How to Solve the Debt Crisis; C. Culp

496 How to Solve the Debt Crisis by Christopher L. Culp T he world is in the midst of a debt crisis, though much of the U. S. financial sector has employed extensive rhetoric and artful accounting to avoid admitting it. The world first became aware that there was a problem when the Mexican government in formed American banks in August 1982 that it was unable to pay the interest on its loans. By 1987, the problem had compounded. Peru had proclaimed that it would devote no more than ten per cent of its total export earnings to in terest payments, and several countries such as Bolivia and Brazil, in effect, had defaulted. The U.S. financial sector greatly fears the word "default," so it employs tidy euphe misms such as "restructure" to avoid acknowl edging that most debtors cannot repay their loans. American banks might do well to re member the proverb: If a bank loans out a thousand dollars and the debtor defaults, the debtor is in trouble; but if a bank lends a hundred million dollars and the debtor defaults, the bank is in trouble.

If a bank holds more liabilities than assets, there is a risk of bank insolvency precipitated by "confidence problems. " When a debtor na tion refuses to pay interest on a loan, it makes it impossible for the lending bank to balance its account. However, to avoid taking losses, banks have engaged in the deceptive process of manipulative accounting. If a debtor nation owes a bank $50 million in interest and the country cannot pay it, rather than writing off Christopher L. Culp is an Associate Policy Analyst for the Competitive Enterprise Institute in Washington, D.C. the loan as unrecoverable, the bank lends the debtor $50 million more to payoff its interest obligation. However, there is interest on that additional loan. Since the debtor could not make the interest payment in the first place, there is little reason to think that it will be able to pay the interest on the additional loan, much less the premium. The ensuing cycle is pain fully obvious.

Unsustainable Debt Unsustainable debt seems to be the case more often than not in the Third World. This problem is magnified by the fact that most lending institutions within developing countries are plagued by problems of illiquidity and in solvency. This financial crisis causes a serious distortion in the incentive structure for the Third World financial sector, in many ways similar to the recent U.S savings and loan de bacle. Once a lending institution is insolvent, it is apt to take greater risks and make more ques tionable loans. This only aggravates concerns about bankruptcy or bank bailouts. Continued uncertainty inevitably leads to further financial crises as investors begin to doubt the ability of banks to provide liquidity. Sir Alan A. Walters, former Economic Ad visor to British Prime Minister Thatcher, de scribes this problem as "absolutely critical" because it makes the debt dilemma increasingly harder to solve as time goes on. 1 Furthermore, developing nations are typically becoming more heavily indebted without showing signs of significant capital growth. From 1982 to 1986, gross capital formation as a per cent of GDP in heavily indebted countries dropped from 22.3 per cent to 16.8 per cent. At the same time, the debt-export ratios of these in debted countries rose from 269.8 to 337.9. 2 , As if the duplicity evident in the official bal ance sheets of many U. S. banks wasn't enough, the American financial sector has been recklessly irresponsible in its lending practices.

Many banks have loaned far more than their eq uity. Consequently, when debtors cannot make their interest payments, such banks' liabilities will become greater than their assets. Their re sulting insolvency will leave these banks un able to guarantee the assets of American in vestors. Enter the Federal Deposit Insurance Corporation, to rescue the failed banks. But what happens if, unlikely though it may seem, all the debtors default and their creditor banks become insolvent? The entire U.S. financial in frastructure is threatened. Obviously, the U.S. financial sector wants to avoid this overly pessimistic scenario. Rather than face reality, though, American lending in stitutions simply resort to a policy of dishonor able accounting to temporarily alleviate the im balance between assets and liabilities. How ever, the banks are only fooling themselves. Creative bookkeeping may work in the short term, but the problem of increasingly unsus tainable loan exposure will continue, necessi tating a solution at some point in the future when the problem is much greater.

Not all U.S. banks have perpetuated the illu sion that all is well. John Reed of Citicorp de cided in May 1987 to write-down his institu tion's Third World loans to their actual value and simply absorb the loss. He then increased Citicorp's debt-to-reserve ratio. Reed's actions were six years late in coming, but by June 1987, 43 of the 50 largest U.S. bank holding companies had engaged in similar measures. Citibank took an important step in starting to pull the U.S. out of the debt crevasse, but its actions and the subsequent actions of other banks cannot solve the crisis. To avert a Third World debt "disaster," it is necessary to ad dress the underlying issue of irresponsible lending and to stimulate growth in developing countries. While irresponsible lending is cer497 tainly a problem in the short term, it is the much greater problem of Third World underde velopment that makes the debt crisis intractable under current systemic constraints. The most obvious solution to the crisis, then, is to facili tate development in less developed countries and improve their ability to repay their debt ob ligations.

The private sector not only provides a means of averting a short-term disaster, but addresses the far greater need of preventing future crises in lending. Three key measures will quell the financial storms and brighten the lending ho rizon: (1) securitization of outstanding U. S. loans; (2) implementation of debt/equity swaps with debtor nations; and (3) privatization of state-owned enterprises in developing coun tries. Securitization of Debt The first necessary step in allowing the free market to get the world out of the debt trap is to prevent reckless bankers, who are far more concerned about their corporate reputation than the integrity of the U.S. financial system, from continually "restructuring" outstanding, un recoverable loans. In short, banks need to take their losses for what they are. Simply because a country cannot pay back its entire loan does not mean that it cannot pay back a part of it. The task becomes one of es tablishing how much of the outstanding bank loan is irretrievable. This can be done easily by "securitizing" the. loan, or selling it on the open market. In securitizing debt, a bank merely converts part of its loan into bonds backed by outstanding debt. The primary func tion of this action is to establish a "market price for the debt." Securitization allows the market to facilitate bank actions such as Citibank's that determine the present value (in real dollars) of problem loans to the Third World.

Dollars loaned to different countries have different market values, depending on the spe cific country's ability to repay. For example, if a bank holds a $2 billion loan to Argentina, it is very unlikely that it will ever get the full $2 billion back. Rather than perpetuating the problem by allowing a banker to make addi tionalloans to Argentina in order to sustain its 498 THE FREEMAN. DECEMBER 1988 ability to make interest payments, the bank can literally sell part of its outstanding debt by is suing bonds. By offering the sale of, for ex ample, 1,000 bonds at $100,000 each (5 per cent of the total loan), the bank can effectively determine the current market value for the loan to Argentina. If these bonds sell at $50,000 each on the open market, then the market value of each dollar loaned to Argentina is at a 50 per cent discount. Once this has been determined, the bank discounts its entire $2 billion loan on the balance sheet to its market value, $1 billion.

The bank has lost $1 billion rather than $2 bil lion (still no small sum). Since investors will buy the bonds at a price consistent with the ability of Argentina to repay the loan, the bank now has a loan that can be sustained and repaid by Argentina. Even though the bank has lost a considerable amount of money outright, it now holds a loan that can be repaid, rather than one that must continually be "restructured" or hidden by fictional ac counting. There are a number of notable ben efits to this process of securitizing loans. First, it decreases (at least marginally) the risk of default by discounting the loan to a value that can be repaid by the debtor nation. Consequently, the total debt exposure of the nation is reduced. Second, by selling debt bonds, the risks of default are spread among many investors. In vestors will not buy debt bonds unless they see some potential for gain, so the transfer of risk is strictly voluntary. The risk of default is cur rently helel, nominally and involuntarily by the American taxpayers, in their support of FDIC guarantees. Securitizing a loan transfers those same risks currently financed by taxpayers to those investors willing to take them.

Third, securitization liquifies the assets of the bank's portfolio by creating convertibility on the secondary market. Furthermore, securi tization gives the indebted country an opportu nity to literally buy back its own debt at a dis count. Fourth, securitization restores "truth in ac counting. " It allows the banks to determine the real market value of debt, cut their losses out right, and consequently reduce the risk of long term insolvency.3 Debt/Equity Swaps The second way that the private sector can eliminate the debt crisis concentrates not on lending practices, but on the borrower's ability to repay. Increasing the real rate of growth in a debtor nation means its debt can eventually be come sustainable. Part of the problem in the current low growth rate of heavily indebted nations is the phenomenon of capital flight pre cipitated by low or negative rates of return on investments. When the return on an investment is particularly low in a developing nation, its citizens will invest their capital elsewhere.

For example, a bank in the U.S. makes a loan to the government of Argentina in order to foster development. The Argentine government dispenses the money to the private sector, but because the rate of return is so low, private in vestors merely place the money in U.S. banks. The result is that the government of Argentina owes money that it cannot repay to American banks, and the Argentine economy has nothing to show for it. The loan money, intended to de velop Argentina, is sitting in U.S. banks, out of reach of both the Argentine government and its original U.S. lenders. Until investment can be made profitable in developing nations, their rates of growth will not improve. Debt-for-equity swaps are an ef fective means of both facilitating growth and contributing to the reversal of capital flight. Such swaps involve the exchange of foreign debt for local equity and have numerous eco nomic benefits.

The success of Chile in this area helps prove the efficacy of debt/equity swaps. In 1986, the market value of Chilean debt denominated in dollars was approximately 67 per cent of its face value (Le., it was trading on the secondary loan market at a 33 per cent discount). How ever, its market value was approximately 92 per cent of its original value when denominated in pesos, since most Chilean investors, unlike u.S. bankers, believed that the debt was sus tainable. Loans must be repaid to U. S. banks in dollars, but local equity is denominated in pesos. Consequently, in 1985 Chile changed some of its foreign exchange regulations to en courage debt/equity swaps so that investors could take advantage of this opportunity for in termarket arbitrage (the purchase and sale of a security on two different markets for the pur pose of capitalizing on price discrepancies be tween different exchange rates) and thereby improve the Chilean investment climate.

Johns Hopkins University economist Steve H. Hanke states that debt/equity swaps are ,'aimed at investors who wish to purchase ex temal Chilean debt for the purpose of capital izing it into investments in Chile."4 The pros pect of converting foreign debt into local equity not only has attracted foreign investment to Chile, but it has stimulated the repatriation of Chilean flight capital. In two years, Chile re duced its debt obligation by four to five per cent. As of November 1987, Chile had con verted approximately $1.2 billion in debt into local equity.5 Encouraging these swaps will enhance the development of capital markets in indebted countries. By increasing capital flows into an indebted nation, its growth rate will increase, eventually raising the rate of return. Debt/eq uity swaps are an excellent means of reducing the loan exposure of a debtor nation while also stimulating economic development.6 Privatization A third means of decreasing the developing world's debt obligation is to reduce the size of the public sector in the economy of developing nations so as to stimulate growth and develop ment. The elimination of state-owned enter prises in debtor nations will strengthen their economies by promoting the development of capital markets. Privatization also will decrease public sector expenditures and improve eco nomic efficiency.

Presently, state-owned enterprises are char acterized by insatiable demands for continuing subsidies, bloated payrolls, low employee per formance, high costs of debt servicing, and underutilized capital.7 They typically allocate resources in a very inefficient manner and respond poorly to consumer demands. Trans ferring state-owned enterprises to the private sector not only will tend to eliminate negative cash flows, but also will stimulate growth by providing opportunities for debt/equity HOW TO SOLVE THE DEBT CRISIS 499 swaps and increasing the economy's productive efficiency. Privatizing state-owned enterprises also pro motes popular capitalism through wider share ownership. Furthermore, it strengthens existing capital markets in developing nations by making such markets more liquid. Indeed, pri vatizing by open stock sale can actually create capital markets where previously there were none. Capital market development promotes economic development because capital market liquidity narrows the gap between what a con sumer offers to pay for a good and what a pro ducer charges for it, known as the bid-ask spread. In nations without capital markets, it is often the case that particular goods cannot be sold because bids are so much lower than the prices asked, largely due to informational defi ciencies in the economy. Liquid capital markets help alleviate this problem.

Privatization, by promoting a liquid capital market through wider share availability, facili tates economic growth and development. Fur thermore, by increasing the role of the private sector and limiting state involvement, an im portant signal is sent to foreign lenders that ef forts are being made to improve real domestic rates of return on investments. In this way, pri vatization promotes foreign investment and the repatriation of flight capital. However, obstacles to privatizing state owned enterprises come in many forms. Priva tization is a very complicated process which re quires economic liberalization to ensure com petition, and the preservation of property rights to mitigate against the threat of expropriation. This is often difficult because of the political instability common in most heavily indebted nations. Many Third World leaders feel that a stronger private sector would jeopardize their political supremacy, and they consequently op pose privatization.

Although most political opposition to priva tization is founded on misconceptions, dis proving these misconceptions is often very dif ficult. The U.S. financial sector certainly has not helped matters. Because of its unwilling ness to acknowledge de facto financial losses already incurred, American banks are allowing the developing world effectively to hold the U. S. financial system hostage. Reckless 500 THE FREEMAN. DECEMBER 1988 lending coupled with irresponsible use of loan money by Third World governments has led to an escalating problem, most of which is purely political: the Third World's unwillingness to compromise or liberalize, and the U.S. finan cial sector's unwillingness to use its better judgment in lending practices. As Heritage Foundation's privatizationexpert Stuart Butler observes, "Privatization, like na tionalization, is first and foremost a political exercise."8 A key step in privatizing state owned enterprises is simply to convince politi cians that privatization works. However, as long as the Third World meets with little or no opposition in its tactics of financial blackmail directed at the banking industry, its leaders have no reason even to bother with liberaliza tion and privatization. To many of them, it is simply a risk that they do not have to take.

Deregulating the U.S. financial sector is a virtual necessity for the long-term elimination of the debt crisis. Banks have irresponsibly overextended their equity and "fixed" their balance sheets primarily because the market does not hold them accountable for their ac tions. American lending institutions must be made responsible to economic realities. Insti tuting a system of "mark to market" ac counting and regularly evaluating the equity of banks can make them accountable to market risks. Under this system, if a bank becomes in solvent, it immediately will be closed, re moving the need for the taxpayer-funded insur ance system (the FDIC). Any long-term solution to the debt crisis eventually requires accountability in finance. Securitizing debt enables the banks to deter mine the real value of their loans and to "cut their losses." Upon cutting their losses, a new system of mark to market accounting will ensure that banks no longer make loans they cannot guarantee. Securitization also allows in vestors voluntarily to assume part of the banks' risk of loan default, thereby removing the burden from the unconsulted taxpayer.

Through securitization and financial sector deregulation, the banking system of the United States will be held accountable to the market. The long-term solution to the debt crisis then comes from stimulating growth and develop ment within debtor nations. Through debt/eq uity swaps and the privatization of state-owned enterprises, capital market development is pro moted. Then, the real rate of growth can be raised to make Third World debt sustainable. The debt crisis can be solved. But until U.S. lending institutions decide to confront the crisis it will continue to escalate. Citibank and many others have made steps in the right direction. Indeed, it is true that most banks have mark edly improved their loan portolios in the last few years. But the current financial system could easily aggravate existing problems. Until the system is changed, recurrent crises in lending will continue to be an underlying threat. D 1. Sir Alan A. Walters, before "Capital Markets and Develop ment," part of the seminar series "Including the Excluded: Ex tending the Benefits of Development," sponsored by the Sequoia Institute, Washington, D.C. June 3, 1988.

2. The heavily indebted countries referred to in this data are Ar gentina, Bolivia, Brazil, Chile, Colombia, Cote d'lvoire, Ecuador, Mexico, Morocco, Nigeria, Peru, Philippines, Uruguay, Vene zuela, and Yugoslavia. This data comes from the International Monetary Fund, World Economic Outlook, April 1987. 3. I am grateful to Sir Alan A. Walters for his insights on securi tization. He is, however, blameless for the above views. 4. Steve H. Hanke, "Chilean Flight Capital Takes a Return Trip," Wall Street Journal, November 7, 1986. 5. Peter A. Thomas, "Debt Equity Swaps: A Review of an Un derutilized Privatization Mechanism" (Washington, D.C.: Center for Privatization, November 1987), p. 3. 6. The positive effects of debt/equity swaps can, however, be lessened by the intervention of non-market forces. With the excep tion of Chile, all Latin American nations which have engaged in debt/equity swaps to date have witnessed government intervention in the process. Often, the host governments either inform investors which equity investments may be considered for conversion, or they approve each investment on a yes/no basis. In either case, the gov ernment has the final say in determining which equity investments are candidates for these swaps.

It should also be noted that, while government intervention in Chilean debt/equity swaps is much less pervasive than in other Latin American nations, the government does play an active role in the process. Internal conversions of debt to equity, for example, have restrictions on the total amount of debt that can be converted by investors, primarily to prevent massive expansion of the money supply. 7. "Why Privatize?" (Center for Privatization: Washington, D.C.), May 15, 1987, p. 6. 8. Stuart Butler, "How to Privatize the Postal Service," before the Cato Institute, April 7,1988, p. 2.