"The Debt-Bomb Threat," Time, January 10, 1983, pp. 42-51

 

Summary:

            The debt-bomb refers to the situation where $706 billion in debt is held by banks, governments and international financial institutions worldwide against troubled developing and East bloc countries.  Most of it will not be repaid, and the consequences of a default somewhere in the system could lead to political and economic reactions across the world.  According to British Financier Lord Lever, “the banking system of the Western world is now dangerously overexposed.  If lending abruptly contracts, there will be an avalanche of large-scale defaults that will inflict damage on world trade and on the political and economic stability of both borrowing and lending countries.”  Growing awareness of this “debt-bomb” become apparent when in the previous 21months, Poland, Mexico, Brazil and Argentina all encountered situations where they could not cover debt payments.  Although short term rescue plans worked, the nature of these occurrences makes it harder for borrowers to raise funds and maintain payments, which could lead to problems for the more than two dozen debtor countries in Latin America, Asia, Africa and the Soviet Bloc.  In 1981, the IMF reported that 32 countries were in arrears on debts, compared to only 15 in 1975.

            The higher energy prices of the 1973 oil shock helped to plunge developing countries into debt, which were further hurt by the 1978-79 shock.  A lingering world recession, high interest rates, slumping exports and flat trade, increased protectionism in industrialized countries and low commodity prices have hurt developing countries ability to pay debt through export earnings.   A combination of several medium countries encountering troubles could be more of a problem than one large default. 

            U.S. banks are the most exposed to the international debt.   Loans to developing and East bloc nations, Latin America and Caribbean countries totaled close to $200billion.  $52billion had been loaned to Mexico, Brazil, and Argentina by mid 1981.  Although only about 10% of total assets are at risk to foreign borrowers, the amount of loans compared to shareholders’ equity shows a much larger problem.  The 9 largest U.S. banks have loaned out 130% of their equity to Mexico, Brazil, and Argentina.  The banks have set aside $3.6billion in loan-loss reserves, which only amounts to 12% of their exposure to in these countries alone.  Regional banks are caught in the same trap as well, especially those in the Southwestern states that deal across the border. 

            A good portion of the U.S. loan money goes to private borrowers instead of government.  Delinquent loans to foreign firms have lowered profits of some major banks by up to 5%.  Bank stocks have fallen in response to concerns over earnings.  Share prices of Citicorp and Chase Manhattan fell by 14% and 11% respectively, despite the high gains the stock market as a whole was experiencing.  In order to help investors, the U.S. Securities and Exchange Commission has asked for public disclosure of loan foreign loan problems. 

            There is much apprehension amongst banks as well, Western European banks are seeking to make loans to countries of questionable risk tax deductible, West German banks are informally recommended to unofficially write off 40% of sovereign risk loans.  U.S. banks have the biggest foreign commitment, with three-quarters of international loans made in dollars.  This makes the U.S. Federal Reserve the means to save the world’s financial system should the need arise.  It is the only central bank capable of providing the necessary liquidity.  The debt problem has also led to the loss of U.S. banks’ ability to get favored short term interest rates in international money markets.  The prevalence of bad debts would also make domestic loans more expensive, as there would be less money to loan.

            The big fear lies in that a rise in the number of defaults could turn the world recession into a depression.  Over 40% of U.S. exports of commodities go to developing countries, figures similar to Japan and Europe.  The countries that purchase these goods are the same ones who are borrowing the most.  Contractions in their demand would lower their imports and help lead to furthering the recession.  The process could continue, causing development of the Third World to stop, stock markets to fall and increase unemployment, creating a situation similar to the 1930s. 

            There has been little prior warning of debt problems, borrowers put off admitting difficulties until the last moment in fear of breaking lender confidence.  In situations where default is a possible, lenders try to avoid default by any means.  Scheduling repayments at least secures some stream of income.  If the debtor defaults and stops payments altogether, the bank has no choice but to write off the loan.  Too many write-offs can lead to insolvency for the bank.  Some countries require further loans to make payments.  The larger banks are in too far to refuse these loans, but smaller banks are not.  The risk lies in a lender calling the borrower in default.  This could lead to cross-default clauses among other creditors. This would make it possible for a small institution that loaned $100,000 to bring down a country with $27million in debt.  A default on one loan could lead other creditors to call in their loans. 

            The origins of the current debt crisis lie in the first oil price increase by OPEC.  The money amassed by these countries was funneled into the world’s major banks which made loans to developing nations.  The amount of money flowing in was vast.  Banks were making larger profits off of loans due to deal commissions and that developing countries paid higher than average interest rates.    Competition among lenders was high, due to the amount of money that as available.  Even in 1974, the danger was present but ignored by the banks.  The loans offered by the banks were eagerly sought out as well.  Developing nations like Mexico and Indonesia borrowed as much as they could to fund development plans and cash in on untapped resources.  As energy prices increased, the countries borrowed more prevent a recession and continue growth.  Many countries sought loans just because the money was there.  Togo, built an oil refinery even though they have no oil.  Countries created airports and hotels, corruption was rampant as well.  The Central African Republic spent half the country’s annual budget on the 1977 coronation of Emperor Bokassa.  Countries borrowed the money in the hopes that their economies would grow faster than oil prices.  The fact that the loans were in dollars and the U.S. was experiencing inflation gave countries more of a reason to borrow.  Countries hoped to borrow now and repay the loans later when the loans would be cheaper due to the lower value of the dollar. 

            In late 1978, OPEC price increases were followed by a U.S. move to curb inflation by constricting their money supply.  This coupled with a surge in foreign money led to a stronger dollar and higher interest rates.  The biggest of the borrowers had debts with floating interest rates, the increased rates and stronger dollars leading to an effective increase in the amount of debt owed.  The change in oil prices and tighter credit led to a recession in industrialized countries and increased protectionism.  Developing nation’s exports and commodity prices fell.  Poland was the first country to have urgent problems, having an $80billion debt.  Initial reluctance of the U.S. to help bail out Poland worked to increase fears of default that could lead to others.   Rumors of a cartel of borrowing nations planning to repudiate their debts added to the uncertainty. 

            Increased uncertainty shrank lending markets, leading to more scrutiny and less money for borrowers.  Mexico was the first to show signs of urgency.  Mexico asked for a postponement of loan payments despite having received $2.5billion 2 months earlier.  At the same time as a plan for Mexico was prepared, Brazil had troubles as well.  The bailout for Mexico succeeded with Brazil’s still under works, but it setup the idea that the central banks would not allow any prime commercial banks go broke in order to maintain public confidence.  This idea has led many lenders to downplay the fear of default, stating that bankruptcies are ill founded.  There are few cases of governments actually getting out of debt.  “Countries do not fail to exist.”

            Governments do come and go though.  Governments can lose access to world credit markets and stop making debt payments.  The possibility of defaulting can’t be dismissed however, if IMF austerity plans would lead to rioting in the streets and severe local unrest, defaulting and being ostracized by the world credit markets would be preferable. 

            Although there have been some smaller banks that have stop international lending, there are more who are pushing for increased lending, such as Regan, Volcker and the Managing Director of the IMF.  This attitude is echoed in a comment by Henry Kissinger, “new loans must be in excess of [borrowing countries’ existing] loans interest payments to allow these counties to keep growing.”  Western Europe and the U.S. are pushing for lenders to issue new loans.  Although a global upturn lies in the future and interest rates are declining, the need for more preventative measures is present.  

 

Some Proposed Measures:

           

An Early Warning System

            William Ogden, vice chairman of Chase Manhattan, proposes that 31 of the world’s largest commercial banks to set up a “private IMF.”  It would collect information on debtors and release material.  This would help banks to prepare for future crises.

 

A Debt Takeover

            The World Bank could take over troubled loans from commercial banks.  This is unlikely to happen, not only because the World Bank would resist this much debt, but that parliaments would not want the banks to go unpunished.

 

New International Institutions:

           The main deficiency of the IMF is a lack of money.  Although having its assets increased by 50% to $90billion, it might not be sufficient to cover an increase in the rate of defaults.  A richer, more powerful IMF could lead banks to loan more, but it could also worsen the situation through its imposed austerity measures. 

 

            The debt-bomb is not something that will go away in the near future.  The best that can be hoped for is that debtor countries practice as much austerity as is feasible and that banks continue to support countries in debt with debt rescheduling and new loans.  Of most importance, is that all those participating understand the capabilities of the others for action in order to better deal with later problems.

 

Summarized by:  Donald Ripley