RANDALL DODD*
March, 1989
Written for presentation at the annual meeting of the Eastern Economics Associations, Baltimore, March 8, 1989
Abstract: This article analyzes the role of risk in the less
developed country (LDC) debt crisis.
LDC debt, mostly in the form of syndicated Eurocurrency credits, exposed
borrowers to the risk of fluctuations in foreign exchange, interest rates, and
export prices. When all three of these
risk factors moved against LDCs in the early 1980s, the crisis hit. Even the apparent over-lending can be
partially explained as the result of banks and LDCs trying to stave off the
impact of higher real debt payments.
This was not an unforeseeable problem.
Thus the question must be asked, why were not more appropriate financial
instruments not used to meet LDCs' borrowing needs?
* Department of Economics, Columbia University, New York, NY,
10025.
INTRODUCTION.
The thesis I want to advance in this study is that international
bank loans laid a risky foundation for financing development in less developed
countries (LDCs). By shifting nearly
all sources of risk onto debtors, International bank loans created the
condition for the possibility of the debt crisis. Once the crisis struck, the initial bailouts and then the Baker
Plan of exchanging austerity for new lending led to an even further rise in
total outstanding debt. Today's
indebtedness of hundreds of millions of Third World workers to a few
international banks gives new meaning to Churchill's words of thanks to the
R.A.F., "Never before in the history of human conflict, have so many, owed
so much, to so few." The best way
to understand the risky nature of financing development through international
bank loans is to compare the risk characteristics of international bank loans
to other forms of international capital flows such as foreign direct investment
(FDI) and currency-diversified bonds.
(I take as a premises here that international banks played the decisive
role in determining that International bank loans would be the predominant debt
instrument for North-South lending. See
my article, Dodd (1989), for a justification of this point.)
During the first two decades following the second World War, most
private capital flows to LDCs were in the form of FDI. Then in the late
1960s, many LDCs as well their state-agencies and state owned enterprises and
private businesses began to borrow from international banks in the U.S. and the
growing Eurodollar markets. At the same
time international banks became eager to lend to LDCs, and Kindleberger (1978,
p.23-4) stated this very well.
"The enormous external debt of the developing countries,
built up not only since the rise of oil prices but importantly -- a widely
ignored fact -- in the several years before that time, as multinational banks
swollen with dollars tumbled over one another in trying to uncover new foreign
borrowers and practically forced money on the LDCs."
Together this markedly changed the composition of capital flows in
the 1970s. Financial capital, mostly in
the form of international bank loans, flowed in increasing magnitudes from
international capital markets to LDCs.
As early as 1970, net flows of financial capital matched that of
FDI. In the year after the 1973 oil
shock, the sum of international bank loans and international bond issues was
250% that of FDI and outstripped
official development assistance for the first time. This trend would continue until the debt crisis came to a head in
1982. The new composition of capital
flows restructured the international economic relationship between the
industrial countries in the "North" and LDCs in the
"South".
The substance of this new relationship was the new distribution of
risk and sovereignty. By borrowing in
order to augment their own capital stocks, LDCs sought to regain sovereignty
over their domestic capital stocks and investments. But borrowing in the form of International bank loans allowed
international financial capitalists to shift much of the market risk of
investing and borrowing onto LDCs.
Thus, after the crisis hit and the IMF arrived, LDC governments
discovered that in trying to regain sovereignty over their domestic capital
stocks they had lost sovereignty over their monetary and fiscal policies.
Different types of risk are associated with FDI and international bank loans. The total risk on FDI, from the perspective
of international investors, breaks down into several sources of risk: business
failure; natural disasters (acts of God); foreign exchange fluctuations;
expropriation or nationalization; and world business cycle. From the perspective of LDCs, the risk on
FDI is of little concern. The risk of
business failure, which might be called entrepreneurial risk, is associated
with any direct investment in a business enterprise. The returns on foreign investments are generally larger than
those on domestic investments because foreign investments are more uncertain
than similar activities at home due to the lack of information, especially the
unfamiliarity with foreign rules-of-the-game, and the relatively less stable
economic environment. Whatever the
cause, business risk on FDI is borne by
foreign investors. FDI also incurs the
risks of 'natural' disasters such as floods, droughts, poor harvests and
earthquakes. As a result of the
distribution of risk associated with FDI, the social losses resulting from a
natural disaster would be diversified or spread abroad. Foreign exchange risk is another source of
risk international investors face on FDI.
An appreciation of the home country's currency, e.g. the U.S. dollar, or
a depreciation of the developing country's currency would reduce the dollar
value of foreign profits as they were repatriated to the U.S.
The international monetary system of fixed exchange rates founded
at Bretton Woods all but eliminated this source of risk, but since the collapse
of that system in 1971, foreign exchange risk has reemerged. Nonetheless, foreign exchange risk is borne
entirely by international investors.
Foreign exchange risks are sometimes mitigated by locating FDI in the export or import competing
sectors where, theoretically, the home currency rate of return is maintained
despite inflation and depreciation by the purchasing power parity or the Law of
One Price. Yet, even if foreign
investments earn "hard" currency in the export sector, host
governments often require foreign earnings to be converted at a fixed rate to
domestic currency at the central bank.
As a result, the foreign exchange risk again fell on the international
investors.
Expropriations and nationalizations, especially during the late
1960s and 1970s, are another source of risk.
The investment experience of FDI
for international investors in the 1970s were described by Naim (1987) as a
"time of trouble for international business." Hawkins, et al, (1975) provides a litany of
the numerous cases of nationalizations and expropriations. They estimate that foreign investors lost
over $2 billion during this turbulent period.
This might sound like a trifle now, but the real dollar value of the
political significance were not. It
seems that the political meaning of the capital losses were not lost on the
international investors. These initiatives
came primarily from Leftist political movements, although they ended up being
administered by Rightist governments (Hawkins, 1975; Dare and Weeks,
1976). Even when these political
movements were not entirely successful at seizing state power, they often
succeeded in crippling economies and the established political order (e.g.
Uruguay, Dominican Republic). At the
least they succeeded in placing restrictions on foreign investments. As Naim (1987) put it, "By the early
1970s in Latin America, granting explicit incentives and other forms of
preferential treatment toward foreign firms became almost
unthinkable."
Another source of risk on FDI arises from the powerful influence
of world economic business cycles on LDCs.
A foreign led recession would adversely affect many foreign owned
businesses since, especially those concentrated in the export sectors of
LDCs. On the other hand, the risk borne
by LDCs from hosting FDI is relatively small.
The impact of either business failure, natural disasters, foreign
exchange fluctuations, expropriation or nationalization, and world business
cycle would be less than if the enterprises were locally owned. In the event of a complete collapse of a
foreign business, the abandoned plant and equipment would remain in the
LDC. Expropriations or nationalizations
would be a wind fall, at least initially, although there would always be the
threat of a cessation of future capital inflows and the likelihood of capital
outflows. In the event of an exodus of
foreign capital, real physical investments, such as plant and equipment, would
have to be sold either to domestic investors or to some other, more
"friendly," foreign investors.
A widespread effort by foreign investors to liquidate their holdings on
the host country's domestic capital market would have the effect of greatly
depressing the price of such capital.
Retreating foreign investors would suffer further capital losses as they
sold their capital for the host country's currency and then flooded world
foreign exchange markets with it in an attempt to repatriate their
capital. Without doubt, the expectation
of just such losses would inhibit foreign investors, as a whole, from
withdrawing their capital. Selling the
capital to other foreigner investors would merely change the nationality of the
foreign investments and would thus have no adverse consequences for the host
LDC.
Changes in earnings associated with global business cycles would,
in this manner, mean that the cost to LDCs of importing foreign capital would
be pro-cyclical. Overall, the risk
on FDI falls almost exclusively on the
international investors. This, it might
be argued, is an appropriate distribution of risk since multinational
corporations (MNCs), who are the source of most FDI, are very capable of managing such risk. Risk management by MNCs is made easier
because many of the above sources of
FDI risk are negatively correlated.
For instance, an appreciation of the U.S. dollar (or depreciation of the
foreign currency) would on one hand increase the U.S. demand for exports and on
the other hand reduce the rate of converting foreign currency earnings back
into dollars.
Before making the parallel analysis for International bank loans,
an apt definition of International bank loans is in order. International bank loans are generally
syndicated Eurocurrency (mostly U.S. dollar), variable rate bank loans of
intermediate-term maturity. They
contain cross-default clauses and high front-end fees. They are issued either directly to states in
LDCs or to private businesses with guaranteed by the state. An estimated 94% of international loans to
Latin America were U.S. dollar denominated, and most private International bank
loans were also variable rate (World Debt Tables). Syndicated Eurocurrency credits are loans issued by a group of
banks which are put together by a "lead bank or core group of banks"
from financial centers such as New York.
Other large and small banks who join in the agreement become minor partners
by purchasing a portion of the value of each loan. Syndication often involve consortium banking practices which
consist of the major banks pooling their research and analysis efforts for the
purpose of issuing loans. Together this
led to a more uniform lending practice, and a more united response by creditors
once the crisis hit.
Interest costs on variable rate debt are set according to some
"spread" above LIBOR, the prime lending rate in the U.S. or other
short-term interest rate. When LIBOR
rises (falls), the interest rate charged on outstanding principle and hence the
interest payment rises (falls). But a
one percent rise in LIBOR does not translate into a one percent rise in
payments. Instead, a percentage rise in
the base rate raises the interest payment by a percentage that is an
exponential function of the magnitude of the interest rate and the maturity of
the loan. For example, a one percent
rise from 9% to 10% on a 20 year loan raises interest payments approximately
10%. LDC borrowers are also charged
substantial front-end fees for initiating the loan and commitments to a credit
line (Goodman, 1980). While this is not
a source of risk, it is a considerable cost that enters into the calculation of
whether the loan is profitable. One factor
that does significantly increase the riskiness of International bank loans is
their effectively short-term maturity.
International bank loans are not short-term assets in respect to their
maturity, which range upwards to 15 years and average from 7 to 10 years (World
Debt Tables). They are effectively
short-term assets because their interest rates are adjusted at frequent
intervals in accordance with such short-term rates as LIBOR (Goodman, 1980). This difference between actual and effective
maturity is akin to the notion of duration which is of great importance in
comparing various lending instruments.
Cross-default clauses mean that borrowers can not default against
one single or particular group of lenders, and that the default by one borrower
in a country will be treated as a general default. In an ironic twist, the international banks have expropriated a
slogan from the Industrial Workers of the World, that a (financial) injury to
one is an injury to all. These features
strongly shape the distribution of risk between borrower and lenders. International bank loans, as opposed to FDI, do not expose international investors
(mostly Eurodollar market banks) to foreign exchange risk. The variable interest rates on international
bank loans do not expose them to dollar interest rate or inflation risk.
The return to international bank loans, unlike FDI, are isolated from the costs of natural
disasters. Holding loans, instead of
equity, means that international investors have fewer worries about labor
strife, expropriations and nationalizations.
And unlike FDI, a worldwide
recession would not necessarily reduce the real return on foreign investments. The only risks they are exposed to are
illiquidity of loans and sovereign or default risk. The later is reduced by syndication which institutionalizes the
relationship among creditor banks and insures that they would act in concert in
order to impose sanctions or take other measures necessary to enforce loan
payment. Moreover, most International
bank loans are guaranteed by LDC states so that even the risk of default is
greatly reduced. It would have been a
reasonable presumption by international banks that LDC states, as opposed to
private firms, would have much greater ability to meet debt payments because of
their taxing power and the growth in exports.
International bank loans from the perspective of LDCs were from
the beginning a disaster waiting for a time to happen. They bear the risk of U.S. dollar
appreciations, the risk of rising U.S. interest rates, the entire risk of
natural disasters and business failures, and the risk associated with global
business cycles. And as time tore off
the false side-whiskers of fate, all these dangers arrived en masse and, in
some cases, stayed. As an indication of
past mistakes, efforts in recent years to mitigate the debt crisis have sought,
although perhaps unwittingly, to change the features of the debt which are
criticized above. Rescheduling has
lengthened the maturity of the debt as interest payments have been
amortized. The portfolio of debt has
become more currency diversified, and attempts have been made to swap and
renegotiate existing debt into fixed rate debt. And the creation of a secondary market testifies to the banks'
own need for a more liquidity lending instrument.
BETTER
ALTERNATIVES
In order to evaluate the appropriateness of any debt instrument,
its properties must be analyzed in terms of borrowing needs. Most LDCs have three basic types of
borrowing needs, and each is associated with a different term of maturity: (1)
short-term trade credits; (2) intermediate-term adjustment borrowing; (3)
long-term development project borrowing.
Short-term credit is needed in order to encourage exports. These export credits are in the form of privately
and publicly issued, short-term instruments as bankers acceptances, discounted
bills of exchange, as well as private and public (states as well as
multilateral agencies) sponsored trade credits.
A sizable minority of outstanding LDC indebtedness is made up of rolled-over short-term debt; it was ostensibly borrowed for use as trade credits but has functioned in many cases as balance of payments bridge loans. Intermediate-term credit is needed in order to adjust to real changes in world commodity prices. The clearest example of this was the enormous rise in borrowing that followed the 1974 oil shock. As Martin and Selowsky (1981) have argued, the cost of adjustment in an imperfectly flexible world is inversely related to the length of the adjustment period. The borrowing costs could therefore be justified by the benefits of extending the adjustment period. Long-term credit is needed in order to finance (long-term) investment in social overhead capital and fixed plant and equipment. The gestation period on such investments is often 10 to 20 years, and therefore the costs of borrowing should be fixed for the same length of time (Williamson, 1987, makes this same point). This is what is most often thought of when the term "development finance" is used. These problems of the past suggest a solution in the future. Development should be financed with long-term, fixed-fate, currency diversified loans or bonds that include contingencies for disasters and economic downturns.
Part of this was suggested by Pollack back in 1974. He recommended that cash rich nations and
institutions should buy World Bank bonds so that the World Bank could expand
its development oriented lending. World
Bank lending is generally in the form of intermediate to long-term, fixed rate
loans denominated in various currencies.
It is also important to note that the World Bank was less strict than
the IMF about the conditionality of loans.
Thus one might infer that Pollack was recommending long-term, fixed rate
development finance. Currency
diversification is an important aspect of LDCs borrowing needs because the
gains to diversification are double.
Primarily it would also reduce debtors' foreign exchange exposure. It would also reduce interest rate risk by
smoothing out the inevitable changes in interest rates. Mohl and Sobol (1983) have shown that
diversification would have reduced the interest rate variance and effective
cost of borrowing by over $30 billion for the years 1979-1982 alone. One road not taken, was that of bond
lending. Historically, many people and
financial institutions took heavy losses following the debt default and
repudiation by LDC in the 1930s (Diaz-Alejandro, 1982). In order for LDCs to use bond financing,
there have to be bond underwriters, issuers, and investors (purchasers of
bonds). The growth of the Eurobond
market, which emerged 22 years ago in 1963, exploded in recent years when the
quantity of new bond issued reached $80 billion in 1984 and $133 billion in
1985.[1] Hypothetically, the same Eurodollar market
banks which issued most of the International bank loans could certainly have
underwritten or purchased Eurobonds issued by developing countries, after all,
these banks are not subject to any government regulation of their portfolio holdings.
CONCLUSION
One immediate conclusion gleaned from the above discussion is that
the manner in which development is financed is crucial. This would apply to both LDC workers who are
the ultimate debtors or to any new socialist state that is integrated into the
world capital market. To close with a
misquote from Churchill upon the disaster at Dunkirk (another instance of the
problem of repatriating foreign resources), the growing interest in and demand
for debt forgiveness signals not the end of the beginning but the beginning of
the end.
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1976. "The Intensification of the Assault Against the Working Class."
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Diaz-Alejandro, Carlos. 1982. "Latin America in the 1930s." Yale
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Dodd, Randall. 1989. "How and
Why International Banks Issued Mostly Syndicated, Variable Rate Loans to
LDCs." Paper to be presented to
conference "Global Imbalances" at American University, May, 1989.
Goodman, Laurie. 1980. "The
Pricing of Syndicated Eurocurrency Credits." FRBNY Quarterly Review,
(Summer).
Hawkins, Robert G., Norman Mintz
and Michael Provissiero. 1975.
Governmental Takeovers of U.S. Foreign Affiliates: A Post-war Profile,
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Kindleberger, Charles. 1978. Manias, Crises and Panics: A History of
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Martin, Ricardo and Marcelo
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Mohl, Andrew & Dorothy Sobol.
1983. "Effects on LDC debt payments of currency diversification on a trade
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Naim, Moises. 1987. Government
regulation of foreign investment: emerging lessons from Latin America, in
Richard D. Robinson (ed.), Direct Foreign Investment. New York:
Praeger.
Pollack, Gerald. 1974. The economic consequences of the energy
crisis. Foreign Affairs (Spring).
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