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Annual Report 19B7 Federal Reserve Bank of Cleveland The Federal Reserve Bank cf Cleveland, its two branches in Cincin- nati and Pittsburgh, and its Regional Check Processing Center in Columbus serve the Fourth Federal Reserve District. The Fourth District includes Ohio, western Penn- sylvania, the northern panhandle cf West Virginia, and eastern Kentucky. two The President's Foreword five Developing-Country Debt twenty Comparative Financial Statements twenty-two Directors twenty-four q/Jicers The President's The past year was especially eventful inflation, the pace of inflation can for the world economy, for the remain relatively moderate if eco- Fourth District, and for the Federal nomic policy is appropriate. Reserve Bank of Cleveland. Events Foreword of the many economic devel- illustrated the sensitivity and resilience opments of 1987, the milestones we of financial markets and reminded us passed in the continuing evolution of of the importance of consistent eco- the developing-country debt situation nomic policy for the continuation of will have far-reaching implications. Since the onset of the develop- our economic prosperity. Financial markets were more unsettled last year than at any other ing-country debt problem in late 1982, the heavily indebted countries time during the current expansion. have undertaken a series of painful Stock prices experienced their largest economic adjustments that many one-day decline in history, and the hoped would enable debtors to fully U .S. dollar continued its record service their international debts. depreciation as market participants Despite these adjustments, the burden began to question the compatibility of debt for many developing countries of world economic policies and the has continued to grow in absolute intentions of policymakers. terms and relative to the debtors' capa- Despite the turmoil in financial city to service the debt. The ability markets and the uncertainty it cre- and willingness of many debtor coun- ated, the economic expansion con- tries to undertake further economic tinued last year and, at long last, adjustments has begun to erode. became firmly entrenched in the At year's end, we were not Fourth District. With the decline in much closer to achieving the resource the dollar, and following several years adjustments necessary to service the of restructuring, the manufacturing debt than was the case in 1982, when sector seems poised to recover and to the debt problem began to unfold. recapture its share of world markets. We anticipate sustained real Major U .S. creditors began to take actions in 1987 that reflected this economic growth in 1988, and we lack of progress. Banks added substan- believe that the trade sector will be an tially to reserves against developing- important source for that growth. country debt. Many increased reserves Narrowing the trade deficit will to levels consistent with the second- require many adjustments, most nota- ary market's assessment of the pros- bly a continued shift from consump- pect for full debt service. Although tion toward investment and exports. these adjustments have been difficult ultimately, this shift must be for banks, equity markets have re- quite large in order to reduce the warded the institutions that have deficit in our trade accounts. Although reserved relative to those that it carries with it the risk of accelerated have not. Achieving a long-term solution to the developing-country debt problem is important for world economic growth and for financial two Chairman of the Board Charles W Parry and President W Lee Hoskins stability. As recent developments goods markets. Debtors must con- suggest, a more market-oriented ap- tinue to pursue the regulatory and proach now seems to offer us greater structural changes in their economies hope of attaining that goal. Market that will attract foreign investments discipline of both creditors and debt- and that will encourage export-ori- ors seems likely to become the decid- ented growth. Viable growth and ing factor that will resolve these debt service require renewed access to difficult issues in the decade of the world capital markets. The essay in this year's annual nineties. Solutions are unlikely to come report discusses the evolution of our from bold new government financing developing-country debt problem, programs. Rather, governments need focusing on the important rela- to provide a regulatory environment tionship between real economic in which individual creditors and adjustment and the financial solutions debtors can adjust the terms, matu- adopted between creditors and rities, and principals of the debts, debtors. taking into account the debtor's abil- We show that a close corres- ity to make the necessary resource pondence exists between the net adjustments. transmission of financial capital and R esource adjustments must involve both creditors and debtors. Creditors must provide debtor countries with increased access to their three the net flows of goods and services, and we illustrate that, in an Independent State Bank of Ohio) and increasingly interdependent world, Richard D. Hannan (chairman of the the adjustment burden and the board and president of Mercury responsibilities for achieving it fall on Instruments, Inc.), both of whom both the debtor and the creditor have served since 1982. countries. In the process, we explore how private markets have assessed the We are also grateful for the contributions of Dr. Sherrill Cleland prospects for debt service and have (president of Marietta College) and reflected this assessment in their valua- Don Ross (owner of Dunreath Farm), tion of debt and of the banks that who have served on our Cincinnati own that debt. Board since 1982; and Charles L. Developing-country debt will Fuellgraf, Jr. (chief executive officer continue to be a major policy issue for of Fuellgraf Electric Company) and the banking system as a whole and James S. Pasman, Jr. (former vice the Federal Reserve System in particu- chairman of Aluminum Company lar. I am fortunate to be following of America), who have served on Karen Horn as this Bank's president. our Pittsburgh Board since 1985 In her five years as president, Mrs. and 1982, respectively. Horn made significant contributions Thomas H. O'Brien (president to the operations of the Bank, to the and chief executive officer of PNC smooth functioning of the Fourth Financial Corp) has resigned from our District financial community, and to Pittsburgh Board, and represents the monetary policy formulation. We Fourth District as a member of the deeply appreciate her efforts and Federal Advisory Council, replacing achievements. Julien McCall (retired chairman and The Federal Reserve Bank of chief executive officer of National Cleveland is guided in its efforts by City Corporation). The valuable con- our directors, to whom we extend tributions of both individuals, as well our deepest appreciation. We are as the dedicated service of the mem- grateful for the leadership of E. Man- bers of the 1987 Small Bank and Small dell de Windt (retired chairman of the Business Advisory Councils, are board of Eaton Corporation), who appreciated. retired from our Board of Directors Finally, I wish to extend after serving as a member since 1981 my personal gratitude to all of the and as deputy chairman since 1984. employees of the Bank for their dedi- Special thanks go to the directors of our Cleveland Board who have cated service during the past year. With their assistance, I look forward completed their terms of service: Ray- to the challenges of serving the mond D. Campbell (chairman, presi- Fourth Federal Reserve District. dent, and chief executive officer of W Lee Hoskins President March 10, 1988 four Developing- Country Last year marked a difficult period debt problem in 1982 was to in the evolution of the developing- reschedule loan repayments and to country debt situation for borrowers maintain debt service by providing and lenders alike. Debt new funds, through both official Some large debtors faltered in channels and commercial banks. The their progress toward making the second step was to institute economic necessary resource adjustments to adjustment programs in the debtor service their foreign debts. The rever- country, usually under the auspices of sals in the adjustment process caused the International Monetary Fund (IMF). repercussions in financial markets throughout the year. The Baker Plan, initially offered in late 1985, essentially took a similar Early in the year, Brazil approach. Introduced by U.S. Treas- announced a suspension of debt serv- ury Secretary James Baker, the plan ice to banks. In March, Citicorp proposed additional funding for the announced the creation of special loan most heavily indebted countries and loss reserves equal to about 25 percent sought more involvement on the part of its credit exposure to Brazil and of the World Bank, the Inter-Ameri- selected other developing countries. can Development Bank, and the IMF. Subsequently, 43 of the 50 largest In addition, it placed more emphasis U.S. bank holding companies created on basic structural changes in debtor similar reserves, principally to cover economies as part of the necessary developing-country credit exposures. adjustments. In mid-December, several large Throughout this period, regional banks in the United States creditors seemed to view the debt announced further substantial addi- situation primarily as a liquidity crisis, tions to their loan-loss reserves against which would be solved by time, their developing-country debts. economic growth in creditor coun- Finally, at year-end 1987, the government of Mexico announced a tries, and resource adjustment rn. the debtor countries. proposal that would reduce both the cost of debt service and the value of the outstanding debt. Resource Adjustments This annual report essay examines the The overwhelming significance real economic adjustments of debtor of these events was that major U .S. countries and shows how the success bank creditors were taking steps con- or failure of these resource adjust- sistent with the growing prospect ments dictates the feasible financial that some heavily indebted countries solutions to the problem. would not sustain the full servicing of their debts. The central issue is economic growth and the transfer of resources between debtor and creditor coun- Belief In Full Repayment tries. The prosperity of nations Prior to 1987, U.S. banks and pol- engaged in international commerce is icymakers embraced approaches to dependent upon the transfer of real the international-debt situation that resources. The transfer of financial implied confidence that full servicing claims, for the most part, follows real of outstanding debts would even- resource flows. tually be achieved. Consequently, the nature and The initial step following the unfolding of the developing-country five A one-to-one correspondence necessarily exists between the net international transmission effinancial funds and the net international flows efgoods and services among countries. six the costs of the economic adjust- undertook in an attempt to meet their ments that enable real resources to be obligations and to the growing recog- exchanged in response to any financial nition by financial markets that the transaction, such as the extension of necessary shifts in real resources may international loans or the servicing of not be achieved. debt, are the crucial areas for eco- common characteristics and collective nomic inquiry. In the following sections, The This essay focuses on the evolution of 15 heavily indebted the events leading up to the 1982 countries. 1 The situation, of course, international debt problem are varies greatly among individual coun- described. Particular attention is given tries within this group and among to the adjustments that heavily individual developing countries in indebted countries subsequently general. • External financing is vital to the The ability to pay is usually economic growth of most developing measured in terms of exports, since Debtors' economies. The important economic they provide the chief means of earn- question is, to what extent can a ing the foreign exchange with which Perspective country supplement domestic savings to service the debt. As long as the with foreign borrowing to accommo- costs of servicing debt remain a man- date a higher level of investment and ageable, nonincreasing proportion of consumption over time? exports, a debtor country can sustain the pace at which it borrows abroad. The Debt Cycle A country is constrained in its bor- Debt Repayment Problems rowing mainly by its ability to service A debt repayment problem arises debt over time. In the early stages of a when external or internal events push debt cycle, a developing country will debtor countries off their expected receive a capital inflow and will gener- growth paths, leaving debtors with ate a trade deficit as it imports capital obligations to service debts that goods to develop its industrial base. exceed their ability to make the neces- In time, as development proceeds, the country builds up its capital sary real resource transfers. History indicates that such base, services its debts, and generates a occasions have not been uncommon. trade surplus. Eventually the country Wars, recessions, political change, and could repay its debt completely and inappropriate domestic policy, at one could even export capital. time or another, have caused difficul- While the idea of a debt cycle is ties for many countries, including the attractive, many developing countries United States, the United Kingdom, have not escaped their dependence on France, Italy, and Germany, in the foreign capital. In itself, this does not servicing of their international debts. imply an unsustainable situation. A nation can continue to import capital almost indefinitely, provided that the costs of servicing that debt do not grow faster than its ability to pay. seven When events seriously disrupt a nation's ability to service its debts, ment " ... are applying the theory of liquids to what is, if not a solid, at least a sticky mass with strong inter- the financial adjustments that it adopts depend ultimately on the real nal resistances." 3 The adjustment economic adjustments the debtor process requires changes in relative country can and is willing to under- prices and income levels that are diffi- take. A one-to-one correspondence cult to accomplish and that may impose severe social and economic costs on the debtor countries. The necessarily exists between the net international transmission of financial funds and the net international flows of goods and services among ing shifts in trade by the creditor countries. countries. For a debtor country to service or repay its debt to the United States, adjustment also requires correspond- To ease the adjustment burden, debtor countries also can seek to the debtor country first must acquire dollars. In the short run, it might do this through the sale of assets, includ- countries involved in the current ing its official international reserve international-debt situation have holdings. However, countries usually hold only a small amount of interna- negotiated debt-restructuring agreements. When accompanied by new tional reserves and do not like to lending, rescheduling sustains a capital deplete them. inflow to the debtor country. It allows a debtor country time to make Eventually more basic adjust- reschedule their debt obligations. Virtually all of the important debtor ments must be made. The debtor country can acquire the necessary for raising the level of exports to dollars only by running an export service the international debt. surplus. Consequently, a country that must make a large, sustained net remittance of financial capital also Rescheduling debts and providing additional loans to debtor countries have helped to reduce strains in must experience a commensurate net the banking sectors of creditor countries. Although the international debts are concentrated among the largest outflow of goods and services via a trade surplus. 2 In a fully equivalent sense, a creditor country can receive a net inflow of financial capital only through a trade deficit. the economic adjustments necessary banks, interbank relations are such that the failure oflarge banks could have repercussions on others and on the entire financial network. Trade Flows vs. Financial Flows This direct correspondence between financial flows and flows of goods and services presents an important, and most difficult, challenge with respect to the international-debt problem. Trade flows typically do not adjust rapidly to changes in financial flows. John Maynard Keynes argued that those who expect a rapid adjust- Rescheduling buys time for adjustment, but when the level of debt servicing becomes unachievable or unsustainable in relation to the debtor country's potential for exports, the debtor country will be unable to fully service its international obligations. History indicates that changes in the terms of indebtedness and protracted delays in repayment have not been uncommon in the process of adjustment. • eight The The 1970s witnessed a rapid growth trade surpluses, while Brazil and in the external indebtedness of devel- Mexico had trade deficits that seemed Cebt oping countries. To a large extent, the increased debt reflected specific devel- consistent with the growth in debt Buildup opments in individual borrowing countries, but certain, more general economic developments also played a role. service capabilities. Financing Growth The apparently excellent growth potential of the developing countries, and the relatively high returns on capital that this growth implied, Oil Price Shocks The sharp rise in the price of oil was attracted foreign capital. In addition, one important factor underlying the buildup of developing-country debt. throughout much of the 1970s, real interest rates (nominal rates adjusted for expected inflation) remained low Many oil-importing, developing countries initially borrowed to finance their higher oil-import bills. Borrowing enabled these countries to mitigate the immediate impacts of the oil shocks on their standards of living and presumably provided them with time for adopting long-term adjustment policies. The sharp increase in oil prices also encouraged many oil-producing countries to borrow against future oil revenues for the purposes of develop- and often were negative. Low real interest rates reduced the real burden of debt servicing. The indebtedness of developing countries increased sharply between 1975 and 1982, both in absolute terms and in relation to the countries' ability to service it. As World Bank data indicate, the ratio of debt to exports for all developing countries rose from 73.5 percent in 1975 to 103.1 percent ing their oil-production capacity and in 1982, and the ratio of debt service of diversifying their industrial bases. to exports rose from 8.5 percent in The oil price shocks of the 1970s, however, did not create an unmanageable debt situation. As a group, the developing countries demonstrated excellent real growth, outpacing growth in the developed countries . The 15 heavily indebted countries, for example, experienced real economic growth at an average 1975 to 16.4 percent in 1982. 5 Although large, the magnitude of the capital flows into the developing countries during the 1970s was not unprecedented. What was unprecedented, however, was that an increasing proportion of the inflow represented debt, rather than equity annual rate of 6.1 percent during capital, and that a growing share was in the form of commercial bank loans, the 1970s. rather than official loans or bond issues. In comparison, the seven largest industrial countries experienced real economic growth of only 3.4 percent per year over the same period.4 Moreover, not all developing countries experienced continuous or excessive trade deficits. Argentina and Venezuela, for example, usually ran nine Many regional and small banks entered the international lending market in the 1970s, but international lending remained the domain of the large money-center banks with expertise in the area. According to data on the exposure of U.S. banks by country, the nine largest reporting banks held 62 percent of the total claims on developing countries at the end of 1982 - an amount equivalent to 222 percent of their total capital and substantially more than the 163 percent of total capital reported in 1977. The growing reliance on commercial-bank debt made both developing countries and U.S. banks more vulnerable to worldwide financial developments, as subsequent events soon proved. 6 largest industrialized countries was very sluggish in 1980 and 1981, and output fell 0.6 percent in 1982. The industrialized countries constitute the major market for developing-country exports. As the economic growth of the major industrialized countries slowed, the exports and income growth in developing countries also slowed. In 1981 and 1982, the worldwide pace of inflation began to moderate, causing commodity prices to fall sharply. The decline in commodity prices further eroded the ability of A Changing World Economy By the late 1970s and early 1980s, rising real interest rates and a worldwide recession left the indebted countries in a position of having to make developing countries to meet the rising service charges on their debts. Internal Policies Important as world economic devel- much-larger-than-expected net payments to their creditors abroad. As inflation accelerated, the international-debt problems of the early Federal Reserve and other central banks adopted disinflationary mone- of the problem. Some countries, like Korea, quickly resolved their debt tary policies. Both nominal and real problems, while others, like the 15 heavily indebted countries, could not. interest rates rose sharply. The London opments were in precipitating the 1980s, world events were only part Interbank Offer Rate (LIBOR), to which interest rates on developing- The ability of debtor countries to country debts usually are tied, nearly doubled, from 10.7 percent in June 1979 to 19.2 percent in March 1981. servicing problems largely depended Since most international lending agreements were generally structured to permit frequent adjustments of interest payments to changes in rates, the sharp rise in interest rates in avoid or to resolve quickly their debton their economic capabilities and internal policies. Many countries persistently ran large government budget deficits that reduced the amount of domestic savings available to finance domestic investment. Foreign capital became a the late 1970s and early 1980s rapidly substitute, rather than a supplement, translated into higher debt-servicing costs for debtor countries. for private savings. In some cases, it did not find its way into productive Soon after the rise in interest rates, world economic activity began to slow. Economic growth in the investments that would generate a return to help service the debt. Instead, it often financed capital flight from the debtor countries. Often the developing countries manipulated exchange rates and prices in ways that distorted relative-price signals and favored an inefficient allocation of resources . Overvalued ren • Trade balance exchange rates also increased the • Net capital flow expected return from investing other lenders becoming increasingly • Rese,ve gain abroad and frequently encouraged reluctant to make new loans, inflows • Rese,ve loss capital flight. of private capital, especially long-term Price controls, subsidies, and Net Capital and Trade Flows Fljieen heavily indebted countries Billions of dollars Chart 1 50 0 81 83 85 87' Note: Positive (negative) values indicate a capital outflow (inflow) and trade surplus (deficit). credits, dried up after 1982 and fre- tariffs encouraged investment in quently reversed themselves, as did inefficient industries. Often, these miscellaneous sources of funds tied to government policies favored import- the financing of exports and direct competing industries over export- foreign investments (chart 3). Even oriented industries and, therefore, official sources of credit slowed some- ignored the developing countries' what after 1983. most important comparative advan79 In addition, with banks and As the debtor countries' net tages. Countries with inappropriate inflow of capital rapidly shrank from economic policies found it especially 1980 to 1981, their collective trade difficult to make the resource adjust- deficit expanded. A change in official ments necessary to fully service their reserves balanced the international mounting international debts. 7 accounts. The further deterioration in the Changing Capital Inflows trade deficit reflected the slowdown in • Other The economic events of the early worldwide economic activity. The • Net interest 1980s were reflected in the balance- volume of goods exported, which Capital Outflows of-payments accounts of the heavily grew annually at an average of 2.8 Fljieen heavily indebted countries indebted countries. At this time, the percent between 1969 and 1978, Billions of dollars Chart 2 70 35 financial position of the heavily slowed in 1980 and actually declined indebted nations changed abruptly in 1981. Import volumes began to from that of a recipient of net capital slow in 1981, but did not contract inflows to that of a net remitter of until 1982. capital (chart 1). 8 Underlying this transformation 79 81 83 85 was a sharp increase in the interest As they drew down reserves and re- charges on developing-country debt, scheduled loans, the heavily indebted resulting from the run-up in world countries began taking steps to gener- interest rates. Net interest payments ate trade surpluses. To create a sur- more than doubled in two years, from plus, the countries attempted to 87' • Other • Official capital Capital Inflows Fljieen heavily indebted countries Billions of dollars $17.1 billion in 1979 to $37 billion in increase private savings (reduce private 1981, and rose to $46 billion in 1984 consumption) relative to private (chart 2). 9 investment, and to lower government Other factors contributed to Chart 3 70 35 the swing in net capital flows. As the countries negotiated such adjustment policies under the auspices of the IMF countries became more uncertain, as part of a rescheduling agreement. "safe havens" accelerated. This is evidenced in a sharp rise in the "errors 81 83 85 •1937 = IMF projection Source: IMF World Economic Outlook, April 1987 87' budget deficits. Often, developing economic prospects of the debtor capital flight out of these countries to 79 Trade Adjustments and omissions" component of the balance of payments from these countries, particularly in the years 1980 through 1983. eleven How the adjustments are view of the adverse world economic achieved, especially the portion that conditions at the time, the adjustment falls on investment, can have a signin- in the heavily indebted countries' cant effect on future economic trade balance was unexpectedly rapid. growth. Most data suggest that the adjustment has fallen predominantly Terms of Trade '- on investment spending in heavily A change in the terms of trade accom- indebted countries.10 panied the adjustment process in the As the governments of debtor heavily indebted countries. The terms countries took over - or guaranteed of trade measures the units of imports - most of their countries' debts, that one unit of export buys. This can their international-debt problems also be calculated as the ratio of export became budget problems. Despite prices to import prices, expressed in government expenditure cuts and tax a common currency. After rising increases, government deficits have throughout the 1970s and in 1980, continued to rise in the heavily the relative price of most developing indebted countries. countries' exports - their terms of Consumption fell sharply in 1983 and has remained below earlier trade - declined in 1981, 1982, and 1983. levels in many debtor countries. With This fall in the terms of trade budget deficits rising and further cuts partially reflected a decline in world in consumption politically infeasible, economic activity and, hence, demand more and more of the adjustment for developing-country exports. It burden shifted onto investment. The also reflected debtor-country policies, decline in investment spending in the such as exchange-rate devaluations, developing countries suggests that designed to encourage exports and to their potential for economic growth discourage imports. In some unfortu- and development will slow - possi- nate cases, however, the decline in the bly long into the future. terms of trade of developing countries In part because of austerity measures and in part because of the feedback effects from the worldwide recession, real economic activity in the was a necessary offset to protectionist policies elsewhere in world markets. A decline in a debtor country's terms of trade can help improve a heavily indebted countries fell in 1982 country's trade balance, depending and 1983. Because of the slower pace on how sensitive trade flows are to of economic activity in debtor coun- changes in relative prices. Primary tries, and because of various trade commodities, which are the chief restraints, import volumes also fell exports of most heavily indebted sharply in 1981 and 1982, and to a countries, are likely to be less sensitive lesser extent in 1983. to relative price changes than man- The trade balance did shift to a surplus in 1983, as was necessary to effect the net transfer of funds. In ufactured goods are. The trade improvements resulting from the decline in the terms of trade come at a cost. If a debtor's exports are cheaper in world markets, it must export more real economic resources to service its debts. twelve The growing reliance on commercial-bank debt made both developing countries and U.S. banks more vulnerable to worldwide financial developments, as subsequent events soon proved. thirteen Temporary Recovery expanding exports than from con- Rescheduling and economic adjust- tracting imports . The 15 heavily ments helped the heavily indebted indebted countries experienced slower countries generate an export surplus outflows of capital and slower inflows sufficient to match their net transfer of official funds. Their trade surplus of financial capital by 1983. In 1982 continued to grow, and they added to and 1983, sharp increases in official reserves. capital inflows, much of which was related to rescheduling efforts, helped Creditors• Perspective continued to improve in 1985 in the to finance interest payments and sense that, with the rescheduling of capital flight. debt, heavily indebted countries were Interest payments leveled off The The international-debt situation increasingly able to generate a large after 1982 and capital flight seemed enough surplus to effect their interest to decline. By 1984 the situation im- payments. World interest rates had proved further. Worldwide economic declined, although real interest rates activity continued to accelerate, often seemed high from a historical enabling the trade accounts of the perspective. Capital flight also seemed debtor nations to improve more from to taper of£ • Thus far, the adjustment burden of Consequently, much of the heavily indebted countries has been adjustment to a trade surplus must discussed. But the international-debt come from increased exports to situation requires adjustments on the creditor countries. This can require part of creditor countries as well. some adjustments on the part of In the absence of continued creditor countries. rescheduling of debt and new lending, the heavily indebted countries Competition In World Markets must generate a trade surplus if they The need to increase debtor-country are to service their debts. Corres- exports increases the worldwide com- pondingly, creditor countries must petition between debtor countries and develop a trade deficit in relation to creditor countries. This is especially the debtor countries. true in cases where debtor countries To a limited extent, debtors have experienced declines in their have been able to improve their trade terms of trade. Declines in the terms balances by reducing their imports. of trade imply that debtors must But developing countries require a export a larger volume of goods to minimum amount of imports to earn a given amount of export reve- secure vital consumption goods not nue. In addition, the shift in the terms produced there, to continue necessary of trade can give a debtor country a investments, and to maintain growth. competitive advantage in the world market as compared with a creditor nation. The reduction in developingcountry imports and the increase in developing-country exports could fourteen lower employment in the industries of 1986, largely reflecting a slowing in creditor countries that compete closely the pace of real economic activity with the export industries of the among industrialized countries. At debtor countries. This does not neces- the same time, the terms of trade sarily imply a net loss for the creditor declined further. Much of this recent country, since the remaining sectors of decline seems to reflect oil prices and a creditor country benefit from the might not adversely affect non-oil inflow of capital and from improved primary commodity exporters. In terms of trade in relation to a debtor addition to the deterioration in the country. external environment, the debtor Nevertheless, the adjustment countries were unable or unwilling to can be difficult for those economic continue with necessary resource sectors of creditor countries that com- adjustments. pete most directly with the industries in developing countries. As a result, Financial Market Adjustments the adjustment process can contribute The recent worsening in the economic to protectionist policies. prospects of the heavily indebted countries has resulted in increased Outlook for Resolution financial market tensions surrounding The success of the debtor countries in the international-debt situation. This handling their debt burdens depends was dramatically illustrated when Bra- upon the forces that determine world- zil unilaterally suspended interest pay- wide economic conditions. For ments on its bank loans early in 1987. instance, if a creditor country has a In the past two years, financial rapidly growing economy, it can markets increasingly have questioned absorb a higher level of debtor-coun- the feasibility of continuing to resched- try exports. In the early stages of the ule debts in their entirety and of current debt situation, a number of offering new funds. These approaches projections suggested that growth by alone have expanded the outstanding the major industrial countries of indebtedness relative to the debtors' approximately 2.5 percent to 3.0 per- capacity to service the debt. cent annually would be necessary to absorb debtor-country exports. 11 The economic performance of Despite economic austerity, rescheduling, and additional funding, the total external debt of heavily the heavily indebted countries deterio- indebted countries rose to an esti- rated in 1986 and, although actual data mated $485 billion in 1987 from $350 are not yet available, another deterio- billion in 1981, according to World ration is estimated for1987. Interest Bank data. 12 Debt burdens remain payments and other capital outflows well above the capacity of heavily have continued to slow, but the heav- indebted countries to service them ily indebted countries were unable to completely. generate a large enough trade surplus. Consequently, the heavily indebted countries lost reserves in 1986. Debtor-country export volumes declined sharply in 1985 and fifteen In an increasingly interdependent world, the acijustment burden and the responsibilities for achieving it fall on both the debtor and the creditor countries. sixteen The ratio of outstanding public These developments influenced and publicly guaranteed debt to ex- financial events last year. In March ports rose from 1m.s percent in 1981 1987, Citicorp announced intentions to 267.9 percent in 1986. The ratio of to create up to $3 billion of loan loss debt service to exports rose from 20.0 reserves for developing-country debt, percent to 29.0 percent over the same about 25 percent of Citicorp's current period. The World Bank does not developing-country debt exposure. As expect a significant improvement, if many as 43 of the 50 largest bank any, in these ratios for developing holding companies in the United countries for 1987. States followed Citicorp's lead. The secondary market reflects In December, the large regional this concern about repayment in its banks also made further substantial valuation of developing-country debt. additions to reserves, raising reserves According to a weighted-average to - and in many cases beyond - 50 value index, outstanding bank debt percent of exposure, more or less in traded at 77 percent of its book value line with current secondary market in January 1986. The index has since prices of developing-country debt. fallen to 47 percent of face value, as One regional bank announced the debt burdens have grown and as the first actual charge-off against a por- capacity of debtor countries to service tion of the developing-country debt their debt has eroded. 13 The U.S. banking system has in its portfolio. The degree to which banks reduced its exposure to developing- have reduced exposure is reflected in country debt significantly. By June how banks are valued in the mar- 1987, the exposure of U.S. banks to ketplace. The stocks oflarge money- the 15 heavily indebted countries had center banks with sizable developing- fallen to $84.4 billion from $90.2 country loans tend to trade well billion in mid-1982, according to a below their book value, as they have survey of bank exposure. since the onset of the debt problem in Furthermore, the banks have the early 1980s. However, the market- made large additions to their capital to-book ratio for banks that have over these years, and foreign debt reduced exposure to half of outstand- exposure of the banks surveyed ing debt through loan-loss reserves declined from 136 percent to 68 has risen sharply since 1982. percent of total capital. The debt At year-end 1987, the govern- exposure continues to be highly con- ment of Mexico and the Morgan centrated at the largest money-center Guaranty Trust Company announced banks. The nine largest banks a proposal to exchange up to $10 billion accounted for 66 percent of total U.S. bank claims on heavily indebted countries in June 1987, up from 60 percent in June 1982. Although exposure of these banks has declined relative to capital, it remains high, generally exceeding capital. seventeen of new, 20-year, interest-bearing rity equal to the principal value of the Mexican bonds for up to $20 billion Mexican bonds. Mexico will place the of outstanding Mexican loans owed U.S. Treasury bonds in escrow inside to the banks participating in the the United States to secure the Mex- arrangement. The exchange will be ican bonds, assuring investors of made at auction-determined prices repayment of principal at maturity. that presumably will reflect market valuation of the debts. with respect to payment of interest on Mexico proposed to use up to The Financial Market the bonds. Nevertheless, the Mexican $2 billion of its $11 billion of foreign- bond proposal represents another im- currency reserves to purchase a new portant step in the evolution toward a issue of 20-year, zero-coupon U.S. market-oriented solution to the inter- Treasury bonds with a value at matu- national debt situation. • This report has focused on the real The underlying economic real- economic adjustment that debtor ities of the adjustment problems have countries must achieve to sustain the become increasingly apparent in net outflow of capital required to recent years. Financial markets have service their international obligations. Despite five years of adjust- Perspective Investors remain at some risk ments, the outstanding obligations of the heavily indebted countries have repriced the debt accordingly and banks have made further additions to loan-loss reserves. The financial markets have continued to grow, both in absolute forced the issue to the forefront and terms and relative to their capacity to have become the vehicle by which the service the debts. problem will eventually be resolved. Moreover, the capacity of the For the first time since the beginning heavily indebted countries to make of the debt situation, the actions further domestic economic adjust- being taken by both creditors and ments seems limited. The recent slow- debtors seem consistent with the mar- ing in worldwide economic growth, ket's assessment of the ability of debt- together with persistently strong pro- or countries to service their debts. tectionist measures, has further inten- As this report implies, sified the tensions between debtor and creditor countries continue to seek a creditor countries. net outflow of financial capital from if the heavily indebted countries, they must absorb the exports of the heavily indebted countries. The close correspondence between net trade and net financial flows ultimately must guide the resolution of the internationaldebt situation. • eighreen Footnotes 1. The IMF's classification of 15 heavily indebted countries includes: Argentina, Bolivia, Brazil, Chile, Colombia, Cote d'Ivoire, Ecuador, Mexico, Morocco, Nigeria, Peru, Philippines, Uruguay, Venezuela, Yugoslavia. 2. We ignore here the reporting, measurement, and timing problems that necessitate an "errors and omissions" account. 3. John Maynard Keynes, "The German Transfer Problem," Economic Journal, vol. 39 (March 1929); reprinted in Howard S. Ellis and Lloyd A. Metzler (eds.) Readings in the Theory of International Trade (Richard D. Irwin, 1950), p. 167. 4. The seven large industrialized countries are Canada, France, Italy, Japan, the United Kingdom, the United States, and West Germany. 5. These data refer to public and publicly guaranteed long-term debt outstanding. World Bank, World Debt Tables, 1987-88 Edition, vol. 1 (1988), p. 5. 6. World Bank, World Development Report, 1985 (Oxford University Press, 1985), chap. 1 and 2. 7. Ibid., chap. 4 and 5. 8. To distinguish more clearly between financial transactions and flows of goods and services, charts 1, 2, and 3 classify certain transactions differently than typical balanceof-payments accounts do. The charts include interest payments in the capital-account transactions. Usually interest receipts and . payments appear among the current-account items as a service. The charts also treat "errors and omissions" as unrecorded capital flows. 9. Charts 1, 2, and 3 present ex post transactions, which reflect adjustments because of the inability of debtor countries to finance ex ante transactions. 10. The arguments presented in this section are discussed and developed in International Monetary Fund, World Economic Outlook, 1986, pp. 78-89. ll. Michael Dooley and others, "An Analysis of External Debt Positions of Eight Developing Countries through 1990;' International Finance Discussion Papers 227 (Board of Governors of the Federal Reserve System, August 1983). 12. World Bank, World Debt Tables, 1987-88 Edition, vol. 1 (1988), pp. viii-ix, Box I, p. xiv and pp. 30-33. 13. Index compiled by Shearson Lehman Brothers, Inc. nineteen Comparativ e Financial Statement For years ended December 31 Statement of Condition 1987 1986 Assets Gold certificate account . . . . . . . . . . . . . . . . . . . . Special drawing rights certificate account . . . . . . . . . Coin . . ..... . . . . . . . . . . . . . . . . . . . . . . . . . Loans and securities: $ 664,000,000 314,000,000 $ 27,530,552 Loans to depository institutions . . . . . . . . . . . . . Federal agency obligations bought outright ..... U.S. government securities Bills ............ . . ............ .. . Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bonds ............ .... .. .... . . .. . Total U.S. government securities ... . ... . Total loans and securities ... .. .... . ... . Cash items in process of collection . . . . . . . . . . . . . 650,000,000 314,000,000 33,248,199 63,475,000 205,960,000 453,028,595 459,763,588 6,459,213,325 6,094,013,060 4,976,685,879 4,000,564,839 1,693,907,233 1,510,589,056 13,129,806,437 11,605,166,955 13,646,310,032 12,270,890,543 293,797,319 375,305,015 32,265,020 31,540,886 Bank premises . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . Interdistrict settlement account ..... . .... . ... . 750,233,144 771,968,876 135,947,039 247,216,013 Total Assets ....... . ....... . ............... .. . $15,864,083,106 $14,694,169,532 $12,987,455,204 $12,482,060,679 Depository institutions . . . . . . . . . . . . . . . . . . Foreign ....... . . . . . . . . . . . . . . . . . . . . . Other deposits . . . . . . . . . . . . . . . . . . . . . . . . 2,123,425,856 1,527,564,394 9,000,000 9,000,000 42,239,230 26,903,549 Total deposits. . . . . . . . . . . . . . . . . . . . . . . Deferred availability cash items . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 2,174,665,086 1,563,467,943 317,030,608 297,722,195 159,545,408 128,290,115 Total Liabilities .... . . . ...... . ... . ........ .. .. . $15,638,696,306 $14,471,540,932 Capital paid in. . . . . . . . . . . . . . . . . . . . . . . . . . Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ Total Capital Accounts.... . ... .. ... . ..... . ...... $ Total Liabilities and Capital Accounts. . . . . . . . . . . . . . $15,864,083,106 Liabilities Federal Reserve notes Deposits: Capital accounts twenty 112,693,400 112,693,400 225,386,800 111,314,300 111,314,300 $ 222,628,600 $14,694,169,532 Income and E x penses 1986 1987 Current income Interest on loans . . . . . . . . . . . . . . . .... ...... . $ 555,846 $ 674,180 Interest on government securities . ... ... . .... .. . 965,834,554 941,194,643 Earnings on foreign currency . . . . .... ... ...... . 20,633,487 23,594,141 Income from services . . . . . . . . . . . . . . . . . . . . . . . 39,224,730 38,173,955 All other income . . . . . . . . . . . . . . . . . . . . . . . . . . 524,982 415 ,209 Total current income ......... ..... ...... . $1,026,773,599 $1,004,052,128 Current operating expenses . . . . . . . . . . . . . . . . . . . 63,432,778 61,298,377 Cost of earnings credits . . . . . . . . . . . . . . . . . . ... . 10,452,713 9,581,389 Current Net Income ..... .. ...... . . .. . .. . . . .. . . ... . . $ 952,888,108 $ 933,172,362 Profit on foreign exchange transactions . . . . . . . . . . $ 108,256,617 $ 118,237,824 Profit on sales of government securities ....... . .. 2,511,011 3,918,560 All other additions . . . . . . . . . . . . . . . . . . . . . . . 20,142 9,134 . .. .......... . .. ....... $ 110,787,770 $ 122,165,518 Profit and loss Additions to current net income Total additions Deductions from current net income Loss on foreign exchange transactions ..... . . ... . -0- $ .. ... .. ... ..... . . ..... Net additions or deductions ........ . . .. ... . . . . $ 691 $ 110,787,079 -05,032,520 691 All other deductions . . . . . . . . . . . . . . . . . . . . . . Total deductions $ $ 5,032,520 $ 117,132,998 Assessments by Board of Governors 3,094,741 $ -0- Board of Governors expenditures . ...... . ... . . . . . 4,822,900 $ 5,865,800 Federal Reserve currency costs . . . . . . . . . . . . . . . . . 10,906,391 Cost of unreimbursable U .S. Treasury services .. ..... Total assessments by Board of Governors .. . . .. ... N et Income Available for Distribution . . . .. . ........ . .. . $ $ 18,824,032 $1,044,851,155 11,299,418 $ 17,165,218 $1,033,140,142 Distribution of net income Dividends paid .. . ..... ....... .... . .... . . . $ 6,719,445 $ 6,590,413 Payments to U.S. Treasury (interest on Federal R eserve notes) . .... . . . ... . . 1,036,752,610 1,022,235,729 Transferred to surplus . . . . . . . . . . . . . . . . . . . . . . . 1,379,100 4,314,000 Total distributed .. ... . .. ..... . .. .. .... . . $1,044,851,155 $1,033,140,142 rwenty·one Federal Reserve Bank of Cleveland Cleveland Directors (left to right, standing) Robert D. Storey, Raymond D. Campbell, William A. Stroud, Deputy Chairman John R. Miller; (seated) Laban P. Jackson, Jr., Frank Wobst, R ichard D. Hannan Directors As of December 31, 1987 Cleveland C hairman & Federal Reserve Agent Charles W. Parry Former Chairman & Chief Executive q/Jicer Aluminum Company of America Pittsburgh, Pennsylvania D eputy Chairman John R. Miller Former President & Chief Operating qfflcer Standard Oil Company of Ohio Cleveland, Ohio Raymond D . Campbell Chairman, President, & Chief Executive qfflcer Independent State Bank of Ohio Columbus, Ohio Daniel M. Galbreath President John W Galbreath Company Columbus, Ohio Richard D. Hannan Chairman of the Board & President Mercury Instruments, Inc. Cincinnati, Ohio Laban P. Jackson, Jr. Chairman of the Board International Spike, Inc. Lexington, Kentucky Robert D. Storey Partner Burke, Haber & Berick Cleveland, Ohio William A . Stroud Chairman & President First-Knox National Bank Mount Vernon, Ohio FrankWobst Chairman & Chief Executive q/Jicer Huntington Bancshares Incorporated Columbus, Ohio twenty·two Pittsburgh Directors (left to right, standing) Milton A. Washington, Charles L. Fuellgraf, Jr.; (seated) Thomas H. O'Brien, Lawrence F. Klima, Chairman James E. Haas Cincinnati Directors (left to right, standing) Jerry L. Kirby, Robert M. Duncan; (seated) Kate Ireland, Don Ross, Sherrill Cleland Pittsburgh Chairman James E. Haas President & Chief Operating Officer National Intergroup, Inc. Pittsburgh, Pennsylvania Charles L. Fuellgraf; Jr. Chief Executive Officer Fuellgraf Electric Company Butler, Pennsylvania Lawrence F. Klima President The First National Bank ef Pennsylvania Erie, Pennsylvania Thomas H. O'Brien President & Chief Executive Officer PNC Financial Corp Pittsburgh, Pennsylvania Cincinnati Chairman James S. Pasman, Jr. Owen B. Butler Former Vice Chairman Aluminum Company ef America Pittsburgh, Pennsylvania Retired Chairman ef the Board The Procter & Gamble Company Cincinnati, Ohio Karl M. von der Heyden Sherrill Cleland Senior Vice President-Finance & Chief Financial Officer HJ Heinz Company Pittsburgh, Pennsylvania President Marietta College Marietta, Ohio Robert M. Duncan Milton A. Washington President & Chief Executive Officer First National Bank ef Louisa Louisa, Kentucky President & Chief Executive Officer Allegheny Housing Rehabilitation Corporation Pittsburgh, Pennsylvania Robert A. Hodson President & Chief Executive Officer 1st Security Bank Hillsboro, Ohio Kate Ireland National Chairman Frontier Nursing Service Wendover, Kentucky Jerry L. Kirby Chairman efthe Board & President Citizens Federal Savings & Loan Association Dayton, Ohio Don Ross Owner Dunreath Farm Lexington, Kentucky twenty-three Federal Reserve Bank of Cleveland W.LeeHoskins Robert W. Price John P. Robins President Vice President Examining Officer William H. Hendricks Edward E. Richardson Susan G. Schueller First Vice President Vice President Assistant Vice President Randolph G. Coleman William C. Schneider, Jr. Burton G. Shutack Senior Vice President Vice President Assistant Vice President John M. Davis Mark S. Sniderman William J. Smith Senior Vice President & Director ofResearch Vice President & Associate Director ofResearch Assistant Vice President Officers John]. Ritchey As ef March 1, 1988 Senior Vice President & General Counsel Robert Van Valk.enburg Lester M. Selby Andrew W. Watts Edward J. Stevens Assistant Vice President &Economist Vice President Walk.er F. Todd Senior Vice President Vice President Assistant General Counsel & Research Officer & Regulatory Counsel Samuel D. Smith Senior Vice President Robert E. White Martin E. Abrams Assistant Vice President Assistant Vice President & Assistant General Auditor Donald G. Vincel Senior Vice President Margret A. Beekel Darell R. Wittrup Assistant Vice President Assistant Vice President Robert F. Ware Senior Vice President Terry N. Bennett Assistant Vice President Cincinnati Branch Senior Vice President Thomas J. Callahan Senior Vice President Andrew J. Bazar Assistant Vice President & Assistant Secretary JohnJ. Wixted,Jr. Vice President Randall W. Eberts Jake D. Breland Charles A. Cerino Roscoe E. Harrison Assistant Vice President Vice President Assistant Vice President & Economist Assistant Vice President William S. Brown John J. Erceg Vice President Assistant Vice President & Economist Jerry S. Wilson David F. Weisbrod Assistant Vice President Andrew C. Burkle, Jr. Vice President Robert J. Faile Assistant Vice President Jill Goubeaux Clark Vice President & Associate General Counsel Assistant Vice President Patrick V. Cost Assistant Vice President Robert J. Gorius Norman K. Hagen Vice President & General Auditor Eddie L. Hardy Examining Officer Lawrence Cuy Vice President Lynn M. Hartig Pittsburgh Branch Harold J. Swart Senior Vice President Raymond L. Brinkman Assistant Vice President Lois A. Riback Assistant Vice President Robert B. Schaub Assistant Vice President Examining Officer Creighton R. Fricek Vice President David P. Jager Assistant Vice President R . Chris Moore Vice President Rayford P. Kalich Directing Officer Sandra Pianalto Vice President Elena M. McCall & Secretary Assistant Vice President James W. Rakowsky Assistant Vice President David E. Rich Assistant Vice President twenty four Columbus Office Charles F. Williams Vice President
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