Mexico Bond Issue Is Just a First Step : Touted Debt Prescription Needs a Dose of Realism to Work

The Mexico-U.S. Treasury initiative to reduce Mexico’s staggering debt burden is a step in the right direction, but one that may be less beneficial for Mexico and the banks than the publicity has warranted.

Without doubt Mexico, as well as the rest of Latin America, needs a reduction in the amount of money that it owes to foreign countries and banks. Growth overall in Latin America in 1987 was a weak 2.6%, less than that of the three previous years. Per-capita growth was only 0.5%, and gross domestic product per-capita figures remained at the level of a decade ago. Inflation surged in more than half of Latin America, with some countries approaching hyper-inflation.

Mexico’s economic recovery, essential to maintaining democratic regimes and political stability in a region vital to U.S. national security, will not be achieved without some significant changes in economic and debt policy. These include a more serious effort by debtors at economic adjustments, a reduction in the rate of interest paid on foreign debts, new development capital and enough economic growth for them to keep pace at the rate of population growth.

The U.S.-Mexico proposal will help at the margins, but its potential benefits to lenders and debtors should not be exaggerated.

The proposal essentially requires Mexico to pay about $2 billion in cash for U.S. bonds that the United States guarantees to redeem for $10 billion in 20 years. Assuming that the proposal works as it is envisioned, it should save Mexico approximately $1 billion per year on its annual interest bill to the banks of $9 billion to $10 billion. That is not an inconsequential saving, but, with an annual trade surplus of $4.5 billion to $9 billion, Mexico will still barely cover its reduced obligations to the banks.

Moreover, the proposal does not address the issue of a potential increase in U.S. interest rates. If the dollar continues to fall and the U.S. budget deficit is not significantly cut soon, interest rates may have to rise in order to continue to attract foreign capital. Such a development, together with the significantly higher rates that Mexico will pay on its new bond issue, would increase rather than reduce the debt-service burden.

For the largest banks the proposal is wrongly focused on principal and fails to address the major problem: maintenance of interest payments. While bankers will not admit it publicly, most have long since stopped worrying about payment of principal, most of which they know will probably never be paid. Bankers now worry most about whether countries will remain able and willing to make interest payments. While the proposal marginally improves the quality of the principal risk by securing the principal with U.S. Treasury bonds, it does nothing at all to protect the interest risk--by far the most serious obstacle in the lending process. The proposal would have been more attractive to the banks if, for example, it had contained some form of guarantee on the interest.

Another obstacle to the success of the plan will be the Mexicans’ demand that the banks offer 50% discounts of the face value of Mexican loans; major banks are not going to be willing to do that.

A more realistic approach would have been to call for the establishment of a new multilateral consortium to carefully evaluate a country’s debt and determine the appropriate discount. Such a consortium should be composed of creditor banks and countries, debtors and international lending institutions like the International Monetary Fund and the World Bank. It would review the potential for economic recovery and modernization, political stability and that country’s cooperation with the international creditor community on a country-by-country basis with a view toward determining an accurate and fair evaluation of that country’s debt.

A market approach to the debt? No. A negotiated solution to the debt? Yes. The former has not worked during its trial run of the past five years. It is now time to try the latter.