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CHAPTER

62
Debt Prob oblem The Debt Problem of LDCs
INTRODUCTION
The problem of external debt of LDCs is a serious one because they depend heavily on inflows of capital from abroad to finance their development needs. LDCs being poor countries, their rates of domestic savings and investment are low. They woefully lack in economic and social overhead capital and basic and key industries. To accelerate the rate of economic development, they borrow to import capital goods, components, raw materials, technical know-how, etc. Besides, they also borrow to finance consumer goods to meet the requirements of the growing population. Their exports being limited to a few primary products, they borrow to supplement and increase their domestic resources. These lead to huge current account balance of payments (BOP) deficits. A current account BOP deficit means that the country is borrowing from abroad. To finance its BOP deficit, the LDC borrows by selling bonds abroad, from commercial banks abroad, from international financial institutions like the IMF, World Bank, IFC, etc., and from private foreign firms. In all such cases, the country accumulates external debt which it has to repay abroad in the future in the form of interest and principal.

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THE DEBT CRISIS


The oil shocks of the 1970s and the reactions of the developed countries to them led to a major debt crisis in LDCs. To repay these debts in the form of interest and capital caused serious problems in such economies. The problem had become very severe by the early 1980s which led to increase in debt-service payments from $ 18 billion in 1973 to $ 140 billion in 1990. Consequently, many LDCs found it difficult to service their debts and it was feared they would default on payment thereby leading to an international crisis. CAUSES OF THE DEBT CRISIS The following have been the causes of the international debt crisis: 1. Oil-Price Shocks. The principal cause of the international debt crisis of the 1970s and 1980s was the increase in oil prices in 1973 and 1979. The first oil shock to the international economy was an increase in oil prices by more than four-fold and the second doubled them. This caused a large increase in the import bills of non-oil producing LDCs. Simultaneously, their export earnings fell due the recession in the developed countries. Consequently, the current account BOP deficit of oil importing LDCs increased much. Their ratio of debt to GNP rose from 15.4% in 1974 to 37.6% in 1986. 2. Bad Macro-economic Management. To cope with the problem of BOP deficit, the LDCs began macro-economic management of their economies. They continued to expand their expenditures to meet demand for their economic development. This led them to adopt expansionary fiscal and monetary measures and to large borrowings from abroad. This resulted in inflation and external debt. As the Bretton Woods System of fixed exchange rates had collapsed in 1973, the LDCs adopted new exchange rate strategies like the crawling peg and managed floating in order to avoid real appreciation of their currencies in the face of rising inflation. They aimed at a declining rate of depreciation against the dollar. For this, they adopted trade reform measures to boost exports, and encouraged the inflow of private capital through international banks. These further increased their external debt. 3. Policies of Developed Countries and their Banks. The policies adopted by the developed countries and their banks were instrumental in creating the debt crisis. The rise in oil prices had increased the revenues of oil exporting countries. But they were unable to absorb them within their economies. They deposited large volumes of petro-dollars in the commercial banks of the developed countries. Thus these banks had accumulated huge funds which could not be used by the developed countries, as the latter were faced with recession. But the LDCs needed funds for their economic development programmes which these banks recycled in the form of loans to LDCs. 4. Rising Interest Rates. The increase in interest rates also added to the debt crisis. During the first oil-price hike, the real interest rates were low and even negative in the developed countries due to inflation. This reduced the real burden of the debt of LDCs. But the second oil shock increased both money and real interest rates between 1979-82. The rise in oil prices led to inflation in the developed countries which adopted restrictive monetary policies to control inflation. This resulted in a sharp increase in money and real interest rates. Consequently, the costs of servicing the past debts and of new debts increased for LDCs. The costs of debt service was made worse by the growing proportion of debt at variable interest rates in the form of loans from commercial banks belonging to developed countries. For instance, the ratio of debt service to exports of all developing countries increased from 13.2% in 1980 to 25.9% in 1986.

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5. Trade Policies. Trade related policies of both LDCs and developed countries also led to the growth of external debt of LDCs. The LDCs followed the inward-oriented import-substitution industrialisation till the 1970s. This policy brought initial gains but ultimately led to inefficiencies in the production of manufactured goods. Agricultural and primary production activities were neglected. The two oil-price hikes which led to recessions in the developed countries and the increase in non-tariff restrictions by the latter led to reduction in exports and export prices of LDCs. During 1981-86, they suffered an annual average loss of $ 8 billion due to reduction in their export earnings. With the fall in the prices of their primary commodities, the terms of trade of LDCs also deteriorated. The cumulative loss suffered due to this by them was $ 95 billion during this period. 6. Immediate Cause. After 1979, many LDCs had accumulated huge external debts which they found it difficult to repay in the form of interest and principal. This led to the international debt crisis of the 1980s. The crisis emerged in August 1982 when the Mexican Central Bank announced that it had run out of foreign exchange reserves and that it could not pay its foreign debt of $ 80 billion. Fearing that Argentina, Brazil and Chile might not follow Mexico, the lender-banks of developed countries started refusing new loans and demanded repayments of earlier loans from these and other Latin American countries. This trend spread to African and some East Asian LDCs. By the end of 1986 more than 40 countries were engulfed by the debt crisis.

MEASURE TO SOLVE THE DEBT CRISIS


LDCs have been receiving loans from the official world agencies like the IMF and World Bank, from banks and from individual countries on bilateral basis. Therefore, there cannot be any clear-cut solution to their debt repayment problems. It has to be on a piece-meal and case-bycase basis. Further, these need to be reinformed by domestic monetary and fiscal measures to solve it. We discuss below the various measures that have been suggested and adopted from time to time. 1. Twin-Track IMF Strategy. The IMF feared that any default by LDCs to repay the debt would threaten the stability of the international bank system in the wake of Mexicos refusal to honour its debt obligations in August 1982. It, therefore, suggested a twin-track strategy so that the LDCs could repay their loans in full. According to this strategy, it would continue to give direct financial assistance to provide time to grow out of their debt problems; and second, to encourage structural adjustment programmes in them to increase their debt service capacity in the long-run. Since the Fund had about $ 120 billion available as per the quota subscriptions of the smallest LDCs, it sought the assistance of the international commercial banks to solve the debt crisis of the large LDCs. We explain these attempts as under : 2. Debt Rescheduling by Commercial Banks. When Mexico and other Latin American countries expressed their inability to service their debts, the international commercial banks devised ways to avert the Banking crisis. The creditor banks formed a Bank Advisory Committee (BAC), known as the London Club, to reschedule debts on case-by-case basis with individual debtor countries. It negotiates an agreement with a debtor country which involves rescheduling the debt for repayment within a number of months or years depending upon the capacity to repay and the size of the loan. But rescheduling depends upon the structural adjustment programme under the IMFs supervision.

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In the beginning of 1983, the rescheduling of debt service was for a short period up to two years. This was called the short-leash approach which required repeated rescheduling of debts. So in 1984 Multi-Year Restructuring Agreements (MYRAs) were introduced which involved rescheduling of debts for longer periods up to 14 years. This strategy of the IMF appeared to be successful throughout 1983 and 1984. But this forced or involuntary lending by the banks led to overdue payments to the outstanding debts of LDCs. These further weakened the balance sheets of the banks. So they started reducing their involuntary lending to LDCs. 3. The Baker Plan. To overcome this problem, the then US Treasury Secretary, James Baker proposed a scheme, known as the Baker Plan in October 1985 based on the Funds twin-track approach. It provided for $ 20 billion of new loans by banks over 3 to 15 years and $ 9 billion of multilateral lending to the fifteen most heavily indebted LDCs. In return, these countries were to undertake growth-oriented structural adjustment programmes. But this Plan failed to meet the debt rescheduling requirements of these countries. Banks were reluctant to lend more to reduce their debts which were bound to increase further. They could judge the inability of these countries to repay even in the long-run. So additional loans fell much below the target of $ 20 billion. The debtor countries on their part found the IMF adjustment programmes difficult and painful in carrying out and abandoned them. So Baker Plan failed to solve their debt probelm. 4. The Brady Plan. In 1989, the new US Treasury Secretary Nicholas Brady proposed measures for debt reduction of LDCs. There were three main elements of the Brady Plan : First, it asked the IMF and World Bank to provide funds to debtor countries for repaying debts to banks. But the debtor countries were to carry out growth oriented adjustment programmes laid down by the Fund and World Bank. Second, it urged banks to accept repayment of less than the full amount of the debt so as to include debt service reductions and debt forgiveness. Third, it called on the governments of developed countries to amend their banking legislations to provide for debt forgiveness in their bank accounting rules. The Brady Plan has been successful to some extent. Such agreements have been negotiated between banks and debtor countries to buy back their debts at a discount rate ranging between 44 and 84 per cent. The largest agreement has been with Mexico involving $ 49 billion of debt which was rescheduled. 5. Debt Swaps. Another solution to the debt probelm of LDCs has been to exchange the debt by what is known as debt swaps. Many banks have entered into agreements with debtor countries to reduce the burden of debt repayments through a number of options such as debtfor-debt swaps, debt-for-equity swaps, debt-for-cash swaps, debt-for-nature swaps, debtfor-development swaps, debt-for-export swaps and debt-to-local-debt swaps (i.e. external debt converted into local currency). Between 1985-92, debt swaps of various types amounting to $ 90 billion were agreed upon between banks and debt countries. 6. Rescheduling of Official Loans. The developed lender countries, which give loans to LDCs are called the Paris Club. The Paris Club decides about the reschedul-ing of official loans, lays down their dates and time of repayment in consultation with the IMF. The LDC debtor countries approached the Paris Club for rescheduling the loans provided by its members many times between 1982 and 1987. In 1982, emergency financing was made available through the Bank for International Settlements (BIS). In January 1982, the IMF established an emergency fund under the General Agreement to Borrow (GAB) amounting to SDR $ 17 billion. 7. Toronto Terms. At the 1988 Toronto Economic Summit of the Paris Club, it was decided to

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give debt relief to the poorest debtor countries with GNP per capita income of less than $ 600. Under the Toronto Terms, the concessional debt (with low interest rate) could be repaid over 25 years with 14 years grace. For non-concessional debt, there were three options : (1) Repayment in 25 years with 14 years grace at market interest rates; (2) repayment in 14 years with 8 years grace at concessional interest rates; and (3) repayment in 14 years with 8 years grace at market interest rates and simultaneously cancelling 1/3rd of debt. 8. The Houston Terms. The Paris Club introduced the Houston Terms in 1990 for the lowermiddle-income debtor countries. Their repayment of debts was spread over 20 years with 10 years grace at market interest rates. 9. Enhanced Toranto Terms. In 1991, the Paris Club amended the Toronto Terms for the severely indebted low-income countries. It offered the alternative of cancelling 50 per cent of a countrys debt and rescheduling the remaining over 23 years with 6 years grace or rescheduling it at concessional interest rates where the debt-service ratio exceeded 25 per cent. Eighteen countries of Africa and two of Latin America had taken advantage of the Toronto Terms in rescheduling their debts by the 1991. In addition to the Toronto and Houston Terms, a number of creditor countries have been concelling debts of their own. Conclusion. The various proposals for debt rescheduling discussed above have not been very successful because they are dependent upon the private international banks to carry them out. The majority of them are unwilling to take such measures which may adversely affect their balance sheets. These proposals do not solve the debt problem of LDCs permanently but for a short period with the result that it will again reappear. LONG-TERM SUGGESTIONS To solve the debt problem of LDCs over the long-run, there is need for concerted efforts on triple fronts. On the part of : (a) the IMF, (b) the developed countries, and (c) the LDCs. We discuss them as under : (a) IMF Solutions. The IMF insists on the debtor LDCs to adopt market-oriented adjustment programmes for availing financial help from it. These include: (1) Tight monetary and fiscal policies so as to reduce budget deficits, through cut in government spending, reduction in interest rates and in inflation; (2) encouraging foreign investment by abolishing controls both internal and external and giving greater incentives to foreigners; and (3) devaluing the currency to encourage more exports and greater competition through a more open trade policy. But the adoption of such policies by LDCs has brought about the Asian Crisis. It has led to more unemployment and poverty and reduced their growth rates. There has been capital flight and worsening of their BOP problem. Instead of reduction in their debts, they have increased them. These measures have led to public riots and even to the fall of governments in many Asian and Latin American countries. (b) Measures by Developed Countries. Since the developed countries are the creditors of LDCs, First, they should provide development assistance to the poor LDCs as grants rather than loans. Second, they should wave a major portion of their debts to LDCs. Third, they should establish a fund which should provide guarantee to private loans by corporations and banks of developed countries in case of default. Fourth, a large portion of the debt of LDCs is due to fall in their export prices and hence in their terms of trade. The developed countries should adopted appropriate measures to overcome price fluctuations in their primary products through the

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creation of international buffer stocks, commodity agreements, compensatory financing, etc. The above noted measures will go a long way in solving the debt problem of LDCs. (c) Measures by the Debtor LDCs. LDCs, on their part, should adopt the following measures which may help in reducing their debts; (1) to strengthen and develop infrastructural facilities so as to encourage foreign investment; (2) to reduce imports through trade restrictions within the provisions of the WTO; (3) to produce more quality products for domestic consumption as well as for exports of all kinds. Greater diversification in quality products for domestic use and exports is essential to face foreign competition both in domestic and global markets; and (4) Monetary and fiscal policies should be in keeping with the overall objective of growth with stability so that the country becomes self-sufficient and there is little need for external debt.

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