The debt bomb’s short fuse

Lenny Glynn,Ian Austen May 21 1984

The debt bomb’s short fuse

Lenny Glynn,Ian Austen May 21 1984

The debt bomb’s short fuse


Lenny Glynn and Ian Austen

The guests at the closed-door conclave, held in the New York Federal Reserve Bank’s fortress-like headquarters last week, were a veritable Who’s Who of global finance: Jacques de Larosière, chief of the 146member International Monetary Fund (IMF), Paul Volcker, chairman of the U.S. Federal Reserve Board, as well as senior officials from the World Bank and the reclusive but vital Swiss-based Bank for International Settlements. And they were supported by a select cast of 20 of the world’s central bankers, including Bank of Canada governor Gerald Bouey. Their goal, according to the meeting’s host, Anthony Solomon, president of the New York Fed, was to seek “concrete and practical steps” to put the Third World’s continuing debt problems “on a sustainable basis.” Solomon tried to play down the importance of the three-day meetingcalling it an informal brainstorming session. But the $700 billion in debt now saddling developing nations is almost as urgent a problem for Western banks as it is for their impoverished clients. (In Latin America alone, Canada’s six largest banks have loaned a total of $18 billion.) Now, amid growing signs that

the current case-by-case method of dealing with recurring debt-repayment crises is inadequate, the world’s bankers are debating proposals aimed at offering long-term relief.

Even before the meeting adjourned last week, there was a troubling reminder of how difficult the search for a solution will be. For one thing, Chase Manhattan led the major U.S. commer-

Last week's U.S. interest rate increase was like a bomb dropping on the economies of developing nations

cial banks in increasing the prime lending rate—that charged to the best and largest customers—by one-half per cent to 12.5 per cent. It was the third rise in the U.S. prime rate in two months. Then the trend-setting Bank of Canada followed suit, raising its rate half a percentage point to 11.72 per cent, the highest level in nearly two years. Major banks in Britain also raised their rates, and analysts declared that interest rates could go much higher.

That was an unnerving development for debt-strapped developing nations, most of whose interest charges rise and fall with the world rates. Each percentage point rise in interest levies another $3.5 billion a year to the Third World’s borrowing costs. Argentine President Raúl Alfonsin compared last week’s U.S. interest-rate increase to dropping a bomb on developing nations—one that would leave their people alive but their productive capacity shattered. Said Alfonsin: “It is as though the world’s financial centres have gone crazy. We are not going to pay usury.”

Concern that an interest-rate increase will swell the debts of the underdeveloped nations to intolerable levels, and eventually threaten the international banking system as a whole, was clearly central to last week’s financial summit. The New York Fed issued only a terse seven-sentence communiqué on the meeting’s result (and Bouey declined to comment), but details of one key proposal—a limit or cap on the interest rates charged to developing nations—did become available.

The leaked proposal would split the interest payments due from Third World debtors into “real” and “inflationary” components. Under the plan,

debtor nations would immediately pay an interest rate comparable to those charged during preinflationary times. This so-called real interest rate could be calculated, for instance, by subtracting the U.S. rate of inflation from the current prime lending rate, resulting in real interest rates in the fourto six-percent range. The developing nations would then be allowed to automatically add the balance of their interest bill to the principal of their loans. In effect, the bankers would be extending them further loans to cover part of the nations’ current interest charges. For their part, banks would likely receive a bond or note for the deferred portion of the interest bill (and added debt) and they could treat that inflationary interest as if it were current income. The proposal would require some bending of U.S. bank regulatory practices and probably some form of guarantee by Western governments, or international agencies, of the notes issued for deferred interest.

Because it enjoys the support of New York Fed president Solomon, some form of the interest cap proposal may surface at this month’s meeting of the Paris-based Organization for Economic Co-operation and Development (OECD). It may be raised again in June, at the London economic summit of the seven leading industrial nations, including Canada. If that happens, last week’s New York conference may indicate, as Felix Rohatyn of the New York investment bank Lazard Frères put it, that “reality is finding its way to the top” of the global financial system.

The debt squeeze is most acute in

Latin America, where spontaneous lending by Western banks has virtually ceased. Caught in the worst economic slump since the 1930s, Latin American countries have already cut back wages, raised prices and dropped their total imports by roughly 40 per cent since 1981. Further belt-tightening may pose serious political risks. Riots last month in the Dominican Republic—which left 50 dead and 200 wounded—followed an IMF-sponsored austerity plan that drove up food prices dramatically. Said New York banking expert Albert Gailord Hart: “We and the IMF are making a mess of Latin American economies by requiring that they suppress needed imports. And they may make a mess of ours by bringing down some of our major banks if we do not stop.”

But preventing financial chaos may require even more dramatic measures than Solomon’s interest-rate-cap plan. As McGill University economist Kari Levitt commented last week, the capping proposal would only forestall defaults by further expanding the underdeveloped nations’ debts. At some point, Levitt said, “the developing nations’ politicians will simply figure that the social costs of these repayment programs are unbearable and unacceptable. And I think that time is coming fairly soon.”

Levitt added that there is merit in a proposal put forward by debtor nations that would tie their rate of repayment to their capacity to service debt through export earnings. But she warned that an “orderly writing off” of much of the debt, under which the banks will forgive many of the loans and call them losses,

would ultimately be required. Levitt suggested that a reorganized IMF—containing more of a voice for developing nations—might serve as the vehicle to review the debts. It could then select those with no hope of recovery for planned writeoffs. Levitt acknowledged that the plan would “force bankers to swallow very large losses” which taxpayers of Western industrial nations would probably have to cover to save the banking system. But the alternative-banks failing because individual debtor nations walked away from loans—would be even less appealing, she added. Said Levitt: “The possibility of loss of confidence in the banks and a breakdown of the banks because of ad hoc writeoffs is a nightmare.”

But any writeoff program—and the resulting support it would require from Western governments—would likely run into major roadblocks on two fronts. First, bankers dismiss the idea as unrealistic. Remarked Volcker: “I do not know of any grand or easy solution to this problem. The banks are not going to volunteer to take losses—that’s not their habit.” As well, many of the industrialized nations, especially Canada and the United States, have enormous deficits of their own. Adding to that total as a way of saving the banking system would almost certainly be politically unpopular. Said a senior official in Canada’s finance department, who declined to be named: “The banks are the ones that have the money at risk, the big stake, and they are the ones that must deal with the problem.” The department’s view, he added, was that the commitments undertaken by the major industrial nations at last year’s Williamsburg economic summit were the best hope for the global economy. They included controlling inflation while spurring economic recovery, cutting trade protectionism, and attempting to hold down interest rates. Still, Ottawa and probably other Western governments remain reluctant to try a fresh approach.

But many other economists agree with Levitt that the need for action is urgent. A study released this month by the Washington-based Brookings Institution rejects both debt restructuring and writeoff plans for Latin America. Rather, co-authors Richard Mattione and Thomas Enders (a former U.S. ambassador to Canada) said that the debtburdened nations will need greatly expanded trade with industrialized nations before they can recover. But the turnaround will be difficult—even with a surge in trade and stable interest rates. Declared Mattione: “It will be the end of the decade before Latin America sees the per capita income it saw in


With James Fleming.