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September 23, 1983
Mon etary Policy an d 't D e Debt
The Federal Open Market Committee
(F OMC) decided at its May 24·25 meeting to
apply slightly more restrainton bank reserve
positions, This move was taken against the
background of narrow money (M 1) growing
at a more than 14 percent annual rate during
the fi rst five months of the year -far above
the 8 percent upper bound of the Fed's target
range at the time-and evidence of some
acceleration in the rate of business recovery,
While most economic indicators suggested
that some modest monetary restraint was
warranted at the time, there remained one
major "fly in the ointment," namely, the
international debt problem,
Concerning the first factor, the accompanying chart illustrates the tight link between the
overnight Federal Funds rate and the sixmonth UBOR. Their close correspondence
suggests that a monetary tightening that
causes a given rise in the Federal Funds rate
will soon be reflected in an equal rise
in UB OR.
With regard to the second factor, the
Organization for Economic Cooperation
and Development (OECD) estimates that the
total net debt (total foreign debt less foreign
assets)tied to floating-interest loans averaged 41 percent in 1982 for the non-OPEC
developing countries (excluding OE CD
member developi ng cou ntries - Turkey,
Spain, Portugal and Greece), These percentages vary greatly among the various LDCs,
but generally the low income LDCs tend to
rely on fixed-rate loans often subsidized by
developed country governments or international agencies, while a few middle- and
higher-income LDCs depend upon private
bank loans at floating market interest rates,
The short-term interest rate increases associated with slower money growth would
directly increase the foreign debt service
costs of developing countries (LDCs) and
exacerbate the liquidity problems faced by
several of them at a particularly vulnerable
time. Some analysts have even suggested
that the policy dilemma posed by the LDC
debt situation was the single largest constraint on Fed policy action. This Letter
explores the policy alternatives facing the
Federal Reserve last May, and considers the
implications of each for the LDC debt
situation.
The latter groupof countries is relativ!"ly few
in number but accounts for an overwhelming portion of LDC foreign debt, LDC
floating-interest debt and LDC foreign debt
service payments, OE CD estimates put the
net floating-interest debt on non-OE CD,
non-OPEC LDCs in 1982 at $166 billion, Of
this amount, four countries-Argentina,
Brazil, South Korea and Mexico-account
for $1 40 bi II ion, or 84 percent of the total.
Individual country percentages of debt
carrying floating interest rates to total debt
(net) stood at 66 percent for Argentina, 62
percent for Brazil, 74 percent for Chile, 55
percent for South Korea and 78 percent for
Mexico. Given the new credits extended
and various foreign debt rescheduling and
refinancing schemes initiated since the end
of 1982, the net floating-interest debt outstanding, and hence the extra debt service
costs associated with interest rate increases,
I nterest rates and debt service
The extent to which annual LDC debt
service costs are raised by increases in U.s.
interest rates depends on two factors. One
factor is the relationship between u.s.
interest rates and the six-month London
Interbank Offer Rate (UBOR), which is the
rate to which the majority of LDC floatinginterest debt is tied, The second factor is
the percent of outstanding external debt tied
to floating-interest loans. Also included in
the latter category may be the refinancing
requirements of old fixed-interest debt
maturing during a given period, and the
nature and size of new credits extended.
1
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Opinions expressed in this newsletter do not
necessarily reflect the views of the rnanagement
of the Federal Reserve Bank of San Francisco,
or of the Board of Covernors of the Federal
Reserve System.
For the purpose of analysis, let's arbitrarily
assume that the Federal Funds rate rise
associated with slower money growth is
between 1 00-200 basis points (the Federal
Funds rate is currently only 70 basis points
above the level prevailing at the end of
May). The discussion above suggeststhen
that net debt service requirements (not necessarily payments) of the non-OECO,
non-OPEC l OCs would jump a minimum
$1.7-$3.4 billion on an annual basis.To the
extent that the duration of higher interest
rate levels is less than a year-and the Federal Funds rate has, in fact, edged downward
somewhat in recent weeks-the increase in
debt service will be correspondingly less.
is probably greater at this time than that
suggestedby OECO estimates in 1 982.
Enter exchange rates
An additional complication is the effect of
U.s. interest rate increases on the real value
of the dollar in exchange markets (market
value adjusted for price developments here
and abroad) and, hence, the real resources
that must be given up by l OCs to service
their dollar-denominated foreign debt.
Interest rate increases in the
have
generally pushed up the dollar's real value
in currency markets, particularly during
periods of stable inflation and when foreign
interest rate increases do not match the rise
in U.S.rates. The renewed strength of the
dollar in recent weeks fits this pattern
closely. U.s. interest rate increases may thus
pose an additional burden on l OCs.
u.s.
Clearly, additional costs of this magnitude
place greater burdens on certain l OCs, particularly those already experiencing difficulties in negotiations with commercial banks
on rolling over existing foreign credits. It is
hardly surprising that international bankers
are uneasy about monetary tightening, even
modest restraint. They suspect that even
small interest rate increases will strain the
current delicate situation.
To the extent that l OCs' currencies
depreciate in real terms against the dollar,
additional domestic resources must be committed to earn convertible foreign exchange
and meet debt service payments. (This effect
will be partially offset by the degree to which
l O C export earnings are based on products
priced in dollars and set in world markets,
e.g., Mexican oil exports. In addition, real
depreciation of l O C currencies improves
their international price competitiveness
and tends to increase net foreign exchange
earnings over a period of several years.
Nevertheless, the domestic resource cost
of servicing or retiring foreign debt will increase, as will the real cost of imports, with
real depreciation.)
Policy alternatives?
Although a policy of modest monetary restraint may exacerbate the l O C debt service
burden in the short-run, it isdifficultto identify credible policy alternatives at this time.
If money growth had been allowed to continue at the rapid clip experienced during
the first half of this year-one possible alternative to immediate tightening-inflationary
expectations would have inevitably reignited and rightfully so: most research suggeststhat the average lag between excess
money growth and accelerating inflation is
between one and two years. Although such
a policy may initially lower interest rates and
ease l OC debt service costs through the
extra liquidity created in the economy, the
temporary respite would most likely be replaced by even higher interest costs for an
extended period. The higher rates, incorporating a higher "inflation premium," would
further drain l OC resources and greatly in-
Current Fed policy
The M 1 surge experienced during the first
part of this year has slowed in recent
months, growing at annual rates of 10.2 .
percent in June, 8.9 percent in July and 2.6
percent in August. One factor behind the
recent decline is presumably the policy of
modest reserve restraint followed since
May, which has brought with it some
upward movement in interest rates.
2
6·MONTH LI BORI FED FUNDS RATE
Percant
20
18
18
14
6·month london
Interbank Offer
Rate on U.S.
dollar deposits..
12
/
10
8
;
,..•.•. ---'
/./"ovemlght
Federal Funds rale
6, U--; ;;; :: -'-==-'--==-'--=:-:
1978
1979
1980
1981
- L_-i_-'
1982
1983
commercial banks would consider extending new credits or rolling over old credits
under these circumstances. And it is doubtful whether debtor countries could institute
the austerity measures that would be necessary to bring about the real transfer of
resources to repay or even service the loans.
crease the worrisome prospect of outright
loan defau Its.*
Another possible alternative to modest reserve restraint would have been for the Fed
to allow money to grow unabated above its
target for a limited period, with the intent of
future tightening once inflationary pressures
had begun to mount. The difficulty with this
approach, however, is that the degree of
monetary restraint needed to meet given
inflation goals would inevitably be much
more stringent and involve a longer period
of time than the present strategy. As recent
experience has demonstrated, a period of
rapid money growth and accelerating inflation followed by severe monetary restraint
usually results in a boom and bust cycle for
the economy.
If, in addition, an economic slump were to
follow, L D C debtor nations would also face
an erosion of their debt service capacity as
falling export sales to the recession-ridden
industrial countries would cut into their
foreign exchange earnings. This point
deserves some emphasis. The ability of LDC
nations to service their debt depends on
both debt service rquirements as well as
debt service capacity, that is, foreign
exchange earnings. Because the u.s.
economy is an important market for many
of the major LDC debtor nations, a period of
sustained growth in the u.s.facilitates an
increase in their debt service capacity. The
U.S. market, for example, accounted for
55.1 percent of Mexico's merchandise
exports and 20.5 percent of Brazil's in 1982.
The problem is that it is much more difficult
to slow inflation, or to reverse the course of
accelerating inflation, than it is to avoid
inflationary pressures at the outset. Once
inflationary expectations are establ ished
among producers and consumers (and Fed
credibil ity to withstand inflationary forces
is called into question), they are hard to
change. The degree of monetary restraint
needed to slow this inflationary momentum,
once begun, often brings with it high real
interest rates for an extended period.
Conclusion
The course charted in May to tighten reserve
positions slightly in order to keep money
aggregates on track probably has the best
chance of maintaining a sustained noninflationary economic expansion in the
U.S., and, in turn, of helping to lay the
groundwork for a long-term solution to the
L D C debt problem. It does the latter by
expanding the L DC debt service capacity
through export growth. Viewed this way, the
probability of a credible long-term solution
to the debt problem is enhanced, while only
the short-term liquidity problem of debt
financing is worsened. This should give confidence to commercial bank lenders and
L D C borrowers that an orderly and timely
solution to the debt problem is possible and
that major LDC loan defaults can be averted.
The Federal Funds rate climbed to very high
levels under similar circumstances in 1 979
and again in the latter part of 1980. Interest
rate increases of that magnitude (5-8 percentage points) in the present environment
would have potentiallydisastrous consequences for certain LDC debtor nations. The
net debt service requirements of non-OE CD,
non-OPEC nations would jump a minimum
$8.3-$13.3 billion on an annual basis-an
enormous increase. It is doubtful whether
"'This discussion considers only the first round effects of
an upturn in inflation. Countries with a high percentage
of fixed-interest rate debt may conceivably be better off
in an inflationary environment, for example, as the real
cost of servicing these loans would decline.
Mkhael Hutchison
3
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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amountsin millions)
SelectedAssetsand Liabilities
large CommercialBanks
loans (gross,adjusted)and investments*
loans (gross,adjusted)--total#
Commercialand industrial
Realestate
loans to individuals
Securitiesloans
U.S.Treasurysecurities*
Other securities*
Demanddeposits- total#
Demanddeposits- adjusted
Savingsdeposits- totalt
Time deposits- total#
Individuals,part.& corp.
(large negotiableCD's)
WeeklyAverages
of Daily Figures
MemberBankReservePosition
ExcessReserves
(+ )/Defidency(-)
Borrowings
Net free reserves(+ l/Net borrowed(-)
Amount
Outstanding
Change
from
9/7/83
161,834
141,506
43,063
56,881
24.424
2,798
7,541
12,786
43,080
29,557
66.450
67,201
61,419
17,656
8/31/83
-, - -, -800
808
- 60
177
- 6
617
7
- 16
882
- 109
773
105
83
- 38
Changefrom
yearago
Dollar
Percent
-
-
Weekended
Weekended
9/7/83
8/31/83
138
64
74
148
136
13
52
97
1,981
662
969
419
1,068
1,217
1,278
1,515
34,703
32,355
28,330
19,443
-
-
0.0
0.1
4.4
1.2
4.1
17.6
16.5
8.7
3.1
5.4
109.3
32.5
31.6
52.4
Comparable
period
141
14
128
* Excludestradingaccountsecurities.
#
itemsnot shownseparately.
t IncludesMoneyMarketDepositAccounts,Super-NOWaccounts,and NOWaccounts.
Editorialcommentsmaybeaddressed
to theeditor (CregoryTong)or to theauthor•••• Freecopiesof
this andother FederalReservepublicationscanheobtainedby callingor writing the PublicInformation Section,FederalReserveBankof SanFrancisco,P.O.Box7702,SanFrancisco94120.Phone(415)
974-2246.
@FedFRASER