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FED RAL RESERVE BANK
OF SAN FRANCISCO
ECONOMI~
REVIEW
FALL 1977
The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by
the Bank’s Research, Public Information and Bank Relations Department under the supervision
of Michael W. Reran, Vice President. The publicatipn is edited by William Burke, with the
assistance of Karen Rusk (editorial) and William Rosenthal (graphics).
For copies of this and other Federal Reserve publications, write or phone the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco,
California 94120. Phone (415) 544-2184.
I.
Introduction and Summary
3
II.
Commercial Bank Financing of
World Payment Imbalances Hang-Sheng Cheng
6
III.
IV.
V.
Economic Indicators and
Country Risk Appraisal Nicholas Sargen
19
International Banking, Risk,
and U.S. Regulatory Policies
36
Robert Johnston
Flexible Exchange Rates, Multinational Corporations,
and Accounting Standards John H. Makin
44
of the Economic Review analyzes the new diseases-and corresponding cures-that have arisen in the risk-infested world of the 1970's, with
special reference to their
on the operations of multinational banks and multinational
corporations.
In the first article, Hang-Sheng Cheng considers the impact of the heavy commercial-bank
financing of payments deficits on the stability of
both the U.s. banking system and the international financial community. Within several
years' time, the world has experienced an abrupt
and large increase in world payment imbalances,
a rapid accumulation of external debt by non-oil
"When America sneezes, the rest of the world
catches pneumonia"-so went the favorite cliche
of the 1940's and 1950's. Now, with the fastgrowing influence of foreign nations upon the
American economy, the metaphor may have to
be revised somewhat, along the lines recently
suggested by Tilford Gaines-"When the rest of
the world has the sniffles, the U.S. may get them
too." But although the international financial
system has shown itself susceptible to a wide variety of economic iUs, it has also demonstrated an
ability to develop antibodies to fight off disease,
in the form of new methods of analysis and new
forms of cooperation and regulation. This issue
3
developing nations, and a substantially enhanced
commercial-bank role in financing those imbalances. Moreover, most analysts expect that this
situation will continue for some time to come.
Cheng reviews the pessimistic discussion of
the subject found in Congressional testimony and
the press, and asks if the system is as inherently
unstable as alleged. Judging from a recent International Monetary Fund study of balance-ofpayments adjustments, he claims that the pessimistic argument is overdrawn. "Balance-of-payments developments and debt accumulation
should be viewed in the context of a growing but
inflation-prone world economy. When proper account is taken of output, trade and price changes,
the world economy has been more successful in
approaching financial stability than is generally
realized."
Cheng finds little evidence to support the argument that balance-of-payments loans are inappropriate for banks. Instead he claims that the
two-way capital flows between international
banks and borrowing countries provide evidence
of world-wide financial intermediation, which
supports the world economy's efficiency of resource allocation. In particular, he notes the role
played by banks as the consequence of a major
shift of international payments-from the earlier
build-up of payments surpluses by industrial nations to the present build-up of surpluses by
OPEC nations and offsetting debt accumulation
by less-developed countries (LDC's). Since the
OPEC nations place a large portion of their surpluses with commercial banks, the latter play an
important part in recycling such funds through
the world economy.
Following on Cheng's argument, Nicholas
Sargen notes that major international banks
strongly discount the possibility of widespread
defaults or rescheduling of developing-country
loans. A more likely situation would be occasional repayment difficulties requiring refinancing or
rescheduling. From the lending banks' standpoint, then, the crucial problem is to detect in advance which countries are likely to experience
repayment difficulties and when these difficulties may arise.
More information and improved analytical
techniques thus are necessary to detect potential
default or rescheduling situations. Sargen finds
many existing procedures wanting in this regard,
and discusses ways of improving country-risk appraisal through the use of several types of economic indicators. "Banks should focus on the
inflation rate (and its determinants) and the
debt-service ratio as the key economic variables
affecting a country's borrowings and its ability to
repay."
Sargen distinguishes between "liquidity" reschedulings, which are associated with the
bunching ofshort-term commercial credits, and
other rescheduling:>, which are identified with
long-term debt· relief on official credits. Monetary (and fiscal) factors appear to be closely involved in the "liquidity" cases. Inflation and
overvalued exchange rates lead to export stagnation and over-importing-=and thence to excessive reliance on foreign borrowing and frequently
to foreign-exchange crises. He argues, 'however,
that cases of chronic-debt relief-for example,
Ghana and India in the mid-1960's-are less
amenable to a monetary framework of analysis.
He notes the difficulty of measuring the extent of
overvaluation on the basis of inflation-rate differentials, because in these cases of chronic-debt
relief, governments tend to resort to price controls, capital controls, exchange controls, and
high tariff barriers.
Official regulators as wen as commercialbank analysts must cooperate in maintaining the
health of the international financial community,
according to Robert Johnston in a third article.
He notes that banks have established a good record of international operations through diversification, improved information systems, and
appropriate internal controls. "However, banks'
collective risk assessment may still result in a
banking system that is too risky from the viewpoint of society, and the function of banking supervision is to keep risk exposure within
acceptable boundaries. Foreign risk, to the extent it affects the stability of the domestic banking system, makes supervision of international
banking necessary."
Johnston argues that there are important distinctions between the types of risk involvedbanking risk and sovereign risk. Banking risk is
essentially the same at home and abroad. Despite
greater potential difficulties in obtaining information on foreign borrowers, the credit factors
4
involved are fundamentally the same as in domestic lending. Sovereign risk is a different matter, for which there is no exact domestic
counterpart. Actually, there are few cases where
countries refuse to repay (or refuse permission
for their citizens to repay) foreign loans, because
borrowing countries don't want to foreclose the
possibility of obtaining foreign credit again in the
future. Rather, the real problem cases are those
where countries get into balance-of-payments
difficulties which force them to reschedule debt.
Makin's analysis represents a pioneer effort to
measure statistically the impact of FASB-8 upon
share prices of multinationals. He notes that
FASB-8 standards were super-imposed upon a
system of quasi-floating exchange rates which
permitted various degrees of exchange-rate flexibility, selectively since August 1971 and more
widely since March 1973. For multinationals,
such flexibility meant increased variability of the
dollar value of foreign-currency items on balance
sheets and income statements, with possibly increased variability of net earnings. This fact
should have been fully appreciated by investors
well before FASB-8 went into effect in January
1976. It was thus necessary to look for possible
effects of floating per seon costs of equity capital
for multinationals, and then see if any additional
effects could be attributed to FASB-8.
Makin concludes that the application of
FASB-mandated accounting standards produced few unanticipated effects on earningsand thus on share prices-of typicalmultinational firms such as the oils, drugs and chemicals.
The performance of such groupings was generally indistinguishable from that of a control group
of domestic firms-whether in the face of floating rates, anticipation of FASB-8, or actual application of that new standard. However, the
performance of a group of companies whose
earnings are especially sensitive to exchange-rate
risk was adversely affected. "Our results suggest
that earnings reports which resulted from application of FASB-8 did provide new information
which helped investors distinguish between multinational groupings regarding the impact of exchange-rate adjustments upon (actual and
expected) volatility of reported net dollar earnings. The new standards are significant, then, not
so much because of their specific form but because they apply a single standard to all multinationals, and thereby enable the market to judge
more accurately the relative importance of firms
within the overall multinational grouping."
Johnston emphasizes that banks have been
successful in reducing their loss exposure, judging by the relatively low losses they have experienced in their foreign operations. But to the
extent that official international lending represents a form of insurance, banks may tend to take
greater risks, and international supervision must
act to counteract that tendency. "At the same
time, this emphasis upon risk-taking should not
interfere with the ability of U.S. banks to function as international lenders. Indeed, efforts to
improve international-banking supervision must
ultimately be judged by their contribution to the
world as well as the U.S. banking system."
John H. Makin follows by analyzing the impact of a specific domestic action-the now-famous FASB-8-upon the operations of multinational corporations. Statement No.8 of the Financial Accounting Standards Board was designed to standardize procedures for reporting
foreign-currency positions of U.S. multinationals. FASB-8 prompted a storm of protest from
many of these firms, which argued that it would
cause violent swings in earnings unrelated to
their basic economic condition, and hence would
penalize their share prices and increase their
costs of raising capital. But some analysts retorted that investors should be expected to "see
through" reported earnings figures to distinguish
between those fluctuations which reflect "fundamentals" and those which don't.
5
Hang-Sheng Cheng"
In September 1977, the Senate Subcommittee
on Foreign Economic Policy began hearings on
the proposed $10-billion International Monetary
Fund (IMF) Supplementary Credit Facilitythe so-called "Witteveen Facility." The Subcommittee's concern focused on the "massive balance
of payments lending that has been done by the
commercial banks since the oil price hike"1 and
its impact on the stability of the U.s. banking
system and the international financial system as
a whole. A subcommittee staff report, prepared
in advance of the hearings, described the problem created by the mounting debt of the borrowing countries as follows:
As the debt service burden balloons for
many countries toward the end of this decade, the point may come when one or several of these countries will find it more in
their interest to simply default or repudiate
their external debts rather than to have to
continue borrowing just to repay old loans.
And if this happens, a domino effect could
take place in which other debtor countries
follow suit: the banks panic and start calling in their international loans; the stock
market drops precipitously; and the international capital market collapses. This
doomsday scenario may be extreme in its
pessimism, but it is being taken seriously
enough by responsible officials that a concerted international effort is now underway
to prevent that first domino from fa lling. 2
The purpose of this paper is to analyze the
grounds for this concern. Section 1 compares the
conditions prevailing in world trade and finance
during the 1974-76 period, with those prevailing
during the 1970-73 period. This survey confirms
the general impression of abrupt and large increases in world payment imbalances since 1973,
rapid external-debt accumulation by non-oil developing nations, and a substantially enhanced
commercial-bank role in financing the payment
imbalances. Moreover, available projections suggest that world payment imbalances will continue large in the foreseeable future and that banks
will continue to handle a substantial part of the
payments financing.
Section 2 turns to the question: Is such a system inherently unstable, as alleged? We approach that question by examining three areas:
(a) balance-of-payments adjustments of deficit
countries, (b) the persistent OPEC surplus, and
(c) the mounting debt of developing countries.
The analysis suggests that the world economy
has been more successful in approaching international financial stability than is generally realized. Although much remains to be done, there is
little reason to be overly concerned over the future stability of the international financial
system.
Section 3 examines two policy-related issues.
First is the prudence of commercial-bank financing of world payment imbalances-in particular,
the extension of medium- and long-term balanceof-payments loans for maintaining domestic consumption rather than investment financing. We
find little ground for concern over such loans.
The second issue concerns the roles of the IMF
and national central banks in enhancing the stability and efficiency of the international financial
system with respect to commercial-bank financing of world payment deficits. Although the system is found to be basically sound, appropriate
national and international measures should be
adopted-indeed, some already have been adopted-for improving its functioning and strengthening its safeguards. This and other conclusions
are set forth in a final section.
*Assistant Vice-President and Economist, Federal Reserve
Bank of San Francisco.
6
I. Deficits and External Debts
World payment imbalances
International debt accumulation
The world current-account payment imbalance shifted abruptly in recent years, from an annual average of $20 billion in the 1970-73 period
to $87 billion in the 1974-76 period. 3 (Table 1)
Incidentally, we separate "Surplus OEeD" from
"Deficit OECD" countries in this comparison, to
underscore the different balance-of-payments
performances among the OECD countries. As a
result, the total world payment imbalance (total
deficits) is much larger than when all OECD
countries are considered as a group.4
The countries that suffered the largest declines (in absolute terms) from the recent shocks
to the world economy were not the non-oil developing nations, as is commonly assumed, but the
"Deficit OECD" countries. As a group, the latter
countries recorded a shift from a current-account
surplus of $3 billion per year during the 1970-73
period to an annual deficit of $29 billion during
1974-76, whereas the non-oil developing countries moved from a $15-billion average deficit to
a $37-billion average deficit over the same
period.
Although nearly all the deficit countries borrowed internationally during 1974-76, data on
external debts are available only through 1975,
and only for the 84 developing countries that regularly report such information to the World
Bank. 5 The data indicate that the accumulation
of public external debt accelerated sharply in the
1972-75 period (Table 2). Most notably, non-oil
developing countries increased their debts to foreign private creditors at a 40-percent annual rate
in the 1972-75 period, compared with a 17-percent growth rate in the 1970-72 period. Consequently, such debts rose from 31 to 40 percent of
the non-oil LDC's total external public debts between the end of 1970 and the end of 1975. According to incomplete World Bank estimates,
external public debts of the non-oil LDC's continued to rise in 1976, but at a decelerated (23percent) rate, to a year-end total of $123 billion. 6
Bank lending
The recent rapid growth of international lending has been a global phenomenon, with banks of
Table 1
World Current-Account Balances,1 1970-76
(Billions of Dollars)
Annual Averages
1973
(1) OPEC2
(2) Surplus OECD3
(3) Deficit OECD4
(4) Non-oil Developing5
(5) Socialist and Others 6
(6) Statistical Discrepancies'
Total Deficits
1974
1975
1976
1970-73
1974·76
3.0
12.8
-1.3
-15.0
-4.0
4.5
63.5
12.0
-34.0
-32.5
-10.5
1.5
35.5
27.4
-20.9
-44.0
-17.5
19.5
44.0
18.6
-32.1
-34.0
-13.5
17.0
1.5
7.9
3.1
-15.0
-4.0
6.5
47.7
19.3
-29.0
-36.8
-13.8
12.5
-28.4
-85.5
-89.7
-85.7
-20.5
-86.9
I. Balance on goods, services and private transfers.
2. Algeria, Ecuador, Gabon, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, U.A.E., and Venezuela.
3. Germany, Japan, Belgium, Netherlands, Switzerland, and United States.
4. Australia, Austria, Canada, Denmark, Finland, France, Greece, Iceland, Ireland, Italy, Luxembourg, New Zealand, Norway,
Portugal, Spain, Sweden, Turkey and the United Kingdom.
5. All countries that are not included in "OPEC" or "Socialist and Others."
6. USSR, Eastern European Countries, China, North Korea, Mongolia, Laos, Cambodia, Vietnam, Malta and South Africa.
7. Attributed to asymmetries in national reportings of balance of payments data. For details, see Organization for Economic
Cooperation and Development, Economic Outlook, July, 1977, Technical Annex, pp. 152-3.
Source:
Based on data in Organization for Economic Cooperation and Development, Economic Outlook, July 1977, pp. 69, 7273,89.
7
1).7 Bank net financing of current-account deficits last year amounted to 55 percent for "Socialist and Others," 23 percent for "Deficit OEeD,"
and only 14 percent for "Non-Oil Developing."
Despite the concern over bank lending to the
non-oil LDC's, the. net banking capital flow to
these countries amounted to only $4.9 billion in
1976, or 25 percent of the total flow to all deficit
countries. Moreover, only Latin American nonoil LDC's were net blink borrowers ($7.9 billion), and Mexico and Brazil accounted for almost that entire amount ($7.1 billion). This
analysis thus suggests the need to consider
many nations participating (Table 3). The data
indicate that the banks' external claims increased by more than 50 percent during the
1974-76 period, and more than doubled between
1973 and 1976 when interba.nk credits were
excluded.
For the three groups of payment-deficit countries, the banking system provided about $51 billion net lending in 1976 (Table 4), but that was
offset by a reverse flow of $31 billion into the
banking system, so that the net banking capital
flow amounted to only $20 billion, or about 25
percent of their aggregate deficit in 1976 (Table
Table 2
External Public Debt' of 84 Developing Countries
Annual Average Increase
1970
Total
Official Creditors
Private Creditors
1975
1972
1970-72
1972-75
(percent)
(Billions of dollars)
51.3
69.0
121.2
35.4
46.1
70.9
50.2
15.9
22.9
17.3
15.1
22.0
Th!
43.8
30.1
13.7
14.9
13.8
17.5
25.5
18.2
40.2
17.9
39.7
Non-Oii Developing
Countries
Official Creditors
Private Creditors
56.8
38.4
18.5
100.3
59.4
40.8
'Disbursed debt outstanding at end of year.
Source: IMP Survey, Supplement on International Lending, June 6, 1977, p. 186.
Table 3
Total External Claims of Banksl, 1973-76
(Billions of Dollars)
1975
1976
-
447
555
185
223
286
183
224
269
215
261
326
83
132
98
163
124
202
1973
1974
n.a.
368
Other banks
n.a.
n.a.
Claims on Non- Banks
154
U.S. banks2
56
98
Total Claims
U.S. banks
2
Other banks
'Includes banks in the United States, Western Europe, Canada and Japan.
2Includes branches.
Source: IMP Survey, Supplement on International Lending, June 6, 1977, pp. 177 and 182; and Senate Subcommittee staff
report, op. cit., p. 44.
8
ence between the two reflects a country's net recourse to the banks during a given period.
changes in bank liabilities as well as changes in
bank claims on developing countries. The differ-
II. Stability of the Present System
continued inability or unwillingness to adopt necessary policy measures. 8
2. The persistent surplus of the OPEC nations is
a "structural surplus," which is not amenable to
normal balance-of-payments adjustment policies. 9 Until oil-importing nations as a group adjust to reduce their dependence on oil imports
and until oil-exporting countries expand their
import-absorptive capacities, oil importers will
The prevailing concern over the stability of
the international financial system may be summarized by three propositions \vhich are ana...
lyzed in this section:
1. Balance-of-payments financing by banks has
enabled the deficit countries to postpone adopting necessary but politically and socially difficult
policy measures for correcting payments deficits.
Continued reliance on foreign borrowing reflects
Table 4
External Positions of Banks 1 Vis-a-Vis Groups of Countries
Year-End 1975 and 1976
(Billions of Dollars)
Claims
Surplus OECD2
Offshore Centers 3
Oil-Exporting'
1975
Liabilities
Liabilities
Change in
Claims
Change in
Liabilities
Change in
Net Position
1976
Claims
61.9
14.3
154.3
40.8
51.8
149.6
83.7
24.1
189.0
56.2
64.2
21.4
21.8
9.8
34.7
15.4
12.4
13.3
6.4
-2.6
204.4
246.9
257.4
309.4
53.0
62.5
-9.5
Deficit OECD5
134.6
Non-Oil Exporting
65.2
(43.5)
Latin America 6
Middle East and Africa (6.6)
(12.9)
Other Asia
(2.2)
Other Europe'
Socialist and Others 8
28.2
138.6
38.4
(16.3)
(10.0)
(10.4)
( 1.7)
9.6
158.5
83.7
(57.4)
(8.8)
(14.7)
(2.8)
36.6
155.2
52.0
(22.3)
(12.4)
(14.7)
(2.6)
10.6
23.9
18.5
(13.9)
(2.2)
( 1.8)
(0.6)
8.4
16.6
13.6
(6.0)
(2.4)
(4.3)
(0.9)
1.0
7.3
4.9
(7.9)
(-0.2)
(-2.5)
(-0.3)
7.4
Subtotal
Unallocated 9
Total
186.6
13.6
447.1
278.8
11.4
547.6
217.8
16.4
543.6
50.8
31.2
19.6
Subtotal
i 28.2
228.0
9.3
441.7
1. Banks in the Group-of-Ten countries and Switzerland and the foreign branches of U.S. banks in the Caribbean area and the
Far East, in domestic and foreign currencies.
2. See Table 1, Footnote 3.
3. Bahamas, Barbados, Bermuds, Cayman Islands, Hong Kong, Lebanon, Liberia, Netherlands Antilles, New Hebrides, Panama, Singapore, West Indies.
4. Includes Bahrain and Oman, which are not members of OPEC.
5. See Table 1, Footnote 4.
6. Includes those countries in the Caribbean area which are not offshore banking centers.
7. Andorra, Cyprus, Gibralter, Liechtenstein, Monaco, Vatican, Yugoslavia.
8. See Table 1, Footnote 6.
9. Includes international institutions, residuals of Western European countries and other developed countries, and statistical
discrepancies.
Source: Bank for International Settlements, Annual Report 1976, pp. 86-87; Annual Report 1977, pp. 112-114.
9
continue to accumulate a large aggregate payment deficit to the oil-exporting nations. So long
as the oil surplus persists, there is no end in sight
to this cycle of a few permanent financial surplus
oil producer countries and burgeoning international indebtedness by weaker oil importing
countries. 10
3. These developments have led to mounting international debts with rising debt-service burdens for debtor countries. If this situation
continues, debtor countries may start defaulting
or repudiating external debts, and this could signal the collapse of the shaky international financial system. 11
by the International Monetary Fund,12 the result
of which is summarized in Table 5. The study
compares IMF staff projections of 1977 currentaccount balances of four groups of countries with
their average balances in 1967-72-"a period of
little bias in cyclical conditions"13-adjusted to
reflect changes in prices and real output. The results indicate that (a) the industrial countries
have sustained the largest current-account deterioration ($32 billion) in comparison with their
1967-72 norm; (b) the deficits of other developed
non-oil countries have doubled since 1967-72;
and (c) non-oil LDC's are the only oil-importing
group which has fully adjusted to the oil-price increases and other economic disturbances.
The IMF study also notes that, as a result of
these changes, the oil-exporting nations have replaced the industrial countries as the major surplus group, supplying national savings for
financing the net imports of goods and services
required by non-oil LDC's. Only the "non-oil
more-developed" countries are now incurring a
substantially greater current-account deficit
than they did in 1967-72. 14 Thus, aside from
these shifts, the global structure of current-account balances has been largely restored to its
1967-72 pattern. If that earlier structure was a
stable one, there should be no cause for alarm
over the present payments structure.
Payment adjustments
Many observers consider persistent large payment imbalances as prima facie evidence of lack
of adjustment by the deficit countries. The blanket indictment, however, is an over-simplification which considers only the nominal
magnitudes involved, in isolation from the major
price and output changes that have taken place in
the world economy. Moreover, the aggregate figures hide a great deal of payment adjustments
that have actually taken place in recent years.
The conventional wisdom-see Proposition 1
above-has been challenged in a massive study
Table 5
Global Current·Account Balances:
1917 Projections Compared to Rescaled 1967·72 Norms
(Billions of dollars)
1967-72 Average
Changes
Oil Exporting 2
Industrial'
Actual
1977
Projections
Effected by
1977
(1)
Country Groupings
Rescaled to
1977 Levels'
(2)
(3)
(4)=(3)-(2)
0.7
10.2
3
31
37
-1
34
-32
-1.7
-8.1
-6
-28
-12
-25
-6
Other Non-Oil
More Developed'
Less Developed 5
3
1. 1967-72 average rescaled to 1977 prices and real-output levels by using (a) a general index of world trade prices for rescaling
prices, and (b) average real-GNP (or GDP) growth rates of the respective country groups for adjustment for output growth.
2. OPEC countries, as listed in Table 1, Note 2, minus Ecuador and Gabon, plus Oman.
3. OECD countries, as listed in Table I, Notes 3 and 4, excluding Australia, Finland, Greece, Iceland, Ireland, New Zealand,
Portugal, Spain and Turkey.
4. OECD countries excluded in Note 3 above, plus South Africa, Malta, and Yugoslavia.
5. All other IMF member countries.
Source:
IMF, Annual Report 1977, p. 13.
10
Persistent OPEC surplus
nominal value of the accumulated debt, in isolation from other factors in world economic
growth. That is hardly a meaningful way of looking at the problem. The magnitude of the problem also depends critically on price changes,
income and export growth, and similar factors.
From 1970 to 1975, the nominal debt of developing nations increased steadily by 145 percent,
while their real debt (adjusted for export-price
changes) rose by only 40 percent-and actually
declined from 1972 to 1974 as a result of steep
increases in primary-commodity prices (Chart 1,
upper panel). Various debt ratios, despite increases in recent years, still remain below their
1972 peaks, and the situation is not expected to
change much in 1977 (Chart 1, lower panel).
These measures include the ratio of outstanding
debt to exports, the debt-service ratio (ratio of
interest plus amortization to exports), and the ratio of interest payments to exports. Thus, after
allowing for price changes and export growth, international indebtedness has not increased disproportionately in recent years.
The current concern over the external-debt
problem is reminiscent of the fears expressed
over consumer-credit accumulation in this country in an earlier era. During the 1950's, the public became alarmed by the fact that in the first
postwar decade, consumer credit had risen at a
26-percent average annual rate compared with
only a 6-percent growth rate of personal income.
What would happen to the economy if the debt
burden became unbearable and debt accumulation had to stop? In a classical analysis of the
subject, Alain Enthoven used a simple debtgrowth model to show the unwarranted nature of
this concern. 17 His model assumed a constant income growth rate, and new borrowings as a constant proportion of income. Over time, both the
debt-growth rate and the debt-income ratio
would asymptotically approach their respective
limits, which are determined by the incomegrowth rate and the new borrowing/income ratio. Moreover, if the initial stock of debt is small,
both the debt-accumulation rate and the debt-income ratio would rise steeply at the beginning
and then asymptotically approach their respective long-run limits. The Enthoven prediction has
been borne out by subsequent developments. The
debt-income ratio rose only from 10 percent to
If the above IMF analysis is correct, then the
persistent OPEC surplus should not be a threat
to the stability of the international financial system. As stated, the OPEC countries have now
displaced the industrial countries as the surplus
group in the world economy. Of course, a persistent OPEC surplus implies a persistent deficit on
the part of the oil-importing nations, but that is
no more a "structural imbalance" than was the
former surplus. The latter represented national
savings that helped to finance the rest of the
world's economic-development expenditures.
Now, the OPEC countries have assumed the role
of supplying such savings-the players have
changed, but the game is the same.
Some worry about the reliability of the new
players. What if for political considerations, they
employ their enormous financial resources as a
weapon and threaten to withdraw funds from the
financial institutions of the major industrial nations? Would that not unsettle the market and, in
particular, the affected institutions?15 The concern perhaps stems from a faulty perception of
how banks compete for funds. A sudden withdrawal of any large deposit always poses a threat
to an individual bank's profit margin, as the bank
has to scurry for funds that may be more costly
than the original deposit. But such an occurrence
does not threaten the stability of the market as a
whole nor the viability of the bank as an institution. The withdrawn funds have to go somewhere, and can be recycled back to the original
bank if the bank is willing to bid for them.
In addition, as Thomas Willett has pointed
out, there are strong economic incentives against
irresponsible behavior by OPEC (in fact, any) investors. 16 In today's highly competitive foreignexchange and financial markets, large sudden
shifts of funds will tum prices and exchange rates
against the one making the transfer. Thus, the
market place exercises its own discipline against
erratic behavior on the part of individual participants. Indeed, to date, there has been no evidence
to suggest that OPEC investors have behaved
irresponsibly.
Mounting debt
Concerns over the so-called "mounting debt"
problem are often expressed in terms of the
II
consider. In the short run, because of transitory
factors, the ratio may rise very sharply for a time.
But in the long run, the ratio depends on two factors-the rate of growth of income, as well as the
ratio of debt accumulation to income. In other
words, a growing economy can service. a growing
volume of debt, and short-run fluctuations in the
debt-income ratio provide little guidance to the
analysis of debt-accumulation problems.
13 percent between 1956 and 1976, and the average annual growth rate of consumer instalment
cr~ditdropped from 22 percent in the first
postwar decade (1946-56) to 9 percent during
the decade ended 1976. 18
The moral of the E,nthoven model is very simple: Debt and economic growth are closely related.• Since debt must be serviced out of current
income, the debt-income ratio is a key factor to
Chart 1
DEBT OUTSTANDING AND DEBT SERVICE RATIOS
OF DEVELOPING COUNTRIES, 1969·77
$ Billions
180
160
Debt, Nominal
140
....
120
100
80
60 L--L---L_.L-.....L---'--.l..--'----'----'
1969
1971
1973
1975
1977
Percent
Percent
15
Ratio of Outstanding Debt
to Exports 1I)IIB-
100
75
10
,/
.......: Debt Service Ratio 11
50
5
25
Ratio of Interest Payments to Exports 11
.......:
o L--..L_...L-_..J._-'---,-L.---'--=.I--.......l.=::-' 0
1969
1
1977
Est.
The debt and debt service figures relate only to medium-term and long-term external public, or publicly guaranteed
debt, as defined in the Debt Reporting Statistics of the IBRD.
Source: International Monetary Fund, Annual Report 1977, p. 22; IMF Survey, Supplement on International Lending,
June6,1977,p.185.
12
III. Policy Issues
Bank lending
Four separate issues have arisen with respect
to bank financing of world· payment deficits: (a)
the risks in extending medium-term (1-7 year)
balance ofpayments loans when bank liabilities
are predominantly short-term;19 (b) the risks in
mat-Jng balance~of-payments loans for maintaining consumption rather than for expanding investment in productive projects;20 (c) the
relationship between profit and risk in foreign
lendirig;and (d) economic efficiency in worldwide allocation of capital through the private
market system.
Balance-of-payments loans present the usual
problem of matching long-term assets against
short-term liabilities. 21 In order to cope with interest-rate fluctuations, banks apply floating
rates to most of their Eurocurrency medium-tolong term loans, with the loan rate adjusted every
six months or so to reflect movements in the London interbank offer rate on deposits (the LIBOR
rate). Thus despite being technically committed
to fairly lengthy loans, banks essentially renegotiate their loans on every roll-over date. 22 In this
way, they have demonstrated the ability to develop successful techniques for managing the liquidity problem in the areas of both domestic and
international banking.
The concern over the use of balance-of-payment loans for domestic consumption rather than
investment ignores the fungibility of capital. This
means that once loan proceeds are received, the
funds can no longer be distinguished from those
obtained from other sources, and are thus completely substitutable with each other. For instance, a loan purportedly for the financing of an
investment project could enable the borrower to
release his own resources for other "non-productive" purposes. On the other hand, a loan purportedly for the importation of consumer goods
could free a country's domestic resources for
"productive" investments. In short, the true test
ofthe soundness of a lQan is not its stated purpose, but the anticipated· income stream of the
borrower-which in the case of a foreign nation
isitsexpected rate of economic growth.
On the question of profitability, banks have
achieved a considerably higher level of profits on
international banking than on dOlnesticbanking
in recent years. In 1976, international operations
accounted for 57 percent of Citicorp's assets but
for 72 percent of its after-tax earnings, and for
48 percent of Chase's total assets but for 78 percent of its earnings. 23 However, critics have asked
whether banks have become so attracted by the
profitability .of international lending as to pave
imprudently incurred an unacceptable level of
country risk. 24 Yet recent surveys On banks' internal.control over foreign lending-conducted
by the Federal Reserve System and the lJ.S.Ex~
imbank-have yielded no evidence to. support
that conclusion,25 Moreover, gross domestic loan
charge-offs rose from 0.42 percent in 1974 to
0.94 percent in 1976, while international loan
charge-offs rose from 0.11 percent to 0.20 percent over the same period. 26 Thus, international
banking to date has been at least as successful as
domestic banking in balancing profitability and
risks.
A final consideration relates to the economic
function of bank lending, in terms of the efficiency of allocation of capital on a world-wide scale.
Most analysts recognize that banks perform an
important task of international financial intermediation in recycling oil-surplus funds, but few
explicitly recognize that the banking role goes
much farther than that. The extensive banking
network that has been built up during the last 15
years is now gathering savings from all parts of
the world and redistributing them on a worldwide basis in response to market forces. In particular, the flows of funds are not uni-directional
from surplus countries to deficit countries, but
are rather two-wayflows with respect to each re~
gion and indeed to each country as well (Table
4). Access to the banking network offers savers
all over the world an opportunity for international portfolio diversification, so as banking capital
flows into relatively high-return countries, savers
in these countries also put funds in the banks for
risk diversification. 27 Again, because of economies of scale and scope of risk diversification,
multinational banks can operate world-wide on a
lower overall spread between deposit and lending
rates, than can local financial institutions. In ei13
their standards for controlling risk and further
expand their foreign lending, thus aggravating
the external-debt problem. 33
In response, it might be noted that the Facility's purpose is not so much to permit the IMF to
engage in a larger volume of lending, as to
strengthen its hands in urging member countries
to adopt appropriate policies to cure payment imbalances. In the words of Federal Reserve Chairman Burns: "One reason why countries often are
unwilling to submit to conditions imposed by the
IMF is that the amount of credit available to
them-as determined by established quotas-is
in many instances small relative to their structural payment imbalance. 34
The key words about the proposed Facilityindeed, about the use of all IMF credits-are
"conditionality" and "payment-adjustment policies." Thus, the intent of the Facility is neither to
"bailout banks" nor to "bail out countries," but
to offer a viable avenue-a financially sound
package-for countries in payment difficulties to
adopt in order to return to health. The outcome
would be reduced payment imbalances and a
healthier world financial climate. The resultant
reduction in risk might induce banks to expand
their foreign lending beyond what they would
otherwise do, but that does not necessarily imply
any lowering of standards of risk-assessment. If
the Facility were administered as intended,
banks could not reasonably expect to be bailed
out from loans to countries that do not accept
policy conditions attached to IMF credits. Thus,
bad loans would still be bad loans, but the Witteveen Facility, by encouraging debtor countries to
adopt payment-adjustment policies, would help
improve the chances of turning potentially bad
loans into good loans.
ther case, the development of the international
banking network means a gain in economic welfare for the world as a whole.
Role of the IMF
Several recent proposals have called for the
InternationalMonetary Fund to playa more active role in helping member countries cope with
their payments financing and adjustment problems. The proposals fall into two categories: (a)
enlargement of IMF resources to provide more
effective assistance to member countries, and (b)
increased coordination with commercial banks to
reduce risks of private lending. 28
(a) Enlargement of IMF resources. The two
proposals of this type include the so-called "Witteveen facility" (described below) and the authorization for the IMF to borrow directly in the
private capital market. 29 Both recognize the fact
that IMF resources have become woefully inadequate in relation to its responsibilities as a result
of the substantial growth of world payments deficits. During the 1974-76 period, IMF lending
rose to record levels but still financed only about
six percent of aggregate payments deficits.so
The Witteveen Facility is designed as a Supplementary Credit Facility at the IMF, consisting of funds borrowed from source countries at 7percent interest and re-Ient to deficit countries at
market-related interest rates. About $10 billion
has been pledged, including $2.5 billion from
Saudi Arabia, $1.7 billion from the United
States, $1.2 billion from Germany, and $1.0 billion from Japan. The Facility is viewed as a stopgap until the IMF's regular quota resources are
substantially increased in about two years' time.
Several misgivings have been raised about the
proposed Facility. One criticism, raised by Senator Frank Church, concerns its size in relation to
the magnitude of the aggregate payment deficits.
"The amount contemplated-approximately $10
billion-is nowhere near the magnitude necessary to cover the balance-of-payments deficits of
the oil-importing countries. Consequently, it is
anticipated that there will be future requests for
additional Congressional appropriations."31 Another criticism concerns the use of the Facility
"for bailing out the commercial banks or taking
over risky loans injudiciously contracted by the
banks."32 Another possibility is that the banks,
with such a "safety net" under them, might lower
(b) Coordination with banks. Enhanced
IMF-bank coordination could take the form of
greater consultation to prevent misunderstandings, greater flows of information to assist evaluation of borrowers' creditworthiness, and cofinancing packages involving a blend of IMF and
private funds. All these proposals raise fundamental questions about the operations of the
IMF and its relationship with sovereign members
and private banks. It is, therefore, not surprising
that the IMF thus far has reacted cautiously to
the various proposals.
14
Difficulties could arise, for example,.over the
proper handling of information flows. There can
be. no disagreement that a larger and freer information .flow would aid risk. assessment and thus
improve the e.fficiency of the market. Specifically, more information-and more systematic and
tirn.elr information--is needed on the magnitu<ies, maturity. structures, external guarantee
provisions, and types of borrowers of both the
public and private external debts of individual
borrowing countries. A multinational project is
novvunderway, under the auspices of the Bank
for Intl':rnational Settlements, to collect such information from banks of major industrial countries and make it available to banks engaged in
foreign lending. 35 More difficult is the development of thorough analytical reports concerning
not only the economic conditions in borrowing
countries, but also the willingness and ability of
their governments to carry out appropriate stabilization policies. The IMF already prepares material of this type, but it is generally not available
to the public because of the confidential nature
of IMF recommendations.
The need for information, however, should not
be overstated, because the market mechanism
can help a<ijust for the volume and quality of the
information available at any point of time. For
instance, if a government is either unable or unwilling to supply information which a potential
crl':ditor deems critical, this should affect the
loanrate or lending terms--or even the decision
to lend. On the other hand, if the availability of
such information in fact makes little difference
to loan terms, it may be a good indication that
theinformation is not so critical after all.
Lastly, several leading commercial bankers
have addressed the question of co-financing
paGkages and coordination in lending policy.
John Haley of Chase Manhattan has noted that
informal consultation already exists between
banks and the IMF, and asks to what extent the
c09peration should be formalized. He argues
against formalizing the situation to the point
where the IMF would become the arbitrator of
both official and private lending. 36 Gabriel
Hauge of Manufacturers Hanover points to the
complications arising from parallel-financing
plans, where the loan agreement between the
IMF and the borrowing country contains clauses
thatllre confidelltial between thetwo parties. He
suggests asas91ution "cross default" clauses in
paralleHoan agreements, so that default against
anyone loan would mean defaultagainstalLthe
loa~s.in the package. Thus protected, •hank participants inthepackage would not need to kn9w
theterrnsofagreernent between the IMF and the
individllalt>orr9wiIlgcountry.37
Role of Central Banks
It! the area of intl':rnational.banking, as in. domesticbanking, a central bank's responsibility
encOrnpasses •. both a regula tory/supervisory
function and a lender-of-Iast-resort function for
supporting the liquidity of a particular institution or of the economy as a whole. The former is
the subject ofanother article in this issue. 38 A few
comments may be added regarding the central
bank's second responsibility-the lender-of-Iastresort function. 39
The concern over foreign lending arises over
the tendency for banks to jump on the bandwagon when things are going well and to stop
lending when things go sour. This tendency creates great swings in lending activities, and at
worst a general banking crisis. 40 That, ofcourse,
is precisely what central banks are supposed to
forestall through their lender-of-last-resort function, by providing ample liquidity to the banking
system through liberal discount policy. The Penn
Central episode of June 1970 provides a vivid example of how the default of a major borrower
can affect financial markets, and how a central
bank's decisive actions can restore liquidity and
marketconfidence. 41
In the international context, cooperation
among national central banks is clearly necessary in carrying out this lender-of-last-resort
role. In fact, major central banks already cooperatein this fashion through their regular monthly
meetings at Basle under the auspices of the Bank
for International Settlement. At one such meeting, theY reached an agreement concerning ways
of extending emergency credits to banks within
their individual jurisdictions and to branches and
subsidiaries of multinational banks. Under this
agreement, parent banks are expected to back up
their foreign branches and wholly-owned subsidiaries. Moreover, in accordance with a 1976 Federal Reserve interpretation, U.S. banks are
15
expe<::t~d
to support mor~ than their own share in
difficulty. with joint ventures-that is,
arrangements involving minority participation
where some mana.gement interestexists.42
The •central· banks participating in the agreementdeliberately Jeft unclarified the exact procedures for providing temporary liquidity.
Instead, they merely statedthatthey were "satisfied that means are available for that purpose
and will be used if and when necessary."43 This is
inline with the tradition ofnot defining and publicizingspecific rules for emergency assistance to
troubled banks, to discourage banks from relax-
ing their bankerly caution and relying instead on
such emergency facilities.
Thus, the present international financial system is cushioned against untoward shocks, first
by banks which have access to a vast international money market with considerable depth,
breadth, and resiliency; then by central banks
acting as joint lenders of last resort; and also by
the IMF with its active surveillance over adjustment policies in borrowing countries. International cooperation in this fashion promotes a
basic condition of confidence, under which banks
can safely and efficiently perform their function
of international financial intermediation.
cas~of
IV. Summary and Conclusions
1. As a result of the post-1973 international
crises-the OPEC oil price increase plus the ensuing world-wide inflation and recession-total
world current-account imbalances more than
quadrupled from an annual average of $20 billion in 1970-73 to $87 billion in 1974-76. Net
bank lending (changes in claims minus changes
in liabilities) financed about one-fourth of the
aggregate deficits in 1976.
2. Considerable balance-of-payments adjustments have now been made-especially by· the
majority of non-oil developing countries-given
the price changes and output growth that have
occurred since the 1967-72 period. While continuedimprovementsare needed, the payment imbalances and growing debt are not as
unmanageable as sometimes alleged. When the
same factors are taken into account, the external
debt burden of non-oil developing countries (as a
group) does not appear to be any larger now than
in the early 1970's.
3. The continuing OPEC surplus has replaced the pre-1973 current-account surplus of
the industrial nations as the principal source of
world savings for financing deficit countries' development needs. Being riskaverters, the OPEC
countries have chosen to place the bulk of their
surplus funds in world financial markets, including banks. They are thus subject to the same kind
of market discipline as other investors and, in
fact, have behaved as responsible investors in
their investment activities.
4. In principle, there is no reason why commercial banks should not extend medium- or
even long-term loans for financing payment deficits, even though the loans may be intended for
maintaining domestic consumption· rather than
for investment financing. There is also no evidence that banks have been any more lax in controllin~risks in their foreign lending than intheir
domestic lending. On the positive side, internationalfinancial intermediation through multinatioualbanks means enhanced efficiency· in
gathering and allocating capital in the world
economy.
5. Although the world financial system is basically sound, there is much that the IMF and
nationalcentral banks cando-and in fact have
done-to improve the system's functioning (e.g.
assurance oflender-of~last-resort facilities). The
proposed Witteveen Facility is a needed step in
this direction.
16
FOOTNOTES
1.lntematlonal Debt, ttleBanks, and U.S. Foreign Polley, a
staff report, Subcommittee on Foreign Economic Policy, Committee
on Foreign Relations, U.S. Senate, 95th Congress 1st Congress
lslSession, U.S. Government Printing Office, August 1977, p. 5.
2. Ibid.
3. According to IMF andOECD estimates, world payment imbalances will continue to be nearly as large in 1977 as in 1976, and
prospects are rather dim for significant reductions in the future. For
detailfl, flee Internationa! Monetary Fund, Annual Report, 1977, p.
13, and OECD, Economic Outlook, July 1977, p. 69.
4. Some arbitrariness was necessary in separating "Surplus
OECD" from "Deficit OECD," particularly with respect to Japan and
the United States, which changed from deficit to surplus (or vice
versa) during the 1974-76 period. The criterion used was whether
the sum of the annual current-account balances during the period
was positive or negative for each country in question.
5. Disbursed debt only. The selection of 1972 was dictated by the
fact that debt accumulation began to accelerate in 1973, even before the oil-price incrsases went into effect.
6. World Bank, World Debt Tables, 1977, Vol. I, p. 42.
7. Changes in banks' external claims indicate banks' net foreign
lending (loans minus amortizations). But, since banks also accept
deposits from foreign nationals, the "net banking capital flow" to or
from a foreign country is obtained by subtracting the changes in
banking liabilities from those in banking claims vis-a-vis that country. Because of interbanking capital flows and of difficulties in idenIilying sources of funds in certain cases, the data pertaining to
"Surplus OECD," "Offshore Centers," and "Oil-Exporting Countries" should be considered together.
6. Senate Subcommittee staff report, op. cit., pp. 50-51.
9. Robert Solomon, "IMF Urged to Borrow in Financial Markets,"
The Journal of Commerce, September 26, 1977, pp. 4.
10. Statement by Senator Frank Church, Preface to the Senate
Subcommittee staff report, op. cit., p. vi.
11. See, e.g., the passage cited on the first page of this article.
12. IMF, Annual Report 1977, pp. 12-24.
13. Ibid., p. 12.
14. Since these findings are contrary to common impressions,
somee.laboration may be needed. In the first place, the sharp deterioration in the industria! countries' current-account balance can be
explained by the $21 billion aggregate 1976 deficit of eight coun·
tries (Austria, Canada, Denmark, France, Italy, Norway, Sweden,
and the United Kingdom), which was nearly offset by the aggregate
$20·billion surplus of the other members of the group (Belgium,
Germany, Japan, the Netherlands, Switzerland, and the United
States). The common impression of "strong" industrial countries
pertains to the latter subgroup only. Secondly, the IMF study notes
that an upsurge of current-account deficits among non-oil LDC's in
1974-75 was sharply reduced in 1976, especially by Asian and Latin American countries. The common impression of the adjustment
problems of this group waa probably based only on those 1974-75
developments.
15. For an articulation of this concern, see Senate Subcommittee
staff report, op. cit., p. 66.
16. Thomas D. Willett, The 011 Transfer Problem and International Economic Stability, Princeton Essay in International Finance,
No. 113 (December 1975), p. 13.
17. Alain Enthoven, "The Growth of Inatallment Credit and the Future of Prosperity," American Economic Review, December 1957,
pp.913-929.
16. Board of Governors of the Federal Reserve System, Banking
and Monetary Statistics, 1941-1970, September 1976; Annual
Statistical Digest, 1971,1975, October 1976; and Federal Reserve Bulletin, September 1977.
19. Foranexprsssion of thia concern, see Gerald A. Pollack, Are
the ()11-PaYment~Deflclts
Manageable?, Princeton Essay in International Finsnce, No. III (June 1975), p. 5.
20. The Senate Subcommittee staff report comments: "Presumably, a corporate loan will beself-liqui~atingonce theinvestm.nt
far which the money waS borrowed beginllyielding a return. But
many of the loans to governmentshsve been used notlo; investment, but to maintain a given level of consumption. This does nothing to increase the future earning power of the borrower, and funds
to service the loan have to be found elsewhere, perhaps through
addltionsi borrowing." Subcommittee staff report, op. cit., p. 5.
21. Jsck Beebe, "A Perspective on Liability Management and
Bank Risk," Economic Review, Federal Reserve Bank of San
Fram~lsco, Winter 1977, pp. 12-25.
22. John Hewson and Eisuke Sakahibara, The Eurocurrency Mar·
keta and Their Implications, 1975, pp. 147-152.
23. Senate Subcommittee staff report, op. cit., p. 47.
24. "Has the profitability of this activity blinded them to the underlying risks?" Sellate Subcommi!tee staff report, op. cit., p.67.
25. See statement by Chairman Arthur F. Burns, Federal Reserve
Board, before the Senate Banking Committee on March 10, 1977;
and also Stephen Goodman, "How the Big U.S. Banks Really Evsluate Sovereign Risks," EuromoneY, February 1977,pp. 105-.1.10.
26. Robert Morris Associates, Domestic and International Com·
merclal Loan Charge-Offs, various issues. For a study of loanloss .experiences of the 1962-74 period, see Fred B. Ruckdeschel,
"Risk in Foreign and Domestic Lending Activities of U.S. Banks,"
Board of Governors of the Federal Reserve System, International
Finance Discussion Papers, No. 66, July 1975.
27. Herbert G. Grubel, "Internationally Diversified Portfolios: Welfare Gains and Capital Flows," American Economic Review, December 1966.
28. See, for instance, Arthur F. Burns, "The Need for Order in International Finance," speech at Columbia University Graduate Sqhool
of Business, New York, April 12, 1977; W. Michael Blumenthl3l, "Toward International Equilibrium: a Strategy for the Longer Pull,"
speech at International Monetary Conference, Tokyo, May 25,
1977; Senate Subcommittee staff report, pp. 62-67; statements by
Richard D. Hill, Frederick Heldering, John C. Haiey,and Irving S.
Friedman before the Senate Banking Subcommlltee on International Finance, August 30, 1977; Robert Solomon, "iMF Urged to Borrow in Financial Markets," Journal of Commerce, September 26,
1977, pp. 5 and 10; Gabriel Hauge, "How the Banks Should Work
with the Fund," Euromoney, October 1977, pp. 57, 59-60.
29. Robert Solomon, op. cit.
30. W. Michael Blumenthal, op. cit., p. 7.
31. Foreword to the Senate Subcommittee staff report, op. cit.,
p.v.
32. Cited in Michael Blumenthal's speech, op. cit., p. 6.
33. "Has the banks' willingness to lend to foreign countries for baiance of payments purposes been premised on the unstated assumption that in the event of a real debt repayment crisis, the
governments of the wealthy industrial countries will come to the
rescue because they cannot afford to see either the debtor countries or their own large banking institutions go under?" Senate Subcommittee staff report, op. cit., pp. 67-66.
34. Arthur F. Burns, op. cit., p. 12.
35. Participating in the project are banks from the Group of Ten
countries (Belgium, Canada, France, Germany, Italy, Japan, the
Netherlands, Sweden, the United Kin9dom, the United States)plus banks from Denmark, Ireland, and Swllzerland-and the affiliates of those banks in offshore centers. The global data for end1976 were released by Bank for International Setllements on June
6,1977; those collected from U.S. banks were released on June 3
17
ence on International Banking, October 6, 1977; and "Discussion"
by Donald Hodgman.
40. See Senate Subcommittee report citation on the first page of
this article.
by the Board of Governors of the U.S. Federal Reserve System.
36. "Neither the Fund nor any other official body should be asked,
or allowed, to become an international credit-rating body with effective control over the allocation of foreign credit." See his statement before the Senate Banking Subcommittee on International
Finance, op. cit.
37. Gabriel Hauge, op. cit., pp. 59-60.
38. See Robert Johnston's article in this issue.
39. For a discussion of this subject, see Henry C. Wallich, "Central
Banks As Regulators and Lenders of Last Resort in an International
Context," remarks at the Federal Reserve Bank of Boston Confer-
41. For a description of the Penn Central episode. see Evelyn M.
Hurley, "The Commercial Paper Market," Federal Reserve Bulletin, June 1977. pp. 532-533.
42. Henry Wallich. "Central Banks as Regulators," op. cit., pp. 1415.
43, !bid.,p_
Issues in Pril'lt
Gold (1975h--Studies. of the.world's past experience with the gold standard and
U.S. gold policy.
Woddlnftatioll (1975)-Studies of the factors which have made inflation worldwide in nature.
Western Enel"gyand Growth (1975)-Studies of potential Western energy sources and of Califc)rniia's
growth problems.
Inflation and Financial Markets ( 1975)-Analysis of the different ways in which inflation affects financial markets.
InterllatlonlilBanking (1976)-8tudies of the impact ofanincreasingly interdependent world economy
onthe banking system.
Financial Markets and Uncertainty (l976)-Analyses of the responses to increased uncertainty occurring in four separate financial markets.
New Perspectives on Stabilization Policies (1976)-Analyses of stabilization policies in both a domestic
and international context.
Real World Risk and Bank Risk (1977)--Studies of the changing response of banking institutions to the
risk environment of the 1970's.
TbeBusiness Cycle Revisited (1977)-Ana1yses stemming from the recession-caused rebirth of interest
in business-cycle theory.
Reacti9nsto Uncertainty (1977)-8tudies of the inflation/unemployment trade-off and of risk premiums.in world financial markets.
18
Nicholas Sargen'
The current debate over commercial-bank
lending to less-developed countries (LDCs) has
primarily centered on the question of whether
private banks have extended too much credit to
the group of non-oil exporting developing countries. Despite the considerable attention given to
the subject in the financial press, the major international banks by and large dismiss the possibility of widespread defaults or reschedulings on
developing-country loans as being highly remote.
A more likely scenario, according to the banks, is
that individual countries occasionally may experience repayment difficulties requiring some refinancing or rescheduling. Most banks, therefore,
believe that the crucial problem is to be able to
detect in advance which countries are likely to
experience repayment problems and when these
difficulties may arise.
The banking community has recently shown
great interest in the utilization of analytical techniques to detect potential default or rescheduling
situations. Relatively little information is currently available to appraise the various techniques now in use, and, as a result, it is often
difficult for bankers to judge the adequacy of
their own internal rating systems as compared
with those employed by other institutions, public
or private.
The difficulty is illustrated by a recent Export-Import Bank survey on bank practices in assessing country risk. 1 That study found that a
large percentage of the 37 U.S. banks surveyed
are dissatisfied with their present country-appraisal methods and are actively seeking new
procedures. From the survey responses, though,
it is not possible to determine how much of their
dissatisfaction relates to their own procedures,
and how much has to do with limitations in the
current state of the art in assessing country risks.
This paper is designed to facilitate appraisal
of existing procedures by comparing techniques
commonly used by commercial banks and official institutions, along with techniques that have
been developed in the economic literature. The
scope of the paper is limited to only one aspect of
country-risk appraisal-namely, the use of economic indicators to rank countries according to
the probability of default. The analysis addresses
the following questions: (i) What are the economic causes of debt reschedulings? (2) Which
set of economic indicators does the best job of
distinguishing between rescheduling countries
and non-rescheduling countries? (3) How reliable are econometric techniques in predicting
debt reschedulings?
Section I briefly reviews the experience with
LDC debt reschedulings since the late 1950's,
and describes techniques employed by commercial banks and official institutions for assessing
country risk. Section II compares two conceptual
approaches used in the analysis of debt reschedulings. The first approach views reschedulings as
resulting from fluctuations in prices of primary
products which then lead to a rapid accumulation of external debt relative to export earnings.
The second approach treats debt reschedulings
as a monetary phenomenon, in which domestic
inflation and an overvalued exchange rate contribute to increased demand for imports and to
export stagnation, and consequently to a rapid
build-up of external debts. Section III employs a
statistical procedure--discriminant analysis-to
identify the set of economic indicators which best
distinguish rescheduling countries from non-rescheduling countries. (A brief discussion of the
*Economist, Federal Reserve Bank of San Francisco.
19
ulings), and the second type of rescheduling is
identified with long-term debt relief on official
credits (e.g. reschedulings for South Asian countries and Ghana). In the "liquidity" cases, monetary (and fiscal) factors appear to be at the root
ofthe problem, and the inflation rate turns out to
be the most imporant explanatory variable.
Cases of chronic-debt relief, on the other hand,
appear less amenable to a monetary framework
of analysis, and it is necessary to include the
debt-service ratio to explain these reschedulings.
statistical procedure is included for interested
readers.) The final section assesses the relevance
of the empirical findings to country-risk appraisal and the desirability of using statistical procedures for this purpose.
Our analysis suggests the importance of distinguishing "liquidity" reschedulings from longterm debt reschedulings. The first type is associated with a bunching of short-term commercial
credits (typical of most Latin American resched-
I. Assessing CouniryRisk
Commercial banks encounter two types of repayment risk in international-lending operations
which do not arise in domestic-banking operations. The first type of risk, commonly referred
to as "sovereign risk," occurs when a national
government refuses to permit foreign loans to be
repaid, or when a government seizes bank assets
without adequate compensation. The second type
of risk, often called "transfer risk," is associated
with foreign borrowers' problems in converting
domestic currency into foreign exchange. Credits
extended to foreign borrowers by banks in the
U.S. market or in the Euro-currency market are
typically denominated in U.S. dollars (or in a key
currency), and government foreign-exchange restrictions sometimes make it difficult for borrowers to acquire sufficient foreign exchange to
repay their loans. 2 Foreign-exchange controls are
particularly common in developing countries,
where fixed exchange-rate policies are still
prevalent.
Commercial banks assess both types of risk in
their country-risk appraisals. Cases of expropriation or outright default on bank loans have been
quite rare in the postwar period, however, and
have been confined mostly to Communist takeovers in Cuba or Southeast Asia. The more common case has been the formal restructuring or refinancing of external-debt obligations in the
wake of foreign-exchange crises. Restructuring
has usually involved a stretching of principal
payments on a previous credit, while refinancing
has involved new credits.
Close to 40 such instances have occurred since
1956, involving about a dozen developing countries which formally negotiated with creditor
countries to postpone payments of their interest
or principal. The total amount of debt service
rescheduled was on the order of $7.7 billion, of
Table 1
International Debt Reschedulings 1960-76 1
(Millions of U.S. $)
Country
Year
Argentina*
1962
1965
1961
1964
1965
1972
1974-75
1966
1971
1966-70
Total Amount
Rescheduled
Amount of U.S.
Debt Rescheduled
0
18
Brazil*
0
44.5
Chile*
43
65
231
Egypt
N.A.
145
Ghana*
0.7
1~4
~O
0
India*
65
1968-72
545
1973-76
688
74
Indonesia*
1965-68
427
96
1970
2100
215
1971-74
987
270
Pakistan*
1968-69
128
0
Peru*
NA
N.A.
1970
Philippines
Turkey*
1965
220
15
1972
114
0
Uruguay
1965
N.A.
N.A.
Yugoslavia
1965
N.A.
N.A.
59
59
1972
Zaire
1976
N.A.
N.A.
* Denotes countries which have experienced multilateral
debt reschedulings.
'Note:
20
240
76
300
200
96
160
597
N.A.
145
295
Information on debtreschedulings was compiled
from a variety of sources including Bitterman
[6], Cohen [7], Feder-Just [l1J, Frank-Cline
[I2l, IMF [I7J [18], OECD [22J.
which roughly $1.3 billion constituted debt owed
to the V.S. government or to U.S. nationals (Tablet). Howiver, the economic cost of debt reschedulings-measured as the difference between the present discounted value of the repayments stream before and after reschedulingwas considerably smaller. 3
Most multilateral debt reschedulings have either involved suppliers' credits (which frequently
carry government guarantees) or official credits.
Many of the Latin American reschedulings, for
example, have involved short-and medium-term
commercial debt, so that negotiations were arranged through ad hoc meetings of major private
creditors (the so-called "Paris Club" or "Hague
Club" meetings). Debt-relief negotiations for
Ghana, India, Indonesia, Pakistan, and Turkey,
on the other hand, have been arranged through
government consortia which were responsible for
coordinating flows of financial assistance to
those countries. Private debts usually have not
been rescheduled in these contexts, in part because the amounts involved were relatively small
compared with official claims.
LDC workouts of debt to private bank creditors have been much more infrequent and have
tended to take the form of refinancing, rather
than rescheduling of existing debt. The principal
cases in earlier years involved Argentina and
Brazil (early 1960's), Peru (1965), and the Philippines (1970).4 Because of rapid expansion in
international lending, however, banks since 1975
have become even more heavily engaged in negotiations with developing countries, as in the recent negotiations with the governments of Chile
and Zaire on debt-relief issues. In additions, they
have provided balance-of-payments financing for
Argentina and Peru to ease potential debt problems of these countries. In this situation, banks
and regulators alike have become concerned
about the need to improve methods for assessing
individual country risks.
of country targets or limits, for the use of bank
management in overseeing the bank's international portfolio. The latter process involves making country comparisons about the risk of nonrepayment, and so subjective judgments play an
important role.
Most banks are reluctant to assign formal
credit ratings to individual countries when setting country guidelines. In the Eximbank survey,
for example, only about a fourth of the banks
surveyed (8 out of 37) translated their country
evaluations into a country rating (usually with a
five-grade letter system A to E). Five of the
banks which rated countries utilized a weighted
checklist system, with economic and political indicators being used to measure a country's repayment prospects. The summary score, or country
rating, in each case was obtained by assigning
weights to individual indicators and then summing the value of individual indicators.
The checklist approach can be criticized for
failing to provide a conceptual framework for selecting individual indicators, and also for its arbitrary selection of weights. However, statistical
procedures are currently being developed to circumvent some of these problems, by such agencies as the V.S. Treasury Department and the
U.S. Export-Import Bank. Their statistical debtmonitoring systems use a single predictive equation, based on information about past debt reschedulings, to screen "high risk" countries from
those with low probabilities of rescheduling.
(The methodology underlying the Treasury and
Eximbank systems is described in Section III.)
Countries singled out as possible rescheduling
candidates are then subjected to in-depth economic and political analyses.
The econometric approach provides a means
for identifying statistically significant variables
and for assigning weights which are not completely subjective. From a commercial-bank
standpoint, though, the central issue is whether
econometric techniques provide a more reliable
means of detecting defaults or debt reschedulings than present procedures. A direct comparison of the two approaches is not possible, since
banks which make country ratings do not publicly test their rankings against experience. Published studies which employ econometric
techniques, on the other hand, report low error
Methods for assessing risk
Country appraisal can come into play at two
different stages. One phase involves the approval
of individual credits, and thus requires a report
by the bank's economics department on the borrowing country's general political and economic
situation. The second phase involves the setting
21
rates in explaining past reschedulings, although
they have been far less successful in anticipating
reschedulings than in explaining most
reschedulings. 5
The problems can be traced to the conceptual
framework used to explain debt reschedulings
(Section H) and to methodological difficulties
encountered in applying statistical procedures to
a small sample of rescheduling countries (Section III).
II. Conceptual Approaches to Debt RescheduUngs
Part of the difficulty faced by commercial
banks and regulatory agencies in assessing risks
can be traced to the absence of a well-developed
conceptual framework for analyzing debt problems of developing countries. Economic models
of "optimal" foreign borrowing largely have been
concerned with the effect of foreign borrowing
on economic growth and with conditions necessary to ensure an efficient allocation of resources
over time. 6 These studies generally conclude that
repayment of external debt is not a problem, provided that the rate of return on domestic investment equals or exceeds the cost of foreign
borrowing.7 Such models, however, do not allow
for the fact that foreign borrowing must be repaid in foreign exchange, and that foreign-exchange receipts may be temporarily scarce.
Second, they typically assume that domestic and
international capital markets are perfectly competitive-assumptions which are highly unrealistic for most developing countries.
The two approaches presented in this section
explicitly deal with the foreign-exchange problems which surround most debt reschedulings.
The debt-service approach traces the LDC's foreign-exchange problems to their heavy reliance
on exports of primary products and to the high
volatility of these products on world markets. Financial ratios derived from individual balanceof-payments components hence are used to measure a country's ability to service its external
debt in the event of a shortfall of export receipts.
The monetary approach, on the other hand, is
primarily concerned with the overall determination of a country's balance of payments, and thus
focuses attention on that country's monetary-fiscal policy and exchange-rate policy. From this
perspective, the underlying causes of debt reschedulings are internally, rather than externally, generated.
debt-filonitoring systems is based on the financial-ratioanalysispioneered by Avramovic and
associates at the World Bank [3]. The approach
views reschedulings as a problem of external debt
management, and thus focuses attention on the
determinants of a country's "debt-service capacity". We are concerned here with that approach's
underlying assumptions and their implications
for the analysis of LDC debt problems.
In the Avramovic study, one type of debt
problem involves the near-term bunching of
debt-service payments, while a second involves
debt rescheduling over a longer time interval. 8
The Latin American reschedulings typified the
first type of problem: debt-service payments on
short- and medium-term commercial debt were
rescheduled over a fairly short time span-e.g.,
one to five years. But in the case of the consortia
creditors to Ghana, India, Indonesia, and Pakistan, long-term official lending formed a significant portion of debt-service payments. In these
cases, the reschedulings covered such a long
time-span-up to 30 years in the case of Indonesia- that they had a noticeable impact on debtservice burdens.
Avramovic analyzes the short-run debt problem as if the developing country were a firm facing a cash-flow or liquidity squeeze. The liquidity
problem in this case reflects a temporary shortfall in foreign-exchange receipts, brought about
by an exogenous decline in the world price of the
LDC'sprincipal export product. Under these circumstances, the country can try to cover payments abroad by expanding its export volume, by
curtailing imports, by further borrowing or by
drawing down foreign-exchange reserves. Avramovic's analysis, however, assumes that most
LDC's cannot expand export proceeds easily in
the short run, and that they cannot easily "rollover" debt by borrowing from private capital
markets. Under these assumptions, a developing
country has only two viable options available in
Debt-service approach
The analytic approach used in most statistical
22
the short run-namely, to draw down reserves
(including drawings from the International
Monetary Fund) or to reduce its import volume.
The Avramovic approach attempts to measure a country's ability to withstand an export
shortfall (or a situation of capital flight) by constructing financial ratios from individual balance-of-payments components. The principal
measure of "reserve adequacy," for example, is
the ratio of foreign-exchange reserves to annual
imports of goods and services. The higher the ratio, the better equipped the country is to cover
imports by temporarily drawing down foreignexchange reserves.
The traditional indicator of debt-service capacity, on the other hand, is the debt-service ratio--the proportion of foreign-exchange earnings
on current account (exports of goods and services) absorbed by interest payments and amortization on external debt. Those analysts using this
indicator do so because debt-service payments
represent contractually fixed obligations which
cannot be easily adjusted; hence, a higher ratio
implies a larger relative burden on import reduction for a given shortfall in export receipts. The
reasoning behind this traditional indicator is that
there is a limit on a country's ability to tolerate a
reduction in its import volume. 9
One of the principal conclusions of the Avramovic study is that the debt-service ratio is a relevant indicator of potential "cash squeeze"
problems associated with foreign-exchange crises, but that it is less useful for analyzing debt
problems of a long-run nature. The reason is that
domestic savings rates normally rise during the
process of economic development, in which case
foreign-borrowing requirements needed to sustain a given target growth rate will diminish
through time. A country's debt-service ratio thus
will tend to rise in the early stages of development, when domestic saving rates are low, but
will tend to level off or decline with the later rise
in domestic savings. The ability to repay external
debt over the long run, therefore, hinges on the
difference between the marginal savings rate and
the initial savings rate, as well as on the relationship between the rate of return on investment
and the cost of foreign borrowing. 10
The usefulness of the debt-service approach as
an analytical tool hinges critically on the exis-
tence of assumed balance-of-payments rigidities
and on the nature of foreign-exchange bottlenecks. In Avramovic's analysis, the foreign-exchange constraint reflects two factors: (I)
limited possibilities for short-run expansion for
export production, and (2) inelastic demand for a
country's major export product. It is assumed
that if a country attempts to expand its export
volume by increasing export production or by reducing domestic consumption, the increased export volume will lead to a deterioration in the
country's terms of trade; so that export receipts
are not increased." But if the "small-country assumption" is applicable-if the country's share
of the world market is so small as to leave the
world price unaffected-the foreign-exchange
bottleneck disappears. That is, the country can
increase its export volume (and its export receipts) through increased domestic savings or
through expanded production.
The assumption of limited (or zero) capital
mobility is also critical to the analysis. If a country is able to borrow from world capital markets
(including commercial banks) to cover a temporary shortage of foreign exchange, the concepts
of "reserve adequacy" or "debt service capacity"
become much more difficult to define. Under
these circumstances, it is not the country's lack
of foreign-exchange reserves or the country's export earnings per se which are important, but
rather the country's ability to acquire foreign exchange. 12 In this case, the country must decide
whether the cost of foreign borrowing exceeds
the cost of adjusting to an export shortfall
through import reductions-i.e., profitability
considerations are relevant even in the short run.
The main limitation of the approach, however, is that it focuses on the events immediately
surrounding a rescheduling, rather than on the
underlying causes. It provides few clues to explain why countries borrow heavily, and it allows
little scope for d6mestic policies to influence foreign borrowings or repayment prospects. Avramovie's analysis, for example, completely ignores
the role which the domestic price level, the exchange rate, and interest rates play in the process
of balance-of-payments adjustment. The key
variables-the debt-service ratio, the reservesimport ratio, the export growth rate, or the domestic savings rate-are either exogenous or
23
rowingforeign currency from abroad (r ,):
r' = if - Pd +
(2)
where: = expected appreciation of foreign
currency.
Real borrowing costs in the two markets (and
real rates of return on capital in the two countries) will be equated- only if the expected exchange-rate change is equal to the expected
inflation-rate differential at home and abroad:
(3)
structurally determined. As a result, the scope
for balance-of-payments adjustment appears
quite limited.
e
Monetary approach
The alternative approach uses a monetary
framework of analysis to study the problem of
debt-reschedulings. The monetary approach
(like the debt-service approach) treats reschedulings as consequences of foreign-exchange shortages. However, it is primarily concerned with the
overall determination of the balance of payments, rather than with individual balance-ofpayments components. The scarcity of foreign
exchange in this case results from: (I) rapid
money-supply expansion (associated with the financing of fiscal deficits) and consequent increase in domestic inflationary pressures, and (2)
maintenance of an overvalued fixed exchange
rate. From this perspective, the underlying
causes of debt reschedulings are rooted in domestic economic policies.
An analysis of this monetary framework involves: (1) the effects of domestic inflation and
an overvalued exchange rate on the supply and
demand for foreign funds, and (2) the implications of exchange-rate flexibility for debt reschedulings. Consider first the case of a developing country which maintains a fixed exchange
rate and which suffers from a higher inflation
rate than the rest of the world.
Inflation can influence the demand for foreign
funds in such a case through its adverse impact
on the trade accounts. That is, inflation would
tend to cause export demand to fall and import
demand to rise, and the growing trade deficit, in
turn, would increase trade-financing requirements. A second type of inflation impact, noted
by Friedrich Lutz [19], concerns the effect of an
over-valued exchange rate on the cost of borrowing funds from abroad. Lutz's analysis assumes
that nominal interest rates in the domestic economy (id) and abroad (if) reflect the real rate of
return on capital (r) and the expected inflation
rate (p):
id = rd + Pd, and
(1)
if= rf+ Pf .
In financing domestic investment, borrowers
compare the real cost of borrowing in the domestic capital market (rd) with the real cost of bor-
e,
If investors believe authorities can maintain a
fixed exchange rate temporarily (despite a higher domestic rate of inflation), incentives will exist
to borrow more heavily from abroad, since real
borrowing costs are then perceived to be lower in
the foreign market than in the domestic
market. 13
Amore common situation, however, is one in
which authorities impose interest-rate ceilings to
keep domestic borrowing costs low. Such a policy
tends to lower domestic saving and to ration potential borrowers out of the domestic market.
The imposition of interest ceilings, therefore,
may also create incentives resulting in increased
demand for foreign funds.
The amount of foreign borrowing, however,
also depends on lenders' expectations about repayment prospects. In a highly competitive market, such as the Eurocurrency market, loans to
developing countries include an interest premium-the spread over the London inter-bank offer rate-which reflects the higher risk of
repayment. An increased demand for foreign
funds associated with an over-valued exchange
rate, therefore, need not result in an increased
volume of foreign borrowing-provided that
there is a contraction (leftward shift) in the supply schedule of foreign funds to offset that increased demand.
While economic theory provides no clear-cut
reasons for expecting domestic inflation to lead
to an increased volume of foreign borrowing, the
effect may not be completely neutral, judging
from the experience of those LDC's which have
rescheduled suppliers' credits. For instance, most
of the Latin American countries of this type were
able to obtain ample suppliers' credits (usually
government-guaranteed) in the early stages of
inflation, but fewer such credits as the inflation
progressed. In these cases, domestic inflation re24
suited in rapid growth of debt-service payments
in the early stages of inflation, but then in subsequentexport stagnation, which contributed to
rising debt-service ratios.
den of transferring real resources abroad to service external debt. Rather, exchange-rate
flexibility is relevant to debt reschedulings because exchange-rate movements are part of the
overall adjustment process, whether the resource-transfer problem is "real" or monetary.
Currency depreciation resulting from a price decline for some major export product, for example, win create incentives towards increased
export production. Similarly, depreciation resulting from domestic inflation will offset the adverse effects of inflation on the trade accounts. In
this sense, exchange-rate flexibility can help reduce the necessity for debt rescheduling. Therefore, one would probably expect fewer debt
reschedulings under flexible exchange rates, although not necessarily so in every case.
Thus far, we have assumed that authorities in
developing countries maintain fixed exchange
rates. ActuaUy, most LDC's today continue to
peg their exchange rates to some key currency,
although a growing number of them have experimented with some form of exchange-rate flexibility in recent years. Under a freely-floating
exchange rate, a country cannot experience a
shortage of foreign exchange, since there is no official intervention in the foreign-exchange market. The absence of a "foreign-exchange
problem," however, does not imply a smaller bur-
III. Empirical Evidence on Debt Reschedulings
This section presents empirical evidence on
the determinants of debt rescheduling, with emphasis on the characteristics distinguishing those
countries which have rescheduled their debt from
those which have not-previous empirical studies have largely concentrated on variables suggested in the Avramovic study. The statistical
results confirm that reschedulings are associated
with a high debt-service ratio and a bunching of
external-debt obligations, but there is disagreement about the importance of other economic
variables.
Frank and Cline [12] used discriminant analysis to investigate the importance of eight indicators for the period 1960-68. They found only
three variables to be important: the debt-service
ratio, the debt-amortization ratio, and the ratio
of imports to reserves. Feder and Just [11], using
a similar set of explanatory variables, applied 10git analysis to explain reschedulings during the
1965-72 period. Their results showed the importance of the three variables identified by Frank
and Cline, but three other indicators as wellthe export growth rate, the level of per capita income, and the ratio of capital inflows to debt-service payments.
Both studies report low error rates in identifying past reschedulings. 14 Nonetheless, questions
arise about the availability of data for testing the
two basic (debt-service and monetary) approaches. For example, the debt-service ap-
proach is difficult to use in any "early-warning"
system, at least pardy because World Bank data
on external debt are available only after a two- or
three-year lag for most countries. The U.S. Treasury Department actuaUy discontinued use of its
debt-monitoring system because of the problem
of obtaining up-to-date, accurate information on
LDC external debt.
With respect to the monetary approach, however, inflation rates and exchange rates are generaUy available with relatively short time lags.
Hence, an indicator system relying on the monetary approach is more likely than one based on
debt information to detect likely candidates for
debt rescheduling. To date, however, there has
been litde empirical work on the relationship between monetary variables and debt reschedulings, so this study attempts to establish whether
such a relationship exists.
inflation and debt rescheduling
A clear relationship between inflation and
debt rescheduling is apparent for the 1960-76 period (Table 2).15 Altogether, 70 percent of the
countries with long-term inflation rates above 10
percent (measured by wholesale prices) rescheduled their debts at some time during that period. Moreover, aU six countries in the "high
inflation" group had to reschedule at least once
between 1960 and 1976.
Other data suggest the important contribu25
sion in the period preceding rescheduling. The
depreciation, however, was insufficient in each
case to offset the adverse effects of sustain.ed
high inflation on the trade account.
tionof currencyovervatuation.......-as well. as. inflation.......-tp •. balance-of-payments difficulties prior
todebtrescn.edulings(Table 3). In every case
cited, except EgyptandTurkey, a majorcurren~
cy devaluation was undertaken around the period
when<i~bt.\Vas rescheduled. Yet with frequent
exchange-rate adjustments, .countries such as
Colpmbia, Israel, Korea, Chile (1965-70 and
1975-76) and Brazil (1965-76) have successfully
avpided .repaYment difficulties despite theirrelatively high inflation. These countries at times
have pursued "craWling peg" policies, where exchange-rate changes are linked .to the difference
between. their own inflation rate and. those of
their principal trading partners. Their experience
suggests that increased exchange-rate flexibility
may help mitigate. the adverse effects of inflation
on export and import performance, on borrowing
incentives, and thus on debt reschedulings.
Exchange-rate depreciation, however, may
not always be successful in avoiding rescheduling. Four of the. five countries which experienced
very high inflation, for example, allowed the exchange rate to depreciate on more than one occa-
Application of discriminant analysis
Theevi<iencepresented above suggests that
monetary factors maybe important for understanding previous debt renegotiations. The questionstiILremains, however, as to whether
indicatprsutilized in the monetary approach can
perfprm as well or better than those utilized in
the debt-service approach. To answer thisquestion we applied a statistical technique (discriminantanalysis) to data on two groups of
developing countries-those which rescheduled
their debt at least once in the 1960-76 period,
and those which did not. The statistical procedure is the same as that employed in the FrankCline study and in the debt-monitoring systems
used by the U.S. Treasury Department and the
U.s. Export-Import Bank.
Discriminant analysis 16 provides a rule (or discriminant function) for classifying observations
Table 2
Inflation and Debt Reschedulings: 1960-1976 1
High-Inflation
Group
(10-20% p.a.)
Very High Inflation
Group
(above 20% p.a.)
I.
2.
3.
4.
5.
6.
1
2
Argentina*
Brazil*
Chile*
Indonesia*
Uruguay*
Zaire*
(33%)
(35%)
(161 %)
(186%)
(53%)
(25%)
1.
2.
3.
4.
5.
6.
7.
8.
Bolivia
Colombia
Ghana*
Israel
Peru*
Philippines*
South Korea
Yugoslavia*
Middle-Inflation
Group
(5-10% p.a.)
(10.2%)
(14.6%)
(11.3%)
(11.0%)
(10.4%)
(10.5%)
(14.6%)
(14.6%)
I.
2.
3.
4.
5.
6.
7.
8.
9.
10.
II.
12.
13.
14.
15.
16.
Afghanistan (8.4%)
(7.9%)
Burma
Costa Rica
(7.3%)
Dominican
(5.1%)
Repub.
Ecuador
(7.3%)
(6.2%)
Greece
(7.7%)
India*
(5.1%)
Ivory Coast
(7.2%)
Jamaica
(5.1%)
Mexico
(7.0%)
Pakistan*
(9.1%)
Par~guay
(5.8%)
Spain
Thailand
(5.5%)
(5.5%)
Tunisia
(9.5%)
Turkey*
low-lnflatlon2
Group
(less than 5% p.a.)
I.
2.
3.
4.
5.
6.
7.
8.
9.
10.
II.
12.
13.
14.
Algeria
Egypt*
EI Salvador
Ethiopia
Guatemala
Guyana
Honduras
Iran
Iraq
Jordan
Malaysia
Sri Lanka
Syria
Venezuela
(2.8%)
(3.9%)
(3.2%)
(4.0%)
(3.9%)
(4.0%)
(3.6%)
(3.6%)
(3.0%)
(4.4%)
(3.0%)
(4.4%)
(4.5%)
(4.4%)
Figures in parentheses represent annual compound (WPI) inflation rates over the period 1960-1975. Asterisks denote debt
reschedulings in the period 1960-76. (See Table I). Data from International Financial Statistics.
U.S. annual compound WPI inflation rate is 4.2% for 1960-75.
26
(e.g., countries) into two or more groups (e.g.,
"rescheduling country" vs. "non-rescheduling
country"). The rule is selected so as to minimize
the expected cost of making two types of errors in
classifying observations. In our analysis, Type I
error occurs when a rescheduling country is classifieda.sanon-rescheduling country, and Type II
error results when a non-rescheduling country is
this value in the rescheduling group, and to categorizecountries with lower inflation rates in the
non-rescheduling grou.p. Applying the "10 percent cut-off rule" to the countries listed in Table
2 yields the following setof results:
Inftanoll
Rate>10%
classified as a rescheduling country.
Rescheduling group
(14 countries)
Suppose, for example, that the only difference
between rescheduling countries and non-rescheduling countries is that the inflation rate is
higher on average in the first group than in the
second group. Under these circumstances a simple way to classify countries would be to select
some cut-off inflation rate, say 10 percent, and to
categorize countries with inflation rates above
Inftanoll
Rate:510%
71%
(classified
29%
(Type 1 errorrate)
correctly)
NonRescheduling group
(30 countries)
13%
(Type 11
error rate)
87%
(Classified
correctly)
Table 3
Debt Reschedulings and Exchange Rate Devaluations 1
3 year
CPllnflation
Rate(OAl)
3 year
Money-Supply (M,)
Growth Rate (0Al)
Exchange Rate
Devaluation
1962
1965
1961
1964
1965
1974
1965
1970
1965
1976
23.3
24.7
31.6
69.7
37.3
43.2
173.8
185.0
40.3
24.6
9.9
31.1
43.9
70.5
48.8
110.3
386.2
73.3
58.8
25.5
1962
1964,1965
1961
1962-65
1962-65
1972-76
1966-68
1970
1965
1976
1966
1974
1968
1970
1965
1972
12.6
16.0
12.6
6.2
16.3
11.4
14.0
29.9
14.4
10.9
16.1
15.8
1967
none
1967
1970
1965
1971
9.4
8.8
5.0
9.2
3.3
11.4
7.8
14.5
14.3
10.1
14.5
21.6
1966
1972
1971
none
none
none
Debt
Reschedulings
Very High Inflation Group
Argentina
Brazil
Chile
Indonesia
Uruguay
Zaire
High Inflation Group
Ghana
Peru
Philippines
Yugoslavia
Middle or Low inflation Groups
India
Paldstan
Egypt
Turkey
,
1968
1973
1971
1966
1965
1972
Data from International Financial Statistics.
27
Thus, four of fourteen countries (29 percent)
which rescheduled their debt had long-term inflation rates less than 10 percent, so that use of a
10.percent cut-off value caused those four to be
classified incorrectly (Type I error). Four of the
thirty countries (13 percent) which did not reschedule, on the other hand, had a long-term inflation rate above 10 percent, resulting in Type II
error.
The same principle applies to a situation in
which there are a number of variables which differentiate the two groups. In this case, a discriminant "score" (or composite variable) is computed
as.a weighted average of the individual variables
for purposes of classifying individual observations. The weights of the composite variable are
selected so as to maximize the difference in mean
values for the two groups, given the specified set
of variables.
The ability to classify countries correctly depends on how close the group means are relative
to the group dispersions. This point is illustrated
in Figures la and 1b, which assume normal
"bell-shaped" distributions for the two-group
case and a cutoff inflation value, c. The probability of Type II error (Le., of misclassifying an observation from the nonrescheduling group) with
a value of p > c ( = 10 percent), thus, is the
shaded area under the bell-shaped function for
group I to the right of c, while the probability of
misclassifying an observation from group 2
(Type I error) is the shaded area to the left of c
under the density function for group 2. Error
rates in classifying observations (Le., the percentage of observations misclassified) will be
much greater when there is considerable group
overlap (Figure la) than if there is only a small
degree of group overlap (Figure 1b). Differences
in group means, therefore, do not always guarantee that the rules will yield a useful classification
scheme in which the errors are small.
(which may entail.a subjective judgment) and on
the frequency of reschedulings relative to nonreschedulings. 17
Methodological Issues
l'hemain • problem encountered in applying
discriminant analysis (or other statistical procedures)to debt-rescheduling data arises from the
small number of obervations of this type. Pooled
time series .and cross-section data are typically
usedtoincrease the number of rescheduling observations, and. this procedure is adopted here.
Each observation thus corresponds to a country
and a year. The Argentine multilateral reschedulingof 1962, for example, is treated as a separate observation from the Argentine rescheduling of 1965.
The procedure of pooling time series and
cross-section data leads to further complications,
however, which must be considered in interpreting our results (and those of other published
studies):
1. The number of rescheduling cases (24) is
still small in comparison with the non-rescheduling cases (442).18 Plots of variables for the rescheduling group, moreover, suggest that the
data are not normally distributed. Thus, one of
the theoretical assumptions underlying discriminant analysis is violated. 19
2. The individual observations are "serially
correlated." A country which exhibits a high (or
low) inflation rate or debt-service ratio in one
year, for instance, tends to exhibit the same characteristic in other years. This will affect the error
rates, since a country which is misclassified (or
correctly classified) in one year will tend to be
misclassified (or correctly classified) in other
years. 20
3. A problem arises with countries which
have rescheduled debt more than once. Ghana
and India, for example, have had debt rescheduled in a number of years since 1966 and 1968,
respectively, in the process of coordinating aid
flows to those countries. Thus, do those reschedulings represent "new events" or extensions of
the original reschedulings?21 A question also
arises regarding the treatment of observations of
rescheduling countries in non-rescheduling
years. The results reported here delete such observation, since we are primarily interested in
Finally, the proportion of Type I and Type II
errors depends on the particular cutoff point selected for classifying countries. Moving the cutoff value, c, to the right in Figure 1, for example,
increases the probability of Type I error and reduces the probability of Type II error, while the
opposite is true if the cutoff value is moved to the
left. Selection of the cutoff point hinges on an assessment of the cost of making each type of error
28
identifying characteristics which distinguish rescheduling from non-rescheduling countries,
rather than identifying the times of
rescheduling. 22
4. The implicit assumption is that the factors contributing to reschedulings are the same in
one period as in other periods-i.e., there are no
"structural" changes affecting reschedulings (or
distributions) during the sample period. It is dif-
ficult to test this proposition because of the limitednumber of reschedulings, although the
discriminant rule appears to explain recent cases
as well as earlier cases.
Several further pitfalls are often encountered
in interpreting results from discriminant analysis.• One of the. most widely misunderstood aspects relates to the problem of determining the
importance of individual variables. Unlike the
Chart 1A
NORMAL DISTRIBUTION WITH LARGE GROUP OVERLAP
Non- rescheduling
Group
Rescheduling
Group
Probability
density
0'-----"'----Inflation
Rate (p)
Type 1 error
Type 2 error
Chart 1B
NORMAL DISTRIBUTION WITH SMALL GROUP OVERLAP
Non-rescheduling
Group
Reschedul ing
Group
Probability
density
0'--....:::;;.--------..10-Inflation
Rate {p}
Type 1 error
29
Type 2 error
coefficients. in the linear-regression model, the
discriminant-function coefficients are not
unique. (However, the ratios of those coefficients
are unique.) Consequently, no test can be made
for< the absolute importance of a particular variai:l1e.(i.e., setting a p<.irticular coefficient equal to
zeroorto some other value), although a number
ofrnethodshave been proposed to determine the
relative importance of individual variables. 23
The mea.ninfla.tion rate for the rescheduling
gi"OUp wa.snea.l"ly Seven times larger than the
nion-rescheduling group; the money-supply
growth rate was nearly four times larger, and the
a.djusteddebhserviceratiowas about three times
grea.ter. The standa.rd deviation of the inflation
rate a.ndmoney-supply growth rate for the rescl'ledulinggroup, however, were also considerabiylarger than for the non-rescheduling group,
owing to the incidence of hyper-inflation and the
sma.ll sample size. As a result, differences in the
coefficients ()fvariation (i.e., the standard deviation divided by the mean) for the two groups
were much smaller than the differences in group
means.
Tests for equality of the multivariate group
means and variance-covariance matrices indicated that group differences were statistically significant. 26 Under these circumstances, the
appropriate rule for classifying countries would
be a quadratic (rather than linear) function. In
most cases tested, however, the linear function
yielded comparable results to the quadratic function. The linear rule also had the advantage of
being easier to interpret, because of the smaller
number of terms involved.
Two separate linear functions were obtained:
Empirical results
Two sets of explanatory variables were used to
differentiate rescheduling and non-rescheduling
cases in the 1960-75 period. The first set included variables identified in previous empirical studies: (1) the debt-service ratio; (2) the reserveimport ratio; (3) the export growth rate (in U.S.
dollars); (4) the growth rate of real GNP and (5)
the level of per capita GNP (in 1970 U.S. dollars). The second set contained variables suggested by the monetary approach, and also (6) the
(consumer-price) inflation rate; (7) the growth
rate of the Ml money supply; and (8) a measure
of relative purchasing-power parity (the difference between the domestic and U.S. inflation
rates, on a wholesale-price basis, less the rate of
domestic currency depreciation vis-a-vis the U.S.
dollar). All explanatory variables were expressed
as three-year annual averages, with the explanatory variables lagging the dependent variable an
average of one year-e.g., with the 1960-62 average inflation rate distinguishing rescheduling
and non-rescheduling cases in 1962. The debtservice ratio was also adjusted to include scheduled (rather than actual) debt-service
payments. 24
A forward step-wise regression procedure was
used to obtain a measure of the relative importance of each variable, prior to applying the discriminant sub"routine. 25 The results suggested
that the inflation rate and the adjusted debt-service ratio were the most important explanatory
variables (Table 4). The inflation rate and the
money-supply growth rate were highly correlated, however, so that the relative importance of
the money-supply variable increased considerably when the inflation rate was excluded. Two
of the variables, the reserve-import ratio and the
level of per capita income, added little in the way
of explanatory power, and thus were omitted
from the discriminant sub-routine.
Inflation RateIncluded
8.72· .21(CPI) - .01(MS) + .04(EX) - .35 (DSA)
+ .03(PP) + .07 (GNP)
(2) Inflation Rate Excluded
7.72 - .lO(MS) + .05(EX) - .36(DSA) .05(PP)
+.lI(GNP)
where:
CPI = average annual rate of consumer price inflation
over three-year period
MS
average annual rate of M, growth over threeyear period
EX
averagleannual rate of growth of exports (in
U.S. dollars) over three-year period
DSA = average debt-service ratio over three-year period (adjusted to include scheduled debt-service
payments for rescheduling countries)
PP
purchasing-power parity (i.e., a three-year average of the difference between the domestic and
the U.S. WPI inflation rates, less the rate of domestic currency depreciation vis-a-vis the $).
GNP = average annual rate of growth of real output
over three-year period.
(I)
The functions were constructed so that the
30
more the negative value, the more likely the
country would be classified in the· rescheduling
group. The prominence of the inflation· rate in
equation 1 (or money-supply growth rate in
equation 2) and the adjusted debt-service ratio is
apparent from the weights of these variables in
the discriminant functions, which corroborates
the finding from the step-wise regression procedure. In addition, the negative signs of the coeffidents of these variables are consistent with the
hypothesis that the probability of rescheduling
increases as their value increases.
The percentage of c()untries classified incorrecdy with these functions ranges from 3 percent
to 11 percent, depending on the cutoff value se-
Iected. (The cutoff value for the results reported
assUl.nestheexpected cost of Type I error is three
times the expected cost of Type II error.) The
over~n error rate is not very meaningful, however, in view of the large difference in sample size
for the two groups ()fcountries. The percentage
ofrescheduling cases in the sample is roughly 5
percent; hence, a rule which classifies aU countries as non-rescheduling cases will have an overaU error rate of 5 percent. For this reason, it is
important to examine the incidence of Type I and
Type II errors and to see how they vary with the
cutoffpoint.
Type I error rates vary from 15 to 54 percent,
while Type II error rates range from less than 1
Table 4
Sample Characteristics of Rescheduling
and Non-Rescheduling Groups'
Rescheduling Group
Non-Rescheduling Group
Variable
Mean
Standard
Deviation
Coefficient
of
Variation'
5.6
5.7
1.02
Mean
Standard
Deviation
48.5
Coefficient
of
Variation'
1.32
(0.9)2
1.57
(0.94)2
1.37
0.40
M, Growth Rate
13.9
8.2
0.59
36.7
(23.8)2
49.6
Export Growth Rate
Debt Service Ratio
Real GNP Per Capita
Growth Rate
Purchasing Power
Parity
16.3
7.6
18.1
5.8
1.11
0.76
(33.2)2
9.7
21.1
(21.5)2
78.0
(31.2)2
13.3
8.5
3.7
3.9
1.05
2.3
2.6
1.13
4.3
7.2
1.67
8.1
15.0
1.85
Inflation(CPI) Rate
Measure of Relative Importance
(Percent of explanatory power accounted for by each variable)
Inflation rate
excluded
Inflation rate
Variable
Included
42.7%
Inflation(CPI) Rate
2.0
M, Growth Rate
Export Growth Rate
11.3
35.5
Debt Service Ratio
Real GNP Per Capita
4.6
Growth Rate
3.9
Purchasing Power
Parity
, Standard deviation + mean
2
•
33.0%
14.5
37.9
7.3
7.2
These figures are affected by the experience of hyper-inflation surrounding the Indonesian reschedulings. Values excluding
data for Indonesia are in parentheses.
Country data are from International Financial Sta tistics and from IBRD, World Tables.
31
TableS
Discriminant Analysis Results:
Classification of Rescheduling Countries 1
Results In<:luding Debt-Service
Results Excluding Debt-Service
Ratio in Discriminant Function
Ratio in Discriminant Function
Countries Correctly Classified
Countries Correctly Classified
Argentina
Argentina
Brazil
Brazil
Chile
Chile
(1966)
(1970)
Uruguay
(1965)
Countries Incorrectly Classified
Countries Incorrectly Classified
Argentina
Egypt
(1962)
(1966)
Ghana
(1974)
Peru
(1968)
Philippines
(1970)
Yugoslavia
Yugoslavia
Zaire
1
(1965)
(1976)
(1961)
(1964)
(1965)
(1972)
Indonesia
Indonesia
(1965)
(976)
(961)
(1964)
(1965)
(972)
(1966)
(1968)
(1973)
(1966)
(970)
(971)
(1975)
(1965)
(1972)
(1965)
Argentina
Argentina
Brazil
Brazil
Chile
Chile
Ghana
India
India
Indonesia
Indonesia
Pakistan
Peru
Turkey
Turkey
Uruguay
(1965)
(1971)
(1976)
Argentina
Egypt
Ghana
Ghana
India
India
Pakistan
Peru
Peru
Philippines
Turkey
Turkey
Yugoslavia
Yugoslavia
Zaire
(1962)
(1966)
(1966)
(1974)
(1968)
(1973)
(1971)
(1968)
(1976)
(1970)
(1965)
(1972)
(1965)
(1971)
(1976)
Results based on two sets of linear discriminant functions; assuming expected costs of Type I error is three times the
expected cost of Type II error:
Debt Service Ratio Included
8.72 - .21 (CPI) - .01 (MS) + .04 (EX)
- .35 (DSA) + .03 (PP) + .07 (GNP)
Debt Service Ratio Excluded
4.07 - .22 (CPI) - .01 (MS)
+ .03 (PP) + .03 (GNP)
+
.04 (EX)
32
Chart 2
rectlyclassified(Table 5). Reschedulings in
these countries are associated with high inflation
and rapid money-supply growth, and the discriminant rule assigns a relatively large weight to
these variables. These countries also tend to have
high debt-service ratios, but that ratio need not
be included to explain their reschedulings.
Reschedulings in South Asian countries, on
the other hand, require some information on the
adjusted debt-service ratio. India and .Pakistan
experienced relatively low inflation rates for the
group Qfrescheduling countries (partly owing to
the use of extensive price controls), but debt relieUor these countries (and for Ghana) has become a means of supplementing aid flows. The
debt-service ratio, in particular, has been used as
anjndicator of need for debt relief by the consortia of aid donors.
The results are somewhat paradoxical in the
light of the traditional approach taken by Avramovie et al. On the one hand, the debt-service ratio is found to be an accurate-but largely
redundant-indicator of those reschedulings associated with short-run balance of payments crises. On the other hand, the debt-service ratio is
found to be a critical factor explaining those reschedulings associated with long-run debt problems. In the latter cases, the reasons are political
as well as economic.
RELATION OF ERROR RATES TO VALUE OF CUT-OFF POINT
(Linear Discriminant Function)
Error Rate (%)
40
Type 1 Error
30
20
10
Type 2 Error
0 ' - - ' - - - - ' - - - - ' - - - ' - - - - ' - - - - - - ' - - Cut-off
-1
0
1
2
(50%)
(75%)
(90%)
Value
percent to 11 percent (Figure 2). The ability to
classify non-rescheduling cases more precisely
than rescheduling cases reflects the absence of a
"well-behaved" distribution for the rescheduling
countries-i.e., the variables are highly skewed
and exhibit large variances.
The discriminant rules perform best in explaining reschedulings in South American countries (Argentina, Brazil, Chile, Peru, Uruguay)
and Indonesia, where 10 out of 12 cases are cor-
IV. Summary and Conclusions
This paper has examined two sets of issues involved in country-risk appraisal-the causes of
past debt reschedulings, and the ability to anticipate future reschedulings. The evidence suggests,
first, that there is a systematic pattern of debt
reschedulings which is amenable to economic
analysis.Reschedulings, in short, are not isolated
or random events, even though their underlying
causes are not the same for all countries.
The analysis distinguishes between "liquidity"
reschedulings, which are associated with the
bunching of short-term commercial credits, and
other reschedulings, which are identified with
long-term debt relief on official credits.
Monetary (and. fiscal) factors appear to be
closely involved in the "liquidity" cases. Inflation
andover-valued exchange rates lead to excessive
reliance on foreign borrowing and thence to ex-
port stagnation and over-importing-and generally to foreign-exchange crises. Cases of chronic
debt relief, on the other hand, appear less amenable to a monetary framework of analysis. In particular, it becomes difficult to measure the extent
of over-valuation on the basis of inflation-rate
differentials, because of the LDC's tendency to
resort to price controls, capital controls, exchange controls, and high tariff barriers.
Knowledge of the causes of past reschedulings
does not necessarily imply an ability to anticipate
future reschedulings. The latter is affected by the
difficulty of correctly forecasting exogenous variables, by changes in structural parameters of estimating equations, and by problems caused by
the small samples used in analyses of previous
resched:uJings. Even so, statistical procedures
have an advantage over commercial-bank check33
list· systems because they provide a systematic
m~thod foridentifying variables and for explicitly considering trade-ofTs.
important for country-risk appraisal. The analysisin thispa~r suggests that banks should focus
on the inflation rate (and its determinants) and
the debt-service ratio as the key economic variables afTecting a country's borrowings and its abilitytorepay.
An understanding of past reschedulings,
moreover, can be useful in delineating what is
FOOTNOTES
economic growth. The condition for equi-proportionate growth of
debt and GNP is writtl:in:
1. •See Goodman [131. The Federal Reserve has also recently conduCtedaninformal survey of bank practices in defining, monitoring,
and controlling foreign lending exposure.
2. ·Sy denominating a loan to an LOC in a key currency, a commercial bitnkcan avoid the risk of exchange rate depreciation of the
LDCcurrency, but not the risk of non-repayment.
3. Estimates of the cost of rescheduling are difficult to obtain
since fairly detailed information on the repayment stream is required to compute the present discounted values. In case of reschedulings of official credits it is customary to compute the "grant
element" of the rescheduling-i.e., the value of the repayment
stream after rescheduling as a fraction of the value of the repayment stream at commercial interest rates.
4. For purposes of this study, refinancings of individual bank credits are treated as a problem of credit risk, rather than as a problem
of country risk. The distinction between refinancings and reschedulings in many cases is moot, although technically a refinancing
involvell an extension of new credit as compared to a "stretch-out"
of an existing credit.
5. Forecasting precision is affected by the ability tc forecast ex·
og&nous variables accurately and by changes in structural parameters, as well as by the standard error in the estimating equation.
6. See Bade [41, Bardhan [51, and McCabe and Sibley [201.
7. Aliber [11 discusses the analogy of the optimum indebtedness of
the firm and that of developing countries. His paper examines
whether bank lending to developing countries constitutes an efficient allocation of the world's resources and whether risk premiums on LOC loans are too large relative to the cost of rescheduling.
8. Avramovic uses a separate analytic framework to examine each
type of problem. Our discussion is primarily concerned with debt
problems associated with a foreign exchange crisis, rather than
with problems stemming from slow economic growth.
The theoretical underpinnings for separating the two types of
problems are the "two-gap" models of economic development,
which assume that foreign exchange earnings are limited by inelastic export demand, and that technical substitution possibilities between f()reign and domestically produced capital goods are fixed.
Under these circumatances, the ex-snte condition for trsde balanceand for equality of domestic savings and investment are written separately, rather than in the usual fashion, S-I = X-M. The
foreign l:ixC/lange constraint is assumed to be binding in the short
run, \Vhilethesavinga conatraint is binding over the long run. For a
critique of the two gap models, see Nelson [211.
9. The popularity of the debt-service ratios as a default indicator
datl:isback to the 1930's, when a number of Latin American countri&a with high debt service ratios (15% or more) defaulted. See
Mrarnovic [31, p.194. Primary producing countries experienced
sharp declines in prices of their export products, increasing their
real dllbt burden; at the aame time, new credits were not forthcoming.On the othl:ir hand, there are several examples of countries
with high debt-service ratios which have not experienced debt diffiCUlties. These include Australia and Canada during the 1930's
(with investment service-export earnings ratio above 30 percent)
and Mexico, Bra~iI, and Israel in recent years.
10. Avramovic examines the properties of a model of foreign borrowing which assumes a Harrod-Oomar (fixed coefficient) model of
i = r(so - s')
(so - Kr)
wherei
So, s'
K
r
=
average interest on foreign debt
average and marginal savings rate
incremental capital-output ratio
growth rate of GNP
See Avramovic [31, Malhematical Appendix, pp. 188-192.
11. "Hitherto, the discussion has been in terms of 'domestic'
growth variables, in particular the savings-investment balance. The
savings-investment gap is equal to the foreign exchange gap, by
definition. However,. this is no more than an ex-post accounting
equality. Mon" interesting is the mechanism by which this equality
is bro!1ght about. The. capacity to transfer savings abroad may be
undermined bye deterioration in terms of trade. The foreign exchange gap, allowing for the movement of export and import prices,
may be much larger than the savings-investment gap at constant
prices. The quality is restored ex-post, by a reduction in the 'international value' of domestic savings and, also, by an actual reductionin thedomeatic savings rate as income growth decelerates
under the impact of the dl:iterioration of the terms of trade." Avramovic [31, p. 50.
12. The fact that countries such as Bra~i1, Mexico, and Israel have
ready access to international capital markets helps to explain why
theyareablet()llUCCeaafully sustain high debt-service ratios. in
thelle countries debt can be "rolled-over" much more easily than in
most othllr developing countries.
13. Thill situation existed in K()rea in the period immlldiately following the financial reforms of 1964-65. For further discussion of
this point, see Sargen [231.
14. Feder-Just report overall error rates in classifying countries
(i.e., TYPe land Type II errors as a percent of the total number of
observations) ranging from 2 to 5 percent, while Frank-Cline report
error rllltesbelween 8 and 18 percent oHhe sample.
15. Countries listed in Table 2 coincide with those used in our statillticlllllllnalysis dillcussed in Section III. Countries were selected
using two criteria: (1) whether they had a debt-service ratio above
5 percent; and (2) whether time series data on key series were
available dating back 101980. The main group of developing countries omiUed from the llample are African nations.
16.For a dascription of the technique, see Eisenbeis and Avery
[91.
17. The discriminant technique attempts to minimi~e the following
"IOllll" function:
L
Cl . P (1/2) 11"2 + C2 P(211) 11"1,
=
where P(1/2) is the probability of assigning an observation to
group l,given it arose from group 2; C1 is the cost of misclassifyingan ()bservation to gr()up l,given it is from group 2; 11"1 and 11"2
are thea priori probabilities of an observation being drawn from
groups 1 and 2 respectively.
34
continuing long·term debt relief to these countries.
22. This procedure is used by Feder and Just in their study. If one
is Interested in identifying the year that a rescheduling occurs, one
can follow the procedure of treating the observations as "hold·
outs" and seeing how they are classified by the discriminant rule.
Alternatively, one may choose to assign observations to three
groups, instead of two.
23. See Eisenbeis [lO],pp. 13-14.
24. The differences in the adjusted debt service ratios and those
reported by the IBRD (based on actual repayments) are especially
large for Chile (1974), Ghana (1966), and Turkey (1966), (1971).
Our revisions are based on information contained in Bitterman [6],
IMF [17] [18], OECD [22].
25. See Eisenbeis and Avery [9], pp. 70-75, for a discussion of the
procedure.
26. The test of quality of the dispersion matrix between. the reo
scheduling and non'rescheduling groups yields an F21 .5646 statistic of 63.7, which is statistically significant (i.e. the variances for
the two groups are unequal). Similarly, the test for equality of group
means (based on the Mahalanobic D2 1 yields an F6,459 statistic
of 43.5. The test, however, assures the dispersion matrices are
equal; hence, the results may not be fully accurate.
Cl lr l
The cutoff value corresponds to In - _ .
C2lr2
18. The countries in the sample are listed in Table 2. Most of the
data cover the period 1960-1975. However, three countries which
experienced debt difficulties in 1976 (Argentina, Peru, and Zaire)
were also included as rescheduling cases. Information on rescheduling was obtained from Bitterman [6], IMF [17] [18] and OECD
[22].
19. Non-normality does not necessarily imply that the results are
invalid, but it may affect the error rate in ways that are not quantifiable. 'tVa are presently experimenting with transformations that
more closely approximate a normal distribution.
20. The presence of serial correlation means that the number of
independent observations is considerably smaller than the total
number of observations. At present, there are no procedures to
correct for serial correlation using discriminant analysis as there
are with regression analysis. To get around the problem, one can
use each country in the 1960-76 period as one observation, but the
number of rescheduling cases is much smaller.
21. Reschedulings for India in 1973 and Ghana in 1974 have been
treated as new events, because major decisions were reached on
BIBLIOGRAPHY
1. Aliber, Robert Z., "Perspectives on LDC External Indebtedness," manuscript, forthcoming in Lloyd's Bank Review 1977.
2. Anderson, T. W., An Introduction to Multivariate Statistical Analysis (New York: John Wiley, 1958).
3. Avramovic, Dragoslav, et. aI., Economic Growth and External Debt (Baltimore: The Johns Hopkins Press, 1964).
4. Bade R., "Optimal Growth and Foreign Borrowing with Restricted Mobility of Foreign Capital," International Economic Review, XIII (October, 1972),544-552.
5. Bardhan, P., "Optimum Foreign Borrowing," in Karl Shell,
ed., Essays In the Theory of Optimal Economic Growth (Cambridge, Mass.: MIT Press, 1967), 117-128.
6. Bittermann, Henry, The Refunding of International Debt,
(Durham, N.C.: Duke University Press, 1973).
7. Cohen, Neil, "Econometric Debt Early Warning Systems,"
U.S. Treasury Department, (Manuscript), August 1976.
8. Dhonte, Pierre, "Describing External Debt Situations: A
RolI·Over Approach," IMF Staff Papers, 1975.
9. Eisenbeis, Robert and Robert Avery, Discriminant Analysis and Classification Procedures: Theory and Application (Lexington, Mass.: D. C. Heath and Co., 1972).
10. Eisenbeis, Robert, "Discriminant Analysis: Application,
Potential, and Pitfalls," FDIC Working Paper No. 75-2, forthcoming
in Journal of Finance.
11. Feder, G. and R. Just, "A Study of Debt Servicing Capacity Applying Logit Analysis," Journal of Development Studies
(forthcoming).
12. Frsnk, C. R. and W. R. Cline, "Measurement o! Debt Servicing Capacity: An Application of Discriminant Analysis," Journal
of InternatIonal Economics I, 1971.
13. Goodman, Steven, "How the Big U.S. Banks Really Evalu·
ate Sovereign Risks," Euromoney, February 1977.
14. Grinols, Earl, "International Debt Rescheduling and Discrimination Using Financial Variables," U.S. Treasury Department
manuscript, 1976.
15. iBRD, World 'fabies 1976, (Baltimore: Johns Hopkins University Press).
16. IMF, International Financial Statistics, various issues.
17.
, Multilateral Debt RlInegotlatlons: ExperIence of Fund Members, (Washington, D.C., August, 1971).
18.
, Multilateral Debt Renegotiations: Experience of Fund Members 1971-1974, (Washington, D.C., September 20, 1974).
19. Lutz, Friecfrich, "Money Rates of Interest, Real Rates of
Interest, and Capital Movements," Chapter 11 in MaintainIng and
RlIstorlng Balance In International Payments (Princeton: 1966).
20. McCabe, J. and D. S. Sibley, "Optimal Foreign Debt Accumulation with Export Revenue Uncertainty," International EconomIc Review, 17, October, 1976.
21. Nelson, R., "The Effective Exchange Rate: Employment
and Growth in a Foreign Exchange·Constrained Economy", Journ,,1
of Political Economy, 78, June, 1970,546·564.
22. OECD, Development Assistance Committee, A Survey of
Past Debt Relief Operations, 1956-1970, DACtFA(71)4, March
1971.
23. Sargen, Nicholas, "Optimum Foraign Borrowing, Interest
Rates and Exchange Rates in Pacific Basin Countries," paper presented at Western Economic Association Meetings, Anaheim, California, June 1977.
35
International Banking,
Risk, and·U.S. Regulatory Policies
Robert Johnston*
The overseas expansion of the U.S. banking
ind.ustry has produced a network of branches and
subsidiaries whose assets and liabilities now exceed $200 billion, primarily on the basis of an upsurge· in activity over the past decade. Despite
concern about this rapid increase in overseas activitY,1 international banking has exhibited great
resiliency in financing world trade in the face of
the strains associated with recession and inflation. Nonetheless, the size and character of the
banks' foreign assets and liabilities present special problems to regulators in supervising inter-
national banking.
This paper presents.an analysis of these international regulatory problems; Section I reviews
recent trends in U.S. banks' international operations, showing the increased numbers of participating banks and the growth in international
credits. Section II discusses the rationale for regulation in general, and Section III examines the
risks in international banking that could require
regulation. The last section assesses current regulatory problems and trends in the light of the
preceding analysis.
I. Growth of International Operations
As recently as 1965, U.S. foreign banking was
dominated by 13 large banks with considerable
experience in the field (Table 1). But then there
began a rush of new banks to establish foreign
offices} By 1973, when the rush slowed, 125 U.s.
banks were operating 737 branches overseas,
with total assets of $129.9 billion; The number of
branches has changed little in subsequent years,
but total assets have continued.to grow, reaching
$222.9 billion by March 1977. 3 This figure
equalled 22 percent of domestic bank assets and
approximately three times U.S. banks' equity
capital. Indeed, for some large banks, claims on
foreigners amount to as much as one-quarter to
one-halfoftotal assets (Table 2).
The decade of the 1960's was marked by rapid
growth of international trade, full convertibility
of most of the major currencies, and rapid expansion overseas by major U.S. corporations. U.S.
banks participated in this overseas movement not
only because of a search for new opportunities,
but also because ofa need to expand overseas operations in order to meet the needs of their corporate customers. In this period, international
trade more than quadrupled and generated additional demand for finance. A major new financial institution arose in the form of the Eurodollar market, enabling foreign branches to raise
needed funds outside the United States without
being subjeCt to domestic reserve requirements
and interest-rate ceilings. In addition, U.s. controls on capital flows affected international
banking trends. From 1965 to 1974, U.S. banks
were hampered from making foreign loans directly from their domestic offices by the socalled Voluntary Foreign Credit Restraint Program. Therefore, during much of this period,
banks were encouraged to fund their overseas
lending from external sources, and banks without
foreign branches were at a disadvantage in competing for international business. At other times,
slow domestic-business demand encouraged U.s.
banks to look overseas for customers.
*Assistant Vice President-Bank Relations, Federal Reserve
This period of enthusiastic overseas expansion
came to an end by 1974. For one reason, the dis-
Bank of San Francisco.
36
mantling of controls on capital flows permitted
more lending from home offices. But in addition,
many banks by this time found that international
banking required skills which they did not have,
and many found that the costs were higher and
the profits lower than expected.
The international-banking scene took on a
new character beginning in 1974. The sharp increase in oil prices that year created massive
trade surpluses for oil-exporting nations along
with .large deficits for the major oil-importing
countries. In part, the deficits were financed indirectly by the oil-exporting countries recycling
funds through the international-banking system.
Commercial banks played a key role in this process by using the oil exporters' deposits to finance
the imports of oil importing countries. International lending jumped 44 percent (in dollar
terms) between year-end 1974 and 1976-an impressive amount even after allowing for the 12percent rise in prices over the period (Table 1).
This explains much of the increase in the assets
and liabilities of U.S. foreign branches during
the 1974-76 period. 4
Despite the movement of many small U.S.
banks overseas, the market remains dominated
by the giant multinational banks. Just 9 of the
14,000 banks in this country account for 540 of
the 737 overseas branches and 77 percent of the
overseas assets. Over 70 of the 125 banks operating outside the United States have only "shell
branches" in offshore money markets, such as
Nassau or the Cayman Islands. 5
In most cases, "shell branches" are more a legal fiction than a real office, yet transactions as-
Table 2
Assets of Foreign Branches of U.S. Banks
(as of December 31, 1976)
I.
All Foreign Countries
$Billion
a. All Currencies
Claims on United States
Parent bank
Other
Claims on Foreigners
Other branches of parent bank
Other banks
Official institutions
Nonbank foreigners
8.0
4.4
3.6
204.2
45.9
83.6
10.6
64.1
Other Assets
7.0
TOTAL
219.2
b. Payable in U.S. dollars
Claims on United States
Parent bank
Other
Claims on foreigners
Other branches of parent bank
Other bank
Official institutions
Nonbank foreigners
7.7
4.4
3.3
156.7
37.8
66.3
9.0
43.6
Other Assets
TOTAL
2.
$BiIlion
3.2
167.6
United Kingdom
Total, all currencies
Total, payable in U.S. dollars
81.5
61.6
3.
Bahamas and Cayman Islands
(British West Indies)
Total, all currencies
66.8
Total, payable in U.S. dollars
62.7
Source: Board of Governors of the Federal Reserve System.
Table 1
Overseas Branches Of U.S Banks
(as of year-end except June 1977)
(June)
1960
1965
1969
1970
1971
1972
1973
1974
1975
1976
1977
8
13
53
79
91
108
122
125
126
127
130
Number of overseas
branches
131
211
459
536
583
627
697
734
762
731
737
Assets of branches*
($ billion)
3:5
9.1
35.3
46.5
59.8
78.2
121.9
151.9
176.5
219.2
NA
Number of U.S. banks
with overseas branches
Source:
Board of Governors of the Federal Reserve System.
*Includes inter-branch funds.
37
signed to such branches are offshore transactions
and not subject to domestic reserve requirements. Lending decisions can be made at the
U.s. head office or elsewhere, and funds can be
raised in London to supply loans to customers
outside the United States through the books of
these branches. This arrangement allows smaller
banks which could not justify the high overhead
expense of overseas-branch operation in such locations as London or Frankfurt to obtain offshore funds for their foreign lending. After adjusting for these shell branches, the number of
banks with true foreign branches or subsidiaries
is much smaller than the totals indicate.
Indeed, only a few large banks have the resourCes to maintain extensive branch networks
and to raise the funds needed by large international borrowers. Because of their size, these
banks can reduce the threat of losses by diversification and can build up the necessary staff to
evaluate foreign credits properly. Smaller banks,
in contrast, try to reduce their risk exposure by
concentrating their efforts in the interbank Eurodollar .market and in the developed countries.
II. Rationale For Banking Regulation
The rationale for banking regulation in this
country is based upon the need, first, to promote
economic stability and, second, to promote competition. The first goal attempts to minimize disruptions originating in the banking sector that
cause fluctuations in output or employment. Because commercial banking in a modern economy
is the source of the bulk of the domestic money
supply and the provider of crucial financial services, public policy is always concerned with the
stability of the banking system as well as the
soundness of individual banks. In fact, the Federal Reserve System from its inception has had the
responsibility of minimizing financial instability.
The System was designed to act as lender of last
resort-from which responsibility evolved its
monetary-policy role-and also to act as the supervisor for state-chartered member banks. The
Comptroller of the Currency, which had been the
first Federal supervisory agency, has retained its
responsibility for nationally-chartered banks,
while the Federal Deposit Insurance Corporation
since the 1930's has taken on supervisory responsibilities for state banks which are not members
of the Federal Reserve System.
This is in contrast to the tradition of continental
Europe, where French and German banks typically combine both functions. In addition, the
Bank Merger Act of 1960 established competitive standards for the approval of banking acquisitions and mergers, while the 1970 amendments
to the Bank Holding Company Act set similar
rules to limit the expansion of corporations controlling banks into nonbanking financial
activities.
Both objectives have resulted in the expansion
of government regulation over banking. The
competitive goal rests upon well-known theoretical foundations: increased concentration in a
market tends to reduce output and to raise market price. It follows that regulation is necessary
to prevent undesirable concentration. The value
of economic stability can also be readily accepted, although the theoretical case for bank regulation is less obvious in this case. The concept of
financial stability-or rather instability-really
concerns attitudes toward risk. Would unregulated banks build their portfolios in a way that
would expose the financial sector to increased
risk, and thus bring about increased (and undesirable) fluctuations in real economic activity? It
may be assumed that regulation, by reducing
risk, improves the functioning of the financial
system by lowering the chance of destabilizing
losses.
The banks themselves, as profit-making institutions, have an incentive to protect themselves
against risk. 8 Risk cannot be avoided but portfolio diversification can reduce it. Banks must de-
The second regulatory policy goal is maintenance of competition. 6 Banking is regulated to
prevent undue concentration of financial resources in commercial banking, and also to preserve competition among nonbanking institutions by keeping banks out of that arena. Various
Federal laws are directed to this end. Under the
Glass-Steagall Act of 1932, commercial banking
is separated from so-called investment banking.?
38
may be tempted to increase risk exposure beyond
some social optimum. While such support may
result in greater overall international stability,
regulation maybe needed to keep individual
banks' riskexposure within acceptable limits.
In addition, regulation may be justified where
regulators are better qualified than the. banks
themselves to assess the banks'own risks. This
may seem to be a strong assumption, but examiners develop considerable expertise through their
constant evaluation of bank records. Banking
regulation can be viewed as imposing standards
based on contemporary "best-practice," with
those standards shifting over time as experience
confirms the safety of new practices. Regulation
standards are moving averages which tend to
smooth trends in banking, thereby reducing the
chance of major variations in riskiness.
Poor internal procedures may induce undue
risk-taking and expose a bank to unnecessary
losses. Managers may gather insufficient information for assessing loan quality, or they may
delegate too much loan authority, or they may
concentrate their loans in too few areas. When
operating overseas they may face excessive costs
cidehow much expected risk they are willing to
trade offfor an increase in expected return. They
may respond to higher risk by charging higher
interest rates, or by demanding increased collateral or loan guarantees. The banks themselves
certainly are aware of the problem of risk. The
policy question comes down to whether, in making individual risk assessments, the banks' private decisions result in risk-taking that is higher
than society prefers.
It has been argued that existing institutional
arrangements tend to encourage risk-taking. 9
Deposit insurance, for example, tends to increase
incentives for banks to take more risk, by taking
over the role traditionally filled by bank capital.
Specifically, government-sponsored insurance
protects depositors by making them less sensitive
to a bank's capital position, and thus encourages
bankers to increase their leverage and, therefore,
their risk exposure.
In effect, deposit insurance tends to shift risk
to the public sector. To the extent that official
international-Iending arrangements-through
(say) the International Monetary Fund-act as a
form of international deposit-insurance, banks
TableS
Assets Held as Claims on Foreign Countries by Head Offices
and Foreign Branchesot U.S. Banks 1
(as of December 1976)
SBillion
Group ofTen and Switzerland
Belgium-Luxembourg
6.1
France
10.0
Germany
8.8
Italy
5.8
Netherlands
2.8
Sweden
1.3
Switzerland
3.0
United Kingdom
41.4
Canada
5.1
Japan
15.8
Otber Developed Countries
15.1
OPEC Countries
Source:
100.1
12.7
Non-Oil Developing Countries
Argentina
1.9
Brazil
11.8
Mexico
11.5
Other Latin America
6.7
Korea
3.1
Philippines
2.2
Taiwan
2.4
Other Asia and Africa
5.6
Eastern Europe
Offsbore Banking Centers
Bahamas
Bermuda and British
West Indies
Hong Kong
Singapore
Other Offshore
Miscellaneous
TOTAL
SBillion
45.2
5.2
23.9
9.3
4.3
2.3
4.6
3.4
5.1
207.3
Board of Governors of the Federal Reserve System
'This includes claims on private individuals, businesses, and banks in foreign countries, as well as foreign governments
andtheir agencies.
39
in obtaining data, or may encounter difficulties
in assessing credit risk because of lack of familiarity with local customers. Yet the same problemexists domestically when a bank considers
lending to customers outside its usual markets.
Similar types of problems occur in assessing
banking risk both internationally and domestically, and the basic process of judging creditworthiness is not fundamentally different.
The factor distinguishing international bankingfrom domestic banking is the presence of
"sovereign risk." Even if the foreign customer is
financially able to repay a loan-that is, there is
no "banking risk" in the sense of commercial
bankruptcy-his country's government may prevent the appropriate conversion of foreign exchange to repay the bank loan. This is a default
on the national level, not the private level, as will
be seen from the discussion in the next section.
International lending thus presents risks similar to the normal commercial risks of domestic
lending, with the one exception of sovereign risk.
What role then does regulation have to play?
Without regulation, commercial banks might
choose a combination of risk and expected return
that iSl.Ul.aCceptable from a social viewpoint. And
even if banks assess risk correctly, they may undertake activities that expose the U.S. banking
system to disturbances which are unacceptable
onpublic-policy grounds.
On the other hand, maintenance of competition is not yet a policy problem for international
banking supervision. Ordinarily, the foreign operations of U.S. banks have no direct impact on
domestic competition. Competitive effects inside
other countries are regarded as matters for those
countries to assess in terms of their own economic policy. U.S. banks are allowed to engage in
many activities overseas that are not permitted
for competitive reasons inside their own country-a prime example being investment banking.
To forbid such activities would be to put U.S.
banks at a disadvantage compared to their foreign competitors. Therefore the principal problem for international-banking regulation concerns risk, not competition. How risky, then, is
international banking?
III. Risk in International Banking
Banking risk-one of the major types of risk
facing international bankers-involves the assessment of borrowers' credit standing or the
forecasting of deposit flows. As noted above, this
is the same type of risk that bankers have to face
on the domestic scene. It may be more difficult to
obtain credit information abroad, but this only
means that U.S. banks have less familiarity than
their foreign competitors with local conditions. A
similar situation exists when a domestic bank attempts to make domestic loans outside its usual
markets. Yet as a practical matter, it takes time
to build the expertise to interpret foreign financial practices and to develop appropriate sources
of information. Consequently, many U.S. banks
tend to restrict their foreign lending to major international corporations or financial institutions.
This policy reflects the costs of gathering local
information, and is not different in character
from the basic process of making credit judgments about domestic borrowers.
When operating abroad, bankers must take
into consideration many of the same economic
factors that they deal with at home-government fiscal and monetary policy, bank regulatory policy, foreign exchange controls and local
economic conditions generally. Although many
countries tend to have unstable economies because of undue dependence on a few basic products or because of political difficulties, other
countries may have greater economic stability
than the United States. Moreover, most developed countries provide ample information on
economic conditions that allow reasonable economic forecasting. For others, however, great uncertainty exists about their economic prospects,
so banking risks may be considerably higher and
sovereign risk may be a greater concern.
Actually, there are few cases where countries
refuse to repay (or refuse permission for their
citizens to repay) foreign loans, because borrowing countries do not want to foreclose the possibility of obtaining foreign credit again in the future. The word default is usually applied-not to
40
Taiwan) represent three-quarters of U.S. banks'
credits in this category-but a strong case can be
mllde for lending to these countries because of
both their international reserves and their longrun growth prospects. 11
outright refusal to repay-but rather to. a case
where loans are rescheduled or renegotiated
through agreement with lenders. (This same situation arises domestically when banks change
loan terms to help troubled borrowers instead of
forcing insolvency.) Because countries generally
attempt to avoid outright default, few cases have
arisen in the last twenty years where banks experienced serious losses from sovereign risk.
Commercial banks have acted to protect
themselves against this type of international risk
exposure. They have built up their systems for
assessing economic conditions in individual
countries-in many cases, systems of considerable sophistication. In addition, they have followed policies of geographic as well as industrial
diversification to reduce risk exposure (Table 3).
In terms of geographic diversification, most
loans are concentrated in developed countries or
in interbank transactions, while loans to underdeveloped countries represent only a minor part
of the total. In particular, loans to less-developed
non-OPEC countries are not unduly large in
terms of the relative commitment by U.s. banks
and the ability of most of these countries to service their debts. 10 Loans to six countries (Argentina, Brazil, Mexico, the Philippines, Korea, and
A measure of the efficiency of U.S. banking
practices is the fact that loan losses on banks' international portfoiios have been smaller than on
their domestic loans. 12 Recent failures of large
banks cannot be attributed simply to risky international loans. Foreign-exchange losses did contribute to the failure of Franklin National Bank,
but those losses reflected poor internal controls
which were also typical of the bank's domestic
operations.
Through diversification, improved information systems, and appropriate internal controls,
banks have established a reassuring record of international operations. However, banks' collective risk assessment may still result in a banking
system that is too risky from the viewpoint of society, and the function of banking supervision is
to keep risk exposure within acceptable boundaries. Foreign risk, to the extent it affects the stability of the domestic banking system, makes supervision of international banking necessary.
IV. Current Regulatory Practices and Problems
Federal supervisory authority over U.s.
banks' foreign operations is exercised by the Federal Reserve System and the Comptroller of the
Currency.13 The Comptroller of the Currency
has the responsibility for examining national
banks, which make up the majority of those
banks operating overseas. The Federal Reserve
System has the responsibility for examining
state-chartered member banks, and for approving national banks' foreign branches and the investments of foreign subsidiaries (either directly
or indirectly through Edge Act subsidiaries).
Foreign acquisitions by domestic-bank holding
companies also require Federal Reserve
approval.
cedure was acceptable as long as few banks had
overseas offices, since the records at hand were
satisfactory for the evaluation of most loans, and
the risks from foreign operations were quite
small. But as the number and size of foreign assets grew, on-site examination of branches also
became necessary. The Comptroller of the Currency now maintains a permanent staff in London, and both Federal agencies are increasing
the frequency of their overseas examinations.
These on-site examinations are used primarily to
check the accuracy of head-office records and
the adequacy of internal controls rather than to
reviewthe quality of local assets. Regular examination of all foreign offices would be very costly,
without any assurance of a compensating increase in supervisory effectiveness.
Supervisory authorities rely primarily on
banks' home-office records in performing international examinations-and until recently they
relied almost entirely on such records. This pro-
For a time, the regulatory agencies assumed
that foreign banking regulators could help moni41
To help meet r~gulatory and bank information needs, a number of international agencies
are now attempting to improve international.financialstatistics. 1sFor example, the Bank for Internatiqn~l Settlem~nts, with the cooperation of
majorcentraLbapks, is now working to develop
newdata on .external private borrowing and lending. Improved statistics of this type should reinforce the effectiveness of banks' own procedures
for assessing risk, and should reduce supervisory
burdensaccordingly.
torthe activities of U.S. banks overseas. However,experienc~has shown that few banking authorities conduct supervision on the scale
practiced in this country. Most countries' authoritiesemphasfze regulation for purposes of
monetary policy, foreign-exchange control or
other\economic-policy. objectives. Even in countrieshavillg.veryextensive regulatory systems,
sucnas Japan, the emphasis is upon checking for
conformity with<banking regulations. rather than
uponexatnining for. the quality of credit exteIldecj by foreign branches. U.S. regulators thus
mustrelyprimarily.upon their own procedures to
supervise U.s. banks' foreign operations.
A, particularly difficult supervisory problem
in assuring adequate diversification concerns the
assessment of the risks assigned to loalls in particular countries-that is, country risk, which
covers both "sovereign risk" and the impact on
"banking risk" of local economic conditions. As
noted above, banks are now developing their own
systems for evaluating economic conditions in
foreign countries. But regulators must also be
able to judge independently whether or not a particular bank has too many resources in countries
with a high level of country risk. Improved methods of assessing such risks would result in greater
uniformity in the treatment of individual banks
as well as a better assessment of U.S. banks'
overall risk. Both the Comptroller of the Currency and the Federal Reserve System are now developing systems to measure and monitor country risk.
***
In conclusion, there are important differences
between banking risk and sovereign risk. Banking risk is essentially the same at home and
abroad. Despite greater potential difficulties in
obtaining information on foreign borrowers, the
credit factors involved are fundamentally the
same as in domestic lending. Sovereign risk is a
different matter, for which there is no domestic
equivalent risk. Foreign governments can prevent the conversion of local currency into foreign
currencies-which amounts to default on a national (but not private) level. There have been
few cases of such default, but regulators remain
concerned about the possibility.
Ba.Il~shave been successful in reducing their
loss exposure, judging by the relatively low losses
they have experienced in their foreign operations. However, to the extent that official international lending represents a form of insurance,
banks have all incentive to take greater risk, and
internationalsupervision must act to counteract
that tendency. The public has an interest in ensuring that risk remains within acceptable limits,
through appropriate actions by bank regulators.
At the same time, this emphasis upon risk-taking
should not interfere with the ability of U.S.
banks to function as international lenders. Bankingl'laysa major role in encouraging economic
develol'tnent through the financing of world
trade and investment. Therefore, efforts to improve international banking supervision must ultimately be judged by their contribution to the
world as well as. the U.S. banking system.
Other considerations must also be taken into
account:
"Bank regulators need to be sensitive to the
fact that admonishments to banks can result in damage to the credit-worthiness of
bOrrowing countries. As a possible way of
dealing with this potential problem, the
Federal Reserve is exploring a supervisory
approach that would focus on the degree of
country concentration of foreign loans in
portfolios of individual banks and on the
quality of information possessed by banks
in assessing the degree of risk attached to
their international loans. "14
42
FOOTNOTES
1. See the recent hearings by the. Subcommittee on International
Finance, !J.S. Sllnatll. Committellon Banking, Housing and !Jrban
Affairs, .and also the staff rliPort of that subcommittee, International Debt,TheBanklil, and U.S. Foreign Pollc:y, August 1977.
2. In this period, overseas offices became desirable because various controls made it difficult to lend abroad from head offices. Today, however, foreign lending is conducted both from U.S. offices
and foreign branches.
3. In addition, foreign subsidiaries of U.S. banks had $30 billion in
assets as ofDecember ·13,1975. the most recent date for which
such information is available.
4. See article by Hang-Sheng Cheng in this issue.
5. These locations are chosen partly because of low local taxes
on offshore transactions and other tax advantages, and partly becausll of savings in investment in staff and physical plant.
6. Of course, the U.S. cannot assure competition in foreign markets, so this consideration is less important in regulating U.S.
banks' operations overseas.
7. This Act was adoptedasa reaction to the investment·banking
activities of commercial banks, which were thought to be a cause
of the 1929 stock market crash and the ensuing depression. AI·
though passed initially a.s a means of reducing financial instability,
the Act has been used llssentiafly to prevent financial
concentration.
8. In a distribution of expected returns from a given investment, the
standard deviation denotes the measure of risk.
9. Sam Peltzman, "Capital Investment in Commercial Banking and
its Relationship to Portfolio Regulation," Journal of POllclal Economy, January-February 1970.
10. Hllnry C. Wallich, Statementpefore Subcommittee on International Finance, U.S. Senate Committee on Banking, Housing and
Urban Affairs, August 29, 1977.
11. Ibid.
12. Fred B. Ruckdeschj3I, u.Flisk .in Foreign and DomllS!.icLending
Activitillsof U.S. Banks," Columbia Journal of World Business,
Winter 1975, pp. 50-54. Robert Morris Associates, Domestic and
International CornrnerclalLoanCharge-Offs (1977).
13. Few nonmember banks are engaged in international banking,
and hence their supervising agency (the F.D.I.C.l has only a limited
role in international-banking examination.
14. Wallich, op. cit., p. 13.
15. The shortcomings of existing international-credit data are noted in International Debt, The Banks and U.S. Foreign Policy, op.
cit.
43
John H. Makin*
In October 1975, the Financial Accounting
Standards Board (FASB) issued a statement
(Statement No.8) designed to standardize procedures for reporting foreign-currency positions
of U.S. multinationals. FASB-8 prompted a
storm of protest from many of these firms, which
argued that it would result in violent swings in
reported earnings not related to the fundamental
economic condition of a firm. Any such volatility
of earnings would, in the view of a widely accepted body of financial theory, penalize share prices
of multinationals and thereby increase their costs
of raising capital. In opposition, some analysts
argue that investors can be expected to "see
through" reported earnings figures to distinguish
between fluctuations due to "fundamentals" and
those due to accounting standards which don't
reflect such "fundamentals."
Despite the obvious inconsistency between
these polar views, no systematic statistical test
has been made to date of FASB-8's effect upon
share prices of multinationals. This reflects the
fact that the new standards have only been in effect since January 1976, and that few companies
had previously followed the accounting procedures mandated by FASB-8. Sufficient data are
now available to test for the effects of FASB-8
upon the costs of capital for multinationals. The
results of such tests are reported in this study.
Any such study must recognize that FASB-8
standards were super-imposed upon a system of
quasi-floating exchange rates which permitted
various degrees of exchange-rate flexibility, selectively since August 1971 and more widely
since March 1973. For multinationals, such
flexibility meant increased variability of the dollar value of foreign-currency items on balance
sheets and income statements, with possibly increased variability of net earnings. This fact
should have been fully appreciated by investors
well before FASB-8 went into effect in January
1976. Therefore we need to look for possible effects of floating per se on costs of equity capital
for multinationals, and then see if any additional
effects can be attributed to FASB-8.
At the outset, it is important to limit the questions we shall try to address. No attempt will be
made here to argue either for or against any of
the specific provisions of FASB-8. Rather, we
take its existence as given, and simply ask: what
impact has FASB-8 had upon share prices of
multinationals over and above the impact of the
recent regime of quasi-floating exchange rates?
In short, has FASB-8 provided investors with
any "new" information on the asset properties of
claims on multinationals? The answer given here
will be a qualified "yes."
We first describe briefly in Section 1 the nature of the accounting changes mandated by
FASB-8. In Section 2, we consider the impact
which FASB-8 might produce on share prices of
multinationals, over and above the impact resulting from the increased flexibility of exchange
rates. Section 3 introduces the methodology used
to test for this impact; Section 4 presents the
findings of our empirical tests; and Section 5 discusses the implications of these findings.
I. Floating: A New Era for Multinationals
Multinational corporations attract a great
deal of attention because of the public's fascination with their size and power.' It is useful to con-
sider how multinationals are different from other
firms, and in particular, which differences are essential for measuring corporate performance.
*Associate Professor of Economics, University of Washington, and Visiting Scholar, Federal Reserve Bank of San Francisco
(Spring-Summer 1977). The author wishes to thank Gigi Hsu and Jerry Stamps for their research assistance, and Jack
Beebe for his helpful comments.
44
sent unrealized gains or losses. 2 It also standardizes the treatment of a number of major balancesheet items. For example, all "nonmonetary"
items, such as depreciation and cost of goods sold
(including inventories), are translated into dollars at "historical" exchange rates; i.e., those prevailing when inventory was acquired or when a
plant was built. In contrast, all "monetary"
items, such as long-term debt denominated in
foreign currencies, are translated into dollars at
"current" rates. As a result, quarterly income
figures become highly vulnerable to changes in
the dollar value of large stock items such as inventories and debt. For example, for goods priced
in foreign currencies, a strengthening of the U.S.
dollar could lower the dollar value of current receipts relative to the dollar cost of goods sold, and
thus could reduce measured net dollar earnings.
Alternatively, the same stronger dollar could reduce the value of long-term debt denominated in
foreign currency, and thus could lead to higher
net dollar earnings. In sum, the effects of FASB8 can be large and unpredictable. An assessment
of their effects on future earnings reports requires detailed information about corporate balance sheets and income statements, as well as
forecasts of exchange rates.
Prior to the enactment of FASB-8, accounting
practices of U.s. multinationals varied considerably, particularly regarding translation rates
(current vs. historical) for inventory and longterm debt. 3 More important, most companies
employed "reserve accounts" to absorb the impact of changes in the dollar value of balancesheet items due to exchange-rate changes, thereby preventing such changes from appearing on
quarterly income statements. The dollar value of
these changes, plus or minus, could be accumulated over time and reported out on the income
statement when the impact was as small as possible, thereby minimizing the impact of exchangerate changes on reported net earnings. With
many multinationals having become accustomed
to using reserve accounts in this fashion to stabilize reported earnings, the storm of protest which
greeted FASB-8 is not surprising.
Multinationals are corporations which find it
advantageous to locate their sales, manufacturing, marketing or financial activities in a number
of different countries. Their major advantages
include economies of scale from intensive employment of indivisible and highly specialized
managerial functions, preferential location vis-avis major markets or suppliers of inputs, perhaps
some ability to avoid govemmental restrictions
on operations and, more generally, various benefits flowing from a widely diversified set of
operations.
Multinational organizations do, however, face
unique costs. Basic problems arise from attempting to manage a far-flung organization whose
lines of communication are frequently stretched
to the point of extreme frailty. In terms of our
main concern, a multinational presence implies a
considerable increase in the complexity of financial statements. On the balance sheet, those
items dealing with debt, inventories and physical
plant-many of which are measured in different
currencies-must all be converted back into the
base currency employed by the firm for accounting purposes. The same is true of all the flow
items in the income account, some of which must
reflect changes in the value of balance-sheet
items, measured in terms of some base currency.
The problems involved in producing informative financial statements for multinationals become more complicated under flexible exchange
rates. The large adjustments of exchange rates
after August 1971 and the openly-acknowledged
continuous adjustments since March 1973 have
made this fact amply clear to financial managers
and investors. FASB-8 represents an attempt to
replace those accounting standards that had been
designed for a regime of fixed-exchange rates
with standards more appropriate to a regime of
flexible-exchange rates, and moreover, to standardize the diversity of accounting practices followed by multinationals in this period of adaptation to flexible rates.
FASB-8 requires quarterly income statements
to report changes in the local-currency value of
balance-sheet items, some of which may repre-
II.
FASB-8: Additional Problem for Multinationals?
The potential for increased earnings variability (measured in U.S. dollars) arises from the in-
creased flexibility of exchange rates, quite independently of a particular set of accounting stan45
For purposes of exploring the impact of increased rate flexibility, however, we will take
these two propositions to be empirically valid.
Exchange rates in recent years have in fact fluctuated more, at least on a quarter-to-quarter basis, than during the pre-August 1971 era of
"fixed" exchange rates. And although multinationals have the potential of minimizing the earnings impact of exchange-rate variability, they
have made only limited progress in this
direction. 7
In this situation, would the application of
F ASB~8 tend to raise multinationals' capital
costs further than would be expected on the basis
of the increased flexibility of exchange rates?
For comparisons of multinationals with purely
domestic firms, the answer depends upon whether pre-FASB-8 accounting standards provide an
accurate measure of earnings behavior over time,
and whether more accurate measures can be devised. For comparisons among multinationals,
the answer depends upon whether reported earnings figures can be standardized by adjusting for
differences in accounting techniques and in the
use of reserve accounts.
Answers to these questions can be sought with
the aid of a model which relates returns on securities both to a systematic (or overall) market
component of risk and to an unsystematic (or
nonmarket) component of risk. We seek to determine how these two risk components are affected
by the increased flexibility of exchange rates,
and subsequently by the impact of FASB-8 on
corporate earnings reports.
dards. Investors are well aware of this fact, and
also of the use of reserve accounts to smooth out
the impact upon reported earnings of exchangerate fluctuations. In this situation, does the enactment of FASB-8 place any added burden on
multinationals over and above the burden implied by exchange-rate flexibility? Was the cry
of protest over FASB-8 justified? Before considering this question, we should first consider what,
if any, burden is implied for mutinationals by a
move toward exchange-rate flexibility per se.
Two assumptions are involved in the hypothesis that the increased earnings variability associated with a move toward floating exchange
rates will raise capital costs for multinationals.
First, we assume that an increase in the permissible flexibility of exchange rates implied by reduced official intervention in foreign-exchange
markets-which defines our current system of
quasi-floating-will result in an increase in the
actual flexibility of exchange rates. 4 Second, we
assume that an increase in actual rate flexibility
raises the variance of multinationals' profits
measured in dollars. 5 Neither proposition is necessarily true. The first depends on conditions affecting the private demand and supply of foreign
exchange, as well as the level of central-bank intervention under our quasi-floating system. Even
granting the first assumption, however, the variance of multinationals' net dollar profits can rise
or fall depending upon the variability and covariability of dollar prices of currencies in which
foreign-currency positions exist. 6
III.
Measuring the Impact of FASB-8
= a + /3j E[Rmtl + ~t
where
E[Rjt l = the expected rate of return on se-
It is well know that movements in the overall
stock market significantly affect returns on individual stocks. Thus, in testing for the effects of
floating and FASB-8, it is necessary to adjust the
returns of the companies being tested for movements in the overall market. This section briefly
describes one widely-accepted method for taking
account of market movements.
Modern financial theory, as developed by W.
F. Sharpe and others, has shown the relationship
between the rate of return on an individual security or portfolio and the overall "market return"
in the following form: 8
(I) E[Rjtl
curity "j" or portfolio "j" at time
"1"
E[Rmtl = the expected rate of return on the
market portfolio at time "t"
/3j
=a
parameter describing the sensitivity of E[Rjl to changes in
E[R m ]
a = a measure of the expected return
to portfolio "j" in excess of or below the average market return re-
46
"expected" had previously been employed.
Floating and/or FASB-8 may tend to cause
changes in either "a" or "fJ". Either event would
be likely to affect overall market risk, in view of
the heavy concentration of multinationals in the
ranks of major U.S. firms. In such a case, some
component of the overall movement in returns
would reflect the impact of changes in foreignexchange rates. Multinational firms would tend
to be particularly sensitive to the (new) foreignexchange component of market risk, and therefore returns to multinational equities would tend
to respond more sharply to changes in market returns, at least to the extent that such changes reflect the foreign-exchange component of market
risk. In short, "fJ" may rise either after floating or
FASB-8.
Alternatively, if either floating or FASB-8
causes "a" to vary significantly from zero, then
ex post, over the sample period in question, some
persistent, exogenous "non-market" disturbance
must be at work. Such a disturbance mayor may
not be associated with a change in "fJ," depending upon whether or not it is associated with a
change in perceived systematic ("market") risk.
A negative value of "a" with no significant shift
in "fJ" would suggest the existence of new information, causing a persistent reduction in the
market's perceived value of multinational firms.
Costs of raising a given amount of capital, which
would now represent a larger share of such firms'
discounted present value, would then rise.
In contrast, negative error terms at a particular point in time would suggest a one-time reduction in ex post returns on multinationals' shares
as a result of floating or FASB-8. In any case, the
results obtained by estimating equation (1) for
various portfolios of multinationals, along with a
control group of domestic firms, indicate the degree to which these events affected the multinationals' costs of capital.
quired for the jth risk class
Et
= the impact of random or "outside"
disturbances on Rj at time "t"
Viewed in a straightforward manner, equation (1) says that changes in the expected return
on a given asset or portfolio occur because of
changes in the overall expected return on all
risky assets, E[Rml, and because of changes in
"other" factors peculiar to such a given asset or
portfolio which are captured in turn by a change
in "a", if they persist, or by Et if they are essentially random and do not persist. Portfolio risk or
movement in E[Rjl that is correlated with returns on risky assets for which the market portfolio is a surrogate is termed systematic risk, while
that which is uncorrelated is termed non-systematic risk. Systematic risk is an unavoidable response of E[Rjl to changes in the overall return
on assets, while non-systematic risk ought, in
theory, to be avoidable through portfolio
diversification.
The relationship given by equation (1) is usually called the security market line. It is derived
from a consideration of the choices made by investors of which assets to hold in their portfolios.
Presumably, investors will demand a higher expected return from a portfolio which they perceive to be riskier (Le., to have more variable returns). As each investor buys and sells securities
in order to put together the portfolio which best
satisfies his preferences for return vs. risk, the
market prices of securities will adjust until equation (1) is satisfied.
The model just described can be employed to
test for the impact of floating and FASB-8 upon
costs of capital for multinationals, relative to
other firms, by substituting actual measures of
past returns for the expected values in equation
(1).9 When this is done, the "a" and "fJ" terms
retain the interpretation given them in equation
(I), except for the substitution of "actual" where
IV.
Empirical Tests of the Impact of FASB-8
Our empirical tests use Equation (1) to measure the performance of share prices of three
groups of firms over five time periods. The firms
investigated include a control group of non-multinational firms (trucking), a group of multinationals influenced to some extent by FASB-8
(chemicals, international oils and drugs), and a
"sensitive" group selected specifically because of
the large FASB-8 impact upon their earnings.
The five time periods investigated are the "fixed
exchange-rate" period (January 7,1970 through
August II, 1971), the "transition" period (August 25, 1971 through March 21, 1973), and
three subsequent "floating" periods-the "floating without FASB-8" period (April 4, 1973
through October 15, 1975), the "floating with
47
FASB-8 standards. 12 Those firms vary significantly in terms of size and industry grouping,
and ex post their only common characteristic is a
high level of sensitivity to FASB-8 standards. 13
The "negative impact on earnings under FASB8" (Table 1) measures the ratio of the change in
earnings under FASB-8 to what total earnings
would have been under previous accounting
rules. For example, the 1976 per share earnings
of American Brands were 28 percent less under
FASB-8 than they would have been under previous accounting rules. In short, Table 1 suggests
the degree to which FASB-8 affected the earnings of the "sensitive" group.
Application of FASB-8 standards apparently
depressed earnings for most U.S. multinationals
during 1976. This result reflected both the particular form of the standards and the behavior of
the U.S. dollar during that period-and as most
corporate reports carefully pointed out, the impact could subsequentiy be reversed given different exchange-rate behavior. Negative earnings
effects under FASB-8 during 1976 possibly reflected the conjunction of a generally strengthening U.S. dollar and the multinationals' typically
heavy investment abroad in inventories, plant
and equipment. Circumstances of this type raise
the cost of goods~sold relative to sales receipts
when each is measured in U.S. dollars, and thereby lower corporate profit margins. Should the
U.S. dollar weaken consistently during 1977, the
losses recorded under FASB-8 in 1976 would become gains. The overall impact would be increased volatility of reported net earnings.
It should be emphasized that the earnings of
firms in the "sensitive" group are generally expected to be more variable under FASB-8, and
not necessarily higher or lower. While the
FASB-8 impact was universally negative during
1976, overall earnings figures for the firms in Table 1 varied considerably during that year. Seven
of the thirteen reported higher earnings in the
first quarter of 1976 than in the comparable period of 1975. Earnings performance for the "sensitive" group as a whole, which had lagged behind
the overall corporate average in earlier years,
continued to do so in 1976 (Table 2).
"Relative earnings growth" remained rela-
FASB-8 expected" period (October 22, 1975
through March 31, 1976) and finally the "floating with FASB-8" period (April 7, 1976 through
March 30,1977).
The grouping of firms is designed to distinguish between the performance of multinationals
and that of domestic firms, and to distinguish between the performance of "typical" multinationalsand that of more "sensitive" firms. Since
"floating" alone could adversely affect performance, we measure their actions during the
fixed-rate period and again during each of the
two periods of quasi-floating after August 15,
1971. Since FASB-8 was officially adopted on
October 15, 1975 to apply effectively to firstquarter 1976 earnings reports, we consider also
the period from October 22, 1975 through
March 31, 1976, when FASB-8's existence was
known but before the appearance of any firstquarter earnings figures. In effect, this period
isolates any impact arising from the application
of a known form of FASB-8. The final period
from April 7, 1976 through the end of our sample, March 30, 1977, tests for the "new information'" if any, that was contained in actual earnings reports under FASB-8 that were then
beginning to appear.
The control group "trucking" is Standard and
Poor's stock index of five trucking firms. 10 Selection of this "non-multinational" control group required a careful search, because almost any
grouping of major U.s.-based firms contains a
significant multinational component, and multinational firms dominate the Fortune 500 list of
major corporations. 11 However, the S & P
"trucking" group is a readily available composite
with virtually no multinational involvement. .
The "typical" multinational group was selected on the basis of substantial multinational involvement of the firms in certain S & P composites. Chemicals, drugs and international oil
companies were most consistently represented in
samples of major multinationals, as is evident
from the listings in the Appendix. The "sensitive"
group of multinationals was selected to represent
those firms whose earnings reports during 1976
were most clearly affected by the application of
48
ing per se and the impact resulting from the expected or actual application of FASB-8. The two
earlier ("fixed rate" and "transition") periods are
rather clearly delineated. (See p.47 above.) In
contrast, it is difficult to identify a date when we
might expect that FASB-8 would begin to affect
the share prices of multinationals. The Financial
Accounting Standards Board began preliminary
consideration of new standards for muitinationals in April 1973. Therefollowed a series of exposure drafts, memos and public hearings,· and
FASB-8 was officially released on October 15,
1975. By the end of 1974 analysts generally expected that new regulations would be forthcoming, although a powerful negative reaction by
multinationals to FASB's Exposure Draft of December 31, 1974 caused some to anticipate a
fairly significant softening of the terms in that
draft. Because of such continuing uncertainty,
we would expect any possible effects of FASB-8
to surface only when the new standards had become "official"-hence our specific identification of the period from October 22, 1975 through
March 31, 1976 as "floating with FASB-8 ex-
tively stable over the 1975-76 period. Relative
earnings growth is the difference between overall
corporate earnings performance, as measured by
the percentage change in current quarterly earnings over those for a year earlier, and that for the
"sensitive" group, divided by overall earnings
performance. (The one exception, in the third
quarter of 1975, reflected the very small improvement in overall earnings in that quarter.) In
contrast, the absolute difference in performance
between overall earnings and sensitive-group
earnings generally widened over the two-year period. However, the figure for first-quarter
1976-a crucial period for earnings variability
under FASB-8-was less than a third of a standard deviation from the mean absolute difference for the 1975-76 period. 14 In short, there was
nothing particularly unusual in the first quarter
of 1976 about the level of earnings performance
of the "sensitive" group relative to the level of
overall corporate-earnings performance.
Next, by considering movements within different time periods, we try to distinguish between
the impact on share prices associated with float-
Table 1
The Effect of FASB-8 Accounting Standards on
1976 Reported Earnings of "Sensitive Firms"
Impact(% jon 1976
Earnings Resulting
from FASB-8 Standards*
Rank in
Fortune 500
Assets
(billions)d
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
American Brands
Armco Steel
Bell & Howell
Celanese
Chemetron
Chicago Pneumatic
Eastman Kodak
Ferro
Gardner Denver
Gillette
I I. Hoover
12. Norton
28
12a
"a
13
25
39
8.6
17
20a
20
59
13
(EPS)c
(NI)
(EPS)
(NI)
(NI)
(NI/EPS)
(EPS)
(NI)
(EPS)
(NI)
(EPS)
(EPS/NIl
57
50
338
85
336
531
22
445
332
170
341
295
$2.456
$2.834
$ .408
$1.910
$ .412
$ .255
$5.524
$ .246
$ .416
$1.071
$ .391
$ .483
13. Sherwin Williams
15
(EPS)
266
$ .587
a.
b.
c.
d.
Industry and SIC Code
Tobacco
Primary metals
Photographic
Chemicals
Chemicals
Air Transport
Photographic
Chemicals
Air Transport
Fabricated Metal Products
Electrical Equipment
Stone, Clay,
Glass and Concrete
Petroleum Refining &
Related Industries
(21 )
(33)
(38)
(28)
(28)
(45)
(38)
(28)
(45)
(34)
(36)
(32)
(28)
Group Average
21.6
140b
$1.307
First three quarters of 1976.
Rank of firm in Fortune 500 with comparable (1.307 b.) assets.
Percent reduction in earnings per share (EPS) or net income (NI) due specifically to the implementation of FASB-8
standards.
Source: Fortune 500 list of U.S. firms in 1976.
*Negative
49
The results obtained from estimating equation
(l}overfive time periods are reported in Table 3.
Rjt, the return on portfolio j, is measured by the
rateofchangeofthe price of portfo.ioJat timet;
that· is,(Pjt .~. Pjt~ 1) IPjt~ l' Rmtis measured by
the weekly rate of change of Standard and Poor's
value~weightedcompositeindex· of 500 stocks. 16
The pricesofthe<non~multinati()nal and"typi~
cal" multinational .portfolios are taken from
Standard & Poor'svalue~weighted indices, and
the price of the "sensitive"portfolioismeasured
both as the average and the value~weightedaver~
age of the share prices of the 13 firms listed in
Table 1.17
The results reported here suggest that the only
significant and persistent impact upon multina~
tionaI share prices occurred in the "sensitive"
group, and then only during the" FASB~8" peri~
od (ApriI1976~March 1977). During that peri~
od, three factors were present together for the
first time-the adoption of FASB~8, theavail~
ability of new earnings reports and the Account~
ing Board's reiteration of its intention to stand
firm on the new standards. Our results for the
"sensitive" group suggest a reduction in the ex
post annual rate of return during the FASB~8 pe~
riod of about one half of one percent below that
for a typical portfolio with the same market risk
(measured by "{3").18 This outcome is based upon
the significant negative level for the estimated
value of "a" for a weighted portfolio of "sensi~
tive" firms in the "after FASB~8" time periodsee column (5) in the "weighted-sensitive" group.
Such a result implies that some force exogenous
pected." In other words, we would expect that the
maximum i pact fromanticipationof FASB-8,
I1l
as opposed to its actual application, would arise
only after this "official" release,when the specificcontentofthe regulations had been absorbed
by analysts.
Two events distinguished the beginning of the
"FASB-8" period. Firstwas the appearance of
the initial set of earnings reports prepared under
FASB~8 .standards. Second was .• the crucial
FASBdecision (April 29, 1976) nottore-consider the "col1troversial" standards contained in
FAS~-8 .• Il1.reporting .the decision,· the Wall
StreetJournaJ observed:
The standard ( FASB-8) has drawn more
criticism than any other issued by the
three-year-oldstandards board, the private
sector's top authority on accounting rules.
Business critics contend that the new rule
introduces erratic and meaningless fluctuations in earnings that will only confuse investors. Some companies have protested to
the Securities and Exchange Commission
and a few have threatened to ignore the
rule. 15
Thus, until late April 1976, many firms and investors still had reason to believe that FASB-8
would be rescinded or altered. Again, many financial managers remained unconvinced that investors had already discounted into share prices
(prior to FASB-8's enactment) all the information which its application might be expected to
reveaL
Table 2
Earnings Performance of "Sensitive" Group Relative
to Overall Performance of U.S. Corporations 1
1
Relative
Difference in
Earnings Growth
Earnings Growth
(Overall-Sensitive)
Time
(Overall-sensitive)
Period
Overall
1975 I
0.58
8.3%
II
1.98
12.5
III
22.60
11.3
IV
1.92
25.1
1976 I
0.64
31.0
II
1.79
65.4
III
2.20
34.1
IV
1.47
13.8
Earnings performance is measured by the percentage change in quarterly earnings over the quarterly figure for a year earlier.
Sources: U.S. Department of Commerce, Commerce News, July 21, 1977 for overall corporate earnings and Wall Street Journal,
various issues, for earnings of the sensitive group.
50
to overall market factors persistently depressed
the performance of “sensitive” shares beginning
in April, 1976. This result is also apparent from
plots of indices of these share prices against the
S&P 500 from January, 1975 through March,
1977 (Chart 1). Since the appearance of this de
pressive factor coincided with the appearance of
the first set of earnings reports under FASB-8
and the FASB’s reaffirmation of its new stan
dards, we cannot reject the hypothesis that the
share prices in this group were depressed by an
increase in their perceived riskiness. Such firms
would have to offer risk-averse investors subse
quent issues of shares at a lower price, and would
therefore experience a higher cost of raising
capital.
Our conclusions are strengthened by two fac
tors which reduce the probability that the ob
served behavior of the “sensitive” group was due
to some phenomenon not related to the impact of
foreign-exchange risk on expected variability of
earnings. First, the diversity in size and industrymix of the “sensitive” group sharply reduces the
probability that some other unspecified event
common to all companies could have depressed
their expected rates of return after April 1976
(Table 1). Second, the fact that the earnings per
formance of the “sensitive” group, relative to
that of all U.S. corporations, was fairly steady
over the period (Table 2), suggests that a rise in
expected earnings variability—not a fall in the
expected level of earnings—depressed the “sensi
tive” group’s expected returns in the FASB-8 pe
riod. In short, an alternative explanation for the
behavior of the firms in the “sensitive” group
would have to include identification of some oth
er event(s) which reduced their attractiveness
after April 1976.
Despite the previous reference to rising values
of “/?” as a possible result of floating rates, that
effect was not evident in the one-year postFASB-8 period. “/3” rose in various “floating”
periods for the chemical and drug groupings, but
it also rose for the control (trucking) group while
failing to rise significantly for the rest of the mul
tinationals. The impact of floating on market
rates apparently was not powerful enough to af
fect the responsiveness of multinational shares to
market volatility, to an extent that would domi
nate the usual instability of “/3” values for indus
try aggregates over relatively short periods of
time.
Several other conclusions emerge from the re
sults reported in Table 3. “Floating” rates per se
apparently produced no significant and persis
tent negative pressure on share prices of any
group of multinationals. In view of the consider
able discretion which multinationals had availChart 1
STO CK
P R IC E
April 1976=100
51
C O M P A R IS O N
Table 3
Impact of "Floating"and FASB-80n Security Prices
(Estimation of equation (1))
Time Periods
Portfolios
PreFASB"8
Floating
Expected
FASB-8
3/7310/75
(3)
After
FASB-8
Overall
10/753/76
(4)
3/763/77
1/703/77
(5)
(6)
.0044
(1.28)
1.110
(9.37)
.40
2.24
.0390
~.0024
(.35)
.858
(2.22)
.15
2.10
.0310
-.0030
(.75)
.616
(2.39)
.08
1.98
.0289
.0031
(1.84)
1.042
(13.83)
.34
1.99
.0332
.000
(00)
1.090
(13.78)
.70
1.70
.0120
.0029
(1.82)
1.080
(19.49)
.74
1.54
.0180
.0015
(.46)
1.200
(6.56)
.66
1.77
.0150
-.00335
(1.51)
1.077
(7.55)
.52
1.50
.0160
.0012
( 1.54)
1.033
(28.93)
.69
1.61
.0157
.0002
(.17)
.891
(14.81)
.73
1.34
.0116
.0033
(2.43)
.956
(11.55)
.62
1.40
.0120
-.0004
(.22)
1.11
(18.37)
.72
1.50
.0200
-.0042
(.73)
.845
(2.67)
.22
1.50
.0250
-.0035
(1.82)
1.290
(10.47)
.68
1.46
.0140
-.0002
(.27)
1.055
(28.06)
.68
1.47
.0166
.0012
(.45)
.900
(6.95)
.37
2.24
.0250
.0014
(.73)
.789
(6.96)
.37
2.13
.0170
.0003
(.14)
.876
(13.56)
.58
1.98
.0210
-.0015
(.46)
.884
(4.77)
.50
1.16
.0150
.0026
(1.39)
.929
(7.64)
.53
1.68
.0140
.0007
(.71)
.854
(18.54)
.48
2.05
.0203
.0009
(.32)
1.02
(8.23)
.45
2.55
.0230
.005
(1.89)
1.12
(7.24)
.39
1.96
.0230
-.0001
(.09)
1.21
(14.61 )
.62
2.31
.0280
.0004
(.09)
1.15
(4.19)
.42
2.26
.0220
-.00975
(3.35)
1.18
(6.36)
.44
2.23
.0200
-.0004
(.29)
1.18
(20.77)
.53
2.21
.0250
.00
(00)
.938
(17.48)
.79
2.01
.QIOO
-.0013
(1.23)
.981
(14.62)
.72
1.98
.0099
-.0003
(.23)
.851
(20.06)
.76
1.93
.0140
.0019
(.83)
1.04
(7.94)
.73
1.14
.0107
-.0034
(2.43)
.808
(8.95)
.61
1.90
.0101
-.0005
(.83)
.900
(32.83)
.74
1.94
.0120
Fixed
Transition
1/708/71
8/713/73
(i)
(1)
.0059
(1.67)
.885
(5.32)
.25
1.52
.0321
.0028
(.96)
1.330
(7.37)
.39
1.58
.0270
.0026
(1.66)
.809
(10.97)
.59
1.94
.0142
Non-M ultinationals
(Truckers)
ex
~
iF
DW
SEE
"Typical" Multinationals
(Chemicals)
ex
~
"R 2
DW
SEE
(Drugs)
ex
~
"R 2
DW
SEE
(International Oils)
ex
~
"R2
RW
SEE
"Sensitive" Multinationals
(weighted)
ex
~
"R 2
DW
SEE
(unweighted)
ex
~
iF
DW
SEE
52
able in the pre-FASB-8period in the use of reserve accounts and in the application ofhistorical
or cu.rrent exchange rates· to balance-sheet valuations, analysts may have become persuaded that
floating rates needn't increase profits variability
for multicurrency firms. Alternatively, the effects of floating rates on multinational share
prices may have been spread widelyenough,over
time and aCross firms, so that statistically significant shifts in performance would become difficult to detect at any single point in time. Inspection of the error terms in the regressions
undedyirtgTable 3 supports the latter hypothesis,
since the standard error of the estimate tended to
rise when moving from the "fixed" to the "early
floating" and "general floating" periods.
The expected application of FASH-8 apparently had little impact in the fourth ofthe five
time periods, although to some slight extent, investors may have anticipated a more harmful impact of FASB-8 on oil-company earnings during
that period than was justified by the actual results which later appeared. The data strongly
suggest, however, that the events surrounding
the application of FASB-8 caused investors to
downgrade multinationals in the "sensitive"
group. In other words, FASB-8 strongly affected
relative returns within the multinational group,
although a broad aggregate index of multinationals would likely show little if any deterioration relative to domestics in this respect. These
results are reinforced by the sharp departure, in
late April 1976, of share prices of the weighted
andunweighted "sensitive" group from a patll
which had previously followed movements of the
S&P500 (Chart 1).
The more pronounced earnings response of
the"weighted~sensitive"group
suggests(}f
course that the larger firms ill the sample· were
more powerfully affected. This is confirmed by
the estimation of equation (1) for each of the 13
companies in thisgroup~especially Eastman
Kodak, which performed very much like thevalue-weighted "sensitive"group as a whole. 19 Why
shou.ld .shares •of relatively large firms-which
suffer a smaller impact in percentage terms-respond more sharply to an expected increase in
earnings volatility reported under FASB-8? The
proximate answer is that the results under the
new standards were more of a "surprise" for relatively large firms than for smaller firms. Perhaps
analysts anticipated more of a rise in the volatility of earnings for relatively small firms under
FASB-8, while at the same time expecting no
significant impact upon earnings volatility for
larger firms. Further, the rise in expected volatility probably was relatively large for large firms
when compared with past volatility. For smaller
finns, the larger absolute effect under FASB-8
was more fully anticipated and relatively less significant when compared with past levels of earningsvolatility.
V. Concluding Observations
The application of FASB-8-mandated accounting standards has apparently produced few
unanticipated effects on earnings, and therefore
on share prices, of typical multinational firms
such as the oils, drugs and chemicals. The performance of such groupings is generally indistinguishable from that of a control group of domestic firms-whether in the face of "floating", anticipation ofFASB-8, or actual application of
that new standard. OUf results suggest, however,
that earnings reports which resulted from application of FASB-8 did provide new information
which helped investors distinguish between multinational groupings regarding the impact of exchange-rate adjustments upon (actual and expected) volatility of reported net dollar earnings.
The new standards are significant, then, not so
much because of their specific form but because
they apply a single standard to all multinationals, and thereby enable the market to judge more
accurately the relative performance of firms
within the overall multinational grouping. Prior
to the application of FASB-8 standards, cross
comparisons between multinationals were very
difficult, because of different conventions regarding the use of reserve accounts and the employment of histofical or current exchange rates
for translation· of such balance-sheet items· as
long-term debt, inventories and physical plant.
Given the problems which some firms encounter under FASB-8, it can be argued that they
should leave diversification of forei~n-exchange
risks to the investment community, which would
choose among claims on a group of firms whose
53
f()rtllIl.eS are weakly correlated so as to cushion
tlleirnpact of foreign-.exchange gains and losses
on portfolio values. This diversification argument presumes, however, that investors possess
very detailed accounting information about multinationals, are able almost immediately to foresee accurately the impact of expected exchangeratecllan.ges upon the value of a collection of
theirsbares, and are able to act subsequently to
bid Il.).ultinational share prices to levels which fullyreflect such information. Given the high cost
ofQbtaining such information and given the considerabl<rpressures from boards of directors, financial officers in multinational firms can probal.>ly be excused for taking little consolation in
the investor-diversification argument. At the
very least, some period of time may be required
to gather the information necessary to make the
new system operable. FASB-8 can have-and
undoubtedly has had-powerful short-run implications for the cost of capital of certain individualmultinational firms. 20
Finally, some consideration should be given to
the implications of our findings for the manage-
rial behavior of multinational firms. Nothing in
our findings specifically suggests that multinationals as a group should expend much effort to
alter the specific form of accounting standards.
The important thing is that the same standards
be applied to all firms. Beyond that, accounting
standards can do little to change the fact that
multinationals' net cash flows (expressed in some
nUJllerairequrrency) become subject to variation
\Vheneverexchangerates move up or down. ManagersCallllQt esCape the fact, for example, that if
they have borrowed large amounts of deutschIl.).al;ksl.>u11191dQnly dollar~denominated receivabIes> and assets, an appreciation of deutschmarks against the dollar will force them to
allocate mQreof their dollar receipts simply to
pay Qff thedeutschmark liability. Consideration
ofproblems of this sQrt may suggest to managers
ofmultinationals that, like it or not, they are in
the foreign-exchange business. Consequently,
theYIl.).l,l.yfindan attractive return at the margin
ifthey utiIi;z;etheir resources to minimize the impactofex:<;hange-rate fluctuations on net earnillgsexpressed in local currencies.
FOOTNOTES
1. See for example, Global Reach: The Power of the Multlnatlonlilis by R. J. Barnet and R. E. Muller (Simon & Schuster, New
York. 1975). for 1I somewhat more even-handed treatment, see R.
Vernon, Storm over the Multinationals: The Real Issues (Harvard
Univ. Press, Cambridge, 1977).
prices Of multinationals relative to share prices in general and to a
control group of n()n multi-nationals. There is no reason to expect a
sYlltllmati!:' differllnce in dividend policies between such broad aggregate firm groupings, and therefore consistent omission of dividendshOuld not affect the relative rates of return on multinational
sl'lllres.ForthellPplication of the market model to actual (ex post)
datll,see Jensen (1969).
10. .All groups of firms are described in the Appendix.
11. ..S!;l.e~ forexllmple, the list of 70 companies in the sample stud·
ies byRodriguez (1977).
12. To discover this group I relied heavily on articles in various
perio~icllisreporting upon the firms for which earnings were most
senllitivetofASB-8 anti exchange rate chllnges. Periodicals and
dlllesotliPpearanclilof arti.cles included, Barrons 12/6/76 and
8/8177; Business Week 1/26/76,9/6/76 and 6/20177; Chemical Week 3/9/77; and the Wall Street Journal 3/13/75 and
12/8/76.
13.• Enactment o.f FASB-8 required a major change in the accounting procedures lor virtually all multinationallirms examined, either
in the fOrl1l of termination of reserve accounts or a switch to
hilltoriclii/!:,urrenttranslation rates for inventory /long term debt
itemll on the balanCe .sheet. A llurvey of such practices by Rodriguez (1977) showed that in 1975 only Pfizer (part of the chemicals
group) had adopted standards generally in line with those required
byFASB-8 in Jllnullry.1976.
g.The mean ofth~ abl30lule differences betw~en overall and
"sensilive"earningll performance for lhe eight quarters of 1975-76
was 25.2 With a I3tandard deviation of 18.8.
t5.TheWaIlStre~tJOllrnal.ApriI29, 1976, p.12.
16..• VVerklyseriel3 of VVe!lnesday cl()sing prices were employed
to calculate rates of change of share prices.
17. Wednesday closing prices for the "sensitive" group were taken fromStan!lard and Poor:s Dally Stock Price Record.
2. For a detailed description of the new standards see FASB's
Statement of Finance Standards No.8, October 1975, Financial
Accounting Standards Board, Stamford, Connecticut. A useful discussion of the new standards and their background is given by
Burns (1976).
3.. For a survllY of such practices see Rodriguez (1977).
4. It may be that the very existence of a higher level of permissible flllxibility of exchange rates will cause investors, for a time at
least, to expect more exchange rate variability and more earnings
variability, thereby leading to a demand for high rates of return on
shares of multinationals.
5. This argument Ilbout the "costs" of floating was advance by
Lanyi(1969).
6. •See Mlikin (1977) for a proof and further discussion.
7. ·Of!:'ourse firms hedge receivables or payables in forward markets and frequllntly borrow lind lend to reduce exposure. But efforts have generally been confined to a currency-by-currency hedgingstratllgyrather than moving to a comprehensive hedging
strategy, For a discussion of such strategies see Makin (1976)
(19n)·
8. For a derivation of equation (I) and a fuller discussion of its
meaning see Sharpe (1970). A good conceptual discussion appellrs in Sl'lllrpe (1972).
9. Expected rlltes of return represented in equation (I) will be
measured, for use in empirical tests below, by actual rates of
change of share prices. Dividends are not included in calculations
of expected returns since we are interested in behavior of share
54
18. The ligures reported in Table 3 reler to weekly returns which
must be compounded over 52 weeks to be converted to annual
rates.
19. Thislinding brings to mind the possible role played by loreign
exchange problems in explaining the recent sharp deterioration in
the value 01 Kodak's shares. Business Week ("The Market Manhandles a Blue Chip, " June 20, 1977) reported on the situation at
Kodak, indicl;iting the view 01 Kodak's management that, "We don't
think it is good management to try to protect against that (Ioreign
exchange) loss by taking out large overseas borrowings, which is
one of the devices used to try to ollset that." (p. 37)
20. When interpreting the results reported here, it is important to
remember that earnings reports measure net returns in terms 01
current dollars, and not necessarily in "real" terms. It is possible,
although not necessarily true, that an earnings stream which is
more volatile when measured in current-dollar terms is less volatile
in terms 01 its real purchasing power over some multinational (or
even national) basket 01 goods and services. In such a case, a rise
in nominal variability may not mean any rise in real risk, and hence
may not 'mean any rise in share prices. 01 course, if the bulk 01
investors buying shares corne Irom a single local-currency area
and concentrate their purchaaes on local goods, there is greater
likelihood 01 volatility in the real purchasing power as well as the
local-currency value 01 the earnings stream.
____,"Risk, Market Sensitivity and Diversification," Financial
Analysts Journal (January-February, 1972).
Standard & Poor, Dally Stock PriceR.cord.
R. Vernon, Storm Over the Multinationals: The Real Issues, Har·
vard University Press, Cambridge, 1977.
APPENDIX
A. Firms appearing in "domestic" and "typical
multinationals" groupings:
Truckers
Consolidated Freightway
McLean Trucking
Overnite Transportation
Roadway Express
Yellow Freight Systems
Oil (Integrated International)
Exxon
Gulf Oil
Mobil Oil
Royal Dutch Petroleum
Standard Oil of California
Texaco
Drugs
Abbott Laboratories
American Home Products
Bristol·Meyers
Johnson & Johnson
Lilly (Eli) & Co.
Merck & Co.
Pfizer Inc.
Schering Plough Corp.
Searle (G.P.)
Sterling Drugs
Warner Lambert
References
R.J. Barnet and R.W. Muller, Global Reach: The Power of the Mul·
tinatlonals, Simon & Schuster, New York, 1975.
Barron's, various issues.
J.M. Burns, Accounting Standards and International Finance,
American Enterprise Institute, Washington, D.C., September 1976.
Business Week, various issues.
Chemical Week, March 9,1977.
Financing Accounting Standards Board, Statement of Financial
Accounting Standards No.8, October 1974, Stamlord,
Conn.
M.C. Jensen, "Risk, The Pricing 01 Capital Assets, and the Evaluation 01 Investment Portlolios," The Journal of Business
(April 1969).
J.H. Makin, "The Portfolio Method of Managing Foreign Exchange
Risk," Euromoney (August, 1976).
_ _ _:'Portfollo Theory and the Problem of Foreign Exchange
Risk," The Journal of Finance, forthcoming.
R.M. Rodriguez, "FASB·8: What Has it Done for Us?", Financial
Analysts Journal (March-April, 1977).
W.F. Sharpe, Portfolio Theory and Capital Markets, McGraw Hill,
New York, 1970.
Chemicals
Allied Chemical Corp.
American Cyanamid
Dow Chemical
duPont de Nemours
Hercules Inc.
Monsanto Chemical
Union Carbide
(All are from Standard and Poor's Stock Price Indexes.)
55
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