems directly from the State Department's various roles. I am one of the "old warhorses" of the debt issue, having been involved with debt policy and rescheduling since 1978. My experience began in those halcyon days when lending to developing countries soared to dizzingly high levels-fed and motivated by oil-exporter country surpluses; the belief that these, and high inflation, would continue-and when only a few (mainly tbe poor countries) ran into trouble.

But that experience also covers the crisis years; I was present at the U.S. Treasury in August 1982, when the outline of the present debt workout strategy emerged in response to the Mexican payments crisis. Also, I have represented the United States at the Paris Club in two different j obs-for a while in 1983 and in my present position. So you won't be misled, I'll warn you in advance that I believe our foreign policy interests are best served by the present flexible, evolutionary debt workout strategy.

The Middle-Income Developing Countries

The overriding theme of that first Mexican package-the overriding theme of the debt workout-has been, and remains, cooperation in a collective effort to solve a problem in ways which serve the mutual interests of all the participants. The mutuality of interests is key to the effectiveness and the duration of the debt workout strategy. The debtors perceived then, and most still perceive, that it is not in their interests, long or short term, to stop servicing their debts and, therefore, cut off their access to capital markets. The industrial countries perceived then, and continue to perceive, that their interests are best served by cooperation to help the debtor countries through this rough patch.

First, generalized default threatened the viability of the international financial system.

Second, a default which cuts off these countries from international capital markets is likely to lead to political instability in the debtor countries.

That mutuality of interests also obtains for our foreign policy interests. The strategy emphasizes a collective effort, a nonconfrontational approach. It preserves a case-by-case approach, allowing official and private creditors the flexibility to shape agreements to the individual needs of the various debt countries. The evolutionary nature of the strategy also maintains flexibility and permits the strategy to change with the times. Most importantly, this approach has preserved some access to international capital markets for these debtor countries, albeit mostly involuntary. It is tbe only strategy that holds open the hope that they can improve the level and quality of that access over time.

A long cutoff in such access would be very deleterious for our foreign policy and national security interests. The middle-income countries need foreign capital to meet their investment needs, thus to grow at optimum rates. For one set of these countries-mainly those in Latin America-the ability to obtain foreign capital in tbe amounts needed is threatened for a significant period of time. Without foreign capital, growth prospects decline, and the possibility of political instability increases. Programs to liberalize and open these economies might be abandoned. These countries might react as they did in the 1930s to the drying up of foreign capital: by turning inward and toward statism. Such a turn would, incidentally, attenuate the movement toward real democracy which has been growing in the past decade.

The Design of the Debt Workout

The basic framework of the debt workout for the middle-income countries remains essentially the same as when it began in 1982. There are two major and related long-term goals:

First, to reduce the vulnerability of the international banking system; and

Second, to improve the debtor country economic and financial performance and structure to promote sustainable growth.

Each participant in the debt workout has had, and continues to have, its own role and set of responsibilities.

* The debtor countries, of course, must change their economic policies and structures to make their economies more efficient so they can regain the capacity to service debt.

* The commercial bank creditors are to reschedule and provide new funding if countries carry out their adjustment programs.

* Creditor governments reschedule their own claims on debtors, providing new money by rescheduling interest, by continuing their export credit programs in these countries, and-in a few cases-by providing other financial assistance. Creditor governments also provide bridge financing in cases in which that is necessary. Finally, creditor governments put in the necessary resources and bring about the necessary policies in the international financial institutions to ensure that these institutions are conducive to the process.

In 1985, Secretary Baker changed the adjustment emphasis of the debt workout from macroeconomic stabilization and demand restraint to structural adjustment policies. Such structural adjustment policies range from trade and financial liberalization to deregulation and privatization of public sector enterprises. Secretary Baker put a new thrust into the debt workout, but he did not change its basic framework.

The strategy has evolved in other important ways while retaining its basic structure. Many new instruments to reduce exposure have been created. More innovations are likely as we proceed.

And much progress has occurred. Progress is particularly apparent with regard to the objective of reducing the vulnerability of the banking system on LDC [less developed country] loans. From 1982 to the end of 1987, the nine U.S. money center banks reduced their exposure to the so-called Baker 15 [major LDC debtor countries] from 212% of primary capital to 90%. The decline for other classes of banks was even larger, on average. This decline is more rapid than we would have predieted in 1982; it results, in large measure, from the efforts of the banks to broaden their capital base.

There has been less visible progress toward the second fundamental objective-structural and economic policy reform in the debtor countries. However, there is much more progress than is generally admitted. Indicators of debt burdens have stabilized. One striking feature is the reduction in the proportion of short-term debt to total debt, which has fallen from 21% in 1982 to 8% in 1987, largely because of reschedulings. The lengthening of the maturity structure in this way has provided most debtors with a more manageable debt service payment stream. Of course, another very prominent factor is the reduction in interest costs from the worldwide reduction of interest rates since 1982. The Baker 15 countries pay 26% of exports as interest now, in comparison with 31% in 1982.

There are many examples of great progress in the attitudes and in the implementation of structural adjustment programs in the major debtor countries. Mexico has liberalized its trade regime and is privatizing its state enterprises. Its export bases are so diversified that now non-oil export revenues exceed oil revenues. Chile's success, both on macro adjustment and on structural adjustment, is well known. It has adopted the most successful debt equity program, which has reduced its debt by about 23%. Bolivia has perhaps implemented the best, most comprehensive, most effective macroeconomic and structural adjustment program of any debtor country. Bolivia has also worked out with its creditor banks an innovative debt reduction scheme. That scheme was an important advance in the debt workout strategy. It was voluntary and worked out between the debtor and its creditors within the market mechanism.

The United States has supported schemes with those characteristics and will continue to do so. As you know, the United States provided zero coupon bonds to collateralize the Mexican debt securitization scheme. We have responded in other ways.

* We have fostered the growth of the so-called menu of options (such as Mexican securitization, exit bonds, and debt/equity swaps) for financing among the commercial banks.

* We have tried to shape the international financial community in ways which would be conducive to voluntary debt workouts; for example, Treasury Secretary Baker proposed a new external contingency facility for the IMF [International Monetary Fund] last year, and that has now been put into place.

The Eroding Consensus

The consensus which sprang from that perceived mutuality of interest in 1982 has suffered much wear and tear The debtor countries are finding the pain of macroeconomic and structural adjustment more and more difficult to bean The creditor banks are finding the provision of new money more and more expensive and risky. The creditor governments are more and more threatened with the prospects of default or massive intervention, which would require large expenditures of public money.

In part, at least, the problem in the debtor countries is political, and this always gives cause for foreign policy concerns. There are fledgling democracies involved who find it difficult, if not impossible, simultaneously to build democratic institutions and to cope with the structural adjustment problems. We have to weigh these shortterm dangers against the longer term benefits to our foreign policy interests that will accrue from a strategy that promises strengthened access to capital markets over time.

But frustration and wear and tear are apparent also on the creditor side. In particular, the commercial banks have become increasingly frustrated by the almost endless negotiations but, more particularly, by the growing reluctance of the smaller, less exposed banks to play their role in providing new financing. This so-called free rider problem appears to be getting worse as more and more banks increase their loan loss reserves.

In part, the consensus is breaking down also because of differing regulatory and tax structures in various countries, giving different national banks impetus in different directions. Even in the United States, the middle-income debt workout strategy is under attack. These attacks are driven by the perception that the debt strategy is designed to save U.S. banks at the expense of other sectors of the U.S. economy, particularly exporting sectors such as agriculture. Calls from both sides of the political aisle for new large facilities to relieve the debt burden of these countries continue to grow.

There are powerful arguments against any schemes for generalized debt reduction toward a general policy using government monies to take the banks out of their LDC exposures and/or to place the banks' risk on the taxpayers. I share in full the aversion to ideas that would throw the burden on the taxpayers. Many schemes which would do so have been put forward. Some are said to be costless. However, none of them would be; all would be very costly.

They would be costly also to our long-term foreign policy interests. They would destroy the cooperative approach on debt, based on mutual interests, and promote confrontation between debtors and creditors.

The implementation of such schemes would cut access to capital markets for the debtor countries for some time. Those who downplay this don't realize that after the Latin American nations settled-often at deep discounts and interest reductions-their defaults of the 1930s, they regained access generally only after about 15-20 years. I underline the"only." Such a long hiatus from adequate levels of foreign capital would be a real threat to our long-term foreign policy and national security interests.

We have to incorporate into our mindset on the debt situation one important fact: the debt workout for middle-income countries is a long-term and very difficult process. There will be much pain involved, both in creditor countries and in debtor countries, and there will be many setbacks along the way. I think that must be clearly spelled out as we move forward. But the strategy as we have it framed now is fundamentally sound on financial, political, and foreign policy grounds. It is the only strategy that promises a full return to capital markets for these debtor countries within the foreseeable future. And, in my view, a corollary of that is that this is the only strategy that promises the kind of structural adjustment and macroeconomic reform that must occur if these nations are to grow, prosper, and sustain open, democratic political systems.

The Poorer Developing Countries

In contrast to the rocky patch and the eroding consensus that we see for the debt workout in the middle-income countries, there seems to be a growing consensus about how to handle debt in the poorer countries with large debt problems and good adjustment programs. Now when we say "poorer countries," we are talking primarily about sub-Saharan Africa. We are talking about countries which are eligible only for very concessional World Bank loans, that are undertaking good adjustment programs in which heavy debt service complicates the adjustment program.

The consensus that has been growing basically revolves around finding options to reduce the debt service burden on these countries in a way compatible with legal and budgetary constraints in the creditor countries. The Group of Seven countries, meeting at the Toronto economic summit recently outlined a proposal for a menu of options for the relief of debt service in these countries. This range of options will be vetted by the Paris Club with a view to implementing them soon.

Let me review how the Paris Club works, then describe how the options will work. The Paris Club is an informal, but official, organization which meets almost monthly to reschedule the official debts of countries which can no longer service these debts. The Paris Club does not reschedule the stock of debt of a country. It reschedules nows. It takes debt service due this broad set of creditors over a certain time period-usually the length of an IMF standby program-and agrees that part or all of that debt service can be paid starting up to 5 years later (in the case of most debtors), or up to 10 years later (in the case of the poorest), and over a 5- to 10-year period.

The Paris Club has traditionally rescheduled debts at an interest rate which reflects the original interest rate paid on the debt. In other words, AID [Agency for International Development] loans are rescheduled at the concessional rates at which they were granted, and commercial-type loans are rescheduled at the commercial rates at which they were originally contracted. (Interest on rescheduled debt is called moratorium interest.) In the Paris Club, moratorium interest rates are bilateral matters settled in bilateral negotiations subsequent to the Paris Club agreement.

The Toronto summit proposal would allow creditor countries to treat this debt significantly differently, with a menu of three options.

The first option, proposed by France, would allow creditors to reduce the debt service due over the period by some fraction, then to pay the reduced amount back over a period similar to, or only slightly longer than, the traditional Paris Club repayment period of 10 years, with perhaps a grace period equal to more than half of the repayment period. The debtor countries would be paying interest on a reduced amount of rescheduled debt service, thus reducing the moratorium interest due during the grace period; in addition, of course, debtors would be repaying less than the full amount of principal and interest during the repayment period.

The second option, proposed by the British, would allow creditors to reschedule the debt due over a similar period, with a similar grace period, but charge a reduced interest rate on that rescheduled debt. Thus, debtors would pay a reduced moratorium interest rate over this period but would repay the full amount of principal and of rescheduled interest during tbe repayment period.

The third option is for those countries, such as the United States, which are unable-legally, politically, or budgetarily-to implement options that reduce the value of loans. It would allow such countries to reschedule debts over an even longer period-perhaps up to 25 years-but would allow these creditors to collect a market interest rate on the debt as moratorium interest. Again, the grace period would be over half of the full repayment period. The benefit for the debtor is that repayment of principal and of interest is put off for a long time.

In more general terms, it is clear that the international community has reacted quickly and aggressively to meet the severe problems of the poorest developing countries. One significant problem in those countries has been the debt of the International Monetary Fund, which is short term and carries relatively high interest rates. Over the past 3 years, the members of the Fund have acted to create, first, a structural adjustment facility and, now, an enhanced structural adjustment facility which is providing close to $9 billion to these countries in conjunction with good macroeconomic and structural adjustment programs worked out witb the Fund and the World Bank. In addition, donor countries pledged $6.4 billion of financing to be used in cooperation with the World Bank for the lowincome African countries with severe debt problems who are undertaking adjustment programs. Members of the World Bank recently approved a $12.5billion IDA [International Development Association] program, half of which is to be devoted to African countries. Finally, many bilateral donors have increased their assistance, and that includes the United States, which recently received additional funds from the Congress for development assistance to Africa and also has received congressional authority for greater flexibility in allocating these funds.

We are convinced that, in the poorest countries, debt is a symptom of major structural development problems, but it is not the problem itself We have concluded that, for the heavily indebted poor countries, the potential level of resource transfer is, in the aggregate, sufficient to provide all the financing needed over the next few years for optimal growth rates in the context of good sound adjustment programs. Thus, the level of net resource transfer-including debt rescheduling-will remain fairly constant at an increased level if these countries continue to implement good adjustment programs.

The outline agreed at the Toronto summit will assure that rescheduling continues to support this approach. Thus, we can prediet with relative confidence that the resources necessary for the poorest countries are there and that resource transfer levels will not fall if those countries undertake, and continue to undertake, internationally agreed adjustment programs under the aegis of the IMF and the World Bank. Frankly speaking, the ball is in their court.

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