Incentives Needed to Reform Debt

The international debt problem dates from the summer of 1982, when Mexico, followed by many others, announced that it was no longer able to pay the interest and principal on its international debts. At the time, most experts regarded the problem as short term, as an important but temporary interruption in the flow of international trade and payments.

By 1985, initial optimism had faded. The international debt problem was still around and, by many measures, getting worse. James A. Baker III, then secretary of the Treasury, announced a plan to solve the problem of the 15 most heavily indebted countries by encouraging growth and exports.

The so-called Baker Plan rejected calls for a global solution. The U.S. government chose to continue the country-by-country approach, based on voluntary decisions by debtors and creditors, that had been the policy since 1982. The Baker Plan shifted emphasis from austerity to growth in the developing countries as a means of working out the problem.

Most of the 15 countries are no nearer to a solution now than in the past. There are a few exceptions, but they are few, indeed. The levels of gross national product or exports for the countries as a group, though higher than in 1985, remain well below the levels of 1980 and 1981. Debt has grown much faster than GNP or exports, so the widely watched ratio of debt to exports increased from about 2.6 in 1982 to 3.0 in 1985 and to more than 3.5 at the end of 1987.

Much of this rise reflects the inability of most debtor countries to earn enough from exports to pay the interest on their outstanding debt. They resolve the problem by borrowing more, using the new loans mainly to pay interest on the old.

As the debt grows, relative to exports, the debt problem worsens. The reason is that each additional dollar of debt raises the interest obligations of the debtor countries and requires a sustained increase in exports in the future. Adding debt and rescheduling payments pushes the problem into the future. The debtor countries that have not been able to service their debts since 1982 face still larger interest payments each year for the indefinite future.

The original loans were dominantly private, mainly bank, debt. At the end of 1985, private lenders had supplied almost 70% of the outstanding debt to the most heavily indebted countries. Since 1985, most of the net new lending has been done by governments and international institutions, a significant change from previous practice. By the end of 1987, the private sector’s share of outstanding debt had fallen to 64%, and it declined further in 1988. Governments and international institutions, such as the International Monetary Fund and the World Bank, increased their outstanding loans to the “Baker 15” by more than $50 billion between 1985 and 1987.

Markets are skeptical about whether the debts will ever be paid or fully serviced. We know that because debts can be bought or sold in limited quantities, often for less than 50 cents on the dollar. Using 50 cents as a rough measure of value means that each dollar of additional loans is worth only 50 cents as soon as it is made.

The governments, and international agencies financed by governments and taxpayers, have been using our money foolishly. They have not so much been buying time as squandering money.

Unfortunately, most critics of past debt policy urge the governments and international agencies to take more responsibility for the debt problem and to spend more of the public’s money or, what is nearly the same, make guarantees that will have to be paid by future taxpayers. This is wrongheaded. We should not shift more of the cost to the taxpayers. Instead, we should increase incentives for debtors and creditors to reach lasting solutions, country by country, on their own.

In sum, there are three main problems with current policy. First, the problem is getting worse. The debt has increased much faster than ability to service, measured by exports. And most of the additional borrowing goes to pay interest on the old debt. Second, there are too few incentives for reform in the debtor countries. Third, there is little incentive for the creditors to take their losses by recognizing that the market value of the debt is far below the face value or the value at which they record the debt on their balance sheets.

Most of the problems have a common cause. Governments, particularly the U.S. government, and international agencies have been so anxious to avoid defaults that they have gotten deeply involved in negotiations with the debtors. To avoid defaults they lend the money that the debtors use to pay the interest and service the old debt. Very little of the additional loan is available to finance reforms in the debtor countries. Since the creditors continue to receive interest payments, financed partly with their own new loans, they have insufficient incentives to recognize the losses they have experienced. They wait for the miracle that does not happen.

A few changes would work to improve incentives on all sides. The U.S. government and the international agencies should stop trying to pay the banks’ interest by lending more and encouraging the banks to lend more. Any additional loans should be conditional on permanent reforms of the debtor countries’ policies, including policies to lower inflation, to reduce subsidies, protective tariffs, trade barriers and regulations and to sell state enterprises to private investors. Without reforms, debtor countries’ output and exports will not rise at rates sufficient to service new and existing debt.

Negotiations about interest payments on the outstanding debt should be left to the debtors and creditors. With the U.S. government and the international agencies no longer lending to pay interest, banks would have greater incentive to recognize the losses that occurred years ago. With new lending tied to reforms, and not to interest payments on old debt, debtors would have greater incentive to reform their policies. If for political or other reasons the debtors choose the status quo over reform, additional loans will be no more productive than past loans. The loans merely throw good money after bad. That’s why loans must be tied to reforms and paid when reforms have been made.

Does reform work? Chile has shown that it does. Inflation has been reduced; state industries have been sold to private investors; tariffs and regulations have been lowered. The economy responded by investing more, growing faster and increasing productivity. Foreign debt has been reduced, lowering interest payments. Chile can now look forward to an end to its debt problem.

Other debtor countries can follow this route, making the hard choices that produce lasting reform. Our role should be to encourage these reforms instead of burdening the countries with ever-increasing debt that, without reforms, will neither be repaid nor serviced.