EVOLVING LDC DEBT CRISIS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP87T00315R000200300007-8
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 20
• Document Creation Date: December 20, 2016
• Document Release Date: March 7, 2008
• Sequence Number: 7
• Publication Date: July 1, 1983
• Content Type: REPORT

r atiu111U
Intelligence
Council
Evolving LDC Debt Crisis
National Intelligence Council
Memorandum
Confidential
NIC M 83-10012 li~
July 1983
Copy 3 7 3
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National
Intelligence
Council
Evolving LDC Debt Crisis
National Intelligence Council
Memorandum
This Memorandum was coordinated within the
National Intelligence Council and with the
Directorate of Intelligence. Comments are welcome
Analytic Group, National Intelligence
Council
and should be addressed to the
Confidential
NIC M 83-10012
July 1983
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The Evolving Process
1
Debtors and Lenders Clash Over Division of the Adjustment Burden
2
Financial Confidence Begins To Be Reestablished and LDC
Economic Recovery Starts
3
Manageable Foreign Financial Positions Are Restored
6
The Timing of the Process
8
Political-Economic Ramifications of a Prolonged Phase II
11
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Evolving LDC Debt Crisis
Scope Note Many observers believe the debt crisis in less developed countries (LDCs)
will persist for many more years. This Memorandum, however, argues that
strong market forces are accelerating the corrective process and thus
greatly deepening the painful consequences over the next six months to a
year.
In the midst of each global economic crisis in the past 10 years, a broad
spectrum of observers predicted that the problems and their devastating
impact would be virtually permanent. For example, many journalists,
politicians, and economists forecasted that the 1973 shortages of food and
industrial raw materials would be long lasting, the dollar would continue to
sag for the foreseeable future (1978), and, most notably, the price of oil
would rise sharply for decades (1973-74, 1979-80). Although these dire
warnings played a useful role in galvanizing the public support needed to
cope with the emergency, they tended to obfuscate analysis of the powerful
and painful reactive pressures that were forcing a correction of the original
problem. This misdiagnosis in part was caused by the lack of experience in
dealing with the particular crisis at hand-nearly all crises arise from a
unique set of circumstances-and by the absence of data indicating that
changes were under way until long after the fact.
There now is developing a similar environment of misunderstanding about
the market forces at work in regard to the LDC debt crisis. As such, this
paper steps back and looks at the unfolding process forced by the debt cri-
sis, paying special attention to the role of short-term capital movements
and their policy implications. This discussion relates only to key LDCs in
serious financial trouble because of sizable commercial debts-Argentina,
Brazil, Chile, Mexico, and Venezuela. A large number of less advanced
LDCs, such as Bolivia, Ghana and Zaire, face severe financial straits, but
their difficulties reflect mainly economic mismanagement or political
turmoil rather than debt-related problems. Moreover, the effort concen-
trates on the shorter term aspects of the evolving crisis and therefore
excludes the medium and longer term political and economic influences.
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Evolving LDC Debt Crisis
Key Judgments The debt crisis in less developed countries has triggered a corrective and
painful process that now is moving faster than most observers had
expected. Most notably, the strong market reaction to the inability of key
LDCs to meet their foreign financial obligations has led to a dramatic and
unprecedented decline in imports of the five key debt-laden LDCs'-from
35 percent to 75 percent from their 1980 or 1981 peaks. In fact, imports
dropped much more suddenly and deeper than planned under government
import restraint programs mainly because of a substantial loss of short-
term capital, especially trade credits. As a result, there have been serious
disruptions in domestic economic activities in these five countries and a
considerable reduction in living standards.
The sharp decline in imports and falloff in economic activity has set the
stage for the key LDCs to achieve a "v" shape rather than gradual "u"
shape adjustment to the debt crisis:
? Their current account position already has improved to the point where,
with normal direct investment and trade credit flows, they would need lit-
tle or no net new loans from commercial banks.
? They could reach a payments position by 1984 that does not unduly
constrain economic growth. Their exports are likely to expand through
the remainder of 1983 and gain momentum in 1984 reflecting the
industrial-country recovery. This should allow imports to grow at near
the same pace as exports, thus maintaining a solid current account
position.
? Although the momentum of the domestic recovery may not bring the
economy back to its earlier peak level for many months, it would help re-
inforce'confidence in the country's economic abilities and heighten
expectations about future gains.
? Once confidence in the foreign financial condition of these LDCs begins
to build, foreign direct investment and supplier credit flows should move
toward a normal level, giving a one-time boost to the financial recovery
process.
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? The timing of the recovery is likely to vary among the five key LDCs,
with Mexico now having the best chance for rebounding the soonest and
fastest.
This favorable prognosis would obviously be adversely affected in all LDCs
in the unlikely event that another industrial-country recession occurs
during the adjustment period. The process could also be sidetracked in
individual LDCs if any one of them had to cope with a prolonged domestic
political upheaval.
A much more likely situation that could cause a painful, but temporary,
delay in the adjustment process would be a greatly increased liquidity
problem sparked by a worsening of creditor confidence. At the present
time, current account gains are being offset by a continuing short-term
capital drain (although at a lower rate than took place just after the debt
crisis began in August 1982). Creditors still fear that any new short-term
trade credits would not be repaid, and foreign and domestic investors
continue to feel safer with more funds outside the key LDCs. This lack of
confidence persists in part because of worries that political upheavals might
be ignited by the current widespread economic austerity. Whatever the
cause of the short-term capital drain, the resulting liquidity problems
would lead to a further reduction in LDC imports (and a corresponding
slide in industrial-country exports) and to increased austerity. This influ-
ence in turn would have an adverse impact on already-depressed domestic
investment. Although the additional economic hardships cannot be trans-
lated into political consequences with any degree of certainty, it seems that,
at a minumum, the result would be heightened nationalism with anti-First
World overtones and, at a maximum, new regimes taking actions, such as
an indeterminate debt moratorium, that could seriously hurt US interests.
Thus, a key policy problem facing industrial-country officials in the next
six months or so will be how to provide sufficient liquidity to ensure that
the ongoing adjustment process continues as smoothly as possible. Several
possible options exist, such as a substantial increase in trade credits
guaranteed by industrial countries and the establishment of a "safety"
fund large enough to convince creditors that a particular LDC will have
sufficient foreign exchange to meet its foreign exchange obligations. Each
of these schemes has drawbacks in terms of its financial costs and of the
possibility that the additional money would go to bailing out those with as-
sets tied up in the LDCs rather than helping the LDCs with their liquidity
crisis.
Confidential viii
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Evolving LDC Debt Crisis
As part of the normal economic development process,
less developed countries (LDCs) are constantly coping
with foreign debt-related problems. Although these
difficulties always become more severe when the
global economy falters, this time a confluence of
unusual and unexpected circumstances created a debt
crisis. There was an oil price jolt, a sudden and
substantial increase in real interest rates, a longer and
deeper industrial-country recession than expected,
and an unforeseen shift in the oil price outlook, from
steadily increasing to'declining or stagnating.
When oil-importing LDCs faced soaring oil prices in
1973-74, they were able to ride out the difficulties by
borrowing huge sums, in large part because interest
rates remained below inflation rates. These negative
real interest rates provided a large transfer of income
from the savers-mainly OPEC members and those
in the industrial world-to the borrowers. The result
was that the LDC debt-servicing burden never be-
came particularly onerous. In contrast, when oil prices
tripled in 1979-80, these same LDCs had to borrow at
interest rates that far exceeded even the high pace of
inflation. As a consequence, while the burden of
repaying principal (as measured against exports of
goods and services) did not increase to any great
extent as borrowing climbed, interest payments did.
The post-1979 interest rate burden turned out to be
double that of the 1970s. The key oil-importing LDCs
reacted to the growing financial bind by cutting
imports and taking other measures to conserve foreign
exchange. In fact, they acted more swiftly and deci-
sively than they did in the aftermath of the 1973-74
oil price rise. These key countries might even have
avoided severe debt problems if the global recession
had not turned out to be so long and deep.
The oil-exporting countries also faced higher real
interest rates on their burgeoning debts. In addition,
they were caught by surprise when oil prices declined.
Governments in many oil-exporting nations quickly
found they could no longer afford the rapidly growing
economic development outlays they had planned
based on rising oil prices. In 1981 and 1982, both oil-
exporting and oil-importing LDCs were forced to
borrow large sums on a short-term basis just to
maintain economic growth at a reduced pace and to
service their foreign debt. With a global economic
recovery not yet in sight, and the loss of confidence
arising from the earlier Polish and Argentine serious
debt problems, the growing reliance on short-term
debt could not continue for long, and the stage was set
for the debt crisis.
Mexico's failure in August 1982 to meet its foreign
debt obligations triggered a crisis that had been
building for months. At the same time, the jolt greatly
accelerated the adjustment process that allows the key
LDCs to achieve again a foreign financial position
that does not unduly restrain economic growth. That
process is likely to move through four stages:
? Initial shock.
? Debtors and lenders clash over the division of the
adjustment burden.
? Financial confidence begins to be reestablished and
LDC economic recovery starts.
? Manageable foreign financial positions are restored.
These stages will overlap considerably. Their timing
will vary among countries and will depend heavily on
the pace of economic recovery in the industrial world.
The Initial Shock
Most experts have long believed that a major financial
disruption in either Mexico or Brazil, with their huge
debts, would severely strain the international financial
system and have adverse economic consequences for
both LDCs and industrial countries. They were cor-
rect. The Mexican problem spread rapidly to other
debt-laden LDCs as commercial lenders sharply re-
duced medium-term lending, refused to extend short-
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term credits, and drew down deposits they held in
LDC banks. Those with assets in the affected LDCs
tried to move as much capital as possible to safehaven
countries. The errors and omissions account of the US
balance of payments provides a good indicator of
these large short-term outflows. It showed an unprec-
edented $12 billion inflow from Latin American
countries in the third quarter of 1982. Meanwhile, the
foreign exchange shortages in the affected LDCs
forced a sharp cutback in imports and a subsequent
decline in domestic economic activity.
A global financial panic was averted mainly as a
result of the quick action of the United States and
other industrial countries to shore up the foreign
positions of Mexico and several other key LDC
debtors. These emergency steps helped sustain confi-
dence in the ability of the international financial
system to withstand shocks. Although the internation-
al financial "safety net" was in some jeopardy, most
market participants apparently continued to believe
that the industrial countries would take whatever
steps were necessary to avoid a disastrous unraveling
of the international financial system. The falling US
interest rates at the time also provided some glimmer
of hope for the future.
During phase I a number of changes took place that
helped make the problem more manageable for the
future:
? Industrial-country leaders became acutely aware of
the impact of the LDC debt plight on their own
well-being-reduced exports, financial chaos, and,
for the United States, increased migration from
Mexico.
? They learned that a crucial aspect of handling the
world debt crisis is cooperation among the govern-
ments of the industrial world and LDCs, commer-
cial banks, and the IMF.
? Borrowing nations have for the most part accepted
the fact that under any circumstances they face a
period of austerity; thus, the best they can do is to
minimize the pain by negotiating debt settlements
with lenders, which provide some increased foreign
funds.
Table 1
Key LDCs: Imports (c.i.f.)
Billion Dollars at Annual Rates
Percent
Decline
Record
Level
Expected
Low Point
Argentina
10.5
(1980)
4.8 (1982 III)
54
Brazil
25.0
(1980)
16.0 (1983 II)
36
Chile
6.4
(1981)
2.4(19831)
62
Mexico
24.1
(1981).
6.0(19831)
75
Venezuela
13.1
(1981)
6.7 (1983 II)
49
? Imports by the debt-restrained LDCs fell dramati-
cally-from some 35 percent to 75 percent from
record highs set in 1980-81. (See table 1 and inset.) In
contrast, countries coping with serious foreign finan-
cial difficulties in the previous 25 years typically
faced a 20- to 30-percent decline in imports.
The initial emergency phase can be considered to have
ended at the close of 1982 or early 1983 when most key
LDCs signed debt-relief agreements with the IMF.
Debtors and Lenders Clash Over Division of the
Adjustment Burden
In the current phase, both debtor and lending nations
are dealing with the grueling task of dividing up the po-
litical and economic costs of overcoming the financial
difficulties. Major Latin American LDCs are now
walking a tightrope between the need to impose more
austerity and the political unrest too much austerity
will cause. Banks remain highly vulnerable to reduced
profits and possible losses over this period. Each side is
trying to shift the burdens involved to the other, and
both are applying pressure on the industrial-country
governments and the IMF to provide more relief.
Negotiations will be arduous and seemingly endless.
During this process, most LDCs will become politically
unable or unwilling to meet the financial and
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economic goals agreed to in IMF rescue packages,
and new targets will have to be negotiated-perhaps
several times.
Despite these highly publicized difficulties, dramatic
improvements in the fundamental foreign financial
position of key LDCs have taken place and further
gains are expected. The initial financial shock cut
imports sharply and stretched out the debt-service
burden significantly. The recently agreed-to IMF
adjustment programs are helping sustain these large
gains and are providing some additional foreign funds.
Further relief from the scheduled debt-payment bur-
den facing LDCs seems likely as a result of ongoing
negotiations to seek a repayment schedule that "rea-
sonably" accommodates the needs of both lender and
borrower. Moreover, key LDC exports have begun to
rebound (or at least bottom out) as a result of the
economic recovery in the industrial world and of
exchange rate changes that are making LDC goods
and services more price competitive. Because LDC
export revival tends to lag industrial-world economic
recovery, it will take up to another year before rapid
export gains can be expected. An exception is Mexico,
which already has boosted foreign exchange earnings
significantly as a result of expanded tourism and
border sales.
In fact, the current account positions of the key LDCs
have improved to the point where, with normal direct
investment and trade credit flows, they would need
little or no net new bank borrowing. Argentina, Chile,
Mexico, and Venezuela have current account posi-
tions ranging from a small deficit to a surplus. If they
now were receiving a normal inflow (or even no
outflow) of direct investment and trade credits, they
would not need to borrow any net new funds from
banks. Similarly, Brazil, which now has a current
account deficit half that of 1982, would have to
increase its outstanding debt by only 5 percent.
Under phase II conditions, however, the capital flows
are not normal. Indeed, the significant current ac-
count improvements are being offset or exceeded by a
continuing short-term capital drain. These outflows
may even be exceeding new loans that are being
provided by banks on an involuntary basis-through
arrearages and IMF funding packages. Financial
markets remain nervous especially with austerity-
related political tensions expected to remain high
within LDCs for many months. Because of the con-
tinuing austerity, the chances have increased that an
LDC might take unilateral action to reduce its debt
burden. In addition, the leverage that banks have over
LDCs has decreased with the reduced LDC need for
new loans. It will take many months of LDC financial
and political stability to renew confidence in the
financial future of these countries. Until then, short-
term capital outflows could still overwhelm the funda-
mental gains, thereby creating a new. financial
crunch, reducing imports further, and postponing the
day when lender confidence is restored.
Financial Confidence Begins To Be Reestablished and
LDC Economic Recovery Starts
During this period, which could start in late 1983 at
the earliest, the LDC current account position would
continue to be sound (or improve somewhat), export
growth would gain momentum, the short-term capital
drain would end, and creditor confidence would begin
to revive. Although key LDCs would still face consid-
erable financial constraints, creditors would see that
these countries are at or near the point that they could
meet their rescheduled debt obligations. Faith in the
long-term economic potential of these countries would
surface once again. As a result of this increasingly
favorable environment, lenders would be inclined to
voluntarily refinance or roll over existing debts as
they come due and would cautiously extend new
loans.
The current account gains achieved in phases I and II
would remain intact as rising exports would permit
imports to begin to move up from their low point. In
some cases, such as Brazil, imports would probably
rise somewhat slower than exports to allow for suffi-
cient funds to repay emergency loans and to rebuild
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The timing of the decline in imports and domes-
tic economic activity in each of the five key
countries has varied considerably:
Argentina was the first to run into serious
problems. Mainly because of increased govern-
ment budget deficits, Buenos Aires had to cope
with mounting payments problems in late 1980.
The result was a sharp decline in imports (see
figure) which was immediately followed by a
drop in economic activity. An austerity program
initiated in late 1981 restored stability to Argen-
tine foreign exchange markets in early 1982, but
soon the Falklands conflict weakened the coun-
try's external accounts as a result of faltering
exports, capital flight, and the cessation of new
lending. By midyear Argentina's real GNP had
fallen some 15 percent and industrial production
about one-third from the 1980 level. Recovery in
both output and imports began in the second half
of 1982 although it was held in check by a short-
term capital drain caused by domestic political
uncertainties and the global debt crisis.
Chile's economic and import plunge began in
late 1981, sparked mainly by faltering exports
and a highly overvalued currency. Austerity
measures soon introduced added to the econom-
ic woes, and the worsening international climate
caused a further sharp falloff in imports and
economic activity in the second half of 1982. By
early 1983 the country's economy seemed to
have bottomed out with GNP some 15 percent
and industrial production more than 40 percent
below the level of the first half of 1981. Unem-
ployment meanwhile more than doubled, to
more than 25 percent.
Mexico has had to cope with the sharpest and
most concentrated fall in imports and economic
activity so far. The government initiated import
controls in late 1981 and devaluated the peso in
February 1982. These moves began to take hold
in the first half of 1982. But, because of increas-
ing government outlays, the domestic economy
was still growing, although industrial produc-
tion was stagnating. Then, during the six months
following the August 1982 crisis, both imports
and output fell off dramatically. Industrial ac-
tivity fell some 20 percent, while construction
plunged 75 percent. Unemployment doubled,
reaching the 20- to 30 percent range. Much of
the decline reflected the sudden and sharp de-
cline in imports, which was greatly exacerbated
by an 80 percent decline in the official value of
the peso since early 1982 and by the need to
impose foreign exchange controls for the first
time in modern history. Until an exchange con-
trol bureaucracy could be put in place, import
delays mounted. The nadir of import levels'and
economic activity was probably reached in the
spring of 1983.
Venezuela's foreign financial problems grew in
1982, reaching crisis proportions in early 1983.
Falling oil revenues, poor debt management, and
massive capital flight led to a mid-February
devaluation of the bolivar and to the imposition
of exchange controls for the first time in 20
years. Imports plummeted in the first half of
1983, and economic activity most likely fell
considerably, although quantitative data is not
yet available.
Brazil's external and domestic economic trends
have differed markedly from the other five key
LDCs. Its imports and domestic activity de-
clined much more gradually and over a longer
period. Brazil implemented austerity measures
in late 1980, and soon thereafter both indicators
began to decline. Between then and late 1982,
real GNPjell some 5 percent. This comparative-
ly small decline reflects mainly the continuing
attempt of Brasilia to balance its foreign and
domestic problems by taking just enough auster-
ity measures to satiny foreign creditors. In the
wake of the Mexican crisis, conditions began to
deteriorate badly, resulting in a steeper decline
in imports and forcing Brazil to introduce
harsher austerity measures. Because of the pro-
longed discussions with the IMF and the result-
ing financial uncertainties, imports may have
dropped particularly sharply around midyear,
although we do not yet have any data.
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Key LDC Import Trends
I 11 111 IV 1 11 111 IV I 11 111 IV 1 11 1 11 ,,IV, II ,,IV, II III IV I II a
1980 1981 1982 1983a 1980 1981 1982 1983
a Estimate based on partner country trade
Chile
140
i i i I
i i i I
i i i I i
I i i i I i i i I i i i I i
I i i i I i i i I I I i I i
I 11111 IV 1
11111 IV 1
11111 IV 1 11
1 II 1IIIV 1 11 111 IV 1 111IIIV I 11a
I 11111 IV I II III IV 1 11 1111V I Ila
1980
1981
1982 1983a
1980 1981 1982 1983
1980 1981 1982 1983
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foreign exchange reserves. In Argentina, Mexico, and
Chile, imports might climb faster than exports be-
cause the decline in imports was so steep that the
current account improvements were unnecessarily
large. In addition, the key LDCs probably would need
less of an increase in imports to feed their economic
expansion than had been the case before the debt
crisis. During the first two phases of the crisis, LDCs
probably increased their self-sufficiency as producers
and consumers, out of necessity, turned to domestic
sources of supply.
At the same time, the key debt-laden LDCs would
begin to show signs of economic recovery. Although
the initial growth would be boosted mainly by in-
creased exports to the industrial world, a number of
domestic factors also would play a role. Domestic
producers would find ways to operate more effectively
under financial constraints, and governments would
have relaxed and simplified the controls they imposed
after the initial crisis. In addition, the sharp decline in
economic activity in 1982 to 1983 would have sowed
the seeds of economic recovery. Consumers, having
postponed purchases, would have a pent-up demand.
Firms, having pruned their costs of business, would be
in a better position to compete. One sign of future
confidence that already has emerged in Mexico and
Brazil is the rebounding of the local stock market.
Although the momentum of this recovery may not
bring back the economy to its earlier peak level for
many months, it would help reinforce confidence in
the country's economic abilities and heighten expecta-
tions about future gains. Similarly, the LDC's infla-
tion rate would probably decline, although it would
still remain high, mainly because of the continuing
impact of the country's currency devaluations. These
improving economic trends would help relieve social
tensions.
Manageable Foreign Financial Positions Are Restored
As a result of constant improvements in their funda-
mental financial position and restoration of lender
confidence, key LDCs could reach the point in 1984
or 1985 at which their foreign financial position would
no longer severely bind economic expansion. A major
factor in this improved financial condition would be
the one-time large boost provided by a reversion of
short-term flows to a normal pattern. A precrisis
atmosphere would return whereby foreign financial
constraints would again become a normal aspect of
economic policymaking. In essence, these countries
would have grown into their debt levels and structure
and would be in a good position to gradually increase
their debt level. Although scheduled debt repayments
are likely to be particularly high in the mid-1980s,
that situation is unlikely to force a new loan crisis
under phase IV conditions. Experience during the
1970s indicates that bankers are inclined to resched-
ule loan payments to overcome such "bunching" when
the financial climate is favorable. Creditors would see
expanding opportunities to provide profitable and
reasonably risk-free loans because of rising LDC
foreign exchange earnings. In fact, the "spreads"
(difference between the cost of money and the amount
charged) that banks are able to obtain from LDCs
would probably fall more slowly than the risks as-
sumed, making the loans exceedingly profitable.
The highly unusual circumstances that led to a 20- to
40-percent annual rise in outstanding loans between
1979 and 1981-soaring oil prices and the large jump
in interest rates-are unlikely to be repeated. In the
absence of such problems, an increase of 5 percent a
year or so in the real level of loans would probably be
adequate to foster the economic expansion of key
LDCs. This last phase of the credit crunch cycle is
likely to end with little fanfare. As with most fading
problems, little attention will be paid to them.
The Importance of Short-Term Capital Flows
Shifts in short-term capital flows have been a major-
factor in forcing the sharp import decline and thereby
accelerating the adjustment process. Because they are
highly sensitive to changes in confidence in a coun-
try's foreign financial position, these volatile flows
have acted to greatly exaggerate the adjustment
process, pushing it beyond what probably took place
under LDC government programs aimed at pruning
imports directly by import and foreign exchange
controls, and indirectly through currency devaluations
and cuts in budget outlays and real wages. When
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confidence is waning, the shift in short-term capital
movements influences imports directly by reducing
new trade credits and indirectly by curtailing the
amount of foreign exchange available to buy foreign
goods and services. In both cases, the most damage to
the country's import capabilities occurs in the early
months of the crisis, although the short-term capital
drain is likely to continue well into phase II at a much
reduced rate. Once financial confidence in the trou-
bled LDC begins to be restored in phase III, the
inflow is likely to turn positive, and this favorable
shift will be an important element in improving the
foreign financial position of the key LDCs.
Although the powerful influence of short-term capital
flows is recognized by most experts, it is given little
attention. Most economists tend to look at the medi-
um-term adjustment process and use annual data that
do not capture the significance of short-term capital
flows. In.large measure, this concentration on the
medium-term changes reflects the paucity of short-
term capital data. They are virtually nonexistent
during the crisis period, and data that do become
available after the fact are meager. Perhaps the best
way of understanding the nature and magnitude of
these large shifts in short-term capital flows is to look
at the groups that, out of the natural instinct to
protect themselves from possible financial losses, are
creating the flows.
Commercial banks want to reduce their exposure in
the troubled country. They have done so primarily by
cutting back on the short-term credit lines, by not
renewing credits once paid, and by drawing down any
deposits they may have with banks of the troubled
nation. In Argentina and Mexico, outstanding short-
term credits provided by foreign commercial banks
dropped some 10 to 20 percent in 1982. In Brazil and
Venezuela, the data available through the end of 1982
show little change in the outstanding amount of short-
term bank credits, but that probably changed as the
financial troubles of these countries mounted in 1983.
More recently, because of the growing possibility of a
Brazilian debt moratorium and the likelihood that
such a move would result in short-term debts being
rolled up into a medium-term repayment schedule,
foreign creditors are curtailing such credits. Brazil
has been partially offsetting such losses by delaying
payments on outstanding credits. For countries with
fairly large regional trade, such as Brazil, however,
their short-term capital position has been adversely
affected by delayed payments from countries that also
are strapped financially.
Even if more data were available on short-term bank
debts that are outstanding, the numbers could not
adequately portray the impact short-term flows are
having on imports. They essentially reflect how much
the banks are able to reduce their short-term exposure
to the troubled country on previous loans. In most
cases declines in these outstanding amounts are being
limited by LDC central bank actions aimed at avoid-
ing further losses of foreign exchange. The missing
statistic is the cutback in new loans. Such reductions
are forcing the key LDCs to pay cash for their foreign
purchases. The major impact of this sudden shrinkage
in new import credits is felt in the first three to six
months of the country's financial crisis with the
timing depending on the average length of normal
credits.
Foreign bank withdrawals of deposits from LDC
banks have mainly affected Brazil. In that country,
deposits were reduced by some $4 billion between
mid-1982 and mid-1983. Although theoretically the
outflow could continue until all these funds are
withdrawn, an agreement between the IMF, the
Brazilian Government, and commercial banks seems
to have slowed the drain. As of July 1983 there was
still $6 billion. deposited with Brazilian banks.
Suppliers of goods and services want to ensure they
are paid for new sales. Foreign exporters have sharply
reduced the 90- to 120-day short-term loans and open
account credits they normally provide Latin Ameri-
can countries, thereby forcing the importer to pay via
a confirmed letter of credit or to pay cash. The
reduction in these nonbank credits probably had a
larger impact on restraining imports than did the
reduction in-short-term bank loans. US Commerce
Department surveys indicate that more than half of
the US goods sold to Latin American countries
involve (nonbank) suppliers credits. In Mexico and
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Venezuela that percentage probably was even higher
because the free movement of foreign exchange in and
out of these countries (until recently) had greatly
facilitated direct commercial relations between sup-
pliers and buyers. As with short-term bank credits,
although the data are limited,' the drying up of new
supplier credits probably had its major impact on
imports in the first six months of the crisis. For
example, between August 1982 and early 1983, Mexi-
co probably lost some $5 billion in new supplier
credits. In Venezuela, according to the US Embassy,
after the early 1983 financial crisis, low-credit-risk
companies that used to make 90 percent of their
foreign purchases on open accounts and 10 percent on
confirmed letters of credit have seen these percent-
ages reversed.
Multinational companies and other foreign investors
want to avoid having their assets in the LDC frozen or
even nationalized, want to maintain the flow of
props, and want to prevent financial losses incurred
by holding a rapidly depreciating local currency.
They have done so by cutting foreign exchange loans
provided their subsidiaries and by not shipping goods
to their subsidiaries unless they pay in dollars or in
other convertible currencies. In the same vein, multi-
national firms have stopped providing guarantees on
bank loans made to their subsidiaries. Sometimes,
however, the foreign investor has decided that, to keep
its subsidiary in business, it has to supply needed
goods on credit. These companies also have sharply
cut back on using foreign funds to provide equity
financing. Any new investments being made are from
retained earnings in the country or are based on local
currency loans. Finally, investors are trying to accel-
erate the outflow of profits earned by their local
subsidiary. All these moves force the subsidiary to
turn to the country's central bank for its foreign
exchange needs and to the local market for a higher
portion of goods and services used in its operations.
' A US Government series that partially covers suppliers credits
(commercial claims of US nonbanks) shows the amount outstanding
to the five key LDCs declined more than 40 percent between the
end of 1981 and end of 1982.
Residents of the LDC want to ensure that they have
sufficient assets abroad in case the economic troubles
at home seriously hurt their financial position or in
case they want to leave the country because of politi-
cal reasons. Individuals and companies have moved
funds out through currency black markets that always
develop when international currency transactions are
not freely permitted by a country. In addition, firms
resident in LDCs (local or foreign) have increased
their foreign exchange holdings abroad by underin-
voicing the value of their exports and overinvoicing
their imports. In the case of multinational firms and
individuals, no data exist on short-term capital flows.
Most of these movements show up in residual catego-
ries of the balance of payments such as errors and
omissions and short-term capital flows, not elsewhere
classified. It usually takes a year or so after the fact
before data are available even in the case of these
ambiguous categories.
The Timing of the Process
With their current account position now reasonably
sound, the speed at which the key LDCs reach phase
IV will depend heavily on their ability to avoid
circumstances that upset the restoring of financial
confidence (assuming the industrial-country recovery
is sustained). That ability centers on the difficult task
of containing domestic political tensions that are
resulting from economic dislocations, rising unem-
ployment, and a reduced standard of living. If all goes
reasonably well, these key LDCs could achieve a
manageable foreign payments position by 1984. If the
path is particularly rocky the agony could last into
1985.
No matter how difficult, the movement toward phase
IV is likely to be sustained because of the market
pressures described above, the common interest of
both lending and borrowing countries in securing such
a result, and the demonstrated ability of all parties
involved and the international financial system to
cope with debt-related problems. Industrial countries,
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Table 2
US Exports to Select LDCs
the necessary corrective steps to maintain a positive
foreign exchange position, when they did hesitate, a
rapidly deteriorating foreign payments position forced
them to take remedial action.
The major commercial banks believe they can continue
to profit handsomely from a prudent expansion of their
1982 1983 LDC lending. Explicitly or implicitly, many commer-
682 412 cial bank officials see the risks involved in lending to
1,450 958 LDCs as low as or lower than domestic loans, because
Chile 382 269 they believe that central banks would not stand by and
Mexico 5,993 3,593 allow major commercial banks to fail and the interna-
Venezuela 2,103 1,150 tional financial system to be disrupted by a default by
Total 10,610 6,382 one or more major LDCs.
South Korea 2,118 2,288
Taiwan 1,820 1,683 Despite these strengths, there are a number of factors
Hong Kong 1,016 1,052 that could undermine the rebuilding of confidence in
Total 4,954 5,123 the financial capabilities of the key LDCs and thereby
All countries 92,925 83,022 prolong the corrective process and make it more
and especially the United States, have a major stake in
promoting healthy economies in the five Latin Ameri-
can LDCs in order to avoid political upheavals there
and to provide growth markets for exports. US exports
alone dropped more than $4 billion in the first five
months of 1983 as a result of reduced imports by the
five major debt-laden Latin American countries. (See
table 2.) The major commercial banks want to protect
their sizable assets in LDCs and would like the LDCs
to remain as major profit centers. The key LDCs want
to stay creditworthy to ensure a continuing flow of new
loans and to avoid a legal default, which their leaders
now believe would produce even greater hardships than
at present.
The key LDCs have demonstrated an economic vitality
for two decades and have amassed considerable
experience in handling political-economic difficulties,
a factor that stands them in good stead for coping with
present problems. Their domestic political stability has
been greatly strengthened by a rising middle class that
has a vital stake in avoiding political upheavals. For the
most part, the elite of these countries understand the
benefits of close economic links with the industrial
world and the need to sustain the growth of foreign
exchange earnings. Although key LDC governments
often have voluntarily taken
painful. For example, the deepening austerity and
resulting political discontent within LDCs are likely to
make the leaders of some key LDCs take a more
nationalistic stance. As a result, these leaders might
oppose further IMF constraints or do little to meet the
already agreed-to targets. The IMF, meanwhile,
probably would not want to relax the economic and
financial constraints placed on the reluctant LDC
because other countries would demand similar treat-
ment. Although some compromise is likely to be
reached between the LDC and the IMF, the reestab-
lishment of financial confidence could be delayed
several months. The uncertainty during that time
would further hurt the economy of the LDC. Imports
would have to be cut again because the short-term
capital drain caused by the fears of lenders would
reduce the foreign exchange available for imports. A
similar circumstance could occur even if there is no
dispute between the LDC government and the IMF.
Incessant political dissension in an LDC, for example,
would make the international financial community
apprehensive as to the ability of the nation's leaders to
maintain their grip on power.
Although confidence-shaking events present a signifi-
cant risk in all five key LDCs, Mexico has the best
chance of moving the fastest toward phase IV. It has
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digested a highly concentrated dose of, austerity and
economic disruptions in a relatively short period and
is now ready to rebound. By year's end Mexico could
have a manageable foreign payments position, a rea-
sonable rate of economic recovery, and, most impor-
tant, a return of confidence in the country's economic
and financial future on the part of both Mexicans and
foreigners. These factors, in themselves, would help
contain political dissension. From a financial point of
view, Argentina and Chile are poised to achieve
manageable foreign payments positions within a year.
Both, however, face a significant risk of political
upheavals. Venezuela may soon begin the recovery
process and probably has less chance of political
upheavals than either Argentina or Chile. It, however,
will go through a period of political uncertainties until
a new or reelected president takes office in March
1984. To add to the factors that could undermine
confidence, the incumbent President, Luis Herrera, is
reluctant to accept an IMF adjustment program.
Brazil probably faces the most significant political
and economic uncertainties that could delay the resto-
ration of foreign financial confidence. Several more
months of sharply reduced imports and declining
economic activity seem likely. This prolonging of
Brazil's long-suffering economy could be particularly
unsettling. Moreover, domestic political tensions are
likely to build with the move toward democracy and
the absence of President Figueiredo for health
reasons.
If the process of resolving the debt crisis during phase
II is prolonged, it might follow the pattern described
below:
? Key LDCs declare an indeterminate moratorium on
debt-service payments (both principal and interest).
? Industrial-country governments (supported by com-
mercial banks) respond by providing emergency
funds to LDCs designed to promote political stabil-
ity and arrest the fall in imports. The aid also is
intended as a quid pro quo for LDC governments to
begin debt negotiations and, hopefully, to resume
paying some debt obligations.
? After several months of negotiations, new austerity/
debt-relief accords are reached. Although the ac-
cords are likely to be tailored to meet the special
circumstances of each LDC, the chances will in-
crease that one of many comprehensive internation-
al debt-relief schemes surfacing in recent months
would be put in place. Most of these proposals
involve creating a new international arrangement
that would stretch out debt-service payments and
provide a guarantee that the bulk of the currently
outstanding debt would be repaid eventually.
? After new agreements are reached, it might take
another six months to restore sufficient confidence
in LDC financial capabilities to end phase II. The
lower import level and stretched-out debt resulting
from the new crisis would improve LDC financial
fundamentals and thus help reduce the time until
confidence is restored. Whether an international
refinancing scheme would help shorten phase II or
prove counterproductive depends on how the com-
mercial banks view the accord. If, for example,
bankers believe that the new arrangement provides
greater incentives to LDCs to seek future debt
relief, they would be less inclined to provide new
loans.
Besides an abridged industrial-world recovery, the
adjustment process could be sidetracked if one (or
more) of the key LDCs repudiates its debt or, more
likely, declares an indeterminate moratorium on debt
servicing. Such moves would quickly end the debt
problems of the LDCs taking the action but would
cause serious economic and financial problems for
both developed and less developed countries. Such
possibilities could be triggered by the following
circumstances:
? Within the LDCs, as a result of austerity or other
domestic problems, political pressures could build to
a point where a country's leaders come to believe
their survivability is best served by a default and by
blaming outsiders for their country's plight.
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? Outside the LDCs, a relapse of the world economy
into another recession during the next two to three
years also could, as a result of reduced exports, force
domestic austerity that would be politically painful.
? In the same vein, the flow of new commercial bank
lending to key LDCs might be sharply curtailed as a
result of new laws or tightened financial regulations
in developed countries. Again, the result could be
that LDC austerity reaches a politically unpalatable
level.
Political-Economic Ramifications of a Prolonged
Phase II
Foreign financial setbacks that would lengthen phase
II would most certainly heighten economic pain.
During the past 18 months the five key LDCs have
faced the sharpest declines in real GNP in more than
30 years (the exception being Chile in 1975). Such
additional financial problems would probably arrest
the recoveries just becoming evident in Argentina,
Chile, and Mexico. They might even cause a renewed
downturn. The declining economic activity now in
train in Brazil and Venezuela would be sharply
deepened. As a consequence of the setback in foreign
confidence, the currencies of the key LDCs would
weaken, adding to an inflationary rate that already
has reached exceptionally high levels. The need to cut
imports again would further add to these inflationary
pressures. Living standards would decline, and, most
important, expectations as to improvements ahead
would dim.
While these economic hardships and the increased
pessimism cannot be translated into political conse-
quences with any degree of certainty, it seems that, at
a minimum, these impacts would lead to heightened
nationalism with anti-First World overtones and, at a
maximum, to new regimes that initiate strong populist
policies that hurt US interests and seriously undercut
the informal codes of international behavior that have
been important in avoiding global depressions since
World War II. So far, despite the unprecedented
economic distress faced by these LDCs, their govern-
ments have continued to play by these informal rules
of behavior. For example, no LDC has yet reneged on
its debt obligations for financial reasons, a fairly
common event prior to 1940. In large part, as men-
tioned earlier, this adherence to the rules represents a
sense among the leaders of the key LDCs that the
countries' self-interest is best served by working out
the problems with the developed countries and within
the framework of international institutions such as the
IMF.
The prolonged economic agony would probably lead,
at first, to a resurgence in deep-seated Latin Ameri-
can nationalism spurred on by organized labor and
leftist groups. These domestic pressures would make
the governments much less inclined to agree to new
austerity measures and to cooperate with the United
States on other issues. The legitimacy of the current
government regimes might even be questioned. While
regime changes cannot be predicted, clearly the risk
of such an event would increase significantly. If new
regimes come to power, they are likely to have a
strong nationalistic and populist bent. If the current
regimes survive, they might do so by being more
repressive at home, a factor that could make the
country more politically unstable in the medium term.
A more extensive treatment of these political conse-
quences will be presented in the forthcoming NIE
3-83: Medium-Term Repercussions of the Debt Prob-
lem in Key LDCs.
Some Policy Implications
? The debt crisis will be resolved in one fashion or
another and probably in a shorter period than
indicated by many observers. The real problem now
facing policymakers is how to make the corrective
process as painless and as short as possible.
? To keep the process from stalling, financial confi-
dence in the key LDCs must be restored and
maintained. To do so, it may require paying more
attention to ensuring that sufficient liquidity is
provided to the few "super" LDC borrowers. Al-
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though LDCs must also accept IMF-imposed cor-
rective goals in order to help rebuild lender confi-
dence, meeting these targets fully now is less
important than sustaining adequate liquidity. With
the political situation fragile, any new disturbance
could boost short-term capital outflows and prolong
the political and economic agony.
? Industrial-country governments would have to take
the lead in ensuring adequate liquidity for LDCs. A
number of schemes are possible; for example, devel-
oped countries could guarantee that the trade fi-
nancing provided LDCs is repaid or could establish
a large enough fund (perhaps $10 billion to $15
billion in the Brazilian case) to assure creditors and
others that the LDC would have sufficient foreign
exchange to meet its foreign obligations.
? Whatever the scheme, it would entail achieving a
delicate balance between sustaining sufficient lend-
er confidence to prevent a large short-term capital
outflow and avoiding the possibility that the finan-
cial "guarantee" would encourage even greater out-
flows. The "guarantee," especially at first, might
induce lenders to reduce their outstanding obliga-
tions and those with assets in LDCs to move them
abroad. Only when it became clear that sufficient
foreign exchange was available to meet the demands
of all would the drain be fully halted.
? The pace of industrial-country economic recovery
will continue to play a vital role in moving, as
rapidly as possible, toward phase IV-the last phase
in the debt-crisis process.
? From the viewpoint of the United States and other
industrial countries, their trade position with LDCs
is likely to continue to be poor and may even
deteriorate in some cases as LDC imports are held
in check and their exports grow.
? Some moves by industrial-country governments to
reshape the international financial system in or-
der to prevent similar future debt crises could be
harmful-for example, much tighter regulations
on foreign lending activities. The current crisis
stems from a unique set of circumstances that are
highly unlikely to be repeated. Such corrective
moves could hinder what now seems to be a
highly flexible and resilient international finan-
cial system.
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