THE IMPACT OF A DEVELOPED COUNTRY RECESSION ON THE LATIN AMERICAN DEBT CRISIS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP89T00295R000400470002-4
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• Document Creation Date: December 22, 2016
• Document Release Date: February 6, 2012
• Sequence Number: 2
• Publication Date: February 1, 1987
• Content Type: REPORT

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Directorate of eonfid
Intelligence
Debt Crisis
The Impact of a
Developed Country Recession
on the Latin American
EUR 87-10004
February 1987
373
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Directorate of Confidential
Intelligence 25X1
Debt Crisis
The Impact of a
Developed Country Recession
on the Latin American
This paper was prepared byl (Office
of European Analysis, with contributions from
analysts in the Office of Global Issues, the Office
of African and Latin American Analysis, and the
Office of East Asian Analysis. Simulations using
the Linked Policy Impact Model (LPIM) were run b
Office of European Analysis
Division, EURA,
Comments and queries are welcome and may be
addressed to the Chief, Issues and Applications
Confidential
EUR 87-10004
February 1987
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The Impact of a
Developed Country Recession
on the Latin American
Debt Crisis
Key Judgments An important effect of a recession of any magnitude among developed
Information available countries during the next two years would be its negative impact on the
as of 12 January 1987 Latin American debt situation. After four years of attempting to cope with
was used in this report.
the debt crisis, the capacity of Latin American countries to service their
debt remains tenuous and highly vulnerable to adverse economic trends on
both the domestic and international scene. A developed country recession
would seriously threaten the progress Latin debtors have made during this
time in improving their current accounts and place the solvency of many
Latin American countries in jeopardy. Meanwhile, commercial banks have
grown impatient with the cycle of new lending packages they reluctantly
have gone along with in the past to keep Latin debtors afloat.
A series of simulations using our Linked Policy Impact Model indicates
that a developed country recession would have a dramatic negative impact
on Latin economies compared with a baseline scenario. The baseline-
under which Latin America would need a total of at least $9 billion in new
financing during the period 1987-88-represents a consensus forecast of
about 3 percent growth for OECD countries in 1987 and 1988. Under an
OECD recession, Latin debtors' loss of exports to developed countries
would swamp any relief likely to be obtained from lower interest rates,
according to our model:
? In the case of a mild recession-OECD growth around 0 percent, or 3
percentage points below our baseline scenario, and assuming no policy
action by Latin governments to slash imports and oil prices steady at $15
per barrel-Latin America would need a total of at least $19 billion in
new money in 1987-88 to overcome the deterioration in its overall current
account.
? In a deep recession-OECD growth 5 percentage points below the
baseline, with no restrictions on imports and a drop in oil prices to $10
per barrel-the minimum amount of new money needed by Latin debtors
would rise to $30 billion.
? In a worst case scenario-OECD growth 5 percentage points below the
baseline, oil prices falling to $10 per barrel, no decline in interest rates,
and worsening nonfuel terms of trade for Latin America-Latin borrow-
ing needs would soar to $55 billion.
Confidential
EUR 87-10004
February 1987
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In all cases, capital flight-which averaged a total of $15 billion a year for
six large Latin debtors during 1980-85-would add to these net financing
needs and probably would more than offset the beneficial effect on Latin
America's overall current account of any policy-induced cuts in imports.
The impact of a recession on individual Latin American countries would
hinge upon price trends for commodities, particularly oil. For example, the
borrowing needs of net oil exporters such as Mexico and Venezuela would
rise steeply if oil prices fell. Brazil and other oil importers, however, would
receive benefits partially offsetting the damage done by a recession.
Nevertheless, a fall in oil prices would aggravate the overall Latin
American debt situation because the region is a net oil exporter.
Under a recession of almost any magnitude, we believe Latin American
countries and international commercial banks would have serious trouble
sticking to their current approach to the debt problem, which focuses on
the negotiation of new lending packages. In our judgment, they would turn
increasingly to developed country governments and multilateral lending
institutions for help. More specifically, we believe that:
? Even under a mild recession, Latin American governments would
demand sharply stepped-up debt relief. If a slowdown were to last more
than a year and no major concessions could be negotiated, several debtors
probably would unilaterally limit interest payments. Commercial banks
with a small stake in the situation would be likely to continue decreasing
their exposure, leaving a shrinking number of large banks to bear the
brunt of any new lending. Banks still in the game would be likely to press
for guarantees or further lending from developed country governments
before making any new loans. The IMF and World Bank would come un-
der increasing pressure to provide more money to debtors through such
channels as a new IMF facility similar to the oil facility of the mid-
1970s.
? Anything more than a mild recession, in our judgment, would threaten to
create a rift between Latin debtors and commercial banks that could lead
to a large buildup of interest arrearages in Latin America. Latin
governments strapped with huge financing needs would move quickly to
slash interest payments unless they got massive commercial bank assis-
tance or help from multilateral institutions and developed country
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governments. The large commercial banks with hefty loan-loss reserves-
mainly non-British West European banks-would be likely to write off
their Latin debt. The banks with low reserves probably would try to save
the largest debtors. In a long, deep recession even the vulnerable banks
would try to cut their losses by urging their governments to ease
regulations so they also could write off their debt. Under these circum-
stances, the breakdown of the cycle of new lending packages would be
likely to precipitate a crisis and compel major actors to consider entirely
new approaches to stave off serious damage to the international financial
system.
We expect officials in Western Europe and Japan would cooperate with the
United States in pursuing a government-led resolution to the Latin
American debt crisis under conditions of a developed country recession but
would continue to look to Washington to take the lead in framing any
formal initiative. They also would be likely to argue that the United States
should provide the lion's share of any assistance to support such an
initiative. The priority Western governments would give their domestic
economies during a recession could even lead to policies, such as protec-
tionism, that would aggravate the situation. Nevertheless, we believe West
European and Japanese governments would favor coordinated action to
protect the international banking system if an intensification of the debt
crisis endangered the assets of enough banks to threaten the system as a
whole.
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Consequences of a Simulated Recession
1
Alternative Scenario 2: Deep Recession
3
Longer Term Consequences
5
... to a Deep Recession
9
Country Reactions
9
Implications for US Debt Strategy
12
B. Impact of an Interest-Rate Decline
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The Impact of a
Developed Country Recession
on the Latin American
Debt Crisis
Introduction
Disappointing growth figures for 1985 and the first
half of 1986 have engendered fears of a recession
among industrially developed countries even though
most private forecasters remain optimistic about the
continuation of the current recovery. Anxieties have
been deepened by concern about the implications this
would have for lesser developed countries-many of
which are bearing crushing debt burdens-and for the
world banking system. This paper uses an econometric
model to assess the threat a recession would pose for
the Latin American debtor countries and their West-
ern creditors if one were to materialize. It does not
examine the prospects and implications for a continu-
ation of the current policies debtors and creditors are
pursuing but, rather, focuses on recession scenarios.
This paper does not evaluate the chances of a devel-
oped country recession and is not intended, in any
way, as a prediction that such a recession is imminent.
Figure 1
Latin America: Cumulative 1987-88 Impact
of Changes in Key Economic Variables
on Its Current Account
Billion US $
1 percentage point
fall in OECD
growth rate
I percentage point
fall in OECD
interest rate
$1 fall in
world oil prices
I-percent fall in
nonfuel terms of
trade
I percentage point
fall in Latin American
trade growth
Consequences of a Simulated Recession
A series of simulations run on our Linked Policy
Impact Model (LPIM)' indicates that a recession
among developed countries would have a dramatic
negative impact on the Latin American debt situation.
One immediate consequence of such a recession would
be a sharp cutback in demand for Latin American
exports and a severe deterioration in the overall Latin
current account. Dwindling export earnings would
hamper the ability of Latin American countries to
service their debt and limit their access to bank credit.
Shortfalls in earnings and a shrinking ability to
borrow abroad would slow their economic growth and
heighten the risk of potentially destabilizing political
and social unrest.
' The LPIM is an econometric model of the world. It integrates
individual 175-equation economic models of the seven major indus-
trialized economies-West Germany, France, Italy, the United
Kingdom, Canada, Japan, and the United States-and smaller
models of regional economic groups-the smaller developed coun-
tries, OPEC, non-OPEC LDCs, and the centrally planned econo-
mies. A Latin American submodel emphasizes trade linkages and
According to our model, falling oil prices and interest
rates would do little to cushion the overall impact of
an OECD recession on Latin America. For every
1-percentage-point decline in OECD growth, Latin
America's current account deficit would increase by
about $2.1 billion in 1987 and $5 billion in 1988. A
simultaneous fall in oil prices, on balance, would
aggravate the debt crisis because Latin America is a
net oil exporter. Although lower interest rates might
offset some of the damage to Latin America's current
account likely to result from a recession, our simula-
tions show that the losses resulting from reduced
export earnings would overwhelm these benefits (see
figure 1).
STAT
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The Current Outlook
To assess the impact of a developed country slowdown
on Latin American debtors, we first estimated the
likely impact of trends projected by current economic
forecasts for the developed countries (see appendix A)
on the debt situation. In this baseline case, we as-
sumed OECD growth rates of 3 percent in 1987 and
3.2 percent in 1988, steady oil prices of $15 per
barrel, and constant nonfuel terms of trade. Under
these conditions, the outlook for the aggregate Latin
American current account would improve somewhat
in 1987 and 1988 because of sharp increases in
exports (see table 1). Latin American countries, how-
ever, still would require at least $9 billion in net new
lending during these two yearn
In our judgment, this figure probably represents Latin
America's minimum credit requirements under the
policies creditors and debtors now are following.
Although the option to further cut imports signifi-
cantly in order to reduce foreign borrowing needs still
would exist in theory for Latin debtors, we believe
fear of political and social repercussions would dis-
courage many Latin American governments from
aggressively pursuing this option. In any event, capital
flight would be likely to more than offset any import
cuts and add to borrowing requirements. This would
certainly be the case under worsening economic and
political conditions (see inset on Capital Flight). Any
decision on the part of Latin debtors to build up
foreign exchange reserves or any deterioration in their
terms of trade without an offsetting rise in export
volume or fall in import volume also would increase
their borrowing needs. The debt service ratio (interest
and principal payments divided by exports of goods
and services), however, would decline gradually dur-
ing the period 1987-88, if-as we assume-the Latin
Americans are able to negotiate a 12-year principal
repayment period on new loans and a two-year grace
period before beginning repayment of principal.
Alternative Scenario 1: Mild Recession
Our model indicates that even a mild recession would
damage considerably the overall current account of
Latin American debtors. In this scenario we assume
OECD growth rates 3 percentage points below the
baseline during 1987 and 1988-in other words, little
or no growth. We also assume steady oil prices at
Current account
balance
-4.2
-9.0
-5.7
-3.7
Trade balance
24.0
17.5
18.8
19.4
Exports of goods
(f.o.b.)
102.0
94.8
99.9
105.3
Exports of services
32.0
34.2
36.1
38.6
Imports of goods
(c.i.f.)
78.0
77.2
81.0
85.9
Imports of services
68.0
65.3
64.6
65.2
Total gross debt a
393.9
402.9
408.6
412.3
Total interest
payments
32.7
28.2
26.5
25.8
Debt service ratio
(percent)
34.3
32.5
29.8
27.9
Oil trade balance
23.6
15.0
13.1
12.3
OECD real GDP
growth rate (percent)
2.7
2.6
3.0
3.2
Latin American
exports of goods and
services to OECD
110.9b
105.6
111.4
117.8
London interbank
rate (percent)
8.2
6.5
6.0
6.0
Oil price
($ per barrel)
27.0
15.0
15.0
15.0
Latin American real
GDP growth rate
(percent)
3.8
1.6
3.5
2.6
a Implied total gross debt for 1986-88. Calculations for changes in
gross debt are based on estimated current account deficits. Net
capital flight, for example, would add to financing requirements
beyond the current account deficit, thereby increasing total gross
debt accordingly.
b Estimate.
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$15 per barrel, a decline in interest rates, constant
nonfuel terms of trade, and no Latin American
government moves to cut imports (see table 2). Under
these conditions, our model shows that a drop in
demand for Latin exports would cause the current
account deficit to worsen from baseline projections by
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Latin Debtors: Grappling With Capital Flight a
being funneled abroad.
Capital flight has bled more than $90 billion from six
large Latin American debtors during the period
1980-85. Mexico has been particularly hard hit,
losing an average of about $7 billion per year during
this period. Argentina and Venezuela also have been
victims of massive capital flight, while Brazil has
done a good job of holding capital within its borders.
Although capital flight has tapered off during the last
few years, it remains a major obstacle to the solution
of Latin America's financial problems because of the
region's diminished access to foreign capital. Since
1980 capital flight has eaten up an increasingly larger
chunk of Latin America's falling net borrowing.
Lenders have seized on capital flight as a justification
for lending cutbacks. Our analysis of past government
attempts to stanch capital outflows indicates that
tighter capital controls have not been effective in
discouraging capital flight and that funds are still
Latin American countries, for the most part, are
responsible for their own plight. Many of their go-
vernments'policies have encouraged capital flight:
? Overvalued exchange rates have made foreign as-
sets cheap and raised the specter of devaluation.
? Fixed nominal interest rates at low levels have
resulted in negative returns on domestic assets.
? Political reluctance to deal with economic imbal-
ances-growing trade deficits, spiraling inflation,
and widening government budget deficits-has
caused investors to seek a more stable environment
for their funds.
We believe the foreign assets accumulated by resi-
dents of Latin American countries could potentially
play a significant role in resolving the debt crisis if
these investors could get competitive returns in their
own countries. On the basis of our estimates, resi-
dents of six large Latin debtor countries own a stock
offoreign assets equal to over one-fourth of their
countries'foreign debt. Structural reforms encourag-
ing noninflationary growth, such as paring back the
government sector of the economy and getting rid of
laws that restrict price movements, would be likely to
entice back some of this capital, help relieve balance-
of-payments pressures, and cut foreign borrowing
requirements. Even if residents were to hold on to
their overseas assets and repatriate only the annual
earnings, the impact on international accounts would
be significant. Without structural reform, however,
we believe capital outflows will remain stubbornly
high and continue to aggravate the debt crisis.
about $3 billion in 1987 and $7 billion in 1988. This
would precipitate an increase in borrowing needs to at
least $19 billion-$10 billion more than the baseline
requirement of $9 billion-during 1987-88. Latin
American exports of goods and services to OECD
countries would fall by about $7 billion in 1987 and
$16 billion in 1988 compared with the baseline be-
cause of a steep drop in export volume and a decline in
prices. In addition, Latin American economic growth
would fall off about 1 percentage point from the
baseline in 1987. An accompanying 1- to 2-percent-
age-point drop in interest rates (see appendix B) and a
slowdown in imports brought on by lower growth
would only partially offset the negative impact of a
downturn in export demand for debtor countries. If
Latin debtors could raise the $19 billion, the simula-
tion indicates that the combination of lower interest
rates, rescheduling of old debt, and the two-year grace
period on new debt would lead to a slight decline in
the debt service ratio
Alternative Scenario 2: Deep Recession
Our model indicates that a deeper recession would do
severe damage to Latin America's overall current
account, reduce its ability to service its debt, and
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Table 2
Latin America: Impact of a Developed
Country Recession a
Billion US S
(except where specified)
1987
1988
1987
1988
1987
1988
Current account balance
-2.9
-7.0
-8.2
-12.7
-15.6
-30.5
Trade balance
-3.3
-7.1
-9.7
-14.6
-11.0
-18.8
Exports of goods (f.o.b.)
-5.2
-11.9
-17.2
-28.8
-18.3
-32.6
Exports of services
-2.9
-6.6
-5.2
-11.8
-5.2
-11.8
Imports of goods (c.i.f.)
-1.8
-4.8
-7.5
-14.1
-7.3
-13.7
Imports of services
-3.3
-6.7
-6.8
-13.7
-0.6
-0.1
Total gross debt b
2.9
9.9
8.2
20.8
15.6
46.2
Net interest payments
-2.8
-5.4
-5.7
-10.9
0.4
2.6
Debt service ratio (percentage points)
-0.4
-0.1
0.9
0.6
6.6
15.5
Oil trade balance
0
0
-4.4
-4.1
-4.4
-4.1
OECD real GDP growth rate
(percentage points)
-3.0
-3.0
-5.0
-5.0
-5.0
-5.0
Latin American exports of goods and
services to OECD
-7.1
-16.1
London interbank rate
(percentage points)
-1.5
-2.0
Oil price ($ per barrel)
0
0
-5.0
-5.0
-5.0
-5.0
Latin American real GDP growth rate
(percentage points)
-1.1
-0.2
-1.8
-0.3
-1.8
-0.3
a Changes from the baseline. The model's export volume elasticity
for Latin American goods-a key parameter in the model-is
about 1.5 (1.9 for nonfuel goods, 0 for fuel). If, after two years,
OECD real GDP is down 6 percent from the baseline-as it is in
Scenario I-Latin America's export volume drops 8.6 percent.
Exports of goods in dollar terms, as shown above, decline somewhat
more because LDC export prices fall as well.
b Implied total gross debt for 1987-88. Calculations for changes in
gross debt are based on estimated current account deficits. Net
capital flight, for example, would add to financing requirements
beyond the current account deficit, thereby increasing total gross
debt accordingly.
sharply raise the borrowing needs of Latin debtors,
especially for oil exporters like Mexico, Venezuela,
and Ecuador. In this scenario, we assume OECD
growth rates 5 percentage points below the baseline
(or negative growth of about 2 percent), a decline in
oil prices to $10 per barrel, and a sharp drop of 3 to 4
percentage points in interest rates. We continue to
assume no change in the nonfuel terms of trade and
no government intervention to reduce imports.
Our model indicates that, as a recession among
developed countries deepens, the severity of the im-
pact on the Latin American debt situation would
increase sharply. In particular, the losses resulting
from depressed exports would swamp the benefits of
lower interest rates, and Latin American borrowing
needs would balloon to $30 billion-approximately
$21 billion beyond the $9 billion baseline require-
ment. The region's current account deficit would grow
about $8 billion in 1987 and $13 billion in 1988
beyond baseline projections. This would be the result
of a deterioration in exports to OECD countries,
which would fall about $20 billion in 1987 and $35
billion in 1988. In this scenario, Latin American
growth would decline about 2 percentage points from
the baseline in 1987. The drop in Latin American
exports would be so steep that the debt service ratio
would rise despite lower interest rates.
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Alternative Scenario 3: Worst Case
If a deep recession struck developed countries and all
other economic developments also went against Latin
America, our model indicates that the region would
no longer be able to finance its current account deficit
and many Latin debtors would default on their loans
without drastic action on the part of creditors. The
current account deficits in this worst case scenario
almost certainly would be impossible to finance. Al-
though all factors are unlikely to turn against Latin
America simultaneously, unfavorable trends in each
are plausible. We assume negative growth of about
2 percent in the OECD (5 percentage points below the
baseline in 1987 and 1988), oil prices of $10 per
barrel, no decline in interest rates, and Latin Ameri-
can terms of trade worsening by 2 percent in 1987 and
5 percent in 1988.
Under this scenario, the aggregate Latin American
current account would deteriorate from the baseline
by about $16 billion in 1987 and over $30 billion in
1988. Exports of goods and services to OECD coun-
tries would slump by about $20 billion in 1987 and
about $40 billion in 1988. Latin American growth
would drop about 2 percentage points below the
baseline in 1987. This simulation indicates that Latin
debtors would need an infusion of about $55 billion
over the next two years-$46 billion more than the
$9 billion baseline requirement-to finance these
deficits (see figure 2). The steep drop in exports would
cause a sharp rise in the debt service ratio.
There would be little that Latin American govern-
ments could do to alter their situation if they imple-
ment contractionary policies to shrink imports as they
have in the past. Our simulation indicates that each
1-percentage-point fall in growth would bolster their
overall current account by only $600 million in 1987
and $1.5 billion in 1988. Latin American leaders, in
any case, would be hard pressed to pursue this
strategy and, in our judgment, would be unable to
slash imports enough to make up the shortfall.
Longer Term Consequences
Our simulations indicate that, regardless of its sever-
ity, the more prolonged a developed country recession,
the more drastic and uniform its impact on Latin
American countries would be. In all cases, their
Figure 2
Latin America: Total Foreign Debt,
1981-88a
-Scenario 3
-Scenario 2
Scenario 1
Baseline
I I I I I I I I
0 1981 82 83 84 85 86 87 88
e Total debt levels are for end of the year. Baseline and all
scenarios assume debtors can raise the funds needed to cover
current account deficits. Data for 1986 are estimated; 1987
represents LPIM simulations based on assumptions of
scenarios.
aggregate current account would deteriorate substan-
tially more the second year of a recession, and their
borrowing needs would be greater. If a recession were
to drag on a third year into 1989, the capacity of
Latin American countries to meet their debt obliga-
tions would deteriorate as scheduled principal pay-
ments on new debt came on line. A prolonged slow-
down also would tend to wipe out the advantages
obtained by oil-importing countries from any decline
in oil prices. Consequently, those countries that had
not been hit hard the first year would be pushed back,
and those already in bad shape would be far worse off.
The Oil Factor
Our simulations indicate that a fall in oil prices would
aggravate the Latin American debt situation because
the area is a net oil exporter. According to our model,
each $1 reduction in the price of oil would mean an
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additional $900 million in the overall Latin American
current account deficit in 1987 and an additional
$1 billion in 1988
The impact of oil price trends on individual Latin
debtors in the event of a developed country recession,
however, would hinge on their oil trade balance. If oil
prices remained at $15 per barrel, major oil exporters
such as Mexico would not suffer much the first year
of a recession. On the other hand, they would be hit
hard if the slowdown were accompanied by a decline
in oil prices. Conversely, oil importers would receive
some offsetting benefits if oil prices were to fall to
$10 per barrel during a recession, but would suffer if
they hold steady.
Mexico, according to our simulations, would experi-
ence a relatively minor deterioration in its current
account in 1987 compared to baseline projections if oil
prices stay at $15 per barrel and if developed country
growth falls 3 percentage points below the baseline
(see table 3). On the other hand, if oil prices were to
fall to $10 per barrel as growth in developed countries
dropped 5 percentage points below the baseline, Mexi-
co's current account deficit would soar by $2.4 billion
over the baseline in 1987 and $2.9 billion in 1988,
while the outlook for economic growth would darken
considerably.'
Similarly, if oil prices hold steady, the Venezuelan
current account deficit would increase very little in
1987 in 'the event of a recession in the developed
countries. If oil prices fall to $10 per barrel in a deep
recession, however, Venezuela's deficit would swell
above the baseline by nearly $2 billion in 1987 and
prospects would hardly dim even under a deep reces-
sion. Brazil's economy would suffer a severe setback,
however, if oil prices were to hold steady as developed
countries sink into a recession. In this case, its current
account would fall at least $1.3 billion below baseline
projections in 1987 and $3.6 billion in 1988 even in a
mild recession. Economic growth, which has been
buoyant the last two years, would slow by as much as
2 percentage points.'
Reactions to a Recession
Most Latin American countries currently are avoid-
ing confrontation and are negotiating for concessions
with their creditors. Several also are implementing
programs-such as the Austral Plan in Argentina and
the Cruzado Plan in Brazil-designed to introduce
economic reforms, improve growth prospects, and
dampen inflation. Large commercial banks generally
are going along with multiple rounds of so-called
involuntary lending to prevent their previous loans
from becoming a complete loss. Developed country
governments, meanwhile, are providing some assis-
tance through multilateral lending institutions and
are encouraging economic reforms to promote growth
in Latin American countries in order to enable them
to pay back their debt. A developed country recession
would endanger this basically cooperative approach to
the debt crisis. If a mild slowdown were to drag on for
more than a year or if a deep recession were to strike
the developed countries, we believe cooperation be-
tween Latin debtors and the banks could endure only
with substantial new assistance from OECD govern-
ments and multilateral lending institutions
$1.5 billion in 1988
On the other hand, damage to a heavy oil importer
like Brazil would be reduced considerably if oil prices
were to decline in tandem with a developed country
recession. With oil prices at $10 per barrel, Brazil's
current account would deteriorate less than $1 billion
from the baseline in 1987. Moreover, its growth
' Mexico's predicament probably would be alleviated somewhat by
the recent agreements with commercial banks and the IMF that
create contingency funds for additional borrowing on the basis of
Mexican economic performance and the price of oil (see inset on
Debtor Reaction to a Mild Recession. We believe that
a mild developed country recession would impel Latin
American leaders to look to developed country gov-
ernments and commercial banks to share more of the
financial burden. Even a short, mild downturn, in our
view, would engender a torrent of calls from Latin
American leaders for more concessions from their
creditors. Latin governments already are lining up to
' For some countries, such as Argentina and Colombia, oil prices
would not play a pivotal role at present because they export only
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Table 3
Latin American Debtors: Impact of an Economic
Slowdown Among Developed Countries
Current account balance
-9.0
-5.7
-3.7
-8.5
-10.7
-13.8
-16.4
-21.3
-34.2
Total foreign debt
403.0
408.7
412.4
411.5
422.2
416.8
433.2
424.2
458.4
Debt service ratio a (percent)
32.5
29.8
27.9
29.4
27.8
30.7
28.5
36.4
43.4
a Debt service ratio represents debt service payments as a percent-
age of exports of goods and services.
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Mexico's IMF and Commercial Bank Agreements
The IMF agreed in August 1986 to relatively easy
terms for a $1.6 billion, 18-month standby program
for Mexico. The principal goal of the program is to
support economic growth. In contrast to the austerity
imposed under the 1982 extended fund facility, the
Fund agreed to permit Mexico's budget deficit to
widen from the 10 percent agreed on previously for
1985 to 16.9 percent of GDP in 1986. Mexico's likely
failure to emerge from recession early in 1987 will
trigger the release of an additional $500 million
contingency fund to allow an increase in government
spending. The Fund also agreed to tie some of the
targets and balance-of-payments financing to oil
prices to compensate for Mexico's sensitivity to
swings in the oil market. If the price of oil drops
below $9 per barrel, the IMF and commercial banks
will be required to make up at least part of the
shortfall. The Fund also will adjust the target ceil-
ings for the budget deficit, international reserves, and
public-sector credit
For their part, commercial banks agreed in Novem-
ber to a three-part financial package for Mexico. This
includes new money, an arrangement for contingency
money, and conditions for restructuring previous
loans. First, banks will lend Mexico $5.7 billion in
new funds. The World Bank will cofinance $1 billion
of the new loan and will guarantee up to $500
million. Second, banks will provide $500 million-
make their case for debt relief. Mexico, in its recent
negotiations with the IMF and commercial banks,
obtained several concessions. These included a reduc-
tion of interest rate spreads-and a contingency fund
based on oil prices. Other debtors watched these talks
closely and now are pressing for similar breaks.F_
Latin American leaders undoubtedly would press
harder for these types of concessions in the event of a
mild developed country recession. They also would be
likely to renew calls for preferential trade treatment
and more lending by multilateral institutions, espe-
cially the World Bank and the Inter-American Devel-
opment Bank. We believe most, however, would not
half of which is guaranteed by the World Bank-if
Mexico's economic growth flags, and up to $1.2
billion in investment support depending on oil price
trends. Third, banks will push back the maturity date
on an already rescheduled $43.7 billion debt by eight
years and grant Mexico a seven-year grace period.
The maturity date for another $8.5 billion borrowed
during 1983-84 will remain the same, but repayments
will not commence for another three years. Mexico
will pay 0.8 percentage point over LIBOR on all the
loans, a reduction of 0.3 percentage point compared
with the average spread over LIBOR Mexico had
paid earlier. Mexico also is seeking bankers' agree-
ment to reschedule again $11.2 billion in private-
sector loans and an affirmation of their promise not
to cut off $6 billion in interbank credit lines.
bankers believe the Mexi-
cans have no definite plans for economic reform and
are skeptical that this rescue operation will do more
than postpone another debt crisis. They expect that
the Mexicans will be back for more money before
1990. In addition, other Latin debtors are already
lining up to get concessions similar to those obtained
by the Mexicans. Venezuela, for example, is expected
to request a link between oil prices and new money,
while Argentina intends to ask for a contingency fund
based on the prices of its agricultural exports.
risk cutting themselves off from trade and develop-
ment finance by taking unilateral action in the event
of a short downturn.
If a mild recession were to drag on, however, we
expect that Latin debtors would increasingly up the
ante and demand even more generous concessions.
Several, in the absence of substantial outside relief,
would consider unilaterally limiting their interest
payments as Peru already has done. Many Latin
governments might well follow Peru's example by
25X1
25X1
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cutting back debt payments to a percentage of ex-
ports, or else link them to GNP growth. If some of the
more desperate countries took this unilateral step,
opposition groups in other countries would press gov-
ernments in power to do the same. The major Latin
debtors so far have avoided this strategy, but they
would be unlikely to let their debt burden drag down
economic growth for long.
joint action would bring.
Under a mild slowdown, meaningful joint debtor
action would be unlikely. The differing effects on
Latin American countries would make a common
position difficult to achieve. Moreover, the largest
debtors-especially Brazil and Mexico-probably
would not want to sacrifice their ability to maneuver
quickly and independently in negotiations with their
creditors, for the limited increase in leverage that
... to a Deep Recession. Almost all Latin American
countries, in our judgment, would drastically step up
their demands for debt relief while threatening to
break off negotiations with their creditors if a deep
recession were to hit developed countries. Latin
American leaders almost certainly would blame credi-
tors for their countries' mounting economic woes. If
Latin governments failed to make a deal with their
creditors to drastically ease their burden, several
probably would break off talks altogether and act
unilaterally to limit debt service payments. If devel-
oped countries did not snap back after a year of deep
recession, we expect the few Latin American coun-
tries remaining in decent financial shape would be
pushed into the same dire economic conditions as all
the rest, provoking almost all debtors to independently
consider similar actions. We believe these debtors, in
the absence of generous concessions, would tie debt
payments to growth or exports. Although Latin gov-
ernments, even under these circumstances, would find
it difficult to take joint action, they probably would
use the Cartagena Group-their forum for discussing
debt-related matters-more actively to share
information.
The exact threshold where individual Latin American
debtors would turn away from cooperation with their
creditors toward confrontation in the face of a devel-
oped country recession would hinge on the economic
conditions of each country at the time of the recession,
the skill of government leaders in handling the result-
ing internal political situation, and the willingness of
creditors to make concessions. In any case, we do not
expect Latin debtors to move in lockstep. For exam-
ple, the largest debtors-Brazil and Mexico-would
have considerably more leverage than the rest to win
concessions because of the damage they could inflict
on the international banking system. The nature of
the recession also would influence the behavior of
Latin debtors. A downturn induced by tight monetary
policy among developed countries, loading Latin debt-
ors with higher interest payments in addition to
hitting them with lower export earnings, would signif-
icantly raise the likelihood of radical action
In spite of the many factors influencing the threshold,
we believe anything more than a mild recession-
0-percent growth during 1987-88, as portrayed in our
simulations-would trigger a move to a much harder
line among Latin American leaders. Even the second
year of a mild downturn could provoke such a move.
We expect Argentina, where President Alfonsin is
under heavy domestic pressure, and Brazil, noted for
its prickly negotiating stance, would be the Latin
debtors most apt to take unilateral action similar to
what President Garcia has done in Peru if substantial
relief were not forthcoming. Other Latin American
countries, in turn, would be likely to try comparable
measures creating a spillover effect where all debtors
would end up taking similar action even in the
absence of a formal debtors' cartel. The longer and
deeper the recession, the greater the chances of this
spillover effect taking place, particularly if Latin
American leaders believed developed country credi-
tors were not sensitive to their plight. All of these
leaders, in any case, would encounter heightened
political pressure to take a get-tough attitude toward
their creditors
Country Reactions. Mexico's ability to withstand a
developed country recession has been bolstered by the
refinancing package worked out with the IMF and the
bank advisory committee, and the outlook is for slow
Mexican growth at best for the shorter term. More-
over, the current regime is well entrenched politically.
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An Emerging Swap Market
Creditors and debtors are increasingly active in a
growing "swap market "for LDC debt. There are two
types of swaps involving LDC debt. One type allows
creditors to redesign their portfolios by trading debt
owed by different countries or with different maturi-
ties. The other type of swap enables banks to sell
troubled LDC loans at less than their face value to
investors who trade this debt for equity in firms
operating in the LDCs. Bankers are expanding their
use of swaps to limit risks, reduce exposure in a given
country, and strengthen their balance sheets. For
some smaller banks, swaps have provided an opportu-
nity to eliminate LDC exposure completely. For other
banks of various sizes, they have 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.
Purchase prices for debt vary widely from about 20
cents on the dollar for Peruvian debt to 75 cents for
Brazilian exposure. Other examples of prices include
65 cents for Argentine loans, 58 cents for Mexican
loans, and 66 cents for Chilean loans
The debt-for-equity programs instituted by debtor
countries, such as Chile and Mexico have benefited
them by reducing their external debt level from what
it otherwise would be and lowering the interest
payments. They also have served as a stimulus for
foreign investment:
? Mexico has just developed a system to handle the
swapping of public-sector debt for equity in private
Mexican companies. For example, a major US
bank arranged a debt-to-equity swap worth about
$40 million to finance expansion of Nissan's Mexi-
can operations.
Peru has established the goal for 1987 of using more
than $200 million worth of processed goods in a debt-
for-exports scheme currently under discussion with
its major creditor banks. Under the most recent
version of the plan, a bank willing to market specified
Peruvian goods would be able to use half the pro-
ceeds to liquidate debts owed by Peru
Some observers believe that swaps could lighten the
debt burden, but we believe the current system of
swaps and conversions provides only a marginal
solution. In our view, both creditor and debtor reluc-
tance to use these techniques will limit the overall
impact. We expect most banks to try to limit partici-
pation in it, particularly larger US banks, which are
constrained 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. We
share the reservations of observers who doubt that
there would be enough buyers for large-scale debt
purchases unless the loans were substantially marked
down. Moreover, if the market for discounted paper
continues to grow, regulators would be likely to face
the issue of whether banks should be forced to value
their entire loan portfolios at the lower market rate.
? Chile's debt-to-equity scheme has converted about
$1 billion of outstanding debt.
Mexico's movement toward internal economic reform
has been disappointingly slow, but the government is
somewhat more receptive to foreign investment than it
has been in the past. For example, it has begun a
program with its foreign creditors to swap debt for
equity invested in the country. On the basis of the
results of our model simulations:
? In a mild recession, we would not expect President
de la Madrid to take the lead on any coordinated
Latin American action to halt debt payments, in
part because of Mexico's new refinancing package.
Nevertheless, he would be likely to curry domestic
political favor by blaming developed country gov-
ernments for any hardships and to call on the
United States to boost its imports from Mexico.
? In a deep recession-especially one in which oil
prices fell and the refinancing package became
inadequate-we believe de la Madrid would be
likely to take action to ease Mexico's debt burden.
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Brazil's relatively solid economic performance over
the last few years probably has made it the Latin
debtor most able to handle a developed country
downturn over the long haul. Nevertheless, cracks in
its recovery program-the Cruzado Plan-are dim-
ming its short-term prospects. The plan's price con-
trols are causing shortages and slowing investment,
and the November price adjustments harmed Presi-
dent Sarney's standing with the public. Moreover,
Brazil's trade surplus plummeted in recent months,
resulting in a rapid drawdown in international re-
serves to meet debt servicing obligations. Brasilia has
kept the IMF at arm's length and already has made
clear its unwillingness to sacrifice growth to satisfy its
debt obligations:
? Under a mild recession, however, the Sarney admin-
istration might be lured back to the IMF bargaining
table by hope of obtaining the concessions Mexico
got and by a deteriorating domestic economic situa-
tion. In any event; we would expect it to decry the
damage inflicted on the country's ability to service
its debt and to permit only a limited drawdown of its
reserves.
? Under a deep recession which threatened to wipe
out its trade surplus, we believe Brasilia would
seriously consider limiting debt payments. Given its
more favorable long-term economic prospects and
the leverage the size of its debt gives it, Brazil
probably would continue to set its policy course
without consulting other Latin debtors
Argentina's improved economic performance brought
on by the Austral Plan probably would be halted by a
developed country recession. The Argentine econo-
my's increasing dependence on exports to sustain
growth makes it particularly vulnerable to such a
recession. Buenos Aires, under these conditions, would
face narrowing policy options as labor unions and
other constituencies pressed the government to take a
radical stand on debt:
? If a mild recession hit developed countries, Presi-
dent Alfonsin probably would continue negotiations
with the IMF and commercial banks for new mon-
ey. He would be unlikely to take unilateral action as
long as he believed prospects were good for Argenti-
na to get enough to finance its trade deficit. Even in
a mild recession, Alfonsin could well resort to
inflationary government spending to boost his par-
ty's chances for success in next November's
election.
? If a deep recession struck and commercial banks
refused to lend Argentina additional money, we
believe Buenos Aires would run up interest arrears
and seriously consider stringent limits on debt pay-
ments. Over the longer term, such a recession would
be likely to overturn Alfonsin's plans to foster a
more open, export-oriented economy.
Other countries also would be prone to adopt a radical
position. Peru already has taken unilateral action to
cut its debt load and would be unlikely to seek any
form of reconciliation with its commercial bank credi-
tors or the IMF under any kind of developed country
recession. Venezuela has caused its bankers fits with
its slow-moving negotiating style and abrupt policy
reversals on schemes to repay its extensive private
debt. It almost certainly would become even tougher
to deal with under a recession-especially one accom-
panied by lower oil prices
Of the other large Latin debtors, only Colombia does
not seem likely to pose major problems. Its recent
economic performance has been relatively good be-
cause of the windfall it received from the rise in coffee
prices in 1986. In addition, its external debt is small in
terms of the size of its economy, and government
management of the economy has been somewhat 25X1
effective. These factors make Colombia more capable
of withstanding a developed country downturn com-
pared with other Latin debtors. Even here, however, a
severe recession could provoke a radical shift in
attitude
Chile, for its part, has done more to promote internal
economic reform than other Latin debtors and has
been successful in swapping debt for equity. Never-
theless, it has the highest per capita debt of the major
Latin debtors, and its poor human rights record could
cause multilateral institutions to delay new loans in
the future despite the country's progress
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Bank Reaction. We would expect international com-
mercial banks, under conditions of a developed coun-
try recession, to have great difficulty establishing
common positions on new lending packages for Latin
American countries. The steps commercial banks are
taking now to protect themselves from widespread
default in Latin America are likely to enable some of
them-especially non-British West European and
smaller US regional banks-to assume a tougher
stance with debtors in the future. For example, banks
are shoring up their balance sheets by increasing their
loan-loss reserves while making few new loans to
troubled debtors. Many regional banks, in the United
States and elsewhere, have reduced their exposure by
writing off the relatively small sums they have lent
Latin debtors or selling off Latin loans at a discount.
Large non-British West European banks-encour-
aged by generous tax breaks and accommodating
regulations-have been much more vigorous than
other banks in building up their reserves against bad
loans. Thus, these banks would have more maneuver-
ing room than their counterparts in the United States,
Japan, and the United Kingdom.
In the event of a mild recession, a small number of big
banks would have to provide the lion's share of any
new lending. Commercial banks that could afford
to-because of low exposure or hefty loan-loss re-
serves-would try to gradually extricate themselves
from the situation by continuing to write off their
debt. Regional banks with little at stake would be
likely to bail out in growing numbers. We believe that
even many large banks would have to be prodded to
go along with new packages of so-called involuntary
lending because of their concern about Latin Ameri-
can creditworthiness. They probably would continue
to insist that the IMF and other multilateral organi-
zations chip in with more new lending and that
developed country governments provide guarantees on
new loans. Moreover, the banks' varying degrees of
portfolio vulnerability and the differing regulatory
environments in which they operate almost certainly
would divide them and make loan packages much
more difficult to put together than in the past.F_
A deep recession would lay waste the common front
commercial banks have tried to maintain. Depending
on the strength and length of the downturn, some
commercial banks probably would try to save the
largest debtors-in particular, Brazil and Mexico-
by making more concessions while taking a rigid
stance toward the rest. A growing number, however,
probably would come to view the debt situation as a
lost cause. Some West European banks and small US
regional banks, in our view, would be the first to jump
ship. Large continental banks in Western Europe with
hefty reserves-already having absorbed much of the
cost of default-then would be in a position to
threaten to leave major banks in the United States,
Britain, and Japan holding the bag if arrangements
for new lending did not suit them. These more
vulnerable banks, in the event of a deep recession,
would be likely to increasingly turn to their govern-
ments to rescue the debtors or to enhance their own
abilit to write off the debt by easing banking regula-
tions.
If a deep recession dragged on, we believe that
commercial bank support for involuntary new lending
to Latin American countries would disintegrate, par-
ticularly if OECD governments did not step in with
assistance. Bankers already are chafing at the de-
mands of Latin debtors. We expect that non-British
European commercial banks with adequate reserves
would write off their debt. Banks with low reserves
then would face the costly choice of writing off their
debt also or caving in to debtor demands. These
banks, in our view, would strongly press their govern-
ments to alter banking regulations in order to allow
them to write off their debt without dire damage to
their financial status. Under these circumstances, it
would be almost impossible for commercial banks to
achieve the critical mass among their ranks necessary
to support new lending packages.
Implications for US Debt Strategy
Even a short, mild economic slowdown among devel-
oped countries undoubtedly would hamper the US
debt strategy, which is aimed at getting commercial
banks and multilateral institutions to step up lending
while encouraging debtor countries to adopt market-
oriented growth policies. Developed country govern-
ments and multilateral banking institutions, however,
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probably still would be able to activate enough re-
sources in addition to further concessions from com-
mercial banks in order to prevent a financial crisis in
Latin America. A new IMF facility geared to trou-
bled debtors-similar to the oil and compensatory
financing facilities-probably would be seriously con-
sidered. The World Bank probably would take a
bigger role also. It already is considering providing
more medium-term financing not attached to specific
projects. Other organizations-the Bank for Interna-
tional Settlements and the Group of Ten-might have
to provide short-term emergency financing again to
tide debtors over a short downturn. Governments in
Western Europe and Japan would be likely to go
along with such plans because concern over the debt
situation would override reluctance to increase world
liquidity. For their part, most commercial banks
currently involved in the situation probably would put
up more new money only if governments and interna-
tional organizations were willing to expand their role.
In the event of a recession, we believe that, although
Western governments would try to cooperate to re-
solve the debt crisis, it would not be easy for them to
formulate long-term strategy on the problem or to put
together short-term rescue packages for Latin Ameri-
ca. Other governments, in our view, would look to the
United States to take the lead and to provide a major
portion of any emergency financing. They would be
likely to argue once again that the greater vulnerabili-
ty of US banks and the United States' proximity to
the region make the Latin American debt crisis more
a US than a European or Japanese problem. Further-
more, their ability to deal with the crisis would be
more politically hemmed in than usual. The main
economic concern of Western leaders during a reces-
sion almost certainly would be their domestic scene.
They would want to avoid the appearance of bailing
out big banks or foreign countries at the expense of
their own constituencies. Indeed, officials almost cer-
tainly would come under pressure to adopt such
policies as protectionism in the name of bolstering
their own economies despite the negative effect these
policies would have on Latin debtors.
A long, mild developed country slowdown or a deep
recession would encourage Latin debtors and com-
mercial banks to adopt progressively more uncompro-
mising positions that eventually would threaten to
overturn the current debt strategy. Latin debtors, as
well as those commercial banks that could afford to,
would be likely to try to break loose from the
situation. Most Latin leaders, already coping with
several years of sluggish growth, probably would be
uncooperative or even hostile toward their creditors.
Some leaders undoubtedly would blame commercial
banks and developed country governments for their
countries' economic problems. Latin American lead-
ers almost certainly would fear turmoil in their own
countries if they attempted to assert any kind of
economic discipline.
We believe developed country governments, under
these circumstances, would have to mount a series of
major financial rescue operations to stave off financial
crisis in Latin America. Developed countries probably
would consider falling back on some major new
scheme to take over the debt of Latin countries, either
through existing multilateral banking institutions or a
new agency established for that purpose. In our
judgment, West European countries generally, as well
as Japan, would be open to such an arrangement to
avoid a massive default in Latin America that could
endanger the international banking system. Neverthe-
less, the task would not be easy, if only because the
efforts of national leaders to ensure that their respec-
tive countries not bear a disproportionate share of the
burden inevitably would produce friction
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Appendix A
Uncertainties in the Outlook for
Developed Countries
Most private international economic forecasters re-
main generally optimistic about the continuation of
the current recovery among developed countries.
Many, however, are backing away from the projec-
tions for strong short-term growth they made after the
drop in oil prices in early 1986, revising growth
figures for 1986 downward, and reducing the odds
against a recession in 1987. They now believe their
earlier forecasts were too optimistic about the effect
of lower oil prices and the ability of developed coun-
tries to rectify the imbalances lurking behind the
scenes of the recovery. In addition, slow expansion in
the United States during the second quarter of 1986
has raised questions among some forecasters about
the health of the US economy
Growth among OECD countries is now expected by
most forecasters to weaken slightly in 1986 to 2.6
percent from 2.7 percent in 1985, and then rebound in
1987 to about 3 percent:
? Growth in the United States, according to the
consensus of private forecasters, will remain slug-
gish at about 2.5 percent in 1986 but recover
sharply to more than 3 percent in 1987. The weak-
ness in 1986 is attributed to a downturn in business
investment because of uncertainty over tax reform
and a lopsided deficit in the current account. They
project a comeback in 1987 propelled by consumer
spending, improved performance by US exporters,
and business investment.
? West Germany is projected to experience moderate
growth rates in the short term because it is already
undergoing a similar transition away from export-
led growth. After a disappointing first quarter in
1986, forecasters believe the West German economy
appears to be bouncing back. They think its
growth-bolstered by tax cuts-should hold steady
at about 2.5 percent in 1986 and 1987.
? Growth in France and other major OECD countries
is expected to be about 2.5 percent overall in both
1986 and 1987, as consumer spending holds up
demand and disciplined fiscal policy encourages
investment in most countries. Growth in the United
Kingdom, however, may be somewhat lower if lower
oil prices continue to depress the energy industry.
Although most forecasters view the current low
growth among developed countries as a pause rather
than an end to the recovery, some trends are making
them nervous. The US economy is a particular source
of concern. They believe that, if US policymakers fail
to deal effectively with the budget deficit, government
borrowing will push interest rates higher and crowd
out private investment. Moreover, many are worried
that the slump in US business investment in 1986 may
drag on and fret that policies designed to cut interest
rates are more likely to reignite inflation than revive
real domestic demand. Given these fears, along with
the prospect that the public-sector stimulus to the
economy will decline, many forecasters believe any
slide in currently strong consumer confidence would
? Japanese growth is expected to slow to 2 percent in
1986-the lowest rate since 1975-as the strong
yen forces exporters to trim investment spending.
Growth is forecast to recover to 3 percent in 1987 as
the real income benefits of the yen's rise take hold
and business steps up investment in nonexport in-
dustries. Forecasters believe Tokyo's recently an-
nounced stimulus package is unlikely to have any
effect in 1986, and probably will provide only a mild
fillip to growth in 1987.
deal a hard blow to US growth.
Forecasters, however, are most troubled by interna-
tional trade problems. The dollar's slide was supposed
to give US exporters a lift and turn back mounting
US current account deficits. It is starting to hurt
Japanese and West German exporters, but newly
industrialized country exporters rather than US firms
are reaping the benefits.
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Developed countries, furthermore, are experiencing
difficulty coordinating economic policies. Tokyo was
slow and Bonn remains reluctant to stimulate eco-
nomic growth by cutting interest rates to boost de-
mand. Consequently, rather than making up for the
slowdown in US demand that occurred in the second
half of 1985, domestic demand actually fell in Japan
and West Germany in the first quarter of 1986.E
Forecasters remain relatively optimistic, but the ele-
ments hindering growth could sweep developed coun-
tries into a recession and buffet other economies if
they persist. If factors other than exchange rates are
behind the US current account deficit, they might
continue to stymie attempts to put US exporters back
on their feet. In addition, most forecasters see little
room for US policymakers to maneuver if the domes-
tic economy begins to slip. Tokyo and Bonn, mean-
while, appear intent on waiting for proof of a down-
turn before taking serious action to stimulate their
economies. A sharp appreciation of their currencies
probably would speed them up, but Tokyo's fiscal
tightness and Bonn's overall cautious policies run the
risk of choking off growth in their own countries. This
would fuel protectionist sentiment among their trad-
ing partners and induce a contraction in world trade.
Whatever its source, a developed country slowdown
undoubtedly would have serious implications for the
entire world economy.
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Appendix B
Impact of an
Interest-Rate Decline
We estimate that a 1-percentage-point fall in interest
rates would reduce total Latin American debt service
during the first year by over $2.5 billion. Because of a
$500 million fall in interest earnings on Latin float-
ing-rate deposits, the net improvement in the overall
Latin American current account position would be
about $2 billion. The full effect of an interest-rate
decline would not be felt immediately because base
interest rates on floating-rate notes generally are set
only every three to six months
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