-13-

Over the five-year 1974-78 period, Peru had great difficulty in
maintaining balance between its current-account deficit and its net capital
inflow and ended up being unable to pay its debts on schedule. Its growth
record also was poor. The rate of real GDP growth rose to nearly 7 percent in
1974 from its 5 percent annual average in the six years 1968-73, but there-
after receded below 5 percent, even turning negative in 1977 and 1978. For the
five-year period through 1978, the rate of real GDP growth averaged 2.5
percent per year, less than the rate of growth of population, which was above
3 percent. Even during the three years since 1978, the rate of real GDP
growth has not risen much above the population growth rate. It is clear that,
except for a very brief period, Peru failed to step up economic growth through
external borrowings after 1973. It is equally clear that the payments crisis,
culminating in an interruption of debt service and debt rescheduling, and the
poor growth record of 1976-78 stemmed from the prolonged deviations from the
second, third and fifth guidelines. The authorities showed great reluctance
to take corrective measures, they tolerated highly neaative real interest
rates, ancl their exchange rate policies did not prevent progressive erosion of
the economy's international competitiveness, except for short periods.
Conclusior:

The main difference between the experiences of Brazil and Peru is
that Brazil came closer than Peru to following the three policy guidelines on
which attention has been focused. Both delayed taking corrective fiscal and
monetary action when their external accounts experienced disequilibrium, but
Peru did so for a far longer period than Brazil. Peru also deviated over a
longer period than Brazil from the realistic exchange rate and interest rate
guidelines. As a result, Peru suffered more severe distortions than Brazil

and its position deteriorated further than Brazil's.


-~-4-

of the fiscal deficit and may weaken the efforts to fight inflation, causing
possible repercussions over other elements of economic policy and incirectly
over the country's international credit standing.

The fifth guideline is that the borrowing country must follow domes-
tic fiscal and monetary policies that inspire confidence in international
financial markets. In particular, such a country must be willing to take
fiscal and monetary policy steps to adjust its balance of payments when it is
subjected to external shocks, so that the period during which external bor-
rowings may have to be devoted, in part, to the maintenance of consumption,
in violation of the first guideline, will be minimized. More generally,
whether there be external shocks or domestic disturbances of an economic or
political nature, the borrowing country must be willing to take fiscal and
monetary policy steps to limit its current-account deficit to a level corre-
sponding to the amount that can reasonably be expected to be available from
external sources of financing. In the absence of such steps, the entire
burden of adjustment would have to be borne by the exchange rate and, through
it, by the export and import-competing sectors of the economy. This would be
likely to cause distortions that would impair the efficient functioning of
the economy, weaken the confidence that the country inspires in world finan-
cial markets, and limit its access to external financing. In theory, quanti-
tative import restrictions and exchange controls could be used to adzust the
balance of payments or to limit the size of the current-account deficit. But
this would not be likely to inspire confidence in international finaricial
markets, because it would not deal with the domestic causes of the external
disequilibrium and would generate concern over the possibility that the con-

trols might interfere with debt service payments.


-9-

attempting to compensate for the inflation differential. They eliminated the
ceilings on interest rates introduced 18 months earlier. !/ They imposed
severe restrictions on spending by state enterprises and tightened monetary
policy, The result was a virtual halt in real GDP growth last year, a heavy
price for the overheating of the economy in 1980, but there also was some
easing cf inflation and a $2 billion reduction in the current-account deficit.
The latter was achieved in spite of a further sharp increase in interest pay-
ments ard resulted mainly from a $4 billion turn-around in the merchandise
trade pcsition--from a $2.8 billion deficit to a $1.2 billion surplus. These
developments, stemming directly from the renewed adherence to the second,
third and fifth guidelines, were not lost on the international financial
community whose willingness to increase lending to Brazil improved markedly
during the year. In the end, last year's net capital inflow exceeded the
current-account deficit and reserves turned up. The stage was set for a possi-
ble resumption of economic growth in 1982.

During the past eight years, Brazil struggled to maintain approxi-
mate balance between the current-account deficit and the net capital inflow.
The pressures on its balance of payments were not entirely of external origin,
as domestic desires to speed up economic growth led to several bouts of over-
heating. But the authorities were willing, albeit with some delay, to take
balance-of-payments adjustment measures, including those leading to a lowering
of the rate of economic growth. In the eight years 1974-81, the rate of real
GDP growth in Brazil averaged 6 percent per year, compared to about 11 percent
during the previous six years. Given the exceptionally rapid growth achieved
during the "miracle years", the virtual halving of that rate in the ensuing

7 However interest rates on loans to agriculture, small business, and exports
remain heavily subsidized.


-6- ;

August 1968 and to the use of an indexation coefficient to bring the real
return on many financial instruments to a realistic, market-related level.
These policies conformed with the second and third of the five guide’ ines
just discussed. In addition, industry paid market interest rates and mone-
tary policy was tight enough to give it an interest rate incentive to seek
financing abroad. However, agriculture, smal] business, and exports obtained
credit at subsidized interest rates, helping to fuel monetary expansion and
distorting resource allocation.

Since 1973, Brazil has had to absorb the impact of two oil shocks,
two world recessions, and the sharp rise in world interest rates. Ir 1974,
it tried to maintain its high growth rate and to finance the resulting
increase in its current-account deficit. But the required amount of external
resources was greater than it could raise in external markets without incur-
ring interest costs that would have exceeded what it was willing to pay, and
and its reserves turned down. This convinced the Brazilian authorities of
the need to embark on an adjustment effort. Late in 1974, they tightened
fiscal and monetary policies and, as an alternative to a faster currency
depreciation, they introduced export subsidies and raised import duties.
They accepted a lower rate of real GDP growth, although there was some back-
sliding in 1976, after which fiscal and monetary restraint was renewed and
the growth rate fell again. The combined effect of slower growth and the
trade policy steps was to reduce the current-account deficit from $7.5
billion in 1974 to about $5 billion in 1977.

These efforts conformed with the fifth guideline and evidertly
encouraged the international financial community. As a result, the net capi-

tal inflow in this period was substantial. By 1976, it was again exceeding


-5-

Adherence to these five guidelines should go a long way toward
enabling a developing country to pursue growth through external borrowings
without running into balance of payments difficulties. A look at the experi-
ence of two Latin American countries over the last ten years will help to
show that when countries disregard these quidelines they pose a greater risk
for the lenders, create greater uncertainty about their cont inuing access to
foreign capital, and, in the end, fail to step up their economic growth on a
sustainadle basis.

In what follows, we shall focus on the second, third, and fifth
guidelinas,

The Brazilian Experience

Consider first the case of Brazil. In 1973, Brazil was in the
sixth year of its economic miracle. The growth of its real GDP had averaged
more than 11 percent per year since 1968. The rate of inflation had been
held to less than 20 percent since 1970, after fluctuating in a much higher
range during the late fifties and the sixties. Its current-account deficit
had increased from less than $200 million in 1966 to more than $2 billion in
1973, for a cumulative eight-year total of more than $7.5 billion, but its
net capital inflow had increased even more and on a cumulative basis totalled
nearly $13 billion during the same eight years. Its external medium- and
long-term public and private debt had risen to about $12.5 billion at the end
of 1973 from about $3 billion six years earlier, but its official interna-
tional reserves (excluding gold) exceeded $6 billion, compared with only $150
million at the end of 1967.

This remarkable record owed much to the policies Brazil had adopted

and in particular to the crawling peg exchange rate policy instituted in


-8-

In 1980, the current-account deficit surged to nearly $13 billion,
nearly twice as much as two years earlier. Brazil's 1980 oi] import bill was
about $10 billion, some two-and-a-half times the 1978 level, and interest pay-
ments on the external debt reached about $7.5 billion in 1980, more than twice
as much as two years earlier. That the deficit did not rise further in this
period stemmed from a $4 billion increase in the non-oil trade surplus, in
part owing to improved harvests and to the completion and coming-on-stream of
a number of important projects the output of which substituted for imports.

The overheating of the Brazilian economy and the erosion cf its
international competitiveness when the balance of payments was already severely
constrained by a heavy oil import bill and very large interest payments
weakened international confidence in Brazil. Late in 1979 and early in 1980,
the spreads over LIBOR that Brazilian borrowers were asked to pay or Euro-
currency credits rose sharply. Toward the end of 1980, market apprehension
about Brazil began to impair the country's ability to obtain new credits.
While the total net capital inflow of 1979-80 amounted to about $16 billion,
this fell more than $7 billion short of the cumulative current-account deficit
of these two years, and reserves fell sharply in both years. The steer size
of the external debt!/ also caused concern because of the very large amounts
maturing each year and requiring either a rollover or new credits to cover
them.

These ominous signs convinced the Brazilian authorities of the need
to change course near the end of 1980. They abandoned the preannounced depre-

ciation rate and indexation coefficient and reverted to the previous policy of

J7 At the end of 1980, the medium- and long-term public and private debt was
nearly $54 billion. To this should be added the short-term debt that may be
estimated at around $13 billion at that time.


Internationai Finance Discussion Papers
Number 203

February 1982

HOW TO BORROW REASONABLY

by

Yves Maroni

NOTE: International Finance Discussion Papers are prelminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished material)
should be cleared with the author or authors.


-lle-

in 1975 and increasingly resorted to the domestic financial system to finance
it. As inflation accelerated, official subsidization of imported foodstuffs
and petroleum products increased, in violation of the fourth guideline. This
further widened the fiscal deficit, and credit expanded more rapidly. The rate
of inflation rose to about 25 percent in 1975, but interest rates on savings
instruments remained fixed in the 7-10 percent ranae, in violation of the
third guideline. In this range, interest rates did not attract resources to
the banking system and indeed encouraged domestic capital to leave the country.
Moreover, the exchange rate established in 1967 continued in effect until the
third quarter of 1975, and the 1975 devaluation offset only part of the differ-
ential between domestic and foreign inflation accumulated in the intervening
years, “eaving the currency still overvalued. Since the new exchange rate was
again pegged to the dollar and domestic inflation continued to be more rapid
than inflation abroad, the real appreciation of the sol was resumed from the
new level. That is, the second guideline was also not being followed.

With these policies, imports more than doubled in the span of two
years, while exports increased only about 25 percent, and the current-accont
deficit soared to more than $1.5. billion in 1975. At this level, the deficit
exceedec the net inflow of capital, especially since the latter failed to grow
that year in spite of a marked hardening of terms. As a result, reserves,
which had continued to rise until early in 1975, dropped sharply.

There followed a succession of abortive attempts at stabilization,
each of which faltered after a few months, as the authorities showed reluc-
tance to follow the fifth guideline. The public sector fiscal deficit remained
large, as outlays were swollen by subsidies and by military expenditures with-

out a corresponding revenue effort, and domestic credit was allowed to expand


- 10 -

eight years still left the country with a growth rate that is quite respect-
able, even when the rate of growth of population, in excess of 3 percent per
year, is taken into account. Only when it deviated from the second, third and
fifth guidelines did Brazil encounter resistance to its efforts to obtain exter-
nal financing and did it suffer a virtual halt to economic growth. In the end,
it avoided extreme payments difficulties that might have called for extra-
ordinary relief measures thanks to a timely resumption of adherence to these
guidelines. Because of its relatively low international reserves, it remains
vulnerable to possible new external and internal shocks and it has only limited
room in which to reconcile its drive for growth and its balance of payments
constraints.

The Peruvian Experience

For a different kind of experience, consider now the case of Peru.

In the six years ending in 1973, Peru had an average rate of real GDP growth
of almost 5 percent per year, an average rate of inflation of about 8 percent
per year, and an average current-account deficit of less than $25 million. In
these six years, the net capital inflow averaged about $120 million per year
and international reserves rose steadily. The currency had been pegged to the
dollar at a fixed rate in 1967, following a 30 percent devaluation, and this
rate was still in effect at the end of 1973.

In 1973, the Peruvian government undertook an ambitious development
program and arranged for a considerable amount of external financing, much of
it from foreign banks. The financing was forthcoming mainly because Peru was
thought, overoptimistically as it turned out, to have strong export prospects
over the long run as a result of recent oi] discoveries and planned investments
in mining. In implementing the development program, the Peruvian gcvernment

allowed the public sector fiscal deficit to rise to more than 10 percent of GDP


-7-

the current-account deficit and reserves had turned up. Brazil's success in
attracting foreign resources was especially notable in 1978, when the net
capital inflow topped $11 billion, compared with an annual average of $7
billion during the previous four years, and Brazil took advantage of this
situation to adopt a somewhat more stimulative fiscal and monetary policy that
year. The result was a moderately higher rate of real GDP growth and a larger
current-account deficit. Even so, more than $4 billion was added to reserves.
Brazil met the second oi] shock as it had the first one, by post-
poning adjustment measures and attempting to finance the resulting increase
in the current-account deficit. Indeed, departing from the fifth guideline,
the authorities stepped up the rate of arowth in this period and allowed the
economy to become overheated. In 1980, real GDP growth reached 8 percent and
the rate of inflation, which was around 40 percent in 1978, soared to 110
percent. In this period, Brazil also deviated from the second and third
guidelines, and abandoned some of the policies that had served the country so
well in earlier years. First, bank interest rates on deposits and on loans to
industry, which had been market-related, were placed under ceilings that
became increasingly unrealistic as inflation accelerated. Second, the depreci-
ation rate under the crawling pea exchange rate system and the indexation
coefficient, both of which had been set so as to compensate for the inflation
differential, both were frozen at levels that were announced in advance, first
for six months, then for twelve months. Both were set to correspond with what
the government hoped would be the future differential between domestic and
foreign inflation. But, when domestic inflation accelerated sharply, they
became increasingly unrealistic. In real terms, the cruzeiro appreciated,
thereby 2roding the international competitiveness of Brazilian industry and

setting the stage for possible speculative capital movements.


-3-

that a substantial devaluation is inevitable and cannot long be postponed.
Both the deterioration of the current-account position and the capital out-
flows daniage the borrowing country's capacity to service its external debts.
The erosion of international competitiveness also works to hold down the
rate of economic growth, since it hurts both import-competing activities and
exports.

The third guideline is that a country pursuing growth through
external borrowings must maintain realistic interest rates, that is, rates
that are high enough to act as a disincentive to an outflow of domestic
capital and as a magnet for foreign funds. Rates at such levels would have
the added advantage of attracting domestic savings to the banking system
where they can be more efficiently allocated to finance productive invest-
ments and thereby promote economic growth. Otherwise, domestic savings
might be held in speculative forms, such as real estate, excess inventories,
or precious metals as well as foreiaqn balances and other assets located
abroad. Moreover, realistic interest rates would serve to discourage invest-
ments in projects which carry an insufficient expected rate of return. They
would also reduce the temptation to rely on non-price considerations, such
as political or personal influence, in allocating credit, as often happens
when interest rates are subject to ceilings set below market-related levels.

The fourth guideline is that the borrowing country must minimize
the use of price controls and subsidies. These measures tend to encourage
overconsumption and to distort the allocation of productive resources.
Price controls also tend to discourage domestic production and to result
in shortages that may impair the efficient functioning of the economy and

hence its debt servicing capacity. Subsidies may result in a widening


-4-

There are, of course, other differences between the two countries,
particularly as regards the structure of their economies and the composition
of their exports. These undoubtedly played a role in shaping their respective
experiences in the period we have reveiwed. But the evidence strongly suggest
that adherence to the policies outlined here was a critical factor.

Two cases are not enough to establish beyond any doubt that adher-
ence to these policies is always a necessary condition to the success of a
strategy of growth through external borrowings. But evidence to the contrary
does not readily come to mind. Until contrary evidence is presented, it seemss
safe to conclude that severe and prolonged deviations from these policies are
likely to provoke financial difficulties and economic instability rather than

helping to step up the rate of economic growth on a sustainable basis.


~-2-

expected from the proposed use of the borrowed funds should be economically
attractive: the expected rate of return should be at least equal to the
cost of foreign borrowing. If foreign funds are used to help finance an
enterprise that will sell goods or services, that enterprise must be able to
stand on its own feet, without the help of highly protective tariff or non-
tariff barriers that will keep out competing products. Otherwise, the
borrowing country may find itself saddled with an activity that not only
fails to enhance its capacity to service external debts, but also imposes
new external burdens. These new burdens may arise if the real value of the
project's output falls short of the cost of imported materials and spare
parts needed to keep the enterprise going and also fails to cover the cost
of importing the additional goods and services that the newly employed labor
is sure to demand with its enlarged disposable income.

The second guideline is that a country pursuing arowth through
external borrowings must maintain a realistic exchange rate to prevert
erosion of its international competitiveness. If it is able to hold its
domestic rate of inflation roughly in line with the rate of inflatior in its
major trading partners, it may be able to peg its currency to that of a
major trading partner country, or to a basket of the major currencies. 8ut,
if there is a significant differential between the domestic and foreign
inflation rates, it will be desirable to adopt a crawling or floating
exchange rate system to offset this differential and to insulate the balance
of payments from its consequences. Otherwise, if domestic inflation exceeds
foreign inflation for any length of time, the currency will become over-
valued, exports will be discouraged, imports will be stimulated, and specu-

lative capital outflows will be encouraged as it becomes increasingly obvious


How to Borrow Reasonably!/

by
Yves Maroni

It is axiomatic that a developing country, with a limited ability
to increzse domestic savings, may step up its rate of real economic growth
by borrowing some of the savings of other countries to supplement its own.
With these borrowings, such a country may increase its imports of goods and
services to undertake additional development projects. As a result, a
developing couritry attempting to step up growth is likely to have a deficit
in the current account of its balance of payments and a net capital inflow.

But it is well known that some countries pursuing growth through
external borrowings run into balance-of-payments difficulties. This happens
when the current-account deficit exceeds the net capital inflow and there
are not enough accumulated international reserves on hand to fill the gap.

The strategy of growth through external borrowings clearly has
its limits, and the question then becomes how to maintain an approximate
balance between the current-account deficit and the net capital inflow.
Common sense suggests and experience has shown that the answer lies in a
combination of five separate lines of action that the borrowing country
should take.

Five Guidelines

The first guideline is that the stepped up external borrowings
should be used, either directly or indirectly, for productive purposes, not
for consumption. Otherwise, the borrowing country may not generate the

Capacity to service the additional external debt. In principle, the returns

7 Paper presented at a conference on Latin American external debt and
‘economic growth, Florida International University, Miami, Florida,
February 24-25, 1982. The views expressed are the author's only and should
not be interpreted as representing those of the Board of Governors of the
Federal Reserve System or of other members of its staff.


~12-

to help finance it. The rate of inflation accelerated and interest rates
remained highly negative in real terms, although they were allowed to rise
somewhat in nominal terms. The sol was devalued in June 1976 and a crawling
peg system was introduced in September of that year. But the crawl process
was interrupted on two occasions for extended periods in 1977 and early 1978.
While the current-account deficit shrank somewhat in 1976 and 1977, the net
capital inflow also diminished, as private lenders became increasingly reluc-
tant to add to their exposure in Peru, and reserves continued to decline in
both years. During the first half of 1978, substantial payments arrears on
current international transactions began to accumulate, as the authorities
preempted a rising proportion of the available foreign exchange to maintain
full service on the external public debt.

In May 1978, with default on ‘the external public debt looming ahead,
the authorities launched a new stabilization effort and soon afterwards the
syndicate of foreign banks to which Peru was heavily indebted agreed to post-
pone the payments due over the balance of the year until early 1979. There
followed agreement with the IMF on a stand-by arrangement and, toward the end
of 1978, a formal rescheduling of Peruvian debts to public and private creditors
maturing in 1979 and 1980.

From June 1978 until the latter part of 1980, Peru successfully
implemented the stabilization program. It was also fortunate in being able to
benefit from sharply higher prices in world markets for many of its exports in
1979 and 1980, and restored virtual balance in its current account. It regained
access to international credit, and rebuilt its reserves. However, serious
new balance of payments strains have since reappeared and reserves fell sharply

in 1981.