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March I, 1989
$24.3 billion; in 1987, it fell to only
$0.1 billion in the first three quarters.f
Various financial plans have been advanced to resolve the ongoing LDC
debt repayment and economic growth
problems. The proposals are divided between plans favoring an increase in
lending to buy time and to finance
structural reforms, and plans favoring a
reduction in debt that is compatible
with the debtor's ordinary servicing
capacity. No matter how the current
LDC debt and economic growth
problems are managed, in the long run
the difficulties encountered in enforcing international loan agreements seem
likely to limit lenders' confidence in
the likelihood of complete repayment.
Creditor and debtor nations will continue to struggle with their debt resolution efforts for many years. Parties on
both sides will undoubtedly search for
new ways to prevent overborrowing
and overlending from repeating. They
will also continue to calculate the costs
and benefits of defaults on current
obligations, and act accordingly.
•
degree that a resumption of internationallending may require basic and complicated structural changes in the
framework of lending itself. Making
Markets (Washington D.C.:IMF, 1988),
World Economic and Financial Surveys
Federal Reserve Bank of Cleveland
Series.
6. Various sanctions can deter defaults and
enable lenders to extend credit to developing
countries. See Jonathan Eaton and Mark Gersovitz, "Poor Country Borrowing in Private
Financial Markets and the Repudiation
Issue," Princeton Studies in International
Finance, No. 47,June 1981.
The Costs of Default and
International Lending
Footnotes
1. See IMF Staff, Recent Developments in
External Debt Restructuring (Washington
o.c. IMF, 1983, 1985), Occasional Paper,
No. 25, 40.
2. Anatole Kaletsky is probably the first person to use the term "conciliatory default."
Refer to the discussion of the costs of default
in his book, The Costs of Default (New York:
Priority Press Publications, 1985).
The debt servicing difficulties of the
past several years have increased
lender's perceptions of risks to such a
eCONOMIC
COMMeNTaRY
5. See IMF Staff, International Capital
3. See Gary C. Hufbauer and Jeffrey J.
Schott, Economic Sanctions in Support of
Foreign Policy Goals (Washington D.C.:
Institute for International Economics, 1983).
4. See "Brazil's Reversal of Debt Strategy,"
Chien Nan Wang is an economist at the
by Chien Nan Wang
Federal Reserve Balik of Cleve 10lid. The
author would like to thank John DOI·is. William Gavin. Owen Humpage, Mark Snider-
In August 1982, Mexico announced
that it was unable to service its nearly
$80 billion foreign debt. Brazil, Argen-
mall. E..I. Stevens. and Walker Todd for
helpfill comments.
The views stated herein are those ofthe
tina, Venezuela and other debtor
countries soon announced their own
debt-servicing difficulties.
author and not necessarily those of the
Federal Reserve Bank of Cleveland or o{ the
Board of Governors ofthe Federal Reserve
System.
Initially, it was feared that these bor-
New York Times, February 22, 1988.
rowers might flatly refuse to repay
their debts, thus repudiating their loan
obligations. Because debt repudiation
could severely hurt both creditors and
debtors, the threat became the focus of
what became known as the 1982 lessdeveloped-country (LDC) debt crisis.
these changes will prove to be very difficult, but if the volume of lending
could be increased as a result, then
both borrowers and lenders would
benefit accordingly."
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 4410 1
Between 1983 and 1986, creditors,
debtors, and the International Monetary
Fund (IMF) generally were able to
work together to manage the debt
problems, keeping interest payments
BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385
on schedule by restructuring old loans
and by making new loans in what can
be described as a process of "cooperative interruptions." I
However, in 1986, Peru limited debtservice payments to not more than 10
percent of its export revenues. More
strikingly, in February 1987, despite an
ongoing effort to reschedule and
refinance its debt, Brazil unilaterally
delayed interest payments. In addition
to Brazil, seven other Latin American
countries, together with several smaller
African countries, delayed interest payments in 1987. However, as will be discussed later, most of these interrupted
Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
payments were renegotiated, with inter-
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department, P.O. Box 6387, Cleveland, OH 44101
ISSN 0428-1276
est payments resuming within a year,
through a set of arrangements that has
been described as a "conciliatory
default.,,2 Earlier this year, Brazil again
announced several measures designed
to delay the repayment of its debts.
Conciliatory default, cooperative interruptions, and outright debt repudiation
can each be regarded as a type of debt
servicing failure-that is, of a
borrower's failure to service and repay
its debt as originally specified in the
loan agreement. There are important distinctions among the types of debtservice failure. Outright repudiation is
the most extreme form of noncooperative default, and occurs rarely. In contrast, both conciliatory default and cooperative interruption are characterized by
important elements of mutual agreement, or at least acceptance of the need
to modify the original loan agreement.
Of these two, the latter procedure is the
most amicable. However one describes
the process, the international debtservice difficulties of recent years raise
questions that are worth exploring.
First, any type of debt servicing failure
can hurt creditors and debtors alike.
Creditors see their capital eroded,
threatening their solvency; debtors
damage their own creditworthiness,
perhaps impairing their ability to borrow again. Given such significant
costs, how do borrowers choose the appropriate response to their debt servicing problems?
-
During the past few years, a number
of less developed countries (LDCs)
have had difficulty repaying their
foreign debt. Sometimes payments
have been suspended or delayedmaking it necessary for debtors and
creditors to renegotiate or reschedule loan payments. These problems
have raised questions about the costs
and benefits of different types of
debt repayment negotiations and
their implications for the future of internationallending.
This article investigates these questions.
Second, international lending to LDCs
currently is declining. Declining capital
inflows make it even more difficult for
LDCs to service their debts and to
finance their growth. Considering the
huge amount of old debt and the uncertain prospects for future repayment, it is
difficult to restore lenders' incentives to
make new loans. Even if overall indebtedness were reduced to a more manageable level, for example, how could
lenders really be confident that debtors
would not default again in the future?
Finally, do widespread problems with
international debt service reveal a fundamental weakness in the structure of
international private lending that does
not exist in purely domestic lending?
The key to answering these questions
of debt-service agreements may help
1979, for example, Morgan Guaranty
of nonbank foreign traders, multination-
There are two other factors that seem
stability. A probable result of these
centers on the benefits and costs of
default in its various forms. This
Economic Commentary investigates
these aspects of default, using the cur-
consolidate the political regime, particularly for countries with pressing
demands for a higher living standard.
The longer-run effect is less certain.
Trust Company successfully attached
the Iranian government's stake in Fr.
al direct investors, and providers of
short-term, direct-trade finance to a
defaulting country might not be as
serious. Foreign equity investors could
changes in the cost-benefit effect was
the 1987 Brazilian interest moratorium.
rent LDC debt problem to illustrate
several issues that seem especially important for future international lending.
The costs of default may make it impossible to maintain a higher growth
profile that will improve the future
living standard, although this will
gresso del Partido was seized by
Chilean plaintiffs for a default by
Cubazucar, the state sugar monopoly.
In general, however, the relatively
• The Benefits and Costs of Default
depend on the severity and the effectiveness of the creditors' sanctions.
limited resort to seizure by creditors
suggests that it is a useful option only
in the most extreme circumstances of
debt-resolution failure.
to be important explanations of the willingness of debtor countries to
renegotiate new repayment tenus. National pride and a sense of fairness
often require making the necessary payments. However, a borrowing country
may simply be unable to generate
enough foreign exchange through export expansion, import reduction, or acquisition of new capital to repay its
debts, thus becoming unable to make
the capital transfer.
International credit agreements involving the direct or indirect obligations of
governments present the most difficult
problems for creditors. The ultimate defenses for creditors against nonpayment
-such as seizure of collateral and
recourse to legal proceedings-are
not
fully available in international lending,
so that repayment from sovereign
debtors is not strictly enforceable.
A country may choose not to repay,
even if it can. When unwillingness to
repay motivates a sovereign debtor's
debt-service decision, this decision is
usually made after comparing the costs
and benefits involved in a continuum
of options ranging from timely debt service to extreme forms of default. One
such option may be to alter the tenus
of repayment.
The primary benefit of altering the
tenus of repayment is the ability in the
short run to save foreign exchange for
domestic consumption and promotion
of economic growth. The amount of
foreign exchange saved is larger in
repudiation cases than in conciliatory
defaults because the former reduces the
debt-servicing load for a longer period
of time than the latter. While conciliatory default relieves or delays full
debt-service payments for a period of
time, cooperative interruption still assumes a certain amount of debt servicing for that period, thus reaping fewer
benefits.
Debtors may also think that altering
debt-service obligations will enhance
domestic political tranquility. It is
reasonable for debtors to believe that
reducing debt service will permit increased domestic consumption and improve the resident population's immediate living standard. Altering the tenus
Altering debt-service agreements,
while perhaps economically and politically attractive, is not cost-free, however. The costs and benefits for the
debtor depend importantly on a wide
range of factors, including the ability to
negotiate new terms with lenders. In extreme cases of unilateral default, the
borrower often faces trade and financial sanctions that impede the ability of
the debtor country to maintain its overall consumption level when its income
is low and then to repay when its income is high. Profitable investment opportunities may also be lost, and trade
credit may be reduced or eliminated.
Trade embargoes imposed by the
lender's government may cause severe
damage to countries dependent on
trade, which includes most major
debtors.
Default may also result in seizure of a
defaulter's foreign assets or exports.
Sovereign immunity from foreign interference with commercial transactions
once was a basic principle in international law. However, the 1976 Foreign
Sovereign Immunity Act (FSIA) in the
U.S. and the 1978 State Immunity Act
(SIA) in the United Kingdom established the legal liability of foreign
governments for their acts of a purely
commercial nature.
FSIA and SIA are crucial statutes because most international loan contracts
are signed under U.S. or British law.
As a result, borrowing countries typically waive sovereign immunity in
commercial loan contracts.
There have been several instances in
which a sovereign defaulter's foreign
assets were seized by creditors. In
Krupp AG through the German courts.
Also, in 1981, the Cuban ship I Con-
• The Uncertain Costs of Default
Economic issues, such as debt repayments, are only one dimension of a
country's overall relationship with
debtors, so that it may be difficult to
define the national interest of the
creditor's country narrowly enough to
impose sanctions. Disagreements may
exist either between various interest
groups within a creditor country or between creditor nations about whether or
not to sanction a defaulter. For example, exporters, nonexporters,
regional banks, and multinational banks
within the creditor country may take different positions on proposed sanctions.
Finally, economic sanctions, if imposed, may be of limited effectiveness,
because trade and financial flows are
multilateral. Factors such as these and
others may operate to reduce the threat
of default penalties from the debtor's
perspective. If debtors regard efforts to
alter debt-service terms as unlikely to
provoke a strong response, they are likely to press forward with some initiatives.
very well retain their equity intact, and
trade credits might still be serviced.
Trade retaliation against a defaulting
nation is another option available to
creditors, although such restrictions are
most effective when applied by the
creditors' governments. Moreover, the
impact of trade embargoes is often
diluted by trade with other countries
and triangular-trade arrangements
through third-country finus.3
The effectiveness of legal sanctions
against sovereign defaulters is also
limited. Although the legal position of
creditors against the sovereign immunity defense has been improved substantially since 1976, the practical
remedies for creditors still are limited.
For example, the Act of State principle,
an established tenet of U.S. law,
prevents U.S. courts from passing judgment on foreign countries' actions in
cases involving our national interest.
Execution of judgment under the legal
process also usually does not apply to
foreign diplomatic, military, and
central bank properties in the U.S.
Private property of individual foreign
nationals located in the creditor
country also is usually protected. Finally, legal actions may be avoided simply
because they diminish the debtor's incentive to renegotiate the debt.
The argument that sovereign nations
can avoid or reduce the cost of altering
the tenus of debt sevice implies that the
benefits of such efforts may often be
term bank debts, for example, would
cut a country off from new mediumterm bank loans for a substantial
period. However, if the debt service in-
greater than the costs. While outright
permanent and unilateral abrogations of
lending agreements are uncommon,
terruption is either temporary or occurs
within a framework of ongoing negotiation and of acceptance by the borrower
of the need to resume debt service,
then eventual renegotiation of the loan
contract is likely to restore access to
credit. In such a setting, the reactions
cooperative interruptions and conciliatory default, as part of an ongoing effort
to reduce debt-service obligations, have
occurred often since 1982. However,
the infrequency of outright debt repudiation suggests that both debtors and
creditors saw benefits in renegotiation
and new repayment tenus.
Brazil's interest moratorium did not
last, however; Brazil and its creditors
were able to negotiate lower fees and
interest on restructured loans, and assemble new-money financing packages. The possibility that creditors
would seek more extreme measures in
order to maintain their reputation for
Both the reputation factor and the transfer problem have been important underlying factors in the default and repayment experiences following the onset
debt-repayment enforcement also may
have contributed to the reluctance of
Brazil to remain in arrears.
of the LDC debt crisis. During this
period, most LDC debtors tightened
their belts in order to generate sufficient trade surpluses to service their
For some countries in arrears, private
medium-term financing virtually
ceased, and short-term trade credits
also declined. Peru, for example, has
received few new agreements on short-
debts, both for preventing sanctions
and for maintaining their reputations.
After the 1982 debt crisis, extensive
debt restructuring was negotiated,
usually requiring debtors to adopt International Monetary Fund (IMF) adjustment programs. These restructuring
packages included lowering interest
terms and stretching out interest or principal payment schedules, which increased the benefits of interrupting the
debt servicing in a cooperative way.
The restructuring packages also included refinancing arrangements that
lowered the costs of cooperative interruptions. Therefore, debtors, after examining the costs and benefits, did not
choose repudiation.
It may also be a misconception to
believe that all foreign economic interests would unite to cut off future loans
to a defaulting country. A permanent
interruption of debt service on medium-
More than 10 other LDCs also delayed
interest payments in the same year.
•
Changing Situation
Recently, lending to LDCs has been
shrinking. In 1983, new bank lending
to developing countries was $34.3 billion; in the first half of 1987, new lending fell to $3.4 billion. Reduced lending reduces the benefits to debtors of
debt service because not much new
financing is likely to be forthcoming
whether they repaid or not. Also, the
longer that debt stalemates continue,
the longer would the benefits of withholding debt service accrue to debtor
countries for enhanced economic
growth, living standards, and political
term trade credits since its default. As
for Brazil, it reportedly experienced difficulties in obtaining trade financing.
(According to Brazil's Finance Minister, Mailson Ferreira da Nobrega,
Brazil's 1987 interest moratorium was
a mistake because it created new
economic uncertainty and affected
credit flows from abroad.)"
The bank trade credit loss for Brazil
was estimated to be a moderate 20 percent. Once Brazil publicly expressed its
intention to renew debt servicing, a
record-high $82 billion restructuring
package was assembled by Brazil's
bank creditors. This event illustrates
that, overall, the costs of debt service
interruptions can be low as long as
debtors show evidence of a cooperative
attitude.
•
Conclusion
After the 1982 debt crisis, difficulties
in securing debt repayment in the tenus
as originally agreed upon has emphasized the risks in international lending,
and has contributed to a decline in lending. In 1983, involuntary bank lending
to Latin America was $13.3 billion; it
dropped to $2.0 billion in the first three
quarters of 1987. In 1981, voluntary
bank lending to Latin America was
The key to answering these questions
of debt-service agreements may help
1979, for example, Morgan Guaranty
of nonbank foreign traders, multination-
There are two other factors that seem
stability. A probable result of these
centers on the benefits and costs of
default in its various forms. This
Economic Commentary investigates
these aspects of default, using the cur-
consolidate the political regime, particularly for countries with pressing
demands for a higher living standard.
The longer-run effect is less certain.
Trust Company successfully attached
the Iranian government's stake in Fr.
al direct investors, and providers of
short-term, direct-trade finance to a
defaulting country might not be as
serious. Foreign equity investors could
changes in the cost-benefit effect was
the 1987 Brazilian interest moratorium.
rent LDC debt problem to illustrate
several issues that seem especially important for future international lending.
The costs of default may make it impossible to maintain a higher growth
profile that will improve the future
living standard, although this will
gresso del Partido was seized by
Chilean plaintiffs for a default by
Cubazucar, the state sugar monopoly.
In general, however, the relatively
• The Benefits and Costs of Default
depend on the severity and the effectiveness of the creditors' sanctions.
limited resort to seizure by creditors
suggests that it is a useful option only
in the most extreme circumstances of
debt-resolution failure.
to be important explanations of the willingness of debtor countries to
renegotiate new repayment tenus. National pride and a sense of fairness
often require making the necessary payments. However, a borrowing country
may simply be unable to generate
enough foreign exchange through export expansion, import reduction, or acquisition of new capital to repay its
debts, thus becoming unable to make
the capital transfer.
International credit agreements involving the direct or indirect obligations of
governments present the most difficult
problems for creditors. The ultimate defenses for creditors against nonpayment
-such as seizure of collateral and
recourse to legal proceedings-are
not
fully available in international lending,
so that repayment from sovereign
debtors is not strictly enforceable.
A country may choose not to repay,
even if it can. When unwillingness to
repay motivates a sovereign debtor's
debt-service decision, this decision is
usually made after comparing the costs
and benefits involved in a continuum
of options ranging from timely debt service to extreme forms of default. One
such option may be to alter the tenus
of repayment.
The primary benefit of altering the
tenus of repayment is the ability in the
short run to save foreign exchange for
domestic consumption and promotion
of economic growth. The amount of
foreign exchange saved is larger in
repudiation cases than in conciliatory
defaults because the former reduces the
debt-servicing load for a longer period
of time than the latter. While conciliatory default relieves or delays full
debt-service payments for a period of
time, cooperative interruption still assumes a certain amount of debt servicing for that period, thus reaping fewer
benefits.
Debtors may also think that altering
debt-service obligations will enhance
domestic political tranquility. It is
reasonable for debtors to believe that
reducing debt service will permit increased domestic consumption and improve the resident population's immediate living standard. Altering the tenus
Altering debt-service agreements,
while perhaps economically and politically attractive, is not cost-free, however. The costs and benefits for the
debtor depend importantly on a wide
range of factors, including the ability to
negotiate new terms with lenders. In extreme cases of unilateral default, the
borrower often faces trade and financial sanctions that impede the ability of
the debtor country to maintain its overall consumption level when its income
is low and then to repay when its income is high. Profitable investment opportunities may also be lost, and trade
credit may be reduced or eliminated.
Trade embargoes imposed by the
lender's government may cause severe
damage to countries dependent on
trade, which includes most major
debtors.
Default may also result in seizure of a
defaulter's foreign assets or exports.
Sovereign immunity from foreign interference with commercial transactions
once was a basic principle in international law. However, the 1976 Foreign
Sovereign Immunity Act (FSIA) in the
U.S. and the 1978 State Immunity Act
(SIA) in the United Kingdom established the legal liability of foreign
governments for their acts of a purely
commercial nature.
FSIA and SIA are crucial statutes because most international loan contracts
are signed under U.S. or British law.
As a result, borrowing countries typically waive sovereign immunity in
commercial loan contracts.
There have been several instances in
which a sovereign defaulter's foreign
assets were seized by creditors. In
Krupp AG through the German courts.
Also, in 1981, the Cuban ship I Con-
• The Uncertain Costs of Default
Economic issues, such as debt repayments, are only one dimension of a
country's overall relationship with
debtors, so that it may be difficult to
define the national interest of the
creditor's country narrowly enough to
impose sanctions. Disagreements may
exist either between various interest
groups within a creditor country or between creditor nations about whether or
not to sanction a defaulter. For example, exporters, nonexporters,
regional banks, and multinational banks
within the creditor country may take different positions on proposed sanctions.
Finally, economic sanctions, if imposed, may be of limited effectiveness,
because trade and financial flows are
multilateral. Factors such as these and
others may operate to reduce the threat
of default penalties from the debtor's
perspective. If debtors regard efforts to
alter debt-service terms as unlikely to
provoke a strong response, they are likely to press forward with some initiatives.
very well retain their equity intact, and
trade credits might still be serviced.
Trade retaliation against a defaulting
nation is another option available to
creditors, although such restrictions are
most effective when applied by the
creditors' governments. Moreover, the
impact of trade embargoes is often
diluted by trade with other countries
and triangular-trade arrangements
through third-country finus.3
The effectiveness of legal sanctions
against sovereign defaulters is also
limited. Although the legal position of
creditors against the sovereign immunity defense has been improved substantially since 1976, the practical
remedies for creditors still are limited.
For example, the Act of State principle,
an established tenet of U.S. law,
prevents U.S. courts from passing judgment on foreign countries' actions in
cases involving our national interest.
Execution of judgment under the legal
process also usually does not apply to
foreign diplomatic, military, and
central bank properties in the U.S.
Private property of individual foreign
nationals located in the creditor
country also is usually protected. Finally, legal actions may be avoided simply
because they diminish the debtor's incentive to renegotiate the debt.
The argument that sovereign nations
can avoid or reduce the cost of altering
the tenus of debt sevice implies that the
benefits of such efforts may often be
term bank debts, for example, would
cut a country off from new mediumterm bank loans for a substantial
period. However, if the debt service in-
greater than the costs. While outright
permanent and unilateral abrogations of
lending agreements are uncommon,
terruption is either temporary or occurs
within a framework of ongoing negotiation and of acceptance by the borrower
of the need to resume debt service,
then eventual renegotiation of the loan
contract is likely to restore access to
credit. In such a setting, the reactions
cooperative interruptions and conciliatory default, as part of an ongoing effort
to reduce debt-service obligations, have
occurred often since 1982. However,
the infrequency of outright debt repudiation suggests that both debtors and
creditors saw benefits in renegotiation
and new repayment tenus.
Brazil's interest moratorium did not
last, however; Brazil and its creditors
were able to negotiate lower fees and
interest on restructured loans, and assemble new-money financing packages. The possibility that creditors
would seek more extreme measures in
order to maintain their reputation for
Both the reputation factor and the transfer problem have been important underlying factors in the default and repayment experiences following the onset
debt-repayment enforcement also may
have contributed to the reluctance of
Brazil to remain in arrears.
of the LDC debt crisis. During this
period, most LDC debtors tightened
their belts in order to generate sufficient trade surpluses to service their
For some countries in arrears, private
medium-term financing virtually
ceased, and short-term trade credits
also declined. Peru, for example, has
received few new agreements on short-
debts, both for preventing sanctions
and for maintaining their reputations.
After the 1982 debt crisis, extensive
debt restructuring was negotiated,
usually requiring debtors to adopt International Monetary Fund (IMF) adjustment programs. These restructuring
packages included lowering interest
terms and stretching out interest or principal payment schedules, which increased the benefits of interrupting the
debt servicing in a cooperative way.
The restructuring packages also included refinancing arrangements that
lowered the costs of cooperative interruptions. Therefore, debtors, after examining the costs and benefits, did not
choose repudiation.
It may also be a misconception to
believe that all foreign economic interests would unite to cut off future loans
to a defaulting country. A permanent
interruption of debt service on medium-
More than 10 other LDCs also delayed
interest payments in the same year.
•
Changing Situation
Recently, lending to LDCs has been
shrinking. In 1983, new bank lending
to developing countries was $34.3 billion; in the first half of 1987, new lending fell to $3.4 billion. Reduced lending reduces the benefits to debtors of
debt service because not much new
financing is likely to be forthcoming
whether they repaid or not. Also, the
longer that debt stalemates continue,
the longer would the benefits of withholding debt service accrue to debtor
countries for enhanced economic
growth, living standards, and political
term trade credits since its default. As
for Brazil, it reportedly experienced difficulties in obtaining trade financing.
(According to Brazil's Finance Minister, Mailson Ferreira da Nobrega,
Brazil's 1987 interest moratorium was
a mistake because it created new
economic uncertainty and affected
credit flows from abroad.)"
The bank trade credit loss for Brazil
was estimated to be a moderate 20 percent. Once Brazil publicly expressed its
intention to renew debt servicing, a
record-high $82 billion restructuring
package was assembled by Brazil's
bank creditors. This event illustrates
that, overall, the costs of debt service
interruptions can be low as long as
debtors show evidence of a cooperative
attitude.
•
Conclusion
After the 1982 debt crisis, difficulties
in securing debt repayment in the tenus
as originally agreed upon has emphasized the risks in international lending,
and has contributed to a decline in lending. In 1983, involuntary bank lending
to Latin America was $13.3 billion; it
dropped to $2.0 billion in the first three
quarters of 1987. In 1981, voluntary
bank lending to Latin America was
March I, 1989
$24.3 billion; in 1987, it fell to only
$0.1 billion in the first three quarters.f
Various financial plans have been advanced to resolve the ongoing LDC
debt repayment and economic growth
problems. The proposals are divided between plans favoring an increase in
lending to buy time and to finance
structural reforms, and plans favoring a
reduction in debt that is compatible
with the debtor's ordinary servicing
capacity. No matter how the current
LDC debt and economic growth
problems are managed, in the long run
the difficulties encountered in enforcing international loan agreements seem
likely to limit lenders' confidence in
the likelihood of complete repayment.
Creditor and debtor nations will continue to struggle with their debt resolution efforts for many years. Parties on
both sides will undoubtedly search for
new ways to prevent overborrowing
and overlending from repeating. They
will also continue to calculate the costs
and benefits of defaults on current
obligations, and act accordingly.
•
degree that a resumption of internationallending may require basic and complicated structural changes in the
framework of lending itself. Making
Markets (Washington D.C.:IMF, 1988),
World Economic and Financial Surveys
Federal Reserve Bank of Cleveland
Series.
6. Various sanctions can deter defaults and
enable lenders to extend credit to developing
countries. See Jonathan Eaton and Mark Gersovitz, "Poor Country Borrowing in Private
Financial Markets and the Repudiation
Issue," Princeton Studies in International
Finance, No. 47,June 1981.
The Costs of Default and
International Lending
Footnotes
1. See IMF Staff, Recent Developments in
External Debt Restructuring (Washington
o.c. IMF, 1983, 1985), Occasional Paper,
No. 25, 40.
2. Anatole Kaletsky is probably the first person to use the term "conciliatory default."
Refer to the discussion of the costs of default
in his book, The Costs of Default (New York:
Priority Press Publications, 1985).
The debt servicing difficulties of the
past several years have increased
lender's perceptions of risks to such a
eCONOMIC
COMMeNTaRY
5. See IMF Staff, International Capital
3. See Gary C. Hufbauer and Jeffrey J.
Schott, Economic Sanctions in Support of
Foreign Policy Goals (Washington D.C.:
Institute for International Economics, 1983).
4. See "Brazil's Reversal of Debt Strategy,"
Chien Nan Wang is an economist at the
by Chien Nan Wang
Federal Reserve Balik of Cleve 10lid. The
author would like to thank John DOI·is. William Gavin. Owen Humpage, Mark Snider-
In August 1982, Mexico announced
that it was unable to service its nearly
$80 billion foreign debt. Brazil, Argen-
mall. E..I. Stevens. and Walker Todd for
helpfill comments.
The views stated herein are those ofthe
tina, Venezuela and other debtor
countries soon announced their own
debt-servicing difficulties.
author and not necessarily those of the
Federal Reserve Bank of Cleveland or o{ the
Board of Governors ofthe Federal Reserve
System.
Initially, it was feared that these bor-
New York Times, February 22, 1988.
rowers might flatly refuse to repay
their debts, thus repudiating their loan
obligations. Because debt repudiation
could severely hurt both creditors and
debtors, the threat became the focus of
what became known as the 1982 lessdeveloped-country (LDC) debt crisis.
these changes will prove to be very difficult, but if the volume of lending
could be increased as a result, then
both borrowers and lenders would
benefit accordingly."
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 4410 1
Between 1983 and 1986, creditors,
debtors, and the International Monetary
Fund (IMF) generally were able to
work together to manage the debt
problems, keeping interest payments
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Permit No. 385
on schedule by restructuring old loans
and by making new loans in what can
be described as a process of "cooperative interruptions." I
However, in 1986, Peru limited debtservice payments to not more than 10
percent of its export revenues. More
strikingly, in February 1987, despite an
ongoing effort to reschedule and
refinance its debt, Brazil unilaterally
delayed interest payments. In addition
to Brazil, seven other Latin American
countries, together with several smaller
African countries, delayed interest payments in 1987. However, as will be discussed later, most of these interrupted
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payments were renegotiated, with inter-
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est payments resuming within a year,
through a set of arrangements that has
been described as a "conciliatory
default.,,2 Earlier this year, Brazil again
announced several measures designed
to delay the repayment of its debts.
Conciliatory default, cooperative interruptions, and outright debt repudiation
can each be regarded as a type of debt
servicing failure-that is, of a
borrower's failure to service and repay
its debt as originally specified in the
loan agreement. There are important distinctions among the types of debtservice failure. Outright repudiation is
the most extreme form of noncooperative default, and occurs rarely. In contrast, both conciliatory default and cooperative interruption are characterized by
important elements of mutual agreement, or at least acceptance of the need
to modify the original loan agreement.
Of these two, the latter procedure is the
most amicable. However one describes
the process, the international debtservice difficulties of recent years raise
questions that are worth exploring.
First, any type of debt servicing failure
can hurt creditors and debtors alike.
Creditors see their capital eroded,
threatening their solvency; debtors
damage their own creditworthiness,
perhaps impairing their ability to borrow again. Given such significant
costs, how do borrowers choose the appropriate response to their debt servicing problems?
-
During the past few years, a number
of less developed countries (LDCs)
have had difficulty repaying their
foreign debt. Sometimes payments
have been suspended or delayedmaking it necessary for debtors and
creditors to renegotiate or reschedule loan payments. These problems
have raised questions about the costs
and benefits of different types of
debt repayment negotiations and
their implications for the future of internationallending.
This article investigates these questions.
Second, international lending to LDCs
currently is declining. Declining capital
inflows make it even more difficult for
LDCs to service their debts and to
finance their growth. Considering the
huge amount of old debt and the uncertain prospects for future repayment, it is
difficult to restore lenders' incentives to
make new loans. Even if overall indebtedness were reduced to a more manageable level, for example, how could
lenders really be confident that debtors
would not default again in the future?
Finally, do widespread problems with
international debt service reveal a fundamental weakness in the structure of
international private lending that does
not exist in purely domestic lending?
@FedFRASER