so what will "zero reset" look like? does it look like this, for example?
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Third World Debt
by Kenneth Rogoff
About the Author
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[Editor's note: this article was written in 1991.]
By the end of 1990 the world's poor and developing countries owed more than $1.3 trillion to industrialized countries. Among the largest problem debtors were Brazil ($116 billion), Mexico ($97 billion), and Argentina ($61 billion). Of the total developing-country debt, roughly half is owed to private creditors, mainly commercial banks.
The rest consists of obligations to international lending organizations such as the International Monetary Fund (IMF) and the World Bank, and to governments and government agencies—export-import banks, for example. Of the private bank debt, the bulk has been incurred by middle-income countries, especially in Latin America. The world's poorest countries, mostly in Africa and South Asia, were never able to borrow substantial sums from the private sector and most of their debts are to the IMF, World Bank, and other governments.
Third World debt grew dramatically during the seventies, when bankers were eager to lend money to developing countries. Although many Third World governments defaulted on their debts during the thirties, bankers had put that episode out of their minds by the seventies. The mood of the time is perhaps best captured in the famous proclamation by the Citibank chairman at the time, Walter Wriston, that lending to governments is safe banking because sovereign nations do not default on their debts.
The loan pyramid came crashing down in August 1982, when the Mexican government suddenly found itself unable to roll over its private debts (that is, borrow new funds to replace loans that were due) and was unprepared to quickly shift gears from being a net borrower to a net repayer. Soon after, a slew of other sovereign debtors sought rescheduling agreements, and the "debt crisis" was officially under way. Though experts do not really understand why the crisis started precisely when it did, its basic causes are clear. The sharp rise in world interest rates in the early eighties greatly increased the interest burden on debtor countries because most of their borrowings were indexed to short-term interest rates. At the same time, export receipts of developing countries suffered as commodity prices began to fall, reversing their rise of the seventies. More generally, sluggish growth in the industrialized countries made debt servicing much more difficult.
Of course, the debtors were not simply hapless victims of external market forces. The governments of many of the seventeen nations referred to as Highly Indebted Countries (HICs) made the situation worse by badly mismanaging their economies. In many countries during the seventies, commercial bank or World Bank loans quickly escaped through the back door in the form of private capital flight (see Capital Flight). As table 1 shows, capital assets that "fled" abroad from the HICs were 103 percent of long-term public and publicly guaranteed debt. Loans intended for infrastructure investment at home were rerouted to buy condominiums in Miami. In a few countries, most notably Brazil, capital flight was not severe. But a great deal of the loan money was spent internally on dubious large-scale, government-directed investment projects. Though well intentioned, the end result was the same: not enough money was invested in productive projects that could be used to service the debt.
TABLE 1
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Capital Flight
(in billions of 1987 dollars)
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Flight Capital Assets As Percentage of Long-Term Public and Publicly Guaranteed Debt
Argentina $46 111%
Bolivia 2 178
Brazil 31 46
Chile 2 17
Colombia 7 103
Ecuador 7 115
Ivory Coast 0 0
Mexico 84 114
Morocco 3 54
Nigeria 20 136
Peru 2 27
Philippines 23 188
Uruguay 4 159
Venezuela 58 240
Yugoslavia 6 79
Total 295 103
SOURCES: Flight Capital, Morgan Stanley as cited in The International Economy, July/August 1989. Debt, World Debt Tables, 1988-89 edition. Data refer to external debt to private creditors. Reprinted from Journal of Economic Perspectives, 4, no. 1 (Winter 1990): 37.
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Not all of the debtor countries were plagued by mismanagement. South Korea, considered by many to be a problem debtor at the onset of the debt crisis, maintained a strong export-oriented economy. The resulting growth in real GNP—averaging 9.8 percent per year between 1982 and 1988—allowed South Korea to make the largest debt repayments in the world in 1986 and 1987. Korea's debt fell from $47 billion to $40 billion between the end of 1985 and the end of 1987.
But for most debtor countries, the eighties were a decade of economic stagnation. Loan renegotiations with bank committees and with government lenders became almost constant. While lenders frequently agreed to roll over a portion of interest due (thus increasing their loans), prospects for net new funds seemed to dry up for all but a few developing countries, located mostly in fast-growing Asia. In this context bankers and government officials began to consider many schemes for clearing away the developing-country debt problem.
In theory, loans by governments and by international lending organizations are senior to private debts—they must be repaid first. But private lenders are the ones who have been pressing to have their loans repaid. As a consequence, official creditors saw their share of problem-country debt double—to nearly half the total—during the first decade of the debt crisis.
Many Third World debtors, particularly in Latin America, chafe at being asked to pay down their large debts. Their leaders plead that debt is strangling their economies and that repayments are soaking away resources desperately needed to finance growth. Although these pleas evoke considerable sympathy from leaders of rich countries, opinions over what to do are widely divided.
A staggering range of "solutions" has been proposed. Some of the more ambitious plans would either force private creditors to forgive part of their debts or use large doses of taxpayer resources to sponsor a settlement, or both. Current official policy, which is based on the Brady Plan (after U.S. Treasury Secretary Nicholas Brady), is for governments of industrialized countries to subsidize countries where there is scope for negotiating large-scale debt-reduction agreements with the private commercial banks. In principle, countries must also demonstrate the will to implement sound economic policies, both fiscal and monetary, to qualify. A small number of Brady Plan deals have been completed to date, the most notable being Mexico's 1990 debt restructuring.
Toward the end of the eighties, a number of sovereign debtors began experimenting with so-called market-based debt-reduction schemes, in which countries repurchased their debts at a discount by paying cash or by giving creditors equity in domestic industries. On the surface these plans appear to hurt banks because debts are retired at a fraction of their full value. But a closer inspection reveals why the commercial banks responded so enthusiastically.
Consider the Bolivian buy-back of March 1988. When the Bolivian deal was first discussed in late 1986, Bolivia's government had guaranteed $670 million in debt to commercial banks. In world secondary markets this debt traded at six cents on the dollar. That is, buyers of debt securities were willing to pay, and some sellers were willing to accept, only six cents per dollar of principal. Using funds that primarily were secretly donated by neutral third countries—rumored to include Spain, the Netherlands, and Brazil—Bolivia's government spent $34 million in March 1988 to buy back $308 million worth of debt at eleven cents on the dollar. Eleven cents was also the price that prevailed for the remaining Bolivian debt immediately after the repurchase. At first glance the buy-back might seem a triumph, almost halving Bolivia's debt. The fact that the price rose from six to eleven cents was interpreted by some observers as evidence that the deal had strengthened prospects for Bolivia's economy.
A more sober assessment of the Bolivian buy-back reveals that commercial bank creditors probably reaped most of the benefit. Before the buy-back, banks expected to receive a total of $40.2 million (.06 × $670 million). After the buy-back, banks had collected $34 million and their expected future repayments were still $39.8 million (.11 × $362 million). How did creditors manage to reap such a large share of the benefits? Basically, when a country is as deep in hock as Bolivia was, creditors attach a far greater likelihood to partial repayment than to full repayment. Having the face value of the debt halved did little to reduce the banks' bargaining leverage with Bolivia, and the chances that the canceled debt would have eventually been paid were low anyway. Similar problems can arise even in countries whose debt sells at much smaller discounts.
The fact that buy-backs tend to bid up debt prices presents difficulties for any plan in which funds taken from taxpayers in industrialized countries are used to promote debt restructurings that supposedly are for the sole benefit of people in the debtor countries. Banks will surely know of the additional resources available for repayment, and they will try to bargain for higher repayments and lower rollovers. The main focus of the Brady Plan is precisely to ensure that the lion's share of officially donated funds reaches debtors. But the fact that debt prices have been stronger in countries that have implemented Brady Plans than in non-Brady Plan countries suggests that the effort to limit the gain for banks has been only partially successful.
Aside from the question of such "leakage" to private banks, there are serious equity concerns with any attempt to channel large quantities of aid relief to deal with private debt. Though poor by standards of Europe and the United States, countries such as Brazil, Mexico, and Argentina rank as middle-to upper-middle income in the broader world community. The average per capita income in the seventeen HICs was $1,430 in 1987. This compares with $470 in developing East Asia and $290 in South Asia. Even Bolivia, South America's basket case, has twice the per capita income of India. On a need basis, therefore, Africa and South Asia are stronger candidates for aid.
About the Author
Kenneth Rogoff is a professor of economics at Harvard University. He has served on the staff of the International Monetary Fund and the Federal Reserve board and has been a visiting scholar at the World Bank.
Further Reading
Bulow, Jeremy, and Kenneth Rogoff. "The Buyback Boondoogle." Brookings Papers on Economic Activity, no. 2 (1988): 675-98.
Bulow, Jeremy, and Kenneth Rogoff. "Cleaning Up Third-World Debt without Getting Taken to the Cleaners." Journal of Economic Perspectives 4 (Winter 1990): 31-42.
World Bank. World Debt Tables: External Debt of Developing Countries. 1990-91 edition.
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