What can be learned from Brazil's decision to indefinitely suspend interest payments to foreign banks? The complacency of the financial community and the Reagan Administration suggest that the answer is: Not much.
A more careful evaluation of Brazil's behavior within the context of the Third World debt crisis suggests a different response--one that carries ominous overtones for the financial system. It is clear that the politics of managing Third World debt are becoming unstable, and that the forces creating instability are growing--not receding.
Since the end of 1984, debtors have shown an increasing willingness to risk default. The case of Mexico, the financial community's model debtor in 1983-84, is the most revealing. Awarded marginal concessions by the monetary authorities and the banks for its good behavior, Mexico nonetheless decided to risk default at the end of 1984, breaking its deal with the International Monetary Fund by reflating--permitting excessive money supply and budget deficits. From model debtor, Mexico assumed the image of irresponsible spendthrift as the International Monetary Fund cut off its money.
Last year, tension between Mexico and its creditors reached new levels when the Mexican government threatened default if it were not granted growth-oriented concessions. Then, last month, Brazil moved tactical escalation one step further--actually taking the first step toward default on its commercial bank debt.
Why are major debtors increasingly prepared to accept the serious risks of default? Mexican and Brazilian leaders, reflecting a growing tide among debtors, have reached the conclusion that the domestic political cost of accepting the traditional prescription of International Monetary Fund-style economic adjustment in exchange for new money sufficient to pay the interest on foreign debts is simply too high.
The traditional remedy for restoring the health of ailing debtor economies is one of fresh debt to finance interest on old debt combined with domestic belt-tightening insisted on by the United States and international financial contributors. That remedy of additional debt plus adjustment has failed. Non-inflationary growth, new investments and a return to voluntary lending have not materialized.
The mounting incentives for default can be overcome only if a new and effective remedy is found, and accepted, by the monetary authorities and the financial community. Any effective cure must recognize that the failed remedy was based on a fundamental misdiagnosis of the malady afflicting economies like Mexico's and Brazil's.
These economies suffer from structural overindebtedness, so that their growth has become dependent on accelerated indebtedness. They can adjust but not grow, or grow but not adjust. To allow both growth and adjustment, overindebted economies require debt relief in the form of reduced interest payments and, ultimately, a reduction in the absolute volume of indebtedness. What they do not need is more debt, especially new non-productive debt that merely services the old.
Evidence of the need for a new remedy has been overwhelming. The plan by Treasury Secretary James A. Baker III was formulated when it was recognized that the traditional approach was not generating politically sufficient levels of growth to stabilize debt management. But the Baker plan subscribed to too may old formulas and too few growth-inducing measures to be acceptable to either debtor nations or creditor banks.
The resurgence of the Mexican debt crisis in 1986 brought the instability of the politics of debt management to a new and dangerous level that was only temporarily lowered through modifications in the traditional formula as monetary authorities retreated on adjustment targets. The banks were brought in kicking and screaming under pressure from the monetary authorities. But even seven months after the International Monetary Fund and Mexico agreed to the plan, some banks were refusing to participate.
Brazil's latest actions represent an escalation in both method and demand, while the banks, having barely supported the Mexico deal, are far more hostile to lending yet more money to Brazil. The time for compromise seems to have passed. Without policy changes that reduce the incentives for default, unilateral action by debtors, with all of its dangers, seems to be inevitable.
If debtors were offered real prospects for growth, the rationale for default would be eliminated. Creditors, who are fed up with being forced to make available fresh loans for interest payments on outstanding debt, would accept a writing off of debt, provided that it was accompanied by the securitization of a good portion of the remaining debt and measures to give them time to take their losses in an orderly fashion.
Such options would permit long-term protection of assets and access to liquidity in exchange for short-term losses in profit. They would also give the monetary authorities sufficient leverage to bring about long-term fiscal, monetary and structural reforms in debtor economies and to stabilize the politics of debt management.