LDC DEBT PROBLEMS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85-01156R000200270011-5
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 14
• Document Creation Date: December 22, 2016
• Document Release Date: August 27, 2010
• Sequence Number: 11
• Publication Date: December 10, 1982
• Content Type: MEMO

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EXECUTIVE OFFICE OF THE PRESIDENT
COUNCIL OF SCONOMIC ADVIISRs
WAMMmwN. D.C. awes
MEMORANDUM
TO: MARC LELAND
FROM: PAUL ERUGMAN
Subject: LDC Debt Problems
Attached is a revised version of the debt-trade paper.
have attempted to take into account the comments from Rorp,
Ammerman, and Fauver.
cc:
Jim Ammerman
Bob Fauver
Ralph Korn
 TEXTNAME: DEBTPaper (R)P: (PX12/9/82) 01
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EFFECTS OF THE DEBT PROBLEM ON U.S. TRADE
Sharp
The slowdown in lending to less developed countries will
force these countries to reduce their borrowing needs by
reducing imports and increasing exports. In the short run
imports will bear the main burden of adjustment.
Reductions in LDC imports will have a genralized depress-
ing effect on world trade and output. We estimate that credit
constraints on non-oil LDCs could, via their direct and indir-
ect efects, ultimately reduce U.S. exports by as much as $14
billion and reduce U.S. real GNP growth by up to 0.9 percentage
points. This full adjustment would occur over a 1-2 year
period.
In the longer run U.S. exports will recover, but LDCs will
increasingly shift from import restriction to export promo-
tion. Based on past trade patterns, the U.S. may have to
absorb $9 billion or more of these additional exports from
LDCs, much of it in imports of manufactured goods.
These numbers assume that a severe but manageable cutback
in private lending occurs, with IMF and other official assis-
tance sufficient to avoid financial crisis. The required
idjus 7oents could be greatly reduced by substituting massive
official financing for private lending, but this is unrealistic
and undesirable. On the other hand, an even more severe
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cutback in lending would have serious financial and political
risks.
The size of the impact on the U.S. economy may be less
than our estimates if the international effort to bring about a
balance of adjustment and financing is successful. However, a
substantial depressing effect on U.S. exports and a substantial
drag on U.S GNP will still occur. The negative effect on the
U.S. trade balance cannot be avoided; it is an inevitable
result of the adjusment process in LDCs and must be accepted by
the U.S. In particular, the U.S. must be willing to absorb
more imports from the LDCs. Protectionism against these
countries would risk provoking a financial crisis.
1. Background
A loss of confidence by international lenders is sharply
reducing the flow of capital to less-developed countries. As a
result, LDCs will be forced to lower their borrowing needs by
reducing their current account deficits. They will probably
accomplish this by adopting domestic austerity programs,
devaluing their currencies in some cases, and most probably
also by more widespread use of import rstrictions and export
susidies. In the short run most of the adjustment will come on
the import side, leading to a lower volume of world trade than
would otherwise have been the case. One aspect of this
contraction will be a decline in U.S. exports, which may
contribute substantially to the already forecast widening U.S.
trade deficit in 1983 and may also significantly slow U.S.
recovery.
CAN_'fnr NTtkt_
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Debt problems are not evenly spread across the less-
developed world. Most LDCs will be little affected by the
lending slowdown, either because their debt is small relative
to exports or because they are mostly financed by public
sources such as the IBRD, aid flows, export credits, etc. Thus
the impact of reduced lending will tend to fall primarily on a
small group of Latin American countries which have relied on
sizable commercial bank borrowing, and are likely to be
constrained in their future borrowing. For the purposes of
this paper, we have identified a group of six 'Credit
Constrained Countries" (CCCs): Argentina, Brazil, Chile,
Mexico, Peru, and Venezuela.
Table 1 presents some background data on the CCCs. Sever-
al points are worth noting:
o The total debt of the CCCs increased more rapidly
during the 1970s than that of other LDCs (24.5
versus 15.8 percent). Although exports also grew
rapidly, the ratio of debt to exports rose substan-
tially.
o The debt-export ratio of the CCCs is much higher
than that of LDCs as a whole. Also, a higher
proportion is private debt, subject to problems of
confidence: 88 percent vs. 54 percent. Thus the
potential severity of liquidity problems for those
countries is much more severe than looking at all
LDCs as an aggregate would indicate. In particular,
ONrittl-idf AI
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'EATNANE: DEBTPaper (R)P: 'R1219/82) 04
the CCCs face debt service payments (including
repayment of short-term debt) which exceed exports,
so that it will be impossible for them to service
existing debt without substantial new lending.
o Finally, the CCCs are such more closely tied to the
U.S. than LDCs as a group, as reflected in the high
percentage of their imports coming from and exports
going to the U.S. This means that the effects of
the lending slowdown will fall particularly heavily
on U.S. trade.
Table 1: Background Data on Credit Constrained Countries
Total debt:
1973
39
(S billion)
1981
?226
Rate of increase
24.5%
Exports:
1973
18.0
(S billion)
1981
76.0
Rate of increase
19.7%
Debt as a %
1973
217
of exports:
1981
297
Debt service as
a % of exports:
1982
120 (estimate)
Trade balance
(S billion)
1981
3.1
% of imports
coming from U.S.:
1980
37.3
% of exports
going to U.S.:
1980
35.6
2. The Likely Extent of the Lending Slowdown
The principal source of uncertainty in assessing the
likely effects of the lending slowdown is that we do not know
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bow much finance will actually be available. One study (by the
OECD) has suggested that net new lending in 1983 to all LDCs
may be only $10 billion below its 1981 levels. Other studies
have considered the possibility of zero net private lending,
implying a fall in financing of some $50 billion to all LDCs,
and more than $35 billion to theeCCCs. In theory, the
financing constraint could be even tighter, with banks trying
to require net repayment.
There are, however, two factors which probably insure that
the lending slowdown will lie between these extreme estimates.
The first is that too severe a borrowing constraint will lead
to forced rescheduling by the major debtors. The CCCs
typically have private debt equal to more than twice their
exports of goods and services, and have in the past been able
to expand that debt by some 20 percent per year. Cutting net
lending to zero would require cutting imports by 40 to SO
percent, requiring some combination of huge devaluations, sharp
reductions in domestic output, and/or very tight import
controls. Debtor countries are unlikely to be willing to do
this, especially since the CCCs are currently running trade
surpluses.
On the other hand, it is extremely doubtful whether
lenders will be willing to extend credit at rates close to
those of 1981, as suggested by some optimistic observers.
Given the perceived risks, banks will be unwilling to actually
increase their exposure in LDCs relative to other loans.
Morgan Guaranty has suggested 10 percent as an optimistic rate
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of growth of private lending; this would imply a cutback of $15
to $20 billion in the borrowing of the CCCs. In fact, the
cutback could be more severe than this. Although the large
banks may try to expand lending to avert defaults, smaller
banks will try to act as 'free riders" and withdraw their
funds. Informal pressures will help limit the capital flight,
but it is unlikely that overall private debt of the CCCs can
expand at much more than 5 percent.
There is a definite possibility that the 'ceiling" growth
of debt imposed by the confidence problems of lenders could
turn out to be lower than the 'floor" on CCC borrowing set by
the ability and willingness of debtors to improve their trade
balances. If IMF financing cannot fill the gap there could be
stoppages of payment by debtor nations, declarations of debt
moratoria, massive reschedulings, and in the extreme repudia-
tion of debt by a few countries. For the purposes of this
paper, we will assume that this will not happen. Instead, we
assume that there is a severe slowdown in lending but that the
borrowing countries are able to live within this constraint.
The largest reduction in lending to the CCC; which we believe
is consistent with non-default is $25 billion. (This is a
deliberately pessimistic number relative to estimates by other
studies.)
For the rest of this paper, then, we will work with the
assumption that the financial constraints on the CCCs require
them to cut their collective trade deficit by $25 billion. It
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 must be stressed that this remains an assumption; thus the
numbers which we present are rough orders of magnitude based on
that assumption, not firm projections. But the results are
proportional to the assumed lending cutback and can thus be
scaled up or down to estimate the effects of alternative
assumptions.
3. Short-Run Effects of the-Lending'Sloudovn
In the short run, less developed countries finding them-
selves constrained in their borrowing will primarily react by
cutting imports rather than by expanding exports. This will
reflect differences in timing: expansion of exports requires
time to extend markets and in the case of agricultural commdi-
ties may have to wait until a new planting and harvest have
gone by. On the other hand, imports can be rapidly reduced
through controls such as quotas and by direct domestic economic
contraction.
The initial effect of an import cut will be that U.S.
exports to the CCCs will fall roughly in line with the U.S.
share. in their overall imports. Since the U.S. accounts for 37
percent of CCC imports, a $25 billion reduction in these
imports would reduce U.S. exports by $9.2 billion.
This does not, however, capture the full effect. World
trade would contract by considerably more than $25 billion,
because of a series of indirect effects:
(i) The CCCs trade with each other. As each country
restricts its imports, it will reduce the exports of the
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others, forcing further cuts.
(ii) The reduction in CCC imports will depress economic
activity in the rest of the world, leading to further declines
in trade. U.S. exports to other industrial countries and OPEC
will fall.
(iii) The decline in world trade will lead to further
declines in CCC exports, forcing further import cuts and gener-
ating another round of contraction.
The magnitude of these indirect effects is obviously
crucial. Some observers have expressed concern that debt
problems could lead to a massive downward spiral in the world
economy. To evaluate these concerns, the CFA has carried out a
small-scale simulation of debt-trade linkages and estimated the
effect of a $25 billion cutback in lending.
The analysis distinguishes five trading regions:
(i) The six credit-constrained countries;
(ii) other non-oil developing countries;
(iii) OPEC;
(iv) the United States;
(v) other industrial countries.
Each region's level of output, through its effects on
imports, affects the output of all the others. Thus the indir-
ect effects discussed above are taken fully into account.
Table 2 reports the effects on world trade of a $25
billion reduction in lending to the CCCs. The indirect effects
are substantial: world trade declines by more than twice the
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initial contraction. U.S. exports decline by 55 percent more
than looking only at the direct effects would suggest.
However, fears of a massive downward spiral in world trade
appear to be unjustified. The total decline in world exports
is only about 3 percent, reflecting the fact that the CCCs are
a small part of the world economy (less than 6 percent of the
GNP of the market economies).
Table 2: Reduction in Exports
From a $25 Billion Lending Cutback
(S billion)
CCCs
3.7
OPEC
8.4
Other LDCs
5.1-
U.S.
14.3
Other industrial
countries
27.8
World Trade
59..3
Table 3 shows the sources of the decline in U.S. exports.
Note that the decline in exports to the CCCS is somewhat larger
than the original $9.2 billion; this is because the contraction
in CCC exports forces further cuts in their imports. Reduced
exports to other areas make up the extra fall. We should also
notice that the fall in U.S. exports will induce a decline in
GNP which in turn leads to a partially offsetting decline in
imports, so that the trade balance deterioration is somewhat
smaller than the impact reduction in exports. The CEA's
simulation predicts a fall in U.S. GNP of 0.9 percentage points
from what it would have been in the absence of the debt
problem.
CON I IL ,1 TIAL
 Table 3: Sources of Decline in U.S. Exports
(S billion)
CCCs
10.5
OPEC
0.7
Other LDCs
0.5
Other industrial
countries
2.6
Pall in U.S. imports
4.0
Change in U.S. trade
balance
10.3
4. Longer-Run Effects
Over the longer run the nature of the effects of the
lending slowdown will tend to shift in character, as eventual
adjustment is reached. Two major factors will lie behind this
shift. First, the self-correcting character of the economies
of the industrial countries will produce a recovery in output
and trade. Second, the credit-constrained countries will shift
from import restriction to export promotion.
Recovery in the industrial countries will come via lower
interest rates. By depressing demand in the industrial
countries, the lending slowdown will reduce the demand for
money, lowering interest rates; these lower rates will eventu-
ally lead to partially offsetting increases in interest-
sensitive components of spending, such as investment, housing,
and consumer durables. Over a still longer run, depressed
output will mean lower inflation, leading to rising real money
balances which will further lower interst rates. The eventual
result will be that the indirect effects stressed in the
previous section will die out.
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At the same time, the CCCs will be attempting to shift
from import restriction to export promotion. A good first
approximation would be that all of the adjustment to lower
capital inflow will eventually take the form of increased
exports rather than reduced imports. The reason is that
several of the CCCs are already importing very little relative
to their GNPs, because of restrictive trade policies. Table 4
gives some illustrative comparisons. Note that Argentina and
Brazil actually import less than the U.S., even though the
U.S. economy is far larger and more diversified. It is also
worth noting that from 1974 to 1981 the volume of imports into
Brazil actually fell by 15 percent, even though real GDP grew
by 42 percent. The point is that there is very little left to
cut. The IMF has traditionally required trade liberalization-
cum-devaluation programs as a way of shifting from import
restriction to export promotion, and. will probably do the same
in this case.
Table 4: Imports as a Percent of GDP, 1980
Argentina
9.1
Brazil
9.1
Mexico
13.5
Korea
43.5
U.S.
11.0
The long-run effects of the debt problem on U.S trade
are, if possible, even more uncertain than the short-run
effects. If we assume, howver, that: the required CCC trade
balance continues to be $25 billion higher than would otherwise
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be the case; the output of industrial countries recovers from
the initial depressing effects; and the improvement in trade
balances is achieved entirely through exports, an estimate is
possible. We estimate on the basis of past trade patterns that
in that case the U.S. would have to absorb at least $9 billion
in additional imports from the CCCs. Much-of this increase
would probably come in non-traditional exports, especially
manufactured goods, rather than in traditional primary product
exports.
5. Policy Implications
The slowdown in lending to LDCs will have substantial
effects on U.S. trade. Initially this will manifest itself as
a decline in U.S. exports; in the longer run the U.S. will have
to accept a larger volume of imports from LDCs.
There is no practical way for the U.S. to avoid these
effects. An increased deficit in the U.S. trade balance is a
necessary counterpart to the adjustment process in debtor
countries. The only way to avoid this process would be for the
advanced countries to substitute massive official financing for
the cutbacks in commercial financing, a course which seems both
unrealistic and undesirable. If current international efforts
to bring about a balance between financing and adjustment are
successful, the effects may be smaller than the CEA's esti-
mates. Any plausible estimate of available financing and LDC
adjustment will, however, still imply a subsantial effect on
U.S. trade.
The most important implication may be for trade policy.
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The O.S. and other industrial countries must not respond to LDC
attempts to increase their exports with protectionist meas-
ures. This would amount to the advanced nations prohibiting,
with one hand, the adjustment that their banks are demanding,
with the other. In addition to its usual costs, protectionism-
in the current context would threaten to provoke a financial
crisis.
COf t[t
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