Michel CAMES Postgraduate Diploma in Development Studies International Processes of Change and Development University of Leeds Essay 1995


The alternatives of managing market-based debt and their prospects This essay aims to illustrate the alternatives offered to debtors and creditors alike, limiting its scope on commercial debt, to find an outlet of the present situation in which the Northern banks and developing countries are equally locked: the debt crisis which has been on the agenda for more than 10 years. It attempts this by presenting a general overview of the policies applied since its outbreak in 1982 and proceeds to introduce the market-based debt-reduction schemes a la Brady with their particularities. Then, it presents one less common but the more interesting and forwardlooking scheme: debt-for-nature swaps and the way they are presently being implemented. The essay continues to shed light on the different schools of thought when it comes to managing the debt crisis and finally concludes with a personal statement about the appropriate handling of this crisis. The main contention of this essay is that in order to understand and settle the debt crisis, we ought not only to grasp the ultimate facts leading to the inability of the developing world to pay back their debt but to view it from a wider angle and to include the self-interest of Northern banks to contract debts, the monetarist policies pursued by their governments and the world wide pattern of trade with decreasing terms of trade for many southern


countries. From this point of view, the debt crisis ceases to be a crisis solely of the South, but it is looked upon as a burden which ought to be shared by all instigators, including the North. Since the debt crisis emerged by the inability of the Mexican government to repay loans due to the private banking system and sovereign lenders, there have been many attempts to design schemes to solve or at least alleviate the crisis to the mutual benefit of both the debtor countries and the creditors. The main response to the debt crisis in the beginning was the attempt to reschedule the debts by stretching their maturities in order to give developing countries more breathing space to ‘grow out’ of their debt problems. This containment strategy with a decline in new bank lending set in soon after the magnitude of the crisis was recognized and lasted until 1985. As Corbridge states, the effects of this strategy on development were not hard to guess at: most African and Latin American countries began to ‘underdevelop’. In Latin America, development had been sacrificed to secure the stability of the international banking system (Corbridge, 1993, p 60). In 1985 then a new debt initiative was announced with the Baker Plan. Its ‘Adjustment with Growth’ policy made provision of additional lending from mainly commercial banks to a handful of severely indebted countries contingent on market friendly, growth-oriented structural adjustment programmes being adopted. Debt reduction was not taken into consideration yet and the limited amount of money and countries involved made the whole scheme turn out rather deceptive. Only four years later, the Brady Plan was introduced. It has generally been looked upon as being more successful. As Oxfam states, it marked a watershed in the international debt strategy for middle-income countries, belatedly acknowledging what had long been evident: that a large proportion of


commercial debt was unpayable, even with the financial squeeze applied under adjustment programmes (Oxfam, 1995, p 176). For commercial debt, concerted debt-reduction schemes have been introduced. As the African Centre for Monetary Studies points out, a concerted debt-reduction scheme is a programme worked out by the debtor country in collaboration with its creditors with a view to restructuring and reducing its debt. Most important, it overcomes collective-action problems such as the equal-sharing clauses and ‘free rider’ problems whereby a bank not participating in a debt-reduction transaction can benefit at the participants’ cost. The equal sharing clause demands that if a deal is made with one lender, the same deal must be offered to other lenders in the consortium. The ‘free-rider’ problem arises when non-participating creditors gain as against participating creditors by reaping the benefit of the rise in the secondary market debt value, which has only be triggered off by the reduction scheme. According to the debt relief Laffer curve, the value of expected repayments increases in the same degree than the face-value debts as long as full repayment is expected. At higher levels of debt, however, the possibility of non-payment arises and grows, so that the expected payment line traces out a curve that falls increasingly off the ‘full repayment’ line. Beyond some point, the disincentive effects begin to outweigh the face-value of the debt and the value of expected repayment actually decreases with increasing debt. Analogically, with debt reduction the Laffer curve comes closer again to the ‘full repayment’-curve which simply means that the remaining debt will increase in its secondary-market value to a degree which can even be higher than before the reduction. This mechanism effectively annuls the benefits of ‘voluntary’ debt reduction and prevents it from being launched. Or, as Jeffrey Sachs puts it: ‘The failure to make real headway with debt reduction is not an accident. Even when a reduction of the debt burden would be beneficial to the broad class of creditors and debtors alike, it is


unlikely to emerge from the current structure of debt negotiations. Meaningful debt reduction requires an appropriate institutional setting to overcome important collective action problems. Instead of ‘voluntary’ debt reduction, we need ‘concerted’ debt reduction’ (Jeffrey Sachs in African Centre for Monetary Studies, 1992, p 106). The ‘free-rider’ problem can also be overcome by building into the schemes a process that turns the potential cost to the holding-out creditor into a benefit to the debtor. By requiring creditors who exchange less than a given amount of their debt through standard options to provide new money, this turns out to a benefit to the debtor. The creditor speculating to obtain the capital gain of the secondary market will have his new provided money discounted back to the new secondary-market price. According to the African Centre for Monetary Studies, the Brady Initiative aims at reducing the debt of middle-income countries owed to commercial banks by using a menu approach, the main elements of which are: 1) the swapping of old debt for new paper at significant discounts, or with the same face-value but lower interest rates, 2) buy-backs of the debt at deep discounts, 3) encouragement of the swapping of debt paper for equity shares in private or privatised enterprises in the debtor country. The menu provides the flexibility, whereby the creditor can exercise its choice on reduction techniques depending upon its own assessment. Thus a creditor that has a strong presence in the debtor country may find it most rational to exchange a large proportion of its debt through a debt-equity swap. A small bank, however, with limited exposure would prefer a combination of some buy-back and some exchange into lower-interest bonds or even simply to exit totally through the cash buy-back option. The debt buy-back operation is the simple buy-back, for cash and at secondary-market prices, of its own debt by the debtor. Besides the open buy-back, ‘secret buy back’ operations are carried out by an agent who


buys the debt anonymously on behalf of the debtor. This opens up not only the possibility of holding the secondary-market price before the purchase when news of the impending deal would increase the price of the debt, but also for the debtor to take actions to depress the price artificially on the secondary market prior to the deal by sending the appropriate ‘signals’ such as current budget deficits to the market. This might however adversely affect future debt-reconstitution negotiations with the creditors if it becomes public. With a debt-equity swap, which is a transaction converting the debtor country’s external debt into equity in a domestic firm, generally a foreign investor acquires a participation of an enterprise by buying it at a discount on the secondary market. This participation can be in the private sector or in the para-public sector that is being privatized as part of the debtor government’s overall privatization programme. Also, a private company’s debt can be exchanged for equity investment in the same company. Compared to simple buy-back operations, debt-equity conversions have several additional benefits from the point of view of the debtor, namely the encouragement of foreign capital flows, risk reduction by replacing debt with equity, support of privatization programmes and the boost to the transfer of technology. Also, the repatriation of flight capital can be encouraged if nationals are allowed to buy into domestic enterprises by this means. However, there are some major drawbacks of debt-equity concessions towards buy-back operations. First, the degree of foreign penetration of the domestic economy has to be accepted. Second, debt-equity swaps might only replace investment that would have been made anyway. Then there is the serious drawback of the misallocation of resources resulting from distortions caused by subsidies paid to investors through debt-equity transactions when the foreign investor is allowed to undertake investment expenditures at a lower cost than his domestic counterparts (African Centre


for Monetary Studies, 1992). Apart from debt-equity swaps, there are numerous other possible combinations of swaps. Among them are debt-fornature, debt-for-development, debt-for-trade and debt-for-health swaps. According to Mahony, 19 debt-for-nature swaps had been completed in ten countries by mid-1991. They implied northern environmentalists buy up some of the loans which developing countries owed to southern banks and which were offered at discounted prices and cancel these foreign debt obligations in return for good behaviour by these countries, which actually meant making payments in local currency up to the face value of the debt to a local NGO. However, there have been two major setbacks in their application. The first concerns the generally voluntary or isolated action of such swaps. Not being integrated into a ‘concerted’ debt reduction scheme, these swaps just let the remaining debt rise in its secondary-market price and consequently the debtor countries are often left with an about equal amount of expected repayments after having reduced the actual face-value debt. The actual benefit from these swaps goes then integrally to the creditor banks. Consequently, First World environmental groups have just given money to First World commercial banks. No transfer has thus taken place from North to South. Also is there no guarantee that eventually the local NGO’s will be founded by the government and even if they are, other environmental spending might be cut to make up the cost. But even in the case when environmentalists pry out the money of their governments, they mostly create, enlarge or administer national parks by merely drawing a line around it on a map and issuing uniforms to a few rangers. Thus, the natural areas will not be more protected than before as


this will not stop poachers, illegal loggers and landless farmers to invade these areas (Mahony, 1992). As Miller points out, the critical obstacle is simply that there is no way that debt can be reinstated on grounds of non-compliance. Non-compliance may not be due to a lack of goodwill or of ignorance of the part of any party involved in the recipient country, but they may be unable to take the appropriate actions if strong political, economic or social pressures militate against the desired corrective action. Frontiers are exceptionally tempting. It is a rare politician that can resist or be strong-armed enough in the face of pressure from the energy-hungry industrial-urban interests, the hungry landless, the covetous powerful landlords allied with the mining and timber barons. Also, pressure for non-compliance is increased when the debt servicing obligation continue to leave little room for meeting immediate needs (Miller, 1991). From a southern point of view, the debt-for-nature swaps do not lead to a democratic management of natural resources and a better quality of life for the local population. Instead, it reaffirms the creditors’ political and economic domination over the debtors and propagates a development model which commercializes life in all its aspects. Also do they legitimize the debt at a time when many indebted countries are putting forward the idea that the debts were incurred illegally (Mahony, 1992). The Debt Crisis Network points at one major call of the South: the elimination of trade barriers in industrial countries, along with the efforts to stabilize commodity prices (The Debt Crisis Network, 1986, p 44). This stance is also taken by a strand of ‘purists’ (Cartwright, 1992) or advocates of what Corbridge terms the ‘system-instability perspective’. Corbridge quotes Susan George who claims that debt was accrued mainly because the West and some local elites were able to define the process of development in initiative terms. This mal-development would mimic


without understanding and copy without controlling. She advocates a strategy for ‘Debt, Development and Democracy’ (3-D). This proposal would recognize that ‘debt is not an economic, but a political problem’. She suggests that countries are allowed to pay back their debt over a longer period of time in local currency. These payments would then be credited to national development funds whose uses are determined by authentic representatives of the people working with those of the state. For the creditors, this solution would amount to cancellation since the local currency would be used internally. Towards critics who argue that her proposals would be utopian, she replies that the international financial system could now bear the costs of cancellation and in the North ethicalbased movements and export-oriented lobbyists would encourage such a scheme (Corbridge, 1993). She points out the ‘boomerang’ effects to the North in case of a further containment policy: deteriorating environment, more drugs, lost markets, increasing immigration and rising potential of conflicts (George, 1992). Among this school of thought are also the proponents of the radical repudiation strategy. It is commended as necessary and put forward as a strategy which refuses to admit the legality of many of the debts contracted, often by military regimes and which refuses to pay monetary debts in human lives. This policy found some sort of expression in Peru when under President Garcia in 1985 a 10 % ceiling on debt-service payments as a proportion of export earnings was imposed unilaterally. According to George, this strategy of debt repudiation will not work unless all debtor countries agree on a total and collective repudiation of debts (Corbridge, 1993). Indeed, Peru still suffers these days under its former president’s policy in having to meet a particularly high degree of conditionality when it wishes to attract foreign capital. Following Corbridge, a more moderate stance is taken by the proponents of the system-corrective perspective. They are attached to Keynesianism and


consequently aim at limiting the ‘laissez-faire’-policy and give priority to pragmatic and aggregate conceptions instead of individual management. They are in favour of structural adjustment policies of one sort or another, but they are wary of the suggestion that ‘from the ashes a new phoenix will arise’. They locate a persistent weakness of the containment strategy in its willingness to assume that an economy in debt servicing difficulties can grow quickly on the basis of a severe pruning of its assets. Thus a premature transfer of real resources to the creditor puts the long-run development of the economy in jeopardy. The alternative is to act pragmatically and to seek an equitable sharing of the burdens of adjustment. They also point out that such a sharing has a historical precedent in past debt crises which have usually ended in some forgiveness. Consequently, ‘a partial write-down of the debt is the norm, not the exception’ (Corbridge, 1993, p 156 quoting Sachs, 1989, p 23). The neo-classical counterpart of this more pragmatic stance is found in the system-stability perspective, which suggests, according to Corbridge, that the international economic and financial system is inherently stable and that the responsibility for particular debt crises should be shouldered by those who acted against the norms of economic prudence. As a major proponent, Bauer argues that the problems of the indebted countries have arisen from policies that have wasted resources and damaged living standard and development. He suggests that it should be made clear that there will be no further funds for countries in default on their debts. A ban on debt rescheduling will encourage a proper moral fibre in such countries .... (Corbridge, 1993). Toye refers to this strand as the ‘new vision of growth’ and concedes it would contain much common sense which in the past has often been neglected by policy-makers. He adds however, that it is but a short step from common sense to uncommon nonsense and Bauer’s vision ‘provides an opportunity to study how this short step has been taken’ (Toye, 1989, p 88).


This perspective of neo-liberalism which attacks the key elements of Keynesianism and rejects the right of the state to engage in macroeconomic planning had re-emerged into prominence among Northern governments by the end of the 1970’s and was thus to dominate the policies of these countries when the debt crisis broke out in 1982. It can also be asserted that the rise of monetarist policies after 1979, when money became scarce and interest rates began to rise, was contributing to the ultimate outbreak of the debt crisis. The main response to the crisis in the early years was containment, adjustment and austerity, which can be found in the system-stability perspective. It was only the inability of this approach which led to more pragmatic approaches when in 1985 the Baker Plan and then in 1989, the Brady Plan were adopted. This gradual shift to a corrective stance has been recognized as a more appropriate approach to dealing with the debt burden even if the magnitude of the debt relief schemes has been far too modest to cope with more than a trillion US-$ of international debt. However, as can be observed in Latin America, the debt crisis is far from over even if the response of some Brady-style debt write-offs was a boom in private capital flows to some countries previously at the centre of the debt crisis were now figuring prominently among the newly favoured ‘emerging markets’. According to Oxfam, a large proportion of this foreign capital is speculative in nature and entirely disconnected from the real economy. Much of the explosion in private capital flows represents high-risk and short-term speculative activity. Such flows have less to do with opportunities for productive investment and employment creation than with the pursuit of the fast-buck in money markets (Oxfam, 1995). All the more it has become clear how necessary initiatives a la Brady have become. From my point of view, Brady-style menu-based concerted debt reduction schemes are on the right track to a final settlement of the debt crisis when it comes to commercial debt as they allow a flexible approach


and the free-rider problem is adequately solved. It is this ‘systemcorrective’ stance which seems the most sensitive and reliable lever to deal with the debt burden. Nevertheless, it has only been the first step to a more honest behaviour and still has deficiencies. The future will show whether the corrective stance, which varies widely in design, will not have to move further into direction of the ‘instability’ perspective for the mutual benefit of all partners. Even if this latter perspective does not seem acceptable regarding equal treatment as imprudent countries will be rewarded for their behaviour, we somehow must admit that we do not live in an ‘all over equal’ world and to strive for settlement of any existing and conceived injustices will only lead to turbulence, conflict and war. It is also in this context that debt-for-nature swaps might eventually become an ‘opportunity window’ (Cartwright, 1992). As Cartwright points out, the value of biological reserves - particularly tropical rainforests - can only increase as our need for, and our ability to use, genetic materials grows. Since the wealthier and more technologically advanced countries of the North would be the first to benefit from the genetic pool, they should be prepared to pay for its survival. The main value however of refraining from further tropical deforestation is the benefit in reducing or bringing to a halt a possible change in global weather patterns. Since the countries of the North have already largely devastated their own natural ecosystems and on top of that are by far the largest consumers of fossil fuels thus producing the lion’s share of carbon dioxide which is responsible for the ‘greenhouse effect’, they should have a strong self-interest in supporting effective conservation measures (Cartwright, 1992). Briefly, it comes down to a ‘right to consume/polluteconservation’-swap and is currently being implemented in parts of the globe, however under a differing objective: in order to achieve the aggregate goal of national carbon dioxide reduction agreed upon at the UN Conference on Environment and Development in Rio de Janeiro, Northern countries invest into conservation, reforestation and pollution control


measures in developing countries instead of at home because in developing countries these measures can be implemented at much lower costs for a given amount of biomass creation or protection regarding none or only crude pollution control facilities in developing countries compared to Northern countries’ industries with already sophisticated devices. This questionable trick to achieve the highest productivity of capital could however be combined with the debt burden of the developing world. Northern countries would ‘invest’ into the southern environment by merely freeing developing countries to pay back part or all of their debt. The reduction or cancellation of debt could thus be able to protect biomass by the simple means of developing countries not having to finance debt repayment by ‘once-off’ environmental degradation activities such as logging virgin rainforests, let alone the temptation to achieve debt relief by using their territory as ‘poison-garbage depots’. It could allow the developing world to save their face and the advanced countries to concede that certain ‘commodities’ such as water, air, the genetic pool and a ‘human’ climate cannot be consumed free of charge only by the more wealthy part of humans. It would further the ‘commercialization’ of all assets, but would help to ‘bend the market system to pay the full cost’ (Miller, 1991, p 137). This possible outlook into the future of a further capitalization of our common natural heritage does not appear like a heavenly prospect, but yet it could be one possible outlet of growing environmental conflict potential and the settlement of one of our world’s crises - the debt crisis.


Bibliography African Centre for Monetary Studies (1992), Debt-Conversion Schemes in Africa, London, James Currey Cartwright, John, ‘Conserving Nature, Decreasing Debt’ in Wilber, Charles K. and Jameson, Kenneth P. (1973), The Political Economy of Development and Underdevelopment, Fifth Edition 1992, p 618 - 630, New York, Mc Graw-Hill, Inc. Corbridge, Stewart (1993), Debt and Development, Oxford, Blackwell Publishers George, Susan (1992), The Debt Boomerang, London, Pluto Press Mahony, Rhona (1992), ‘Debt-for-Nature Swaps - Who Really Benefits?’, The Ecologist 22/3, 1992, Dorset, Ecosystems Ltd. Miller, Morris (1991), Debt and the Environment, New York, United Nations Publications Oxfam (UK and Ireland) (1995), The Oxfam Poverty Report, Oxford, Oxfam Sachs, Jeffrey D. (1989), Developing Country Debt and Economic Performance, Chicago, The University of Chicago Press The Debt Crisis Network (1986), From Debt to Development, Washington, D.C., The Institute for Policy Studies Toye, John (1987), Dilemmas of Development, Second Edition 1993, Oxford, Blackwell Publishers Williamson, John (1989), 25 Voluntary Approaches to Debt Relief, Washington D.C., Institute for International Economics


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