SEPTEMBER 8TH PEPAB MEETING

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP83M00914R002300010015-4
• Release Decision: RIFPUB
• Original Classification: K
• Document Page Count: 8
• Document Creation Date: December 21, 2016
• Document Release Date: April 1, 2009
• Sequence Number: 15
• Publication Date: September 3, 1982
• Content Type: MEMO

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September 3, 1982
MEMORANDUM- FOR PRESIDENT'S ECONOMIC POLICY ADVISORY BOARD
FROM:
SUBJECT:
THE WHITE HOUSE
WA S HI NGTON_
September... 8th PEPAB Meeting
As you all know, the next meeting of the President's Economic' Policy
Advisory Board will be on September 8th in the Roosevelt Roora from
10:00 ain to 3:00 pm., The President will be with us from 2:00 - 3:00
We'll begin the session with a discussion of the international
lending situation. As preparation for that discussion, Walter
Wriston, wham the President has asked to serve as the Chairman of
PEPAB, has asked me to send you.a copy of the enclosed paper
"International Lending - Manageable Problems or Approaching Crisis?"
Martin Feldstein, wham the President has nominated to be the next
Chairman of the Council of Economic Advisers, will discuss his views
on the outlook of the economy.
Next, Dave Stockman will give us an update on the budget outlook. and
his major concerns as we go into-the preparation of the FY 184
budget. Herb Stein and Bill Simon will also be speaking on the
spending issue.
The period from 1:30 - 2:00 pm is reserved for the purpose of
organizing our discussion with the President. As indicated, the
President will be joining us at 2:00 pm.
I look forward to seeing you on September 8th.
P. S . Paul Volcker was invited to join us for, lunch per the
suggestion of a number of members of PEPAB. Paul indicated that he
would very much like to join us but that he had a long standing
commitment to remain in Toronto at the IMF meetings on Wednesday
morning-: and, would not be able to get back in time to join us. tie's
given us a.raincheck for a future meeting.
NSC review completed.
Soo B
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-International Lending -- Manageable Problems
. or Approaching Crisis?
In recent weeks, several international problems (i.e.
Poland, Argentina and Mexico), added to the major domestic
failures -(Drysdaleuand Penn Square) have raised questions about
the health of the world financial system. Some of the commercial
banks'-larger international client-s, both countries and firms,
clearly have become less creditworthy, at least temporarily.
The question arises whether this deterioration in the borrowers'
condition. is mainly a transitory development associated with the
business- cycle or reflects a trend toward an eventual crisis.
One cannot ignore the recurring fear that the-continuou
growth in bank lending to developing countries inevitably will
lead to a crisis.. The perception exists that commercial banks
during the past decade have been 'overloading the developing
countries with an almost unbearable.burden-of external debt.
What are the facts behind this idea?
Between 1973 and 1981, the long-term foreign debt of the
109 non-OPEC.developing'countries increased from $97 billion to
$437 billion. Without dispute, this is. an enormous increase.
Nevertheless, it must be kept in mind that prices more than
doubled during this-period and all economic variables were
affected by this inflation. In the same 8-year period, the
gold (revalued to market prices) and foreign exchange holdings
71 7" 7
of these same countries more than tripled and their exports of
goods and services quadrupled. So, while the foreign debt rose
rapidly, the growth was much less marked in relation to the
export earnings which must service the debt. For-the group as
a whole, foreign debt rose at a compound annual rate of 20.7%,
while exports of goods and services rose by 18.5%. The growth
of export receipts relative to debt was even more favorable for
the larger developing countries, such as Mexico, Korea and Brazil,
who are the major clients of commercial banks. Mexico's exports,
for example, increased by ninefold in this period, from $2.1
billion in 1973 to $19.8 billion in 1981.
While in retrospect, more moderate growth of the debt might
have been preferable, these numbers do not foretell` an inevitable
crisis. In fact, commercial bank international lending of the
past decade was an appropriate response to the needs of this time.
Following the rise in oil prices in 1973, an increasing portion
of the world's saving was concentrated in.a few oil exporting
countries with 'limited opportunities for domestic investment.
The "unmanageable" crisis caused 'by the oil embargo was handled
by the Euro-markets with . art efficiency few foresaw.- Never in
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August 3-0, 1982
history-has there been so massive a transfer of financial
assets in--so short a time with so few casualties. The private
capital-markets deserve considerable credit for having managed
to channel these savings to those relatively capital-poor
developing countries, which because of varying combinations
of unexploited natural resources, disciplined labor, and sound
economic policies has the potential for rapid economic growth.
On. balance, the international lending to developing
countries of the past decade was effective and prudent. The
rapidly advancing countries who were the major borrowers from
banks are in general a well-managed group who have adjusted to
the economic difficulties of the past decade at least as well
as the industrial countries of Europe and North America. The
borrowed. funds were generally well used, and both total national.
output and exports of these countries grew considerably faster
than that of the industrial countries.
Another region whose borrowing has become a matter of special
concern to the markets is Eastern Europe. A degree of uncertainty
stems from the current debate over just how this lending should
be viewed in terms of the East-West political conflict: questions
.are raised over whether or not.the.activities of U.S. banks have
fueled the Soviet bloc's military expansion, and over whether
there might. be some effective way to exploit Poland's debt-
servicing difficulties to advance foreign policy objectives
aimed at the Soviet Union. rirst, as to the magnitudes, contrary
to popular opinion the outstanding claims of U.S. banks on Comecon
countries actually declined. from $5.9 billion in 1977, the earliest
date for which complete data are available, to-$4.6-billion in
1981. (By contrast, in the same period, claims of U.S. banks.on
Korea. alone, to use one example, rose from`$3.3 billion to $9.0
billion, -- about twice the total claims on the entire Comecon
region even though Korea's GNP is equivalent to less than 3% of
the GNP of Comecon.) As to the possibility of using Comecon's
Western borrowings as a political weapon,. history demonstrates
the difficulty of achieving the desired political objectives
through the use of economic weapons, as well as the likelihood
that, as with our experience with trade embargoes in recent years,
we will not only fail in achieving the intended-aims but will do
possibly significant damage to our own economic.-and financial
system. In addition, proposals for increased government inter-
vention in and use of our financial institutions for foreign
policy objectives ignore the lesson of recent history that it
was the-U.-S. banking system, with its relative independence of
government direction, that was able to make-its own credit
judgments and hold back-ontilending to-Eastern Europe at a-time
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August 30,. 1982
when other lenders, both official and non-official, in
countries with closer ties between governments and banks,
were increasing their exposure to this region. Indeed, it
was the. United States Government, in response to farm.
pressure-r--which more than tripled its Than and loan guarantees
to Polandd:between 1977 and 1981 while the private sector was
not increasing. its exposure at all.
Whatever judgment one reaches on the wisdom of past lending,
two major developments. in recent months are forcing banks to
reevaluate-the creditworthiness of international borrowers.
First, the high real interest rates in the past two years have
weakened the financial position of almost all borrowers including
both sovereign countries and private firms. Second, the recent.
volatility-in exchange rates, commodity prices, output, interest
rates, and-in the behavior of financial markets far exceeds the
swings of earlier years and introduces a higher degree of
uncertainty in judging creditworthiness. These two developments,
high interest rates and unprecedented volatility-have weakened
borrowers, increased the risks of international lending, and
could ultimately produce problems in the financial system unless
they are handled carefully.
The sharp rise in interest rates alone is enough to force
a.reevaluation of international lending. An international debt
of $70 billion for Mexico or Brazil takes on different meaning
when the interest rate on the debt is 16% instead of 10%. This
is particularly true when the increase in interest rates is in
real terms, as was the case in the past two years.
The higher interest rates. have not been limited to the US$.
In several. major Latin American countries (Brazil, Argentina,
Chile, etc.) domestic real interest rates during the past two
years have been substantially higher than in the U.S. Savers-
in these countries perceived such enormous risks and uncertainties,
including the risks of major devaluations, that exceptionally
high interest rates are required to stimulate savings and retain
them in the country. While realistic interest rates are an essential
part of any effective economic program, the level to which rates
have risen has been unprecedented and has severely' weakened the
creditworthiness of many private sector borrowers.
In-addition to high and widely fluctuating interest rates,
many other crucial economic variables have been unusually volatile
in recent' months, increasing -the, adjustment problems of firms and
countries and enlarging.the risks in lending. Exchange rates;
commodity prices, output,'and financial markets themselves, to
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name only four of the more important variables all have
.experienced large swings. The fluctuations of the?U.S.$
with respect to the currencies of other industrial countries
are well-known. But the devaluations of many Latin American
currencies. are even more dramatic. At the beginning of the
year, when the Mexican exchange rate was 27 pesos to the US$1,
conventional. wisdom said that the peso was. 20 to 25% overvalued.
Bank credit officers, when extending loans to.a Mexican firm
included an analysis of whether the firm could withstand a
devaluation to 35 pesos to the dollar. Today, eight months
later, firms are facing an exchange rate of nearly 100 pesos
to the dollar for repayment of these debts. The same
exceptionally large devaluations have occurred in Argentina,
Chile, and Ecuador, weakening private borrowers in these
countries who were. heavily- indebted in dollars. These problems
of individual firms. may turn out to be a bigger threat to
international lending-than the more-publicized balance of
payments crises. That is to say, the Mexican authorities almost
certainly will resolve the country's balance of payments-problems,
but perhaps with a program which includes such large exchange rate
adjustments and such high interest rates: that the financial.
condition of many private firms is severely weakened.
The recent volatility in commodity markets and in output
also have been a threat to creditworthiness of both firms and
countries. The decline in gold prices from over $800 to under,
$300 in two years was typical of many metals. Zaire, which has
been struggling financially for several years, failed to pay
the full interest due on.its rescheduled debt early this year.
This arrear was heavily influenced by a combination of historically
low copper prices (60~.a pound) and historically high libor (19%),
both of which would have been almost inconceivable 2 or 3*years
ago. Today, interest rates have fallen substantially and copper
prices are marginally better. It'is ironic that while the greatest
perceived danger of recent years was that non-oil producing
developing countries could not cope with the escalating oil prices,.
it was in fact a weakening of the oil market and the problems
this caused oil exporters which. contributed to the major payments.
crisis of 1982.
Potentially the most disturbing new "volatility" is-that-
in the financial markets themselves. The markets in recent weeks
seemed to be poised on a thin edge from which they could fall to
one side or the other quite easily. An error of judgment by a
commercial bank (bad loans to the energy sector) or by a country
(Mexican wage increase which annulled the previous devaluation)
can cause depositors to withdraw funds on a massive scale. In
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many smaller banks, the herd instinct is stronger than the
analytical capacity to judge the creditworthiness of an
international borrower. Mexico is creditworthy because
everyone--else is. lending to it and it becomes uncreditworthy
because-.others stop lending.
-The--major need for the moment. is for a calming influence
from al-X'_--the important players on the international scene:
commercial banks, governments, bank regulators, and the
International Monetary Fund.
After a decade of rapid growth, a marked slowdown in
international bank lending now appears to be occurring,
there is a danger that the pendulum will swing too farinnthat
direction. Mexico is a good example. It appears that Mexico
borrowed net, mainly from banks, about $18 billion in 1981.
This large borrowing was due to several factors. Early in
1981, $10 billion of net borrowing would have been a reasonable
estimate of the needs for the year, a sum which already-was
large enough to be worrisome. Nevertheless, at that time the
future stream of oil revenue looked-very promising;
creditors were confident that as soon as the election lwasdoveron,
in mid-1982, the new authorities would take action to reduce the
annual borrowing needs to a more sustainable level, perhaps
$5-7.billion. Abruptly, in mid-1981 the world oil market
changed, and both the volume and price of Mexican O;,
declined. By late in the year, Mexican private savers chad=t~
sensed a crisis and.were taking advantage of the overvalued rate
to.send funds abroad. By the -end of the year the world financial
community had let Mexico net $18 billion, by far the largest
amount ever to go into a developing-count
this was used to support one year, and
pport an untenable program.
The hope now is that Mexico'will agree on a program with
the IMF for 1983 and beyond which would limit net foreign
borrowing to perhaps $4 billion. per year. A $4 billion annual
addition to the present outstanding debt of.$80 billion would
cause debt to grow at a 5.. rate, which.-appears to be a. reasonable
plan for the next few years. The mood of the market has changed
so dramatically, however, that Mexico, after borrowing $18 billion
in 1981 to finance an unsatisfactory set of policies, might now
find it difficult $4 billion net in 1983 to finance a good program.
This is. an example of the swings in mood which threaten to
dominate the markets.
The commercial banks face a challenge" in' organizing
themselves to handle the Mexican case and other similar cases
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which may arise. Provided Mexico adopts a satisfactory program,
the country clearly is. fully creditworthy in the medium term.
Banks as._a group have a strong self interest in supporting the
country through a short-run crisis, which they themselves have
played`.__some_role in creating through heavy lending. The
.management.of the larger banks will see the problem in these
broad terms, but it may be too much to expect the smaller banks
to see.more than their. own immediate-self interest. Many small
banks will have become frightened by the short-run crisis and
simply-want to get their.-funds out of Mexico. This of.course
will not be possible because?neither the larger banks nor
official lenders such as the IMF will be prepared to inject
sufficient funds to-.allow other lenders to withdraw.;
Bank regulators will need to-avoid an overreaction in this
situation, which will. not be easy at a time when they are under
attack. The German bank regulators, for example, after tacitly
allowing a large build up in exposure in Eastern.Europe are now
reportedly pressing German banks to reduce their international
exposure almost indiscriminately, and a withdrawal of short-term
funds by German banks from Mexico apparently has contributed to
the present nervousness of the markets about that country at a
time when. the appropriate reaction by banks would-be to reconfirm
their commitments to support the-borrower in the short-term
provided it takes the measures required for the long term. The
dangers of an overreaction are increasingly being recognized,
however, as shown by a'recent warning to commercial banks from
a high official of the Bank of England against a precipitous
withdrawal from international lending.
Both banks and bank regulators need to be reminded that
large government and corporate borrowers almost never repay debt
except by issuing new debt. This is true both of the U.S.
government and the telephone company. The key question is not
whether debt will be repaid in a stated time frame, but whether
the borrower manages in a way which permits continued access to
capital markets. Naturally rich countries such as Argentina have
from time-to time been managed poorly and been frozen out of
capital markets, while relatively poor countries-such as Korea
which with good financial management have been. able to continue
to tap the markets. Many large importers of.oil have been able
.to adjust to. the higher price of petroleum while some oil
exporters. have got into difficulty. In the end, the central
issue in. being able to handle debt is the fiscal, monetary and
exchange rate management.of the.country.
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Finally, a word about the role of the IMF in underpinning
the international system. Because the size of the IMF has
lagged-vie-11 behind the growth in.world trade, the funds which
can be-.supplied by the IMF in problem countries are relatively
small in:---relation to the emerging needs.' The-maximum the IMF
can provide Io Mexico, for example, is about $1.3 billion per
year for--3 years. There are several reasons for this lag in
sizes o_f `:-.IMF quotas. Perhaps most important is the loss of
confidence by the.major industrial countries in the adequacy
of IMF (and also World Bank) policies in the late 1970`s. During
,that period, the:-.IMF, in order to curry favor with developing
countries, occasionally supported programs which seemed designed
mainly to provide financing for deficits rather than to bring
the deficits down. to levels which were sustainable in the medium-
term. This absence of a strong adjustment pressure from the
IMF left a serious gap in the system, because even the largest
of the commercial banks does not have the trained manpower or
access to confidential information to permit it to spot a
dangerously developing country situation as quickly as the IMF
can do. Nor do the banks have the political power to force
adjustments on countries where these are required. Fortunately,
the permissive period of the IMF now seems to have ended, largely
as a result of the clear support of the U.S. and other industrial
countries for more adequate programs. This has created a situation
in which there is a strong case for enlargement of IMF resources
either through increases in national quotas or by giving the IMF
access to private capital markets, while using U.S. influence to
ensure that the institution plays its full role in the adjustment
process.
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