Mexican Debt Scheme Would Need Revision to Work for Other Nations

Mexico’s new approach to rescheduling a part of its debt is based on the most creative and promising idea for dealing with the debt problem that has emerged since the crisis first hit nearly six years ago.

But Mexico’s proposal may not be completely successful even on its own rather limited terms. Unless there is more political leadership and imagination in dealing with the debt problem--and these have been notably lacking--the considerable potential benefits of this new approach will not be realized.

First dismissed as only transitional, the debt problem is now widely understood to be both durable and dangerous. The dangers are many: Stunted economic development of the debtors, growing poverty, the risk of political instability, friction between debtors and creditors and threats to the world banking and financial systems. To the average American, the debt problem could mean fewer export-related jobs, more tax-financed foreign aid and increased risk of political instability in the Third World.

In general terms the nature of the solution to the worldwide debt problem has not been a mystery. In order for the debtor countries to meet their financial obligations, it will be necessary for them to grow, expand production and trade and generate the necessary income. But in order to grow and develop, two ingredients are vital. First, they must pursue policies that enhance economic growth. Second, they need additional outside resources such as loans, investments and expanded exports to finance domestic investment and to sustain living standards. The debt problem is, therefore, really a problem of economic development and how it is to be financed. It can only be successfully treated by a strategy sustained over time.

The major missing ingredient has been sufficient capital from outside sources. After 1982, new lending by commercial banks began to dry up; the banks had very little incentive to provide new loans when they were uncertain about whether the interest and the principal of old loans would be paid. Of course, the International Monetary Fund and World Bank have continued lending, but in limited amounts given the need. A measure of the need is found in the fact that on the average over the past three years, Latin America paid out to the rest of the world about $25 billion to $30 billion a year net in interest and principal.

In an effort to respond to this dilemma Secretary of the Treasury James A. Baker III in late 1985 proposed some sensible and desirable goals: More lending to debtors, primarily by commercial banks and the World Bank, and the debtors’ adoption of economic reforms and adjustment policies that would improve their ability to grow out of the debt problem over time. But the Baker Plan, as it came to be known, languished because it was not so much a plan as a hope.

What is needed is a method--a well conceived strategy--for putting the Baker Plan to work. The method is the “zero-coupon” bond, a financial instrument, which in the Mexican debt case means that Mexico will pay $2 billion in cash for U.S. bonds that Washington guarantees to redeem for $10 billion in 20 years. This technique, at the core of the Mexican initiative, can serve as the base in a broader strategy of debt management and can be adapted to meet the differing needs of the debtor countries.

The essence of the scheme remains valid today--to wipe out the existing debt held by the banks by guaranteeing the repayment of the debt principal at a specified future date.

Two important consequences flow. Banks will now be able to lend new money to the debtors without being concerned about “throwing good money after bad.” Moreover, since there is no longer any risk of repayment of the principal--and decreased risk of nonpayment of interest--the interest rate, which reflects risk, can be substantially lowered. Both factors add up to a substantial improvement in the availability of resources to the debtors.

As in the Mexican proposal, zero-coupon bonds act as the collateral for the repayment of the principal. Both debtors and creditors benefit and the technique involves no governmental subsidies.

There are many possible combinations of this technique to accommodate the interests of various debtors and different classes of creditor banks. The point to be made is that any program would include the amount of new money, if any, that the banks are to lend; the level of interest rates, and the extent of the discount on existing debt.

There is a certain trade-off among these factors. For example, in the Mexican proposal, no new money is being sought by Mexico from banks since the country received commitments for $6 billion to $7 billion from the banks when it renegotiated its latest rescheduling at the end of 1986. This was the most important factor in Mexico’s decision to seek a 50% discount on the old debt.

Mexicans also had in mind that their debt was already being sold at a 50% discount, and that banks were disposed to sell off the debt at a discount because they had already set aside reserves to cover the possibility that the debt was worth a lot less than its face value. Similarly, Mexico’s offer to raise the interest rate on its new obligations, where a lowering would be in order for a more secure obligation, was designed to compensate the banks for the expected 50% loss in principal.

It remains to be seen how the Mexican proposal will fare in the marketplace. While the 50% discount is a goal for the Mexicans, there’s no obligation for banks to bid a 50% discount. If the full 50% discount is realized, Mexico will save just over $500 million in the first year. However, if there is only a 25% discount, Mexico will save nothing. Deeper discounts will be attractive to the smaller banks who want to get out of the Mexican lending business and to the European banks who have substantially written down their Mexican debt holdings.

The Mexican debt package is clearly not one that will be of great interest to those debtor governments--the majority--who seek and need new money. This is a position in which Mexico may again find itself if, for example, oil prices fall, U.S. economic growth slows down and interest rates rise. Should such an unhappy scenario prevail, the number of banks disposed to lend--presumably the major U.S. banks--will be much reduced and their disposition to lend much cooler.

There is another very important respect in which the Mexican proposal is not a model for other debtors. Unlike virtually all the other debtors, Mexico has substantial reserves of foreign exchange, the product of an impressive increase in non-oil exports and of the new loans that it obtained. It can draw on these reserves to pay for the zero-coupon bonds that it proposes to buy from the U.S. Treasury. Other debtors must seek outside sources for such funds.

This need, among others, presents an opportunity for devising a broader-based strategy, adaptable to the needs of different debtors, which can serve to put the Baker Plan to work.

The strategy would include the World Bank establishing a special fund to which rich countries would lend money. This fund would be drawn on to finance the purchase of zero-coupon bonds by the debtors. Commercial banks would, in exchange for swapping their existing debt holdings for the new obligations secured by the zero-coupon bonds, provide a new financial package to the debtors made up of an appropriate combination of new money, lower interest rates and discounts. As a condition for the above, the debtor countries would negotiate an agreement with the World Bank on the measures they will take to insure the most efficient use of these funds to promote their economic growth.

Such an approach can moderate the burden of the debtors, improve their growth prospects over time and give greater security to commercial banks and encourage their continued participation in solving the debt problem.