INTERNATIONAL DEBTS: WHAT'S FACT AND WHAT'S FICTION: PRESIDENTIAL ADDRESS TO THE WESTERN ECONOMIC ASSOCIATION, JULY 2, 1988

SCHWARTZ: INTERNATIONAL DEBTS The official strategy on the international debt problem was breached in May 1987 when Citicorp, acknowledging the likelihood of credit losses on its Latin American loans, announced that it was increasing its reserves by $3 billion. Nineteen banks between 26 May and 8 July also announced additions to their loan loss reserves, in aggregate amounting to over $12 billion, according to Musumeci and Sinkey [1988]. In May 1988, the General Accounting Office (GAO) estimated that reserves of U.S. banks against their troubled loans to LDCs totaled about $21 billion, whereas adequate provisioning would require reserves of $49 billion (see the Wall Street Journal, 19 May 1988). The GAO used prices on secondary debt markets in determining the adequacy of loan reserves. The banks and regulators, however, dispute the GAO's report (see the Wall Street Journal, 13 May 1988). The secondary markets, they contend, are thin, and transactions of even moderate size cannot be executed at quoted prices. The price quotations may also misrepresent the prospect of repayment for the following reason. By holding a foreign country's debt, a creditor bank has been subject to the implied obligation to lend new money pro rata to that country. However, by selling the debt on the secondary market, a creditor bank is released from that obligation, and hence may accept a lower price than would otherwise be the case. On the other hand, as Sachs and Huizinga [1987,579-87] note, the decline in bank equity prices since 1982 closely matches the secondary market valuation of LDC exposure. The qualifications concerning the significance of the secondary market prices of foreign debt did not apply to prices of foreign bonds that in the past traded at a discount in the market. Those prices reflected solely the probability of repayment of the bond. The additions to loan loss reserves in 1987 reduced the banks' reported income and their book capital. Equity was reduced by a transfer to reserves, and plans to issue equity were announced by many banks following their additions to reserves. The reserves, however, are not charged against current income for tax purposes. Should write-offs occur in the future or agreements be reached with the debtors to reduce outstanding debt, the losses will be charged to reserves with no effect on reported income. Latin American debt has not been written down because of the additions to reserves, and no forgiveness is involved for LDC debts. The banks face difficulties in reducing their developing country debt by sales, swaps, and write-offs. Loan agreements may prohibit repurchase of the debt by the borrower, hence limiting the sales option. (14)Swaps for local currency or equity have had only small effects on debt reduction. J.P. Morgan and Company earlier this year devised a program with Mexico that had the blessing of the U.S. Treasury. Morgan swapped $400 million of its Mexican government debt for $263 million twenty-year Mexican government bonds. The Mexican issue was collateralized by twenty-year U.S. Treasury zerocoupon bonds (at time of sale, priced to pay 8.41 percent annually) that Mexico bought with $2.56 billion of its international reserves. Swaps by other banks participating in the program reduced Mexico's bank debt by about $1 billion, although a $10 billion reduction had been forecast. Morgan regarded the swap as advantageous because it also served to reduce its obligation to supply future loans to Mexico. For other banks the size of the discount on the swap made the deal unattractive. (15)The third way for the banks to reduce exposure to developing-country debt is write-offs. Write-offs have limited appeal. They risk inciting political pressure to force debt forgiveness. The regulators, the U.S. government, and international-agency lenders continue to pressure the banks to provide additional loans to the Latin American debtors that are either in arrears on interest payments or pay a large percentage of their trade surplus to cover service charges. …