LESSONS LEARNED FROM THE PRE-WORLD WAR II DEBT CRISES

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T01058R000304840001-7
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 22
• Document Creation Date: December 22, 2016
• Document Release Date: November 24, 2009
• Sequence Number: 1
• Publication Date: August 6, 1985
• Content Type: MEMO

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6 AUG 1985
MEMORANDUM FOR: See Distribution
Chief, Economics Division
Office of Global Issues
SUBJECT: Lessons Learned from the Pre-World War II Debt
Crises
Attached is a report which I think you will find of
interest. It describes the debt default situations in which the
United States was involved prior to World War II. We have
included a final section which outlines what we think are the
lessons learned from how these situations were handled. If you
have any questions or need further assistance feel free to call
Attachment:
As Stated
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Central Intelligence Agency
DIRECTORATE OF INTELLIGENCE
6 August 1985
Pre-World War II Debt Crises: Some Lessons Learned
Summary
After emerging,ap a major internati.onpl creditor during the
First World War, the United States became entangled in three loan
repayment problems. The US government negotiated settlements
during the 1920s with its Allies for wartime debt and with
Germany for repayment of war damages. Private US lenders also
readjusted debt for several Latin American countries after
defaults were brought on by the Great Depression.
The settlements used various techniques to provide debt
relief and to set the stage for debt servicing. Several of these
techniques--including loan refunding and maturity extension--are
found in current debt restructuring arrangements. Other
techniques were unique, such as drastic reduction in interest
rates, write-off of principal, and widespread repurchase of
defaulted debt by borrowers.
This memorandum was prepared at the request of Richard McCormack,
Ambassador to the OAS by
Fina
ncial
Issues Br
anch
, 25X1
Office of Global Issues. Comm
ents may b
e dir
ected
to Chief,
Economics Division,
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Although the settlement of interwar defaults resembles
current approaches to debt relief, crucial differences in the
nature of the underlying debt allow only broad insights on
contemporary debt restructuring exercises. Debt readjustment
strategies ultimately succeeded only when debtors were able to
export enough to finance debt repayments. The significant debt
relief provided for the Allies and Germany failed to prevent
default when exports collapsed during the Great Depression.
Latin America, however, successfully serviced its readjusted debt
after the Depression because the Second World War generated
strong demand from the United States and other creditors for the
region's exports.
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Debt, Depression and Default
The United States first emerged as a major international
creditor during the First World War and during the interwar
period became entangled in several loan repayment problems.
These problems involved two classes of international
obligations: wartime debts and postwar private loans.
The war debts comprised two distinct groups. One group
represented official US short-term credits to Allied governments,
issued to finance war material sales and postwar relief and
reconstruction, which amounted to over $10 billion. The other
group involved about $33 billion of reparations payments charged
against Germany for war damages owed to the United States and
other Allied governments.
Private long-term lending abroad after the war generally
took the form of investment in foreign bonds; medium- and long-
term international bank lending was negligible before the Second
World War. Most foreign bonds were long-term, fixed-interest
instruments issued by foreign governments and sold to US
businesses and individuals through New York investment banks.
About 80 percent of the increase in US investments in Latin
America during 1919-1930 took the form of bonded debt. All told,
foreigners issued $10.5 billion of bonds in the New York market
from 1920 to 1931, a figure larger than the total of foreign
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overnment bonds floated in London -- the leading world financial
center -- during the previous half century. These foreign bonds
were widely issued and were traded on an active secondary
market.
The explosion of US foreign lending during the 1920s largely
reflected economic conditions in the United States. Relatively
low domestic interest rates--the product of easy US monetary
policies--encouraged investment in higher yielding foreign
bonds.1 The inherent riskiness of foreign bond purchases was
discounted by US investors, who were caught up in the domestic
economic boom, the intense banker competition for lucrative
commissions on foreign bond sales, and the widespread perception
that Europe and Latin America afforded profitable investments.
Foreign borrowers eagerly sought US credit. Europeans
raised funds to reconstruct war-torn economies, to stabilize
exchange rates, and to finance growth and world trade after the
mid-1920s. Latin American credit demand intensified with the
increase in primary commodity prices and industrial growth.
Serious repayment problems emerged after 1929 with the onset
of the Great Depression. Severe US economic problems quickly
spread to Europe and Latin America through the international
system of fixed exchange rates. Foreign trade declined under the
1 The average yield (at prices offered to the public) of new
Latin American dollar bonds issued between 1921 and 1928 remained
consistently 40 percent above the yield on high-grade US domestic
bonds.
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weight of increased protectionism and the fall in US demand for
imports. International liquidity fell as the main creditor
countries--led by the United States--cut net foreign lending by
84 percent from 1928 to 1930.
These macroeconomic shocks strained the willingness of
Germany and Latin America to service foreign debts. The decline
in export prices greatly increased the real cost of servicing the
massive amount of fixed high interest rate bonds issued during
the 1920s. Germany and Latin America initially serviced their
debts by liquidating holdings of international reserves,
requiring them to deflate their economies as long as they
maintained fixed exchange rates. After 1930, debtors
increasingly chose to depreciate their currencies to limit their
economic contraction, but the severe deterioration of business
conditions eventually encouraged debtors to default--i.e., to
fail to pav contracted interest or amortization. Almost all
defaults took place by 1934.
President Hoover temporarily suspended the servicing of
Allied war debts and German reparation payments in 1931 in view
of the deteriorating world economy, but debtors subsequently
failed to resume repayment. The value of delinquent principal
owed by the Allies in 1931 exceeded $9 billion. Interest
payments on about 40 percent of outstanding foreign dollar bonds
held in the United States were also in default in 1935, involving
nearly $2.5 billion of the $6 billion of outstanding bonds. The
proportion of dollar bond defaults was highest in Latin America
(70 percent) and Europe (51 percent).
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A second wave of defaults on interwar foreign government
bonds occurred during World War II. By the end of 1945,
$2.1 billion of a total of $4.5 billion of outstanding foreign
government dollar bonds were in default. The drawn out
adjustment of Latin American defaults arising out of the Great
Depression ended in 1958, when Bolivia negotiated a revised
payments schedule to clear the last bond default in the Western
Hemisphere. By the end of 1962, all countries outside of the
Sino-Soviet bloc--except the Republic of Congo--had settled their
defaulted dollar bonds by resuming full or adjusted debt
service.
Readjustment of International Debt: Case Studies
Once a country defaulted on its debt, the terms of the loan
had to be readjusted. The US settlements of defaulted debt in
Latin America and Europe resembled those involving British and
other foreign creditors.
Latin American Dollar Bonds
The US government played an insignificant role in the
adjustment of defaulted Latin American obligations held by US
citizens. In 1933, President Roosevelt proclaimed a policy of
non-interference in private debt situations as part of the
country's Good Neighbor policy. In accordance with this policy,
default settlements were negotiated strictly between US
bondholders and foreign borrowers. The State Department largely
limited its involvement to protesting foreign government
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repayment plans that treated US bondholders less favorably than
other foreign creditors. Diplomatic intervention sometimes won
better treatment for US bondholders but was used infrequently.
Private bondholders held no effective legal recourse over
defaulting foreigners. Official borrowers could not be sued in
their own courts without their consent. Even if US bondholders
could obtain a favorable judgment in the courts of a defaulting
government, enforcement was improbable. While foreign private
defaulters did not enjoy these general immunities from lawsuits,
legal action rarely proved effective. Although foreign private
bonds issued in the United States fell under US jurisdiction,
plaintiffs were compensated only in the few instances when
foreign debtors held attachable assets in the United States.
Left without official or legal redress, private bondholders
attempted to negotiate directly with defaulting foreigners.
Through the early 1930s, investment banks and third-party private
negotiators independently organized about 40 special committees,
each concerned with readjusting the terms of particular foreign
bond issues in default. The decentralized system of special
committees failed to represent bondholders effectively, however,
because the committees often lacked credibility with foreign
governments. They often worked against one another in separately
securing settlements. The committees also were criticized for
allegedly profiting from fraudulent settlements.
Bondholders, negotiating from a position of weakness,
accepted various debt readjustment plans essentially dictated by
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the defaulting foreign governments. The borrowers offered
bondholders about 25 temporary settlements during the early 1930s
designed to relieve their debt service burden during the
depression without defaulting and thereby foreclosing future
access to private bondmarkets. Settlement plans were short term,
covering 1-5 years. Most plans completely suspended amortization
payments during the contracted period, although certain
arrangements allowed the issuer to cancel his bond through
repurchase. Interest payments in scarce dollars were reduced
over the life of the arrangement; they were either written-off or
paid (in part) with new funding obligations2 or nonconvertible
foreign currencies.
The failure of the system of special committees to represent
bondholders adequately prompted Washington to act. The US
government in 1933 requested the formation of a private
organization--the Foreign Bondholders Protective Council, Inc.--
to represent all private bondholders in negotiations with
defaulting foreign governments. Almost all readjustment plans
subsequently were negotiated under the auspices of the Council.
The Council successfully represented bondholders in 34
negotiated settlements between 1933 and 1958 involving
2 Script and funding bonds were issued. Script bonds were short-
term obligations which could bear interest. Funding bonds were
long-term securities which bore interest. Although holders could
cash these bonds for dollars on the secondary market, the
obligations usually exchanged hands at substantial discount from
face value.
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22 countries, 13 of which were Latin American. Once negotiated
and recommended by the Council, the settlements were broadly
accepted by private bondholders.3 The Council oversaw the
resumption of servicing on $3.4 billion of formerly defaulted
bonds. Defaults on the revised terms of the Council's
settlements proved rare.
Settlements recommended by the Council shared several
general characteristics. Debt relief primarily took the form of
interest rate reductions, ranging from 10 to 70 percent of the
nominal rate, and maturity extensions. Most approved settlements
stipulated partial payment on arrears of interest, usually in the
form of additional bonds. At no time did the Council recommend
any plan that prevented the bondholder from potentially regaining
full repayment of his initial investment.
The permanent settlement of Brazil's defaulted bonds was
typical of the Council-sponsored agreements with many Latin
American countries, including Chile, Colombia, Cuba, El Salvador
and Peru. After making partial interest payments between 1934
and 1941 under a series of temporary adjustment plans, Brazil
negotiated an approved Council settlement, known as the Souza
Plan, which took effect in 1944. The plan offered bondholders
two options. The first option maintained the face value of the
bonds but cut interest rates by two-thirds and extended the
3 Individual bondholders occasionally exercised their right to
reject the Council's recommendations in hopes of securing better
settlements later. Some bondholders also accepted readjustments
rejected by the Council rather than risk no settlement at all.
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issues were retired in 1968.
amortization schedule by 1.5 to 10 times the original period.
The second option cancelled 20-50 percent of the principal,
halved interest rates, and extended maturities by less than the
first plan. Under the Souza Plan, Brazil cut its aggregate debt
servicing obligation by about 75 percent. Full debt service on
the reduced debt was subsequently resumed, and all the dollar
At least one Latin American country readjusted defaulted
bonds under terms deemed unacceptable by the Council. The
longstanding International Committee of Bankers on Mexico
negotiated its own agreements with Mexico in 1942 and 1946 which
cancelled 80 percent of principal and over 99 percent of interest
arrears. The 1946 agreement also provided for the retirement of
bonds at prices as low as 21 percent of their face value. Most
bondholders accepted these drastic debt write-offs as the best
settlement possible, and Mexico subsequently redeemed the
adjusted bonds in 1960.
Although negotiated settlements brought a great reduction in
defaulted dollar debt, a still larger decrease occurred through
unilateral action by various debtor states. Foreign governments
effectively cancelled many of their defaulted bonds by
repurchasing them from US bondholders in the secondary market at
discounted prices as low as 10 percent of face value. Official
debtors also eliminated many defaulted dollar bonds held by their
nationals through costly, enforced settlements. Some of these
bonds were repudiated outright, while others were repurchased
with less desirable local currency. Foreign governments also
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converted many of their locally held defaulted dollar bonds into
domestic obligations payable in local currency in order to
economize on scarce dollars.
German Reparations
Unlike Latin America, Germany had to generate income to
service its external debt with an economy devasted by war. The
settlement of Germany's war reparations consequently was
complicated and dominated Western financial relations between the
wars. The Allies undertook three programs over ten years to
facilitate war compensation payments: the London Settlement, the
Dawes Plan, and the Young Plan.
The London Settlement remained formally in operation from
May 1921 to September 1924. The Plan specified annual
instalments to repay about 50 billion marks, carrying 6 percent
interest, of the 132 billion mark ($33 billion) liability
established by the Allies as full compensation for war
damages.4 Payments consisted of a fixed sum of 2 billion marks
and a variable sum equivalent to 26 percent of the value of
Germany's yearly exports. Payments were to be in cash and in
kind, with the initial fixed payments payable in cash. The
Allies expected that the variable payments schedule, conditioned
on export performance, would ensure proper debt servicing by
4 The repayment schedule for the remaining 82 billion marks of
reparations was not drawn up because credits for past German
payments and the contributions owed b other Central Powers had
not been determined.
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Germany.
Germany encountered payments difficulties immediately,
however, and defaulted within 15 months. War obligations
exceeded the nonborrowed revenues of the government during
1.922-23, resulting in large deficit spending that was financed by
inflationary currency issue. Inflation and the vigorous efforts
of the government to purchase foreign exchange for reparations
payments stimulated a rapid mark depreciation. The currency
depreciation increased Germany's reparations obligations in terms
of marks, encouraging further monetary expansion and inflation.
Payments shrank and Germany--experiencing severe economic
problems including hyperinflation--was declared in default in
January 1923 after having made cash payments totaling only
1.7 billion marks during 1921-22.
Germany's failure to meet its payments under the London
Settlement inspired the design of the next program, the Dawes
Plan. Allied reparations policy turned from effecting full
compensation at any cost to ensuring a feasible repayment plan by
rehabilitating the German economy. The Dawes Plan was conceived
as a temporary arrangement by its authors until Germany developed
the capacity to shoulder a comprehensive settlement.
The Dawes Plan reduced Germany's short-term reparations
obligations to give Germany time to increase the country's
capacity to pay. Political considerations prevented any
reduction in Germany's total liability, but annual payments--
payable in cash and in kind--were reduced significantly through a
repayment schedule running for an indefinite term. The annual
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obligation for the first year was 1 billion marks, 80 percent of
which was financed by an international bond issue sponsored under
the Dawes Plan. The annual instalments rose steadily through the
fifth year when they leveled off at 2.5 billion marks.
Thereafter, the annuity became variable, adjusted if price
fluctuations of gold exceeded 10 percent or if the German economy
prospered.
The payment mechanism included safeguards to protect the
stability of the German financial system. Germany's cash
obligations to the Allies were denominated in marks and therefore
were not subject to default when foreign exchange was
unavailable. The Allies, in turn, agreed not to convert marks to
their currencies if the mark's value were threatened.
Reparations payments to the Allies subsequently could be waived
if too many marks accumulated in Allied hands. Mark annuities
could also be suspended if German government revenues declined
appreciably.
The Dawes Plan proved successful over its five-year lifespan
but only because Germany borrowed heavily abroad. All annuities
due--totaling 7.6 billion marks--were paid promptly and in
full. Domestic economic prosperity returned to Germany, and the
currency regained stability. These successes, however, were
underpinned by a massive buildup of foreign debt. Germany
borrowed over 14 billion marks abroad--much of it in the form of
short-term bank credits--to finance economic recovery. These
credits, unlike the reparations obligations, could be serviced
only with foreign exchange. Export earnings during these years,
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however, barely returned to prewar levels, far short of the
amount needed to finance debt payments and domestic economic
recovery. Germany, in effect, borrowed from foreigners to pay
their reparations, avoiding compression of domestic living
standards as long as capital inflows continued.
Germany and the Allies sought to implement a definitive
reparations settlement in 1929, encouraged by the ongoing
economic recovery in Germany and the industrialized world. The
Young Plan reduced Germany's liability to 121 billion marks5
($29 billion), payable over 59 years. Annuities were set on a
slowly rising scale beginning at two-thirds of the fifth-year
annual payment under the Dawes Plan and averaging four-fifths of
that amount. Fixed payments replaced variable instalments; the
gold price and prosperity adjustments specified by the Dawes Plan
were suspended, along with the provision to safeguard the
currency. The Young Plan also sponsored a $300 million bond
issue to help finance the annuities.
The onset of the Great Depression buried the Young Plan
within two years and, with it, German reparations. Germany
quickly was engulfed in financial chaos, suffering declining
exports, the cutoff of credit, and capital flight. Germany made
payments on only three annuities, ending service with the Hoover
Moratorium in 1931. Germany is estimated to have paid only
$5-$9 billion on its $33 billion reparations bill.
Including interest obligations.
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Allied War Debts to the US
The difficulties Germany experienced in paying reparations
to the Allies complicated the Allies' effort to repay war loans
to the United States. The United States agreed to readjust
Allied war debt because it recognized that economic conditions
after the war were not conducive to servicing over $10 billion
worth of debt, almost all of which was due during the early
1920s. The settlement of US war loans with 13 European countries
took place between 1923 and 1926.
Although terms varied widely, the readjustment of Allied
debt significantly reduced annual servicing requirements by
extending repayment periods. Short-term credits were
consolidated and converted into bonds maturing in 62 years. No
principal was cancelled, and interest arrearages were partially
reduced before being incorporated as funded principal.
Additional debt relief instead was provided by interest rates
fixed at reduced levels. Provisions also were included for
postponement of servicing under certain conditions. Total debt
consequently was cut approximately in half--to about $6 billion--
for the 13 European debtors as a group, with reductions ranging
from 19 percent (Finland) to 75 percent (Italy) to reflect the
debtors' differing capacities to repay. The instalments of
principal and interest were payable in gold or in US bonds.
Significant debt relief failed to prevent Allied default,
however, during the Great Depression. The Allies confronted the
same problems encountered by Germany, including balance of
payments problems and the absence of external credit, and they
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too halted payments with the Hoover Moratorium. Only Finland
resumed full debt service after the Moratorium. To date, the US
has received only $2.8 billion in principal and interest on
growing obligations that now probably exceed an estimated
$30 billion.
Lessons Learned
Debt readjustment policies adopted early this century
resemble current restructuring arrangements for lesser developed
countries. Creditors sought to assist debt-troubled countries by
lowering the level of annual debt obligations and maintaining
debt service in the face of adverse external shocks. Debt relief
was provided by various combinations of interest rate reductions,
maturity extension, refunding, cash substitution, and sometimes
principal reduction.
The interwar experience in debt readjustment, however,
cannot guide action in current rescheduling exercises. The
relative merits of particular debt strategies crucially depend on
the nature of the debt involved. The war debt derived from the
destruction of productive capacity in Germany and the Allied
countries, undercutting Europe's capacity to service debt for
many years; under this unique circumstance, drastic cancellation
of principal and token repayments probably were appropriate. The
default settlements adopted for interwar Latin America debt also
are inapplicable today because of the differences between bonds
and bank loans, the predominant form of debt currently owed by
Latin America. Banks today cannot liquidate their Latin
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portfolios as bondholders did earlier without possibly
endangering the international financial system.
Broad lessons, however, can be learned from the settlement
of interwar debts. Although interwar debt relief techniques
reduced hard-currency debt service obligations in the short run,
debt repayments continued to represent a steady burden on the
budget and balance of payments of debtor countries. Even
readjustments that incorporated flexibility clauses--for example,
the conditional annuities on export performance and on domestic
and international conditions included in Germany's various
readjustment programs--failed to prevent default when economic
conditions deteriorated as they did in the early 1920s. While
the provision for flexibility afforded some protection to
debtors, it tended to lower the credit standing of the debtor
country in the view of investors, whose repayment prospects were
much less certain. Foreign financial support consequently was
quick to disappear when economic conditions worsened.
The historical record of international debt readjustment
confirms that restructuring schemes can help resume stalled debt
servicing but cannot insure debt repayment over the long run. In
the final analysis, debt servicing depends not on the
effectiveness of restructuring techniques but rather on the
ability of debtors to earn the foreign exchange of creditors
through trade. Other means of acquiring foreign exchange cannot
finance debt repayment on a sustained basis: accepting foreign
loans only increases the amount of debt owed; liquidating
portfolios of foreign securities is a limited option and
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eliminates a source of foreign exchange in the form of future
interest income; and purchasing with domestic currency ultimately
debases the currency's value until foreigners refuse to accept
it. Debtors, therefore, must export more than they import to
repay debt. If their debt must be repaid with their creditor's
currency, however, the creditor must be willing to run a trade
deficit with the world; otherwise, the necessary foreign exchange
will not be available to the debtor at a feasible exchange rate
to fund his debt repayment.
Although the debt relief afforded Germany and other European
countries was significant, debt readjustment policies alone
failed to resolve debt problems because they did not insure
creditor cooperation--i.e., creditors were allowed to pursue
policies that hindered debtors from servicing debt. Allied war
debts to the United States were halved and German reparations
annuities were scaled down appreciably. At the same time,
however, creditors restricted debtor exports to creditor and
third-country markets. The United States, in particular,
increased import tariffs in 1922 and 1930 to restrict European
access to domestic markets. Private foreign lending masked for a
decade the debtors' inability to earn foreign exchange through
trade. The lending cutoff after 1928 left debtors to repay with
their own resources, exposing the flaw of the readjustment
policies.
Latin American debt defaults were resolved because export
opportunities accompanied the standard readjustment techniques.
World War II greatly increased the demand of the US and Great
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Britain for raw materials from Latin America. The war also
enabled Latin America to broaden its export base through
encouragement of agricultural diversification and increased
industrialization. As a result, Latin America was able to
replenish its reserves of foreign exchange and gold and to
finance the resumption of debt servicing and the repurchase of
much of the defaulted debt. Without its strong export position,
Latin America probably could not have settled its defaulted debt
merely on the basis of negotiated debt relief.
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SUBJECT: Lessons Learned from the Pre-World WarII Debt Crises
OGI/ECD/FI (6Aug85)
Distribution:
1 - The Honorable Richard McCormack
D/OGI 1 - Beryl Sprinkel, Council of Economic Advisors
Signature 1 - Lowell Kilday, State
1. - Richard J. Smith,-State
1 - Charles Dallara, Treasury
1 - Albert Hamilton, Exlm Bank
1 - Byron Jackson, Commerce
1 - David Wigg, National Security Council
1 - Jacqueline Tillman, National Security Council
1 - Martin Bailey, State
1 - W. Robert Warne, State
C/ECD I - Luigi Einaudi, State
Signature 1 - Director, Planning and Economic Analysis Staff,
State
1 - Lauralee Peters, State
1 - John DeWitt, State
1 - Ralph Lindstrom, State
1 - Ciro DeFalco, Treasury
1. - Douglas Mulholland, Treasury
- D/OGI
1 - C/OGI/ECD
3 - OGI/ECD/FI
11.1 Sanitized Copy Approved for Release 2009/11/24: CIA-RDP85T01058R000304840001-7