Missing Chapter in Third World Debt

Among the four largest debtor countries in the Third World, South Korea currently commands an A-1 credit rating in world capital markets, enabling it to borrow amply at rates equal to the best available to any borrower in those markets.

The other three countries--Argentina, Brazil and Mexico--can borrow only by pleading with new creditors, or by coercing old ones using the threat of default as the stick. In either case the A-B-M countries are obliged to accept restrictive conditions, as well as interest rates, that reflect the extra risk that lending to them is believed to entail.

As an indication of this risk, the existing debts of Mexico, Argentina and Brazil trade on the secondary debt market at discounts of 38%, 33% and 24%, respectively. By contrast, the existing debt of South Korea is worth 100 cents on the dollar.

Among the four countries, Brazil and Mexico have debts totaling $108 billion and $100 billion, respectively; South Korea’s is $52 billion, and Argentina’s $50 billion. As a group, the four account for more than half the total Third World debt.

What explains the striking differences in the credit standings of the four countries? The explanations include several that are familiar, and one that is much less familiar but that is probably of greater importance.

The familiar explanations relate to the fact that South Korea has been and is a rapidly growing (more than 10% in 1986) economy, with booming export industries, a manageable debt-service ratio (about 15%) and an increasing inflow of direct and equity investment from abroad.

By contrast, Argentina, Brazil and Mexico are experiencing only modest or very slow economic growth, limited export growth in relation to their debt burdens, and a dearth of foreign capital inflow.

The less familiar explanation lies in the sharply contrasting history of capital flight in the three poor credit risks on the one hand and in South Korea on the other.

To a very substantial degree the debt accumulated by the A-B-M countries simply financed capital flight, whereas nearly all of South Korea’s debt contributed directly or indirectly to the formation of capital and to increased production and export capacity; it is the latter that accounts for South Korea’s strong credit rating and competitive position in world markets.

Between 1976 and 1985 cumulative capital outflows from Argentina and Mexico represented more than 50% of their total debts. The corresponding capital-flight figure for Brazil has been estimated at 10% to 18% of its debt, but this figure is probably an underestimate. In other words, for the three A-B-M countries capital flight amounted to about $95 billion of their total collective debt of $260 billion. In effect, 35% of these countries’ total borrowings was directly nullified by the acquisition of foreign assets by their own citizens and by other non-bank institutions. So-called “sovereign debt” was thus incurred by the three governments in exchange for foreign assets that were acquired by private citizens or by institutions of their countries.

This situation has a direct bearing on the predicament in which these and other Third World debtors and their creditors find themselves as they seek to improve matters and find a more promising approach to resolving the debt problem.

If the flight of capital from Argentina, Brazil and Mexico is reversed, their demands for further borrowing will be reduced, their access to it will be eased, and the effectiveness of their new borrowing will be enhanced. On the other hand, until capital repatriation occurs, there is every reason to expect that additional borrowing will be nullified by more capital flight. Even with the existence of tighter exchange controls in the three countries, new borrowing can still be converted into capital flight in various ways. For example, imports can be overinvoiced and exports underinvoiced to circumvent controls.

To ease the Third World debt problem, the conditions causing capital flight must be addressed. These conditions relate to political stability, tax and monetary policies, labor and wage legislation, regulatory policies and the general political and administrative climate for investment--whether by repatriated “old” capital or by new internal or foreign capital. If these conditions improve, less borrowing will be needed, more will be accessible and the burden of servicing existing debt will be eased. In the absence of progress along these lines, new loans will be wasted and the burden of outstanding debt will be magnified, further dimming prospects of repayment.