View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

]E1@lill
Jk
@lill IF'lf@,lill«:311 ((j)
«:3
July 29,1 983

1
@0
BailingOut Banks?
Congress is currently considering a bill that
would authorize an $8.4 billion increase in
U.S. contributions to the International
Monetary Fund (IMF). President Reagan has
requested the legislation on the ground that
it is essential for averting an international
financial crisis that might arise frorn large
defaults on banking debts of the lessdeveloped countries (LDCs). The bill has
encountered considerable opposition
because of a widespread suspicion that its
real purpose is to bailout banks from their
past lending excesses. Although it has
passed the Senate, a different version with
more stringent restrictions on future international bank lending is being considered by
the House.
This Letter will examine four questions
related to the proposed legislation: (1) Is it
indeed for bailing out banks? (2) Should
there be conditions attached to it for guardi ng agai nst future lending excesses? What
(3)
wou Id be its cost to U.S. taxpayers and its
impact on U.s. financial markets? and (4)
Why should we spend money to help foreign nations instead of our own economy?

Bank bail-out?
Like Damocles' sword, the threat of large
L DC-debt defaults has hung overthe international financial system since last summer.
Particularly worrisome is the extent of U.S.
banks' exposure to the threat. According to
Federal Reserve data, U.s. banking clairns
on the LDCs amounted to $99 billion at
mid-1 982 and accounted for 149 percent of
the total capital of all the banks that made
significant (exceeding $20 million) internationalloans. For the nine largest banks, the
total exposure arnounted to 222 percent of
their capital; their loans to Mexico, Brazil
and Argentina accounted for 112 percent.
Large exposure to LDCs are also common
among all the major banks outside the
United States. Thus, any large LDC-debt
defaults could seriously disrupt the U.S. and
world banking systems.

What has led to the current condition?
Broadly speaking, there are two schools of
thought on this subject. One might be called
the "solvency school," and the other the
"liquidity schooL" The former maintains
that the current distress is a result of
excessive borrowing by the LDCs abette(1by
banks' competition for loans. From this
viewpoint, the borrowing countries are not
unlike households or firms that have overextended themselves and are thus in a state
of "insolvency." The liquidity school, on
the other hand, emphasizes the ternporary
nature of the borrowing countries' current
payment difficulties, stressingthat they
arose from special factors during the last
three years: the prolonged world recession,
unprecedentedly high interest rates,and
banks' reluctance to roll over credits. From
this viewpoint, the present difficulties are
symptomatic of a "liquidity crisis" that arose
from a particularly severe world recession.
The truth may lie between these two polar
views. But wherever it lies, to try to pin
blame and fix responsibility now is perhaps
futile and pointless. When fighting a fire,
one cannot wait for a determination of its
cause before deciding on a strategy for putting it out. Fortunately for international
lending problems, a strategy has already
been developed and, thus far, successfully
implemented.
The strategy has five elements. First and
foremost, the commercial banks have been
induced, cajoled, or pressured to continue
lending to the hard-pressed debtor countries. From their individual Viewpoints, it
may not seem prudent to renew credits to
risky borrowers, and many banks have not
renewed loans. However, what might
appear to be individual prudence is collective folly, for a failure to renew loans is
precisely what would precipitate a financial
crisis. Second, in order to convince bankers
that they are not being asked to pour good
money after bad, public international finan-

Ie=
J

Opinions expressed in tf'lLs newsletter do nol
necessarily retleet the vievv5 of tnp managernent
of the.'Federal Rl'serve Bank of San Frandsen,
or 01' the Board of Covernors of tfw federal
Reserve Svstem.
lending. In addition to credit risk, foreign
lending entails a "country risk" in that an
ordinarily sound loan may turn sour because
of unforeseen balance-of-payrnents difficulties or political upheavals in the borrowing
country. This concern justifies extra caution
in assessing foreign lending risks, but it does
not warrant governrnent restrictions on foreign lending. After all, risk-taking is the
essence of the free-enterprise system, and it
is doubtful thatthe system would be well
served by legislation that lirnits risk-taking.
Furthermore, there is little evidence that
government agencies are any wiser than
market participants in assessing risk.

cial agencies, such as the I MF, must take up
the slack in financing. Todothe job, the I M F
musthave sufficient resources. The Administration's request is butthe U.S. share
in a proposed $43 billion increase in IM F
resources.
Third, as a part of I MF loan conditions, the
debtor countries must adopt and carry out
adjustment programs designed to reduce
their payments deficits. Fourth, since the
IMF loan packages take time to negotiate,
national governments and the Bank for International Settlements have provided large
emergency credits to debtor nations to tide
them over in the interim. Fifth, because
ultimately the debtor nations' abilities to pay
depend on a worldwide economic recovery, the industrial nations have agreed to
pursue economic policies that promote a
strong and sustainable recovery.

Another legitimate concern is the long run
advisability of relying on banks to finance
world payment imbalances, thereby incur"
ring the risk of recurrent crises in the international financial system. However, this is a
long-run problem. Until a safer avenue is
found, there is no alternative butto follow
the same road and deal with crises as they
arise. In the rneantime, the current strategy
calls for banks not to reduce lending to the
hard-pressed debtor nations. To restrict
foreign lending atthis juncture would be like
cutting the water supply to fire fighters in the
midst of a dangerous conflagration.

Thus, the proposed bill for authorizing an
increase in I MF resources is not a bail-out of
banks-the banks are being asked to continue lending-but an essential element in
the current strategy for safeguarding the
soundness of the international financial
system. As the world learned from the experience of the 1930s, a collapse of the world
financial system would have disastrous
effects on the world economy, including
our own.

Budget cost and market impact
The fund request comes at a time when
Congress is under pressure to trim government spending to reduce the budget deficit.
Would approval of the $8.4 billion bill not
increase the budget deficit?

Restrictions on future lending?
Under public pressure, Congress is attaching conditions to the proposed bill intended
to avert future recurrences of lIexcessive"
lending. The version that has passed the
Senate is less stringent than that being considered by the House. The latter requires,
among other provisions, that banks set aside
loan-loss reserves on foreign lending in
anticipation of potential repayment difficu Ities. The total effect of the proposed
restrictions would be to make it more costly
and cumbersome for banks to make foreign
loans.

Surprlsi ngly, the answer is no. What happens
after thebill is passed is that the Treasury
would extend a standby credit to the I M F; no
funds would need to be made available until
actual drawings occur. Upon a drawing, the
Treasury would raise funds from the market
by issuing securities. The fund transfer to the
I MF would be a budget outlay, but unlike
other budget outlays, it would be balanced
by an increase of the same amount in the
Treasury's reserve position at the IM F.·
This reserve is an international liquid asset
available to the United States to draw upon,
without interest and without strings

These proposed restrictions stem from a
valid concern over the riskiness offoreign
2

attached, to finance U.S. payments deficits.
In fact, over the past 19 years, the United
States has drawn on the IMF some 24 times
and, with a cumu lative total drawing of $6.5
billion, is the second largest user (after the
United Kingdom) of I MF funds. Thus, borrowing from the market and transferring the
proceeds to the I MF is not unlike a household borrowing from an uncle and placing
the funds in a bank account. In no sense can
it be interpreted as resulting in an increase in
the budget deficit -either for a household or
for government.

and services in the United States. In either
case, the funds would not be restored to the
U.S. financial market, U.S. interest rates
would rise, and some U.S. expenditures
would be crowded out. Indeed, the rise in
interest rates would be the market mechanism for making the resource transfers to
foreign nations.
In short, the Treasury financing would result
in a rise in U.S. interest rates only if the funds
were used to finance a rise in U.s. exports.
Since under the present circumstances the
I M F loans would be used almost entirely for
helping the LDCs repay their existing debts
(nearly 40 percent of which is owed to U.S.
banks), any "real transfer" effect would
likely be small relative to the total size of the
U.S. financial market of more than $400
billion net borrowing a year by domestic
non-fi nancial sectors.

Some might argue that even though the
analysis may be valid in budget accounting,
it nevertheless makes little economic sense
because the fund transfer implies that purchasing power would be taken from the
market and transferred to the debtor nations
through the IMF. This action presumably
would "crowd out" other market borrowers
just as other types ofTreasury borrowing for
financing government spending would do.

Foreign aid?
Lastly, the question of whether the proposed
bill aids foreign nations or ourselves can be
answered quite simply: it aids both. As
stated, the proposed bill is an essential
element in the existing strategy to ensure the
stability of the world financial system, one in
which the U.S. national interest is clearly at
stake.

This argument, though seemingly persuasive, fails to carry the analysis through to the
end. Itcan be shown that, unlike other types
of budget outlays, fund transfers through the
IMF to the debtor nations would raise U.s.
interest rates and crowd out U.s. domestic
spending only under certain circumstances.
There are only two types of cases to consider: one may be called "pure financial
transfers" and the other, "real transfers."
The former arises if the debtor nations used
IMF funds to repay U.S. banks, thus restoring
the funds to the U.S. financial market. If the
repayment were made to non-U. S. banks,
the same would result if the latter invested <
the funds by purchasing U.s. securities. In
either case, there would be no effect on U.S.
interest rates, no crowding-out, and zero
impact on the real economy.

A concrete case may help illustrate the
point. Mexico is our third largest trade
partner, after Canada and Japan. In 1 982,
because of its external debt problem, it cut
its imports back drastically. As a result, our
exports to Mexico fell by a staggering 60
percent, and our $4 billion trade surplus
with Mexico in 1981 turned intoa $4 billion
deficit in 1 982. Based on an estimate that
every $1 billion increase in U.s. exports
creates 24,000 new jobs in the U.S. economy, the Mexican debt problem alone
appears to have cost the U.S. 200,000 jobs
in 1 982. Clearly, in this case, any aid to help
Mexico service its external debts will not
only help promote, world financial stability,
but will also benefit the U.S. economy.

Real transfers would arise only if the debtor
nations used the funds to increase their net
imports from the United States and not to
repay debts, or to repay debts to non-U.s.
banks and the latter transferred the funds to
bank customers for them to purchase goods

Hang-ShengCheng
3

S S\I, O .LSl:lI:l
UOl5U!4Sl?M
• 4\nn • uo8(}JO • epeA<:lN 0ljepl
•
lreMl?H • E!UJOj!!E':> E'UOZpV. E'>jSl?IV

y;:})
"me:>

sdI
@

ues

lSl 'ON llWIHd
OIVdl!)VlSOd 's'n
llVW SSVD lSHB

\illlI

BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)

Selected
Assets Liabilities
and
LargeCommercialBanks
Loans(gross,
adjusted) investments"
and
loans (gross,
adjusted) total#
Commercial and industrial

Realestate
loans to individuals
Securitiesloans
U.S.Treasury
securities*
Othersecurities*
Demanddeposits- total#
Demanddeposits adjusted
Savings
deposits- totalt
Time deposits - total#
Individuals,part.& corp.
(large negotiable CD's)

WeeklyAverages
of Dailv He:ures
MemberBankReserve
Position
Excess Reserves (+ )/Oeficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed{ -)

Amount
Outstanding

7/13/83
162,235
140,788
43,932
56,124
23,944
2,504
8,392
13,053
41,937
30,527
66,794
65,523
59,786
18,912
Weekended

Changefrom
year ago
Dollar
Percent

Change
from

716183
-

878
888
- 329
61
25
- 108
17
7
-4,048
490
- 474
- 225
198
- 234

1.562
891
36
- 1,276
594
261
1,765
1,094
2,091
2,294
36,052
- 32,200
- 28,437
- 17,524

-

Weekended

7/13/83

7/6183

122
l tl
42

1.0
0.6
0.1
- 2.2
2.5
11.7
26.6
7.7
5.2
8..
1
117.3
- 33.0
- 32.2
- 48.1

Comparable
"ear-aoo neriod

141
807
666

-

56
10
46

* Excludes trading account securities.
# Includes items not shown separately.
t Includes Money Market Deposit Accounts, Super-N OW accounts, and N OW accounts.

Editorialcomments
maybeaddressed theeditor (Gregory
to
Tong)
orto theauthor.... Free
copies
of
this and other Federal
Reserve
publications beobti1iined callingor writing the PublicInforcan
by
mation Section,FederalReserve
Bankof SanFrancisco,
P.O.Box7702,SanFrancisco
94120.Phone
(415) 974-2246.

\\ll;j)
Jl1?1

CQI