The Debt Crisis WORLD

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Commercial banks greatly expanded lending to developing countries in the 1970s. Later, however, a slowing world economy led to lower exports which, coupled with higher interest rates, made it difficult for the borrowers to repay their loans. Since the mid-1980s, initiatives to reduce the debt have been proposed by various countries and by international organizations, including the World Bank.

D ebt has become a central issue in economic development. The obligation to repay debt has become a heavy burden for developing countries with other pressing needs that also require financing. The debt crisis, which began in the 1980s, was marked by three major turning points: the suspension ofloan payments to commercial banks by Mexico in 1982; the 1985 Baker Plan of new lending to indebted countries; and the Brady Initiative for debt reduction devised in 1989. In the 1990s debt will continue to be a burden for some developing countries. Further debt reduction, resched­uling and cancellations are needed so that highly indebted, developing countries can devote a greater portion of their resources to productive investments.

1970s Loans to Developing Countries Mount

Commercial bank lending to developing countries expanded significantly in the 1970s. Banks became flush with "petrodollars" deposited by oil-producing countries after the 1973 rise in oil prices. To offset this sharp increase in deposits, the banks accelerated their lending to developing countries. Some of these countries used this finance to help with growing balance of payments problems, which were themselves brought on partly by the increasing costs of energy.

The debt that the developing countries acquired through increased borrowing seemed manageable at a time of solid economic growth. But in the 1980s, the global economy sank into a recession, interest rates rose, and prices dropped for raw materials that many developing countries rely upon for export earnings.

Between 1972 and 1981, the external debt of developing countries increased sixfold to $500 billion and, in real terms, at more than double the rate of increase in either GDP or export volumes. At the end of 1991, total external debt of these countries -­including the hard-currency liabilities of the former Soviet Union - stood at $1,608 billion. This was expected to increase in 1992 to $1,703 billion.

1982 The Mexican Payment Suspension.

With the August 1982 decision by Mexico to suspend its debt repayment, the world became aware of the serious financial burden that accumulated debt can impose on developing countries. There were fears that a failure to pay back debt would lead to a complete breakdown of the international banking system. To avoid that outcome, banks and creditor governments responded with several measures, including reschedul­ing of payments and new loans.

1985 The Baker Plan

Many indebted countries had trouble attracting fresh loans from commercial banks. To overcome this impasse then-U.S. Secretary of the Treasury James Baker put forward a three-year plan to stimulate new bank lending by fostering economic growth in indebted countries. This growth would result from a combina­tion of trade liberalization, increased foreign invest­ment, and privatization of state enterprises.

Baker proposed that commercial banks lend up to $7 billion a year to a total of 17 countries. The multilateral development banks were to increase their lending to these countries by $3 billion. The industrial­ized countries were asked to augment these measures with greater trade and investment.

The Baker Plan envisioned the debt crisis as a long-term, structural problem whose ultimate solution would lie in better overall economic performance by the indebted countries. But the Baker Plan was not able to meet its main objectives. Commercial banks did not increase their loans as expected and indebted countries continued to pay more back to the banks in interest and principal than they received in new money. Foreign investors were slow to act and privatization was not introduced in some of the major indebted nations.

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1987 The Brazilian Moratorium

The decision by Brazil to suspend interests pay­ments in 1987 led to a drop in the value of much Latin American debt, and so made holding such debt much less attractive to commercial banks. Many wished to sell their debt once and for all. In response, Secretary Baker proposed as an addition to his plan that several solutions be offered to debtors and creditors. This "menu" approach included measures to convert debt into equity (debt/equity swaps), or bonds (exit bonds), which would allow banks to be free of their problem loans without resorting to outright cancellation.

African Initiative

Meanwhile the World Bank launched its Special Program of Assistance for poor, debt-distressed African countries. This program quickly channeled loans to countries to support adjustment programs in conjunction with debt relief measures and help from the International Monetary Fund (IMF). Most of the debt was owed to official sources (national and international aid and credit agencies), not commercial banks, and so debt reduction in these cases did not present a threat to the international banking system. Though the amount of money owed was not great compared with other developing countries, the debt was a major obstacle to economic growth.

1988 The Toronto Terms

Attention continued to focus on the problems of the poorest indebted countries, mostly in sub-Saharan Africa. At the June 1988 Toronto Economic Summit meeting of the Group of Seven industrialized countries, a set of rescheduling terms was proposed to the Paris Club to ease the debt burden of qualifying countries, both for concessional (at below-market interest rates) and for non-concessional loans.

1989 IDA Lending

The World Bank, through its concessional lending arm, the International Development Association, began a program to support commercial debt reduction for the poorest countries. The IDA Debt Reduction Facility is one of the few efforts to ease the burden of the commercial debt of poorer countries. Though commercial debt in IDA countries is a small part of

total debt owed by developing countries, the high, market interest rates of this debt make the burden of repayment greater.

The Brady Initiative

The most important step to ease the debt burdens of middle-income developing countries was the initia­tive ofthen-U.S. Secretary of the Treasury Nicholas Brady, announced in March 1989. The assumption underlying Brady's idea was that banks would not provide new lending to less developed countries, and foreign investors would not return to them, until old debt had been reduced. Under this plan, the World Bank, IMF, Inter-American Development Bank, and governments have provided loans to indebted countries to help finance debt buy-backs or debt swaps. Mexico, the same country that precipitated the debt crisis in 1982, was the first country to benefit from the Brady measures in 1990. Through the Brady Plan, old debt began to be retired. Repayment prospects rose for the remaining developing country debt, reducing the risk for the banks holding such debt and prospects bright­ened for new loans and greater foreign investment.

1991 Polish and Egyptian Debt Reduction

In April 1991, the Paris Club of government creditors announced a 50 percent reduction in Poland's official debt, and in May it offered a similar write-off to Egypt. The decision to reduce Poland's debt was based on its severe economic difficulties and its reform program, which is likely to cause additional temporary hardships for its people. Egypt's debt was reduced because of its role during the Gulf War, and its new economic reform program sponsored by the IMF.

1992 The Argentina Debt Reduction

In December 1992, Argentina signed an agreement that will greatly reduce its debt and debt service obligations to commercial banks. The arrangement, agreed to by Argentina's commercial bank lenders, permitted a restructuring of the country's $29 billion public debt, including $8 billion in interest arrears. Overall, debt and debt service to the commercial banks will be reduced by the equivalent of about $11 billion.

The program was supported with loans from the World Bank, the IMF, the Inter-American Develop­ment Bank and the Export-Import Bank of Japan. (Apr.1993)

World Bank Information Brief# C.02.4-93 The World Bank• 1818 H Street, N.W. •Washington, D.C. 20433 • (202) 473-1 793 •Fax (202) 676-0578