Foreign Debt Crisis in Developing Countries: An Overview

The below mentioned article provides an overview on the foreign debt crisis in developing countries.

Subject-Matter:

Borrowing from abroad can make sound eco­nomic sense. For instance, much of the develop­ment of railway networks of the USA, Argentina and various developing countries in the 19th cen­tury were financed by bonds issued in Europe.

Over the past two decades, many firms and governments of developing countries borrowed billions of dollars from banks in the developed countries. But while the 19th century railway companies were able to repay their debts, it become apparent in the 1980s that some of the countries that had borrowed heavily—particularly Brazil, Argentina and Mexico, could not repay what they owed.

The resulting crisis threatened the economic prospects of the developing coun­tries and the financial viability of many banks in the rich countries. The 1970s saw large-scale external borrowing by developing countries from international banks. By 1982, the accumulated debt of developing countries totalled $600 billion. Increase in US interest rates from 1979 and the appreciation of the dollar put pressure on the abil­ity of the developing countries to service their debts.

During the 1970s and early 1980s develo­ping countries accumulated a huge foreign debt which they subsequently found difficult to ser­vice (i.e., repay along with interest). This debt burden seriously hampered their development planning during the 1980s. The debt arose as many developing countries borrowed heavily from private banks in developed nations to finance their growing capital needs and to pay for sharply rising crude oil bills during the 1970s.

All these adverse developments occurred in the face of slowly expanding exports to developed coun­tries (as the latter faced the problem of slow growth), lower prices for their commodity exports, and higher interest rates. By borrowing heavily abroad, developing countries somehow managed to grow at a relatively rapid pace even during the second half of the 1970s. However, in the early 1980s, their huge and rapidly growing foreign debts caught up with them and large- scale defaults were avoided only by repeated large-scale intervention by the IMF.

The World Bank uses two main criteria to judge whether a country’s level of debt is sus­tainable whether the debt to export ratio exceeds 200-250%; and whether the debt service ratio exceeds 20-25%. The debt-service ratio is parti­cularly crucial because this measures the amount of foreign exchange earnings that cannot be used to purchase imports and is, therefore, measure of the extent to which a government might decide to default on its repayment obligations.

The more the debt service payments, the more that deve­lopment is thwarted (hampered). Many develop­ing countries, particularly in Africa, are in a debt crisis situation with debt-export and debt-service ratios much above the World Bank limits of sustainability.

The debt-service ratio measures the ratio of amortisation and interest payments to export earn­ings. A constantly rising ratio means a greater fixed claim on export receipts, and, therefore, there is a greater proneness to default if these receipts fluctuate and foreign exchange require­ments for other purposes cannot easily be cur­tailed.

In this sense, the world debt problem is essentially a foreign exchange problem. It repre­sents the inability of debtors to earn enough foreign exchange through exports to service foreign debts, and, at the same time to sustain the growth of output (which requires foreign exchange to pay for imports). Either debt service payments have to be suspended or growth curtailed, or a combination of both.

Facing default several developing countries were forced to renegotiate their debt repayment schedules and interest payments with their credi­tor banks in the developed countries, with the help of IMF and as directed by it. As part of the deal debtor nations were required to adopt austerity and to cut inflation, prevent wage increases and curtail domestic programmes, so as to be able to achieve economic growth on a more sustainable basis.

The debt crisis first started in the middle of 1982, when Mexico became the first country to suspend the repayment of loans due to the private banking system and sovereign lenders, the crisis has become more and more serious since then with more and more countries finding it difficult to service accumulated debts out of foreign exchange earnings. In 1987 Brazil became the first country to suspend interest payments to for­eign creditors.

The origin of the current debt problem of developing countries can be traced to the huge balance of payments surpluses of the oil exporting countries in the early 1970s with counterpart deficits elsewhere. The factors that caused the supply of capital to increase created its own demand. Private banks were eager to lend their surplus funds and there was no deficiency of demand.

Demand was very strong due to world commodity boom, exports were buoyant and inflation had reduced the real rate of intersect on loans to almost zero. Credit became cheap and risk of lending was low. But things changed very quickly. Depression in the developed countries, caused by the adoption of domestic anti-inflation­ary policies, caused world commodity market to collapse, prices of tumble, exports to languish and real interest rates to soar. On top of this, nominal interest rates moved upwards and the dollar appreciated.

The LDCs’ debt problem was exacerbated by the uses to which much of the money has been put. Instead of being invested in productive pro­jects, it has been spent by the Government on cur­rent consumption to gain popularity or for keep­ing inefficient state enterprises alive, or it had simply disappeared in the pockets of politicians and officials. The outcome was that, by 1982, many LDCs were burdened with vast debts that they were unable to service.

The debt crisis began in August 1982 when Mexico, the second largest LDC debtor, announced a payment moratorium. New loans and rescheduled time-table for repayments were required. The new Mexican moratorium was a shock to the international banks, which realised that other LDCs faced similar problems.

Causes:

Four main causes of the international debt crisis of the 1980’s were the following:

(i) The root cause of the debt crisis was a rise in US interest rates and the inability of the debtors to anticipate it and to appreciate its adverse effects.

(ii) The second reason was miscalculations of the county risk.

(iii) The third reason was that banks have relaxed their credit criteria in their lust (passionate desire) for profit from the petro-dollar recycling business.

(iv) Finally, the syndicated loan system pro­vided a false sense of security. To every­body’s surprise all the banks were involved in wrong doing at the same time.

Surely the main cause of the debt crisis was rising interest rates. In the 1970s, real interest rate were low, and banks were flushed with petro­dollars — dollars that oil produces, particularly in the middle East, had earned from selling their oil at the high prices that prevailed from 1973 and wanted to invest or deposit them abroad. Both borrowers and lenders were optimistic that the loans would stimulate economic growth, and repayments would be easy.

Then three things happened. First nominal and real interest rates rose sharply in the late 1970. Secondly, the world economy was hit by a recession in the early 1980s, and the worldwide slowdown in growth made it even more difficult for the developing countries to pay back their loans. Thirdly, oil prices fell in the early 1980s. This made it difficult for some of the largest bor­rowers, mainly oil producers such as Mexico and Indonesia, to repay their loans by selling oil.

Those countries like the Republic of Korea borrowed heavily but invested the money wisely and have been able to repay it. In contrast, Mexico, Indonesia and several countries invested the borrowed funds in projects that were not eco­nomically viable. Since funds were not invested productively repayment because virtually impos­sible.

Effects:

Bank exposers to highly indebted countries posed a threat to the western banking system. Governments of developed countries and interna­tional institutions such as the IMF and World Bank became involved in the management of the debt crisis through various structural adjustment programmes.

Resolution of the debt problem imposed burdens on the borrowers, in the form of austerity and unemployment, on bank sharehold­ers and on taxpayers in the developed world who ultimately paid for their governments rescue operations through the international financial institutions.

Most international banks reported losses to their shareholders. Others started the process of restoring the quality of balance sheets.

Reverse Flow of Capital:

In the 1970s and early 1980s, prior to the Mexican moratorium of 1982, the developing countries were net recipients of international capital flows, that is, new loans exceeded interest paying plus repaying of principal. With the onset of the debt crisis, the payments pattern reversed and there were substantial net transfers from developing to developed countries. These were achieved by developing countries at the cost of recession.

Solutions:

1. Rescheduling:

Massive defaults on loans were avoided only by debt rescheduling. As a payment came due, the banks lent the debtor country more money. So the date of repayment was postponed. As a condition for this scheduling, the lenders insisted that the borrowers cut back on their huge budget deficits. But this did not solve the prob­lem.

The only way the countries could repay was for them to grow faster than in the past. But growth required additional capital, which foreign lenders were reluctant to provide. The only way out was to forgive some of the debt and then count on the ‘rest’s being repaid.

2. Debt forgiveness:

Debt forgiveness amounts to a gift to the debtor countries. But it creates other problems. It may encourage countries to borrow more in the future than they have the capacity to repay. Under this scheme a country like Brazil is at an advantageous position compared to poor countries in Latin America, Africa because the former bor­rows heavily. Debt forgiveness is just like a huge gift to Brazil.

IMF’s Role:

The IMF played a vital role in coping with the Mexican debt moratorium of August 1982 that marked the beginning of the ‘debt crisis’. It assumed the key role in brokering debt reschedu­ling and restructuring agreements between banks and borrowers countries were obliged to imple­ment austerity measures and economic reforms; and banks were required to make further loans.

The IMF itself took the lead as a lender. The Fund not only provided assistance from its own resources, but coordinated and cajoled contribu­tions from international banks and creditors. The IMF took on the role of key intermediary between all the parties.

A balance was struck between ‘rescheduling’ — the extension of existing loans and the supply of new funds — and ‘adjustment’ — the adoption of more stringent economic poli­cies by borrowers — on a case-by-case basis. The Brady Plan of 1989 added a new dimension, allowing the IMF to set aside 25% of the resources provided by a funded programme for debt reduction.

To main elements of the plan were:

(i) Providing funds via the IMF and the World Bank for various forms of debt relief to those middle income debtor countries that were willing to adopt policy reforms, and

(ii) Encouraging countries to buy back- from banks at a discount, thereby reducing future obligations. On possibility was for coun­tries to swap old loans for new long-term (30-year) bonds at a discount of some 35% and an interest rate only marginally above the market rate — the bonds were guaran­teed by the IMF. Agreements of this type were reached with Mexico, the Philippines, Costa Rica, Venezuela and Uruguay. The deal with Mexico relieved it of $20 billion of debt service payments.

However, the debtor countries soon became this enchanted with the economic hardships inflicted by the IMF-brokered adjustment pro­grammes. Debt reduction and debt forgiveness are particularly relevant in the cases of some of the poorest countries. Since the 1980s the IMF has been confronted with the problem of repayment arrears.

Some countries have been suspended from eligibility to use the Fund’s resources until the arrears were cleared. In 1995 a plan was intro­duced by the World Bank to establish a multilat­eral debt facility to allow 40% of the poorer coun­tries in the world, mainly in Africa, to write off part of their $160 billion debt — the so-called HIPC (Higher Indebted Poor Country) initiative.

The first comprehensive plan to assist Heavily Indebted Poor Countries (HIPCs) was drawn up in 1996. But the results were disappointing and by 1999 only three of them — Bolivia, Gyana and Uganda — had benefited. At the Group of Seven meeting in thirty-three poorest countries (with a total population of 430 mn.) stood to benefit from the Cologne Initiative, cutting their outstanding debts from $130 billion to $60 billion.

The World Bank has always been against write-offs, but, the share of debt-service payments going to multilateral creditors has increased in recent years, accounting for nearly 50% of the debt service payments of African countries. This World Bank facility, therefore, marks a radical departure in thinking and attitude.