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DEC 3 1 1386
For release upon delivery
10 A.M. CST (11 A.M. EST)
December 29, 1986

The Debt Crisis and the Future of International Bank Lending

H. Robert Heller
Member, Board of Governors of the Federal Reserve System

Annual Convention of the American Economic Association
New Orleans
December 29, 1986

The Debt Crisis and the Future of International Bank Lending

As we approach 1987, the Gordian knot of the international debt
problem seems to be tightening again. Rescheduling agreements and
requests for new money by several important countries are on the
agenda. It will take farsighted and strategic thinking on behalf of
all participants to overcome the mounting problems confronting us.

Nevertheless, I firmly believe that the problems will continue to be
manageable if all participants focus on their long-term interest in
coming to a satisfactory solution. It is within that general
framework that I would like to approach the topic of "The Debt Crisis
and the Future of International Bank Lending".

The role of the banks in the debt crisis cannot be seen in isolation.
Important interdependences must be considered, including the
responsibilities of the debtor countries, the industrialized
countries, and the international agencies.

The Causes of the Debt Crisis and Initial Management Success
During the 1970's, commercial banks became the principal source of
external finance to the developing countries. The volume of new bankrelated financial flows surpassed by far the volume of official
government lending, financing provided by the multinational agencies,
and foreign direct investment.

The global recession of the early eighties and the associated fall in

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commodity prices produced a sharp curtailment of the earnings of the
developing countries. At the same time, real and nominal interest
rates surged, straining the financial resources of the LDCs until
they were no longer able to fulfill their financial commitments,
thereby triggering the international debt crisis of 1982.

The initial management of the debt crisis has been generally
satisfactory. Immediate liquidity assistance was provided by the
central banks of the industrialized countries under the auspices of
the Bank for International Settlements.

Subsequently, the International Monetary Fund assumed a central role
by assisting in the implementation of financial adjustment programs
and providing $35 billion in financial assistance between mid-1982
and mid-1986. Allowing for $12 billion in repayments (albeit not
necessarily by the same countries), net funds provided amounted to
$23 billion.

The World Bank also made significant contributions by disbursing over
$32 billion in new loans through the IBRD over the period from mid1982 to mid-1986. Allowing for $11 billion in loan repayments, the
net new money provided by the IBRD amounted to $21 billion.

Adding the concessional IDA credits further enhances the role of the
World Bank. During the same 1982-86 period, IDA disbursed $10.8
billion dollars.

Repayments amounted to less than half a billion,

resulting in a net new IDA money flow of $10.4 billion.

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Over the same period, commercial banks increased their net LDC
exposure by $45 billion. Debt reschedulings were agreed upon between
the banks and all the major debtor countries.

Banks, and in

particular U.S. banks, also increased their capital rapidly during
the period, thereby reducing the ratio of outstanding LDC debt to
their own capital and enhancing their capacity to withstand possible
adverse developments.

Many of the developing countries implemented tough financial
adjustment programs that resulted by 1985 in a drop in imports by $82
billion or 14 percent below the 1981 level. Of course, lower export
prices also played a role in this drop of export revenue, but the end
result was just as painful for the developing countries.

At the end of 1986, we can look back upon a record of considerable
accomplishments both for the debtors and the creditors. Key to that
progress has been the cooperative attitude between borrowers and
lenders, facilitated by the good offices and resources provided by
governments and international agencies.

A Strategic Perspective on International Bank Lending
If the international debt problem is to be solved in a cooperative
fashion with the continued active participation of the commercial
banks, it is important to investigate whether the long-term interests
of the banks are served by such a course of action.

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Similarly, from the viewpoint of the debtor countries the key
question is whether the countries wish to maintain a long-term
relationship with foreign commercial banks.

The costs associated

with debt repudiation became abundantly clear in the case of Cuba,
and no country that wishes to remain part of the international
commercial and financial system will consider this a viable

In more recent history, Peru's unilateral decision to

limit its debt service payments has not put that country on a path to
economic health and prosperity.

The formation of valid expectations about the future of international
bank lending requires an understanding of what motivates a bank. In
that sense, the future of international bank lending to developing
countries should be seen as a long-term strategic decision and not
merely a credit judgement about a particular borrower at a given
moment in time or the expected rate of return on a specific loan.

If banks reduce and eventually eliminate their international
activities either by engaging in a slow retreat or by divesting the
international division, they engage in a strategic retreat that will
not be easily reversed within a decade or more. The central issue is
whether it is in the banks own long-term interest to maintain a
business relationship with the developing countries.

The business interests of commercial banks are highly complex, and it
is clear that not all aspects can be fully considered within the
limited space available.

It should also be borne in mind that not

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all banks are similarly situated, and that business judgements by the
senior managers may well differ.

With these caveats in mind it is useful to consider three broad areas
of foreign banking activity in arriving at an assessment of the
future prospects of international bank lending: the international
short-term transaction business, medium and long-term lending, and
direct investment activities in the international banking area.

The first segment of international banking activities comprises
payment and transaction oriented services. Examples include the
execution of international payments, foreign exchange services,
letters of credit, trade finance, traveller's checks, and credit

Many of these transactions are self-liquidating and arise in

connection with the payment for international goods and service

The total amount of cross-border exposure that will be

generated by these transactions may be quite small. These services
are generally provided by a small number of banks with an extensive
international presence: the international network banks.

Only banks with an extensive international network are able to
compete in this market effectively as principal players.

Other banks

partake in these transactions on a one-off basis through
correspondent banks.

Historically, the largest North American and European banks have
dominated this market, although in recent years Japanese banks have

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made significant efforts to become major players as well. The global
total of banks in this category is probably less than 20, and due to
the high costs of entry, there is little prospect that the number of
banks in this category will increase significantly.

Conversely, the

banks active in this market see their franchise as a valuable
possession and are not likely to give up this area of activity.

However, banks may well question how many countries need to be
included in such a global network strategy. The potential market
size, and thereby profit potential, drops rapidly after the largest
countries are accounted for. The smaller countries may therefore find
it increasingly difficult to retain a large number of banks that are
willing to incur the substantial up-front costs of maintaining the
necessary offices and overhead expenses. On the other hand, there is
a strong self-interest on behalf of the banks to remain active in the
large countries.

The second market segment involves the medium and long-term financing
of projects and balance of payments imbalances. By their very nature,
these activities involve the creation of relatively large and
persistent cross-border credit exposures.

In years past, innovative financial techniques, such as syndicated
Eurocurrency credits, made it possible for many banks to participate
in these lending activities. The lead banks were able to spread the
associated risk among a large group of smaller banks that participated in the syndications. In addition, the large banks benefited

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from the income derived from the management and syndication fees.

There is a broad tendency in financial markets toward the
securitization of lending. International markets will not be exempt
from that trend. International loan syndications are therefore likely
to be replaced by the securitization technique. It also stands to
reason that securitization is better suited for traditional project
lending with an identifiable stream of repayments rather than for
balance of payments lending to governments, where the availability of
funds for repayment often depends on the implementation of
appropriate policy measures.

In order to gain access to the international security markets, the
credit quality of the borrowers must be unquestioned. It is therefore
in the interest of both the debtor countries and the creditor banks
to do everything in their power to enhance the creditworthiness of
the debtor nations, so that the security markets can eventually be
used to offer a broader access to world financial resources to the
developing countries.

Debt to equity swaps offer one tool to ease the fixed payments
commitments of the debtor countries.

Several commercial banks have

pioneered debt to equity swaps and many more promising opportunities
exist in this field.

For instance, the possibility of "mutual funds"

that could be used by smaller banks to pool their equity investments
is now being explored.

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But even under the best of circumstances debt to equity swaps will
make only a marginal contribution towards the resolution of the
entire problem. This assumes the full cooperation of the debtor
countries in liberalizing their regulations towards foreign direct

Difficult regulatory and supervisory issues may arise in connection
with debt to equity swaps.

I believe that it will be possible to

overcome these problems, so that debt to equity swaps can make a
useful contribution by reducing the magnitude of the fixed payment
commitments of the debtor countries.

Both from the viewpoint of the banks and of the countries involved it
is desirable that debt to equity swaps involve more than a mere
liquefication of the initial loan at a discount.

From the viewpoint

of the country it is desirable that the debt to equity conversion
constitute a net addition to the foreign direct investment inflows.
From the viewpoint of the bank it is desirable that the bank be in a
position to partake in the potential profits that the equity
investment affords to the holder. Merely selling a loan at a discount
to a potential foreign investor does not fulfill that objective.

New investments in the financial service sector in the various
countries are particularly well suited to fulfill the dual objective.
The country's consumers and business establishments will gain by
increasing competition in the financial service sector, the bank
gains new business opportunities in a field of its own expertise, and

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the country and the bank forge a long-term strategic relationship.

This brings up the third strategic business relationship between
banks and foreign countries: the local presence of foreign banks via
branches and/or subsidiaries. Banks in this category will have a
continuing involvement with the domestic economy of the country and
engage in a wide variety of financial activities. It goes without
saying that the deepening of such a relationship is very much in the
interest of both the banks and the countries. Not only will the banks
involvement with the local economy enhance their interest in the
economic health of the country, but the country may gain by having
access to new and varied sources of financial services. It therefore
stands to reason that the rapid liberalization of financial markets
in the developing countries by opening the markets to full and equal
participation by foreign banks on a "national treatment" basis offers
a promising avenue that will increase the long-term congruence of
interests among debtor countries and their creditor banks.

The issue whether some of the LDC loans should be written down or
"marked to market" has been discussed frequently in that connection.
My personal view is that there exists good reason to treat a loan on
the books of a bank at face value as long as there is a reasonable
expectation that the debt service payments will be made and that the
loan will eventually be repaid. The bank may enhance the likelihood
of this event by participating in restructuring and new lending

Such actions may therefore lend credence to a bank's

expectation of eventual repayment. In contrast, banks that refuse to

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partake in refinancing activities may thereby signal their own doubt
as to the future collectability of the loan and may wish to make
appropriate value adjustments.

The Responsibility of the Industrialized Countries
The international debt problem cannot be solved on a bilateral basis
between the banks and the debtor countries.

To a large extent these

bilateral negotiations involve arguing about who should make the
bigger sacrifice: the debtor or the creditor.

With the exception of

the new investment opportunities in the financial sector discussed
above, the argument revolves around redistributive questions rather
than an enlargement of the total amount of economic and financial
resources available to both parties.

Ultimately, the international debt crisis can be overcome only by
enlarging the economic pie through economic growth and increased
exports by the debtor countries. This involves not only a concerted
effort by the debtor countries to increase their exports, but also
continued access to markets in the industrialized countries.


latter condition is absolutely essential in order to allow the debtor
countries to earn the foreign exchange needed to service the debt.

Total exports by the developing countries amounted to $595 billion in
1981 (IMF, Direction of Trade data), the last year before the debt
crisis, but fell to $508 billion by 1985.

While much of that

shrinkage in exports was due to reduced trade among the developing
countries themselves, the industrialized countries reduced their

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purchases from the developing world by over $50 billion. LDC exports
to the United States remained essentially constant with $102 billion
in 1981 and $101 billion in 1985. However, LDC exports to Japan
dropped from $79 to $67 billion over the same period. Other countries
with sharply declining imports from the LDCs include Australia,
Belgium, Canada, France, Germany, the Netherlands, Sweden,
Switzerland, and the United Kingdom.

It is true that much of that change in trade was accounted for by
lower petroleum prices. All the more important is it that the
industrialized countries that benefitted the most from the fall in
petroleum prices and commodity prices utilize the funds saved to
purchase more products from the developing countries.

Much of the record trade and current account surpluses enjoyed by
countries like Germany and Japan is not due to their own greater
export efforts, but due to reduced purchases from the LDCs. Thus it
is clear that there exists much room to expand imports from the
developing countries.

Without access to growing markets, it will be

difficult for the debtor countries to earn the foreign exchange
needed to make the debt service payments.

The balance of payments

surplus countries are in a unique position to make a contribution
toward overcoming the international debt service problems and
increased international financial balance and stability.

The proper

way to reestablish the creditworthiness of the developing countries
is through more trade and not through debt relief.

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The Role of the International Organizations
The IMF and the World Bank must continue to play a leadership role
not only by providing continued financial assistance, but also by
assisting in the implementation of market-focused adjustment programs
in the debtor countries. Strong pressure on the surplus countries to
allow the necessary adjustments in their external imbalances is also
called for. The record profits enjoyed by the World Bank place it in
a unique position to use some of these profits to grant loans at
lower interest rates. In addition, it may utilize its seldom used
authority to guarantee commercial bank loans in order to serve as a
catalyst for more private lending.

By guaranteeing, say, 50 percent

of a commercial bank loan, the World Bank may effectively double the
leverage of its own scarce capital.

There is no doubt that international debt service problems will
remain an important concern in the years to come. There is also no
doubt that it is in the long-term strategic interests of the creditor
banks and the debtor countries to cooperate in overcoming the current

Banks will have to continue to make temporary sacrifices if they want
to see the long-term quality of their assets improve and if they wish
to maintain their strategic interests as international financial
institutions. Some banks may see their own strategic interests better
served by equity investments rather than a continuation of debt

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The debtor countries can enhance the long-term strategic interests of
the banks by opening up their financial markets and granting new
franchises. A continuation of the adjustment effort that focuses on
strengthened export performance, rather than arbitrary import
curtailment, is also called for.

The industrial countries with strong current account positions are
now called upon to lead the world toward a more open and growthoriented economic and financial system that will not only benefit the
developing countries in need of export markets, but also make their
own.citizens better off by providing them with a wider and cheaper
variety of products.

The IMF and the World Bank should continue to play the key role
envisioned in their respective charters as the providers of balance
of payments assistance and development finance. In addition, they
must serve as a forum for the international policy discussions on
appropriate adjustment measures to be implemented by surplus and
deficit countries alike.

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