LDC DEBT PROBLEMS OUTLOOK TO 1990 (SANITIZED)

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP97R00694R000700190001-3
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 22
• Document Creation Date: December 22, 2016
• Document Release Date: December 19, 2011
• Sequence Number: 1
• Publication Date: March 1, 1987
• Content Type: REPORT

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/qlt"^ Directorate of
f ) Intelligence
I-I
LDC Debt Problems:
Outlook to 1990
Confidential
GI 87-10023
March 1987
COPY 2 I 9
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Directorate of
LDC Debt Problems:
Outlook to 1990
This paper was prepared byl (Office
of Global Issues. Comments and queries are welcome
and may be directed to the Chief, International
Finance Branch, OGI,
Confidential
GI 87-10023
March 1987
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LDC Debt Problems:
Outlook to 1990
Key Judgments Brazil's unilateral suspension of interest payments has plunged the interna-
Information available tional financial system into a new, dangerous phase. Driven by a rapidly
as of 6 March 1987 deteriorating economy, a plunging trade surplus, soaring inflation, and
has used in this report.
growing political pressures, Brasilia is confronting international bankers
with demands for sharply lower interest payments, some $2.5 billion in new
money, and no IMF conditionality. This situation will not necessarily end
in a dramatic outcome or a new approach to Third World debt problems,
however. All parties have a great deal to lose from a complete breakdown
of negotiations, and strong incentives exist to keep both sides at the table.
Even resolution of the current Brazilian imbroglio, however, will not set
Third World debt problems on a smooth path toward resolution. We
believe the best outcome that can be expected over the next few years is
lurching from crisis to crisis. While the odds are good that each time a so-
lution will be reached, albeit in many cases after further rounds of
brinksmanship by both debtors and creditors, there is a strong risk that
other actors eventually will balk, threatening a collapse of the debt strategy
and causing major financial problems for debtor countries and creditor
banks and governments. In our view, the risks of this outcome will continue
to rise, with banks becoming increasingly reluctant to provide new money
or make concessions and debtors upping their demands for concessions.
If the current strains between debtors and creditors were based on
temporary economic conditions, we would be less concerned about the next
few years; as economic conditions improved, so would the debt negotiation
atmosphere. Our examination of the factors that will affect the LDC debt
situation in this period, however, indicates the underlying trends will get no
better:
? World trade will not grow rapidly enough to alleviate LDC debt service
burdens. The IMF projects a 3.5-percent increase in world trade in 1987,
roughly the same growth rate as that predicted for LDC debt and no
more rapid than in 1985-86.
? Interest rates seem certain not to go much lower than current levels and
more likely will increase over the rest of the decade. The consensus of
major forecasting services is that interest rates will rise by 2 percentage
points over the next three years, a reversal of the downward trend since
mid-1984.
Confidential
GI 87-10023
March 1987
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? Commodity prices could recover slightly, but we believe they will remain
far below levels necessary to bring a major improvement in LDC export
earnings.
? Pressures for protectionism in industrial countries, particularly in Eu-
rope, seem likely to grow rather than abate, which will continue to
restrict LDC export growth, in our judgment.
At the same time, we anticipate that political constraints will prevent the
kind of reform needed to increase debtor country competitiveness. More-
over, without tangible moves toward improvements by debtor governments,
commercial banks will continue to restrict the growth of new lending to
In addition to what we see as insufficiently favorable economic trends, our
concern about the outlook for the debt situation is heightened by our belief
that debtor attitudes and negotiation stances are hardening. In our view,
Brazil's actions are symptomatic of a generally changing attitude in nearly
all debtors. While debtor demands are not new, we detect a markedly
increased toughness and arrogance in their present stances. In our
judgment, these harder, more forcefully stated positions are not just
negotiation ploys; rather, they represent a growing general perception
among debtors that it is time for developed country governments and banks
to bear more of the burden of the debt. Even if the current problems with
Brazil are resolved, we do not see the debtors' negotiating toughness
ebbing. Indeed, each additional bailout of a key debtor will harden these
attitudes further, making it more difficult to reach agreements on debt.
Confidential iv
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Key Judgments
Preface
The Record Since 1982
Key Elements in the Future
The Trade Problem
The Role of Direct Investment
LDC Domestic Policy Changes
A Pessimistic But Manageable Scenario
Effects on Debtor Countries
The Impact on Commercial Banks
Downside Risks
A More Optimistic Scenario
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10
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debt situation is monitored both through crosscutting papers such as this
This paper is part of a continuing DI effort to monitor and assess the status
and implications of the international debt situation. In this effort, the LDC
one and through examinations of the debt situation in specific countries.
Vii Confidential
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Outlook to 1990
The Current Setting
Third World debtors and creditors appear to be on
another collision course. This time the crystallizing
problem is Brazil, where rapid economic deteriora-
tion, underscored by a plunging trade surplus and
soaring inflation, is accompanied by growing domestic
political pressures.' As a result, Brasilia has taken a
confrontational stance in negotiations with commer-
cial creditors by declaring an interest moratorium and
demanding from bankers a sharply lower interest
spread, some $2.5 billion in new money, and no IMF
conditionality. Chile and Ecuador also have stridently
demanded new concessions such as retiming of inter-
est payments, and Chile has received much of what it
asked for.
Argentina and the Dominican Republic are consider-
ing moratoriums. At the same time, completion of the
Mexican package, which contains unique terms such
as a linking of debt payments to oil prices and
economic growth rates, continues to be held up by the
reluctance of many regional US and foreign banks to
sign on to the agreement.
The common thread in all the current negotiations-
including those involving Brazil, Chile, the Philip-
pines, Ecuador, and Venezuela-is that debtors are
taking stronger stands while creditor banks and gov-
ernments are increasingly divided. In our judgment,
the debtors-best symbolized by Brazil-are being
spurred by growing domestic protests over their dete-
riorating economies as well as a perception that their
leverage over creditors is substantial. Threats of inter-
est payment delays or reductions are becoming bolder.
Debtors probably reason that the commercial banks
are not in a strong enough position or united enough
to deal with a major writeoff of loans, while official
creditors are unwilling to step in and assume the
burden from the banks. Moreover, recent publicity
On 20 February, President Jose Sarney announced an
indefinite suspension of interest payments on Brazil's
$68 billion medium- and long-term debt to commer-
cial banks. Since the announcement, Brasilia has sent
conflicting signals to its creditors. In an official press
statement on 23 February, a key presidential adviser
said Brazil will not demand debt solutions that
involve lossesfor creditors. At the same time, howev-
er, Finance Minister Funaro told reporters that Bra-
zil will not negotiate away its growth targets or agree
to an IMF program.
Bankers, for their part, expressed uncertainty about
what steps Brazil will propose in forthcoming negoti-
ations. They are especially concerned about the lack
of a credible domestic economic program. As a result,
a few banks withdrew a portion of the $15.5 billion
short-term trade and interbank lines. To prevent a
major loss of these credits, Brasilia sent instructions
to Brazilian banks overseas directing them not to
repay international banks that seek to withdraw such
credits, but instead to deposit the money in an
account in Brazil's Central Bank, according to Em-
bassy reporting.
Sarney's decision was prompted by a number of
factors, in our judgment. These included a rapid
drawdown of foreign exchange reserves since last
September to a current level of less than $2 billion,
an escalation of inflation to an annualized rate of 800
percent, a sharp drop in the trade surplus to a point
that will remain well below interest obligations for
several months, Brazilian concerns that bankers were
not aware of the seriousness of the problem, and
rising domestic pressure for unilateral action to
divert attention from domestic problems.
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about banks building reserves against future writeoffs
probably is leading debtors to conclude that their
leverage will wane over time.
Even with these preconditions in place, an impasse or
breakdown will not necessarily ensue. Both parties
have a great deal to lose from a complete breakdown
of negotiations, and strong incentives exist to keep
both sides at the table. In these circumstances, the
skill of the individual negotiators and the ability and
willingness of the debtors and creditor banks and
governments to make the hard choices and compro-
surpluses, LDCs have had to continue to restrict
imports because of less-than-expected export earn-
ings. Even where volume growth occurred, prices fell
so sharply during the past few years that the increases
in volume did not offset the decline. The oil exporters
bore the brunt of the burden, with a 46-percent drop
in export earnings in 1986, according to IMF esti-
mates, but non-oil-exporting LDCs also suffered from
a 12-percent fall in their export earnings because of
weaker primary commodity prices and slower indus- 25X1
trial country growth. Trade protectionism in industri-
al countries, particularly restrictions on imports from
mises will be pivotal.
The Record Since 1982
The debt problem has changed in several aspects since
it first emerged as an international issue in 1982. To
sustain debt servicing, individual debtors have under-
taken economic adjustment programs under the aus-
pices of the IMF in exchange for debt restructuring
and additional new funds from creditor governments
and commercial banks. This strategy has avoided a
default or repudiation involving a major debtor, as
well as a collapse of major banks, while slowing the
growth of LDC debt. The basic debt problem none-
theless remains. Almost every year, some major debt-
or has had to again restructure its debt, often in a
strained, crisis atmosphere. Last year, creditors com-
pleted another arduous round of negotiations with
Mexico; this year, they face rigorous talks with Brazil
and probably Argentina.
Despite the continuing financial problems and subse-
quent negotiations, aggregate LDC debt has contin-
ued to grow. At yearend 1986 the LDC debt total
reached about $860 billion, up from about $637
billion at yearend 1981. Meanwhile, interest pay-
ments on the total debt still approximate $65-70
billion per year despite the sharp decline in interest
rates since the debt crisis began in 1982.
The most important factor that has prevented a
solution to the debt problems of the Third World, in
our judgment, is that world trade has moved sharply
against LDCs; indeed, except for 1984, LDC exports
have increased below historical norms every year since
1980. As a result, instead of being able to resume
some import growth while maintaining their trade
LDCs, also contributed to LDC trade problems.
Although debtors have benefited substantially from
declining interest rates, these gains have been offset
somewhat by reduced amounts of new lending and
restrictions on LDC access to international capital
markets as banks' concern over LDC financial prob-
lems has grown. Voluntary lending now goes to a
limited number of LDCs that are the least risky,
primarily in East Asia. For countries with debt prob-
lems, new financing comes in the form of involuntary
lending as part of restructuring packages. Bank port-
folios are also being adjusted, with banks-mostly US
regionals and foreign banks swapping, writing off, or
converting to equity in debtor countries some or all of
their loans; such activity serves to limit the banks'
incentive for future lending.
Meanwhile, debtor countries have borne almost all of
the financial adjustment. For example, the $37 billion
improvement in the aggregate Latin American cur-
rent account position in 1982-85 was due primarily to
import declines totaling $21 billion, in contrast to
export increases of only $5 billion. As a result of this
pattern, the pace of aggregate LDC GNP growth has
also fallen, from an average of 4 percent in 1977-81 to
2.5 percent in 1982-86. In addition, Latin America
has experienced a net outflow of funds over the past
several years and has seen per capita income levels
fall to no better than levels of the late 1970s. In
contrast, most of the major banks involved in Third
World lending have continued to receive the interest
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Table 1 Billion us $ Table 2
Improvements in Current Account Key Economic Trends: Average
Balances, 1982-85 Annual Figures
Total
Improve-
Due to
ment
Increased Import Other
Exports
Cutbacks Changes
Argentina
1.4
0.8
1.4
-0.8
Brazil
16.0
5.3
6.3
4.4
Chile
1.0
0.0
0.6
0.4
Colombia
1.7
0.6
1.7
0.6
Mexico
6.6
0.6
0.8
5.2
Nigeria
8.5
0.5
6.6
1.4
Peru
1.6
-0.3
1.8
0.1
Philippines
Venezuela
payments on these loans, albeit at occasionally re-
duced spreads above base interest rates such as the
London interbank offer rate (LIBOR) or the US
prime rate.
Key Elements in the Future
The variables that will most affect the LDC debt
situation over the next five years include: external
trade, commodity prices, interest rates, external fi-
nancial flows, and industrial country and LDC eco-
these variables will do little to improve the LDC debt
situation over the next five years, and the LDCs will
probably not be much better off in terms of debt
service, capital account balances, and per capita
incomes than they are today. Specifically, we expect
slow growth of world trade, limited improvement in
commodity prices, higher interest rates, continued
slow growth of bank lending and foreign investment,
and less-than-optimal changes in debtor and creditor
country policies.
The Trade Problem. We and other observers expect
world trade to grow no faster over the rest of the
decade than it did over the last two years, an annual
Growth of world trade (percent) 5 3 4
OPEC oil price ($/hhl) h 29 27 20
Real nonoil commodity prices -3 5 3
(percent change)
Nominal interest rate--LIBOR 14
(percentage points)
Real interest rate LIBOR 6 5 4
(percentage points)
LDC net external borrowing 91 47 40
(billion US $)
Foreign investment in LDCs I I 10 12
(billion US $)
LDC total debt/exports ratio 100 150 140
(percent)
LDC total debt/GNP ratio 35 48 45
(percent)
LDC debt service/exports ratio 18 21 20
(percent)
LDC interest payments/exports 10 12 11
ratio (percent)
a Projected.
h Market prices.
growth rate of barely 3 percent in volume terms.
Several factors will contribute to this projected slow
growth:
? The lack of a strong revival of trade in primary
commodities, in turn due to slower than previous
OECD economic growth and widespread structural
changes.
? The threat of greater protectionist measures in
industrial countries, particularly with regard to
trade in manufactures, an important component of
exports for many LDCs.
? An expectation of slow progress in LDC domestic
adjustment, along with limited support for that
process from foreign creditors, that will keep many
LDC exports uncompetitive in world markets.
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In our judgment, the weak outlook for world trade
will be the key external economic factor constraining
resolution of the debt crisis. The need for a large
number of debt-troubled countries to run large trade
surpluses simultaneously will again put the onus on
the developed countries to run trade deficits. For this
to be successful, however, other OECD countries
besides the United States will have to do more to
absorb LDC exports. In the event US growth slows
from its present 3-percent pace or the US trade deficit
shrinks, possibilities that will become more likely over
the next few years, the outlook for LDC exports will
not be as promising.
Weak Commodity Prices. Even with no increases in
volume, the LDC trade picture could improve if there
was a rebound in the prices of LDC exports. The
aggregate nonoil commodity price index currently is
almost 30 percent below its long-run average in real
terms, with most commodities at their lowest levels in
the past 40 years. Nonoil commodity prices fell by an
estimated 18.5 percent in real terms during 1986,
according to the IMF. The weakness in prices for
agricultural commodities can be attributed largely to
an oversupply of many goods brought on by favorable
growing conditions, the adoption of more market-
oriented pricing policies in many LDCs, agricultural
subsidies in industrial countries, and increased pro-
ductivity in certain LDCs.2 Metals prices, on the other
hand, have suffered from reduced demand as well as
increased mining capacity and substantial cost reduc-
tions in metal production.
Most observers do not expect a major recovery in
commodity prices in the near term. Many of the
factors that led to the current oversupply and weak
demand will remain, including sluggish growth in
industrial production in developed countries, govern-
ment agricultural subsidies in producer nations, in-
ventory reductions resulting from high real interest
rates and low inflation expectations, and foreign
exchange shortages in many LDCs.
Table 3
Nonoil Commodity Prices
1979-82
1983-86
Key LDC Exporters
Aluminum
(cents/lb)
64
56
Brazil, Jamaica, Guinea
Cocoa ($//b)
1.10
1.01
Ivory Coast, Brazil, Ghana
Coffee ($//b)
1.41
1.44
Brazil, Colombia
Copper
(cents/1b)
84
65
Chile, Zambia, Peru
Cotton
(cents/lb)
82
68
Egypt, India
($/cubic meter)
Iron ore ($/ton)
25
Maize ($/ton)
120
Natural rubber
53
40
Malaysia, Indonesia,
(cents/lb)
Thailand
Palm oil
563
494
Malaysia, Singapore,
($/ton)
Indonesia
Rice ($/ton)
386
240
Thailand, Burma, Pakistan
Soybeans
($/ton)
280
249
Brazil, Argentina
Soybean meal
($/ton)
243
194
Brazil, Argentina
Soybean oil
($/ton)
554
Tea ($/kg)
2.09
2.42
India, Kenya, Sri Lanka
Tin (cents/lb)
672
488
Malaysia, Indonesia
Wheat ($/ton)
167
140
Argentina, India
Source: IMF.
The Impact of Exchange Rates. LDC exchange rates
should continue to depreciate if the US dollar declines
over the next few years, improving trade prospects for
the LDCs and their ability to service debt; major
econometric forecasting units foresee continued de-
clines of the US dollar relative to other major curren-
cies as Washington seeks to reduce its trade and
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budget deficits. According to a UN study, for exam-
ple, a 20-percent fall in the nominal effective ex-
change rate of the dollar over three years-1986-88-
will yield a positive growth effect on LDCs because of
improvement in dollar-denominated commodity
prices, an increase in LDC exports to the United
States to replace exports from Japan and the EC, and
a lowering of the burden of dollar-denominated debt.
Depreciating LDC exchange rates, however, will not
be enough by themselves to substantially ease the debt
problem.
Some improvement in this area already has occurred
as LDC real exchange rates declined sharply during
1985-86, a result of many LDC currencies being tied
to the dollar, or even depreciated against it. On a
weighted-average basis LDC real exchange rates have
fallen by an estimated 20 percent since early 1985.
We expect these declines to help improve the external
competitiveness of many of these countries. The gains
will be limited, however, by the fact that most of the
increased competitiveness has occurred vis-a-vis
Western Europe and Japan, which are relatively less
important markets for these countries' exports. Com-
petitiveness gains in the far more important US
market have been much less. Nonetheless, exchange
rate changes should help LDCs recover some losses in
export market shares that occurred when their curren-
cies appreciated with the US dollar.
Interest Rates. Changes in world interest rates will
continue to have a direct and visible impact on LDCs;
each I-percentage-point shift in major interest
rates-LIBOR and the US prime rate-equates to a
$4-5 billion movement in interest payments on debt.
The largest debtors, Mexico and Brazil, are the most
affected, with an $800 million change for each per-
centage point. Changes in interest rates also affect
deposits held by LDCs in foreign banks, although this
impact is much smaller than that of interest payments
because of the limited amount of deposits held by
government entities.
The forecasts vary as to the magnitude of future
interest rates, but none call for major declines similar
to those that benefited debtors over the past two
The Impact of Industrial Country Policies on LDCs
The policies undertaken by the industrial countries
will continue to have a large influence on the outlook
for developing countries, especially as these policies
affect trade, exchange rates, and interest rates. In the
short term, we believe industrial country governments
will continue to emphasize controlling inflation and
reducing budget deficits, while trying to maintain
steady economic growth. The effect of these policies
on debtor countries will depend on how these restric-
tive policies are implemented vis-a-vis maintaining
growth and how stable exchange rates and sustain-
able current account balances are attained. According
to one study, optimal industrial country policies-
such as fiscal restraint, more flexible monetary poli-
cy, and reduced trade barriers-could add 1.75
percentage points annually to major debtors' growth
rates, while inefficient policies could cut growth by 3
percentage points. Debtors that rely on official financ-
ing will benefit much less because economic develop-
ments in those countries generally reflect changes in
domestic policies rather than those of industrial
countries.
years. For the short term most of the econometric
forecasting units show a slight decrease in interest 25X1
rates in 1987, with rates beginning to climb again in
1988. For the longer term, interest rates generally are
projected to rise until 1989 and then decline through
the mid-1990s.
External Financing. LDCs will remain dependent on
external sources of funds, both official and private.
Despite the recent declines, foreign borrowing is
second to export earnings as a source of funds for
LDCs. We believe the prospects for major increases in
lending to LDCs, however, are extremely poor, given
the continuing financial problems of these countries
and renewed emphasis by banks on voluntary lending 25X1
to only the most creditworthy countries. More likely,
debtor countries will receive at best a small increase
in lending from banks.
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Figure 1
World Interest Rates, 1978-91
Percent
20
3-month
LIBOR
Real 3-month
LIBOR
F
11 I`1?8 80 8S 87x88'89a9091a
The most consistent source of funds will remain
official lenders-governments and multilateral insti-
tutions. The slow but steady growth of official loans
has been the primary source of funds for most smaller
debtors, many of which have chronic economic prob-
lems rather than strictly debt-related problems, and
even for some of the medium-sized debtors such as
Bolivia, Egypt, and Morocco. Bilateral lending from
OECD countries is projected to increase at a rate of 2
to 3 percent over the next few years, or about $1
billion annually; this rate is about the same as that of
the period 1982-86. Additional increases beyond this
projection, in our assessment, are unlikely because of
developed country budget restrictions.
Multilateral lending can be expected to assume a
greater role in LDC financing, both through increased
loans and more cofinancing deals with private lenders,
according to some observers. The World Bank-the
largest multilateral lender-will be under pressure
from debtors and some other creditors for not doing
Figure 2
Private Sources: Net New Lending
to LDCs, 1980-86
enough to stimulate capital inflows to LDCs. Indeed,
the results for the fiscal year that ended on 30 June
1986 show that total repayments from LDCs to the
World Bank exceeded new disbursements. Among the
primary goals of new IBRD President Conable is to
strengthen the role of the World Bank and become
more involved in ensuring continued lending to LDCs.
We believe it will take several years to build up this
capacity, however, and also will depend on a firm
commitment from member countries to underwrite a
general capital increase, a questionable proposition at
best because of some budgetary constraints that will
restrain growth in bilateral lending.
We see almost no chance that lending from private
sources-primarily commercial banks and historically
the largest source of funds for LDCs-will rebound in
the next few years. Since the onset of the debt crisis in
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1982, the growth of bank lending has slowed sharply,
in contrast to the LDC borrowing boom of 1978-81.
Medium-term syndicated loans have become scarce,
except in the case of IMF-led rescue packages, with
only a limited number of countries like South Korea
and Taiwan still considered favorable credit risks.
Short-term credit lines also have been reined in as
banks seek to limit their exposure to manageable
Bank lending probably will continue to increase at a
pace of 3 to 5 percent each year, with as much as half
of this amount made on an involuntary basis, in order
to allow the debt-troubled countries to remain current
on their interest payments. Trade-related financing
will move in relation to the volume of trade activity,
but medium-term credits will only be extended for
specific projects. Even then, many lenders will insist
on some form of government or multilateral institu-
tion guarantee. Any increase in the amount of loan
writeoffs and loan loss reserves without regulatory
adjustments also will prevent a quick resumption of
large-scale bank lending to LDCs.
The Role of Direct Investment. Foreign direct invest-
ment is viewed by some observers as a way to make up
for reduced lending flows from commercial banks.
Investment flows, however, usually follow those of
bank lending, with investors tending to be more
cautious than banks in investing capital in LDCs.
Direct investment is more productive than bank lend-
ing from the LDCs' standpoint, but the problem of net
outflows still exists, and investment flows will not be
large enough to substitute for bank lending. Over the
past 10 years, investment flows generally have been
equivalent to only 10 to 15 percent of bank lending.
Although many LDCs-particularly in Latin Ameri-
ca-have embarked on foreign investment promotion
drives, IMF forecasts project only slight growth in
foreign investment over the next few years. Invest-
ment flows to LDCs are expected to be $12-13 billion
in 1987 and 1988, down from the high mark of $14
billion in 1981. The reasons for the slow growth
include:
? Limited economically viable investment opportuni-
ties. While good investment opportunities exist in
most countries, they tend to be small-scale opera-
tions that are not well developed and consequently
are hard to identify. Certain industries deemed to be
in the national interest, such as energy-related
industries, are usually the best known to investors
but will remain untouchable for foreigners.
? Foreign ownership restrictions. Many countries
have laws requiring majority local ownership. Mexi-
can law, for example, requires that local owners
hold at least a 51-percent stake in foreign invest-
ments in Mexico unless special exception is made by
the government.'
? Exchange restrictions. The presence of restrictions
on access to foreign exchange for domestic firms
along with limits on repatriation of profits abroad
also will hinder new foreign investment. 25X1
? Long-term security. Prior actions or threats of
government interference such as nationalization or
expropriation will turn away foreign investors.
LDC Domestic Policy Changes. One positive out- 25X1
growth of the continuing debt problem is that LDC
economic policy makers appear to be more aware of
the importance of proper economic adjustment poli-
cies. Several trends indicate that steps are being taken
in the right direction:
? LDC exchange rates are becoming more realistic,
after being overvalued for a number of years.
? Domestic interest rates in LDCs are being adjusted
to levels that encourage domestic savings ahead of
foreign savings.
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? A growing number of countries are gradually loos-
ening some of the barriers to new direct foreign
investment.
Although these steps are positive, in most cases we do
not see them as nearly enough to placate creditors and
stimulate a return to voluntary lending. Problems
with inflation and controlling the public-sector budget
deficit-partly because of a reluctance to cut subsi-
dies-will continue to hinder adjustment efforts of
many LDCs. Moreover, creditors remain concerned
that debtor country governments will backtrack on
implementation of these policies as soon as their
current accounts turn around or if pressed politically
for more populist economic policies. In addition,
continued capital flight indicates that local popula-
tions are not yet confident of the ability of their
governments to manage the economic situation.
The privatization effort in LDCs, in our judgment,
also is proceeding on an uneven course. Debtors have
long been burdened with large, inefficient state-owned
enterprises and, at the same time, have hindered the
growth of the private sector by implementing exces-
sive government controls and restrictions. However,
the selling off or restructuring of public-sector firms
has been a domestically unpopular move politically
for most countries, and we expect that further
changes will be slow in coming
In contrast to internal adjustments, debtors have been
far more successful in making external adjustments
since 1982, but we believe they will not be able, or
willing, to do much more. The generation of large
trade surpluses has reduced financing needs but has
come at the expense of slower economic growth,
higher inflation, and lower standards of living. More-
over, the trade surpluses were brought about by
sharply restricting imports rather than boosting ex-
ports. These countries will be hard pressed to spur
economic growth without increasing imports and
thereby eroding the trade surpluses.
A Pessimistic But Manageable Scenario
Under the conditions outlinec above, we believe the
LDC debt situation over the next several years will be
marked by a lurching from crisis to crisis. Although
strong forces will encourage c ventual agreement to
end each crisis, in many case., brinksmanship by both
debtors and creditors will occur. In these circum-
stances, we expect both sides to do only the minimum
necessary in order to avoid any serious disruption.
Nonetheless, each individual country we have exam-
ined would continue to face debt servicing require-
ments that stretch its ability to meet them unless
considerable new funds become available.
Effects on Debtor Countries. If debtors and creditors
are able to eventually work out each subsequent crisis,
we see little incentive for debtors to significantly alter
their slow movement toward economic adjustment
over the next several years. The short-term benefits
from implementing serious economic reforms still will
not be great enough to offset the political risks for
LDCs faced with substantial domestic dissatisfaction,
net outflows of capital, and declining standards of
living. LDC governments generally will concentrate
on the short run in their views; they will talk about
long-term solutions but will want immediate results.
At the same time, most LDC's will realize that they
need to play the negotiating game with creditors,
although domestic pressure could force debtors to
take more drastic actions-a; ; Peru has done-such as
debt payment limitations.
Prospects for individual debtor countries vary consid-
erably. Even LDCs with similar characteristics-such
as oil exporters, middle-income countries, or large
debtors-will have vastly dif-erent results. For exam-
ple, the two largest debtors, Brazil and Mexico, have
nearly opposite medium-range outlooks. Most finan-
cial observers believe that Mexico will continue to
face problems over the next ive years because it will
still be far too dependent on oil earnings. Brazil, on
the other hand, will have some short-term liquidity
problems, but its diversified economy makes the long-
term outlook much more encouraging. Debtors that
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Table 4
Key Debtors: Medium-Term Prospects
Floating Rate
Manufactures
Oil Imports
General
Major
Share of Debt
Share of Exports Exports
Medium-Term
Problem
Oil importers
Argentina
(percent)
82
(percent)
18
(percent)
6
Outlook
Fair
Areas
Domestic spending: large foreign debt
Brazil
81
56
25
Fair
Overheated economy; short-term borrowing needs
Chile
85
25
15
Fair
Dependence on commodity prices; high debt level
Colombia
53
15
11
Fair
Diversification of exports
Philippines
66
36
16
Poor
Dependence on commodity prices; economic
Oil exporters
Fg}pt
32
18
38
Good
Poor
management
Large debt; susceptibility to world trade
slowdown
Drop in oil, remittance revenue; domestic
Indonesia
37
8
67
Fair
spending
Adjustment of spending to lower oil revenues
\lcsico
84
26
68
Poor
Diversification of exports; domestic spending
N igeria
84
2
97
Poor
Diversification of exports; poor economic
Peru
50
management
Venezuela
91
are highly dependent on commodity exports-includ-
ing Chile, Peru, and Ivory Coast-as well as oil
exporters will have to seek to reduce that dependence
by developing their industrial sectors.
Countries that previously had avoided or had only
occasional difficulties, in our judgment, may also face
debt problems. For example, several East Asian debt-
ors, including Indonesia and Malaysia, could require
debt relief within the next two years, largely as a
result of low oil and other commodity prices.' Other
countries such as Egypt face the prospect of repeated
debt problems over the next five years. In addition,
Sub-Saharan African LDCs appear to have little
chance of improving their already poor economic
outlook as debt restructurings become a regular event.
Meanwhile, we believe political pressures within debt-
or countries also will continue to build. Most Third
World political observers expect increased dissatisfac-
tion with continuing debt problems as LDC living
standards remain depressed; as perceptions build that
the notion that these countries would require only a
one-time dosage of adjustment measures has proved
to be false, this dissatisfaction will be likely to
intensify. As time goes on, making the necessary
serious economic adjustments will be much tougher
for LDC leaders than if they had made them when
debt problems first broke out because of the built-up
public resistance and the requirement that the adjust-
ment be much greater to resolve the added problems
built up during the interim period.
The Impact on Commercial Banks. In this scenario,
we believe the international financial system will
remain vulnerable to LDC debt problems. Despite
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concerted efforts by commercial banks to strengthen
their balance sheets through increases in capital and
loan loss reserves, they remain heavily exposed to
LDCs. A prolonged payment stoppage by Brazil or
Mexico-or a combination of two or more other large
debtors such as Argentina and Venezuela-would
cause serious earnings losses for banks and could
threaten the solvency of some major banks, particu-
larly in the United States.
Meanwhile, we believe further confrontation will
stimulate the metamorphosis in the commercial
banks' relationship with debtor countries, even those
LDCs that have not previously experienced debt
problems. The growing reluctance of commercial
banks to provide any new medium-term, and in some
cases short-term, credits to many LDCs will be
particularly damaging to LDC growth efforts. Despite
some cutbacks in short-term trade-related and inter-
bank credits to LDCs, we expect banks to continue to
extend such credits because they are less risky than
medium-term credits and are very profitable. Any
new medium-term loans, however, will be tied to
specific projects or guaranteed by a third party. A
greater number of cofinancing arrangements with
multilateral institutions may help to resume medium-
term loans to debtors, but it will still be on a small
scale. In addition, many banks will seek to further
reduce or even eliminate their international exposure
and will engage in additional debt-for-equity swaps,
sales of discounted debt, and debt writeoffs.
There also will be a continuation of the shift under
way regarding LDC financial rescue packages, in our
judgment, resulting in an increased concentration of
bank exposure to LDCs among a fewer number of
banks. Many regional US banks, most of which have
limited LDC exposure, will choose not to participate
in involuntary loan packages such as the recent
Mexican $6 billion loan and upcoming packages to
Brazil and Argentina. In past rescue packages, these
banks were pressured by the larger US banks to
participate; however, the experience of the Mexican
deal will make it extremely difficult for larger banks
to use the same tactics again.
The split also will probably widen between US and
non-US banks, in our assessment. The Swiss banks,
and more quietly the German banks, will call for more
alternative measures to new money for LDCs, includ-
ing interest capitalization, and could choose not to
participate in new packages at all. The different set of
banking and tax regulations governing non-US banks
is the primary basis for their views; these banks have
more aggressively set aside reserves for bad loans and
are in a stronger balance sheet position than their US
counterparts. European banks also will continue to
view Latin America as a US banking problem in
general and will remain less willing to become more
involved in the region. We expect these attitudes to
continue; therefore, there will be added pressure on
the large US banks to modify their approach to LDC
debt.
Downside Risks
There are some downside risks that could lead to a
serious deterioration of the LDC debt situation. Prob-
ably the most damaging event would be a recession in
the OECD countries, which could emanate from a
variety of sudden global economic changes such as a
surge in interest rates or sharply higher oil prices; in
our judgment, a downturn in OECD growth is proba-
ble during the next five years. A reduction of OECD
growth would be devastating to developing countries
largely because of the accompanying contractions of
trade and financial flows. The situation could ulti-
mately deteriorate to a point that threatens the
stability of the international financial system, which
then would require major creditor government inter-
vention in the system.
The impact of a recession, according to a CIA study,'
would be especially severe for Latin countries. Al-
though all debtors would be hurt by reduced exports,
the effects on individual debtors would hinge on oil
price trends. Net oil exporters such as Mexico and
Venezuela would be additionally hurt if oil prices fell
further, while Brazil and other oil importers would
receive benefits that would partially offset the dam-
age done by a recession. Meanwhile, new money
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Table 5
Key LDCs: Vulnerability Ratios a
Argentina
0.50
1.34
Brazil
0.95
6.40
Chile
0.65
5.77
Colombia
0.65
1.41
Ecuador
0.48
1.56
Egypt
0.69
1.88
India
0.32
0.86
Indonesia
0.60
1.76
Ivory Coast
0.65
3.18
Malaysia
-
0.37
1.24
Mexico
0.70
7.44
Morocco
0.66
1.35
Nigeria
0.35
3.02
Peru
1.01
1.37
Philippines
0.53
8.08
South Korea
0.67
0.84
Thailand
0.88
0.54
Venezuela
1.37
2.10
requirements for LDCs would increase by at least $19
billion in 1987-88 if a mild recession occurred, but the
total would jump to $30 billion in the event of a deep
recession.
The debt situation could also worsen if debtors be-
came convinced that creditors were not doing enough
to maintain the minimum flows of funds to keep the
debtors financially solvent. The incentive for debtors
to service their debts will diminish sharply if new
money from creditors only covers interest payments.
An examination of 18 key debtors reveals that all but
three Asian countries paid more in interest than they
received in new money in 1985, the most recent year
of data available; this is in sharp contrast to the period
1980-82, when there were only two countries with so-
called vulnerability ratios above 1.0. We expect that
ratios will remain above 1.0 for most key debtors over
The LDC Debt Vulnerability Ratio
There are many indicators used in attempting to
determine the relative debt burden of a country. The
most common ones are the debt-service-to-exports
ratio, total-debt-to-exports ratio, and total-debt-to-
GNP ratio. A different and unique measure derived
by financial analyst Anatole Kaletsky is the vulnera-
bility ratio. The indicator is used to provide a quick
reference point to a country's temptation to default
on, or repudiate, its debts.
The vulnerability ratio is computed by dividing total
interest payments by net new external borrowing. The
key is whether the ratio exceeds 1.0.?
? If the ratio is below 1.0, there is a positive or
normal transfer offunds to the debtor country. This
implies that the incentive is for the debtor to service
its debt in order to keep the flow of funds coming.
? If the ratio exceeds 1.0, there is a negative transfer
offunds out of the debtor country, meaning that the
debtor will be forced to consider the option of not
paying. At higher ratios, the incentive is greater to
suspend or limit debt payments.
Using IMF data, the vulnerability ratio has been
above 1.0 since 1983 for LDCs as a group, and this
trend is projected to continue. The aggregate for
Latin American countries has been the driving force
behind the LDC average, with vulnerability ratios as
high as 5.0 to 6.0 over the same period. It should be
noted, however, that, despite the high ratios, only
Peru has formally limited debt payments. Presum-
ably, individual countries have different thresholds
as to when to cease payments on their debts.
the next several years because of the probable in-
crease in interest rates and the slow growth of new
lending, which will make unilateral payment stop-
pages or limitations an increasingly attractive and
viable option to the debtors.
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We believe debtors will take such radical actions only
as a last resort, but much depends on the perceived as
well as the actual amount of flexibility demonstrated
by the creditors. Domestic political pressure in debtor
countries also will have a major influence on the
governments' actions. If a major debtor decided to
take unilateral action such as severely limiting debt
payments, creditors almost certainly would have to
accommodate it through additional debt concessions
because they would have a hard time isolating the
country's action. Most creditors probably would be
able to deal with writeoffs of one major debtor, but a
combination of several debtors would be too much to
handle simultaneously.
Should a debtor or debtors decide to take unilateral
action, they generally are in a better position to deal
with the expected credit reductions or cutoffs than
they were a few years ago. LDCs have bolstered their
foreign exchange reserves and accumulated greater
stocks of imports. In addition, countertrade and other
barter arrangements have become more common.
Debtors also have made progress on import substitu-
tion as part of their need to maintain trade surpluses.
Individual country situations vary widely, however,
and most LDCs do not yet perceive themselves as
being able to withstand a break with international
creditors.
A More Optimistic Scenario
A more optimistic scenario suggests that creditors and
debtors will be able to build on a number of positive
steps already undertaken. After a sobering couple of
years, the players will seek to maintain overall pro-
gress, a key challenge given the severe liquidity
problems that periodically plague key debtors like
Mexico and Brazil. Debtors and creditors will contin-
ue to show flexibility in resolving these periodic crises,
which have resulted in improved terms-such as
lower interest rates and longer tenors-on existing
debt. This flexibility, in conjunction with new initia-
tives by the private sectors and the debtor govern-
ments themselves, could lead to some, albeit slow,
progress in resolving the issue.
The debt situation also will improve if creditors and
debtors will continue to seek ways of reducing the
debt levels instead of merely adding to the already
Table 6
The Optimistic Scenario:
A "Solution Set" of Events
Moderate and steady increases in nonoil com-
modity prices
Stable oil prices
Industrial Elimination of barriers and restrictions on
countries imports
Coordination of exchange rate and monetary
policies
Increased flow of funds to LDCs through
either increased lending or greater guarantees
of private lending
Developing Serious and sustained commitment to adjust-
countries ment policies
Removal of barriers to foreign investment
Strengthening of the private sectors by reduc-
tion of governments' role in the economy
Commercial Maintain or increase existing short-term trade
banks credit lines
Return to medium-term lending for specific .
projects
Reduce the volume of existing loans that have
little or no chance of being repaid
high total debt. Following Chile's example, other
major debtors, such as Mexico, Brazil, and the Philip-
pines, will take advantage of debt-for-equity swaps,
although this will affect only a small portion of their
total debt. Meanwhile, a growing number of banks
will look more seriously at granting concessions on
existing debt to LDCs instead of extending new
money. The recent Mexican negotiations brought
some of these ideas to the table, including interest
capitalization, tying of repayments to commodity
prices or economic growth, and interest forgiveness.
For the optimistic scenario to fully materialize, how-
ever, we believe world economic trends would have to
improve. Above all, OECD growth would have to
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Table 7
Key Debtors: Foreign Exchange Reserves
Argentina
6.1
2.6
2.4
1.2
1.2
3.1
2.3
Brazil
5.0
5.9
3.6
4.4
11.5
10.6 --
- 5.0
Chile
3.0
3.1
1.7
2.0
2.3
2.4
2.3
IgYpt
1.0
0.7
0.7
0.7
0.7
0.8
0.9
Indonesia
5.0
4.5
2.6
3.6
4.7
4.8
3.9
Mexico
4.2
5.0
1.8
4.9
8.1
5.8
6.3
Nigeria
9.6
3.1
1.6
1.0
1.5
1.7
1.0
Peru
2.0
1.2
1.3
1.4
1.6
1.8
0.9
Philippines
2.8
2.1
0.9
0.7
0.6
0.6
1.7
Venezuela
5.6
7.1
5.4
6.4
7.7
8.9
5.0
accelerate above the pace we expect. Only in 1984
when OECD growth exceeded 4 percent did LDC
debt problems actually recede. This scenario also
would require continued low nominal and real interest
rates and limited changes in oil prices. The latter
seems possible but most observers expect interest rates
There may be some future benefits to LDCs emanat-
ing from the current world economic situation. Low
commodity prices, including oil, have forced many
countries to more closely examine ways of diversifying
their exports. Other debtors, however, will have to
follow Brazil's example and diversify to a point where
commodities and manufactured goods are in better
balance. Debtors that have the longest way to go are
oil exporters-such as Mexico, Venezuela, and Nige-
ria-and major commodity producers such as Ivory
Coast, Peru, and Chile; progress on export diversifica-
tion in these countries will have to improve dramati-
cally in order to reduce their dependence on commod-
ity prices.
A New Risk
In addition to what we see as insufficiently favorable
economic trends, our concern about the outlook for
the debt situation is heightened by our belief that
debtor attitudes and negotiation stances are harden-
ing. Aside from Brasilia's unilateral interest moratori-
um on its medium- and long-term commercial debt:
? Ecuador, previously a model debtor with a good
payments record and good relationships with credi-
tor banks and governments, suddenly has begun
allowing interest arrearages to build.
? Chile has also taken an unusually tough negotiating
stance, threatening a payments moratorium unless
creditors accede to their demands for additional
concessions. Chile, however, has reached tentative
agreement with its bank creditors, obtaining favor-
able terms.
? Argentina and the Dominican Republic are consid-
ering suspension of interest payments identical to
that put in place by Brazil if new money or conces-
sions are not forthcoming from creditors.
While debtor demands are not new-they always
have asked for more than they have eventually been
willing to settle for in negotiations with their credi-
tors-we detect a markedly increased toughness and
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arrogance in their present stances. In our judgment,
these harder, more forcefully stated positions are not
just negotiation ploys; rather, they represent a grow-
ing general perception among debtors that it is time
for developed country governments and banks to bear
more of the burden of the debt. We believe debtors
are becoming especially unwilling to let reserves be
depleted again to the rockbottom levels of 1982-83-
Brazil, in our view, is already at its minimum accept-
able level of $1.5 billion-or to place their people
under a new round of further austerity.
Even if the current problems with Brazil are resolved,
we do not see debtors' negotiating toughness ebbing.
Indeed, each additional bailout of a key debtor by
creditor banks and governments will be viewed by
debtors-not just the one affected but all others as
well-as affirmation of their attitudes. In turn, we
believe the debtors will perceive that they can contin-
ue to postpone their day of reckoning with the blessing
of their creditors. In such a case, we see debtor
attitudes hardening further in the future, making it
more difficult to reach agreements on debt.
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