International Lending and Capital Flows FRANCISCO GIL-DÍAZ
The basic argument that I want to present here today is that foreign debt in emerging market countries is public debt. The problem with emerging market governments and emerging market countries is that emerging market debt is, in the end, public debt. This is evident in so far as local hard-currency lending of last resort by central banks or treasuries is leveraged on official outside support, for example through rescues by the U.S. Treasury, the International Monetary Fund (IMF), the World Bank, and the Bank for International Settlements (BIS). I would like to start with a brief historical perspective, pertinent because the development of international capital markets over the past few years has been surprisingly fast and varied. This evolution has promoted profound changes in the structure of external finance in emerging market countries and increased their reliance on official outside support. This shift may also have enhanced moral hazard. The capitalization of markets has undergone tremendous growth in recent years, jumping from US$14 billion to US$24 billion between 1993 and 1997 (see Chart 1). The rising amount of assets in equity and mutual funds is another change that has been well documented. David Hale (1996) has shown how these assets grew threefold in the five years between 1990 and 1995 (see Chart 2). The relative positioning of banks vis-à-vis mutual funds is quite different from what it used to be. In 1973 and 1974, rising oil prices triggered a substantial increase in savings by the Arab countries and some other oil-producing countries. International markets started changing because the Arab countries had to find borrowers, and they found ready sovereign borrowers in developing countries, which took out a huge amount of debt. Most of the new debt was channeled through private banks.
Then in the late seventies, U.S. interest rates rose and the debt burden of Latin American countries increased sharply. Since most of our debt was at floating rates, this translated into increased interest payments. Chart 3 shows how interest payments ballooned from 1977 to 1980, after just a few years. These data do not include Eastern Europe and the former Soviet Union, but it is still evident that interest payments rose due to the higher interest rates. There was simply no proportional relation between the growth in interest payments and gross domestic product (GDP) growth in these countries. In addition to all this debt, it became increasingly hard to borrow internationally for two reasons: the petrodollar bulge ended, and real financial returns improved in home markets when inflation fell in the industrialized world. That was the situation in the eighties. Mexico’s debt problems in 1982, after it could no longer service its foreign debt and had nearly exhausted its international reserves, marked the beginning of the contamination type of crisis. In 1982, Mexico was the second-largest emerging market debtor, after Brazil.
There were spillover effects, one of which was of course contamination. Brazil and Argentina became unable to take out additional loans or even to roll over maturing short-term debt. In 1982, Brazil’s debt was close to US$88 billion and Argentina’s was near US$40 billion. Hundreds of banks had claims on Latin America. Giants like Citicorp, Bank of America, and Manufacturers Hanover had loaned the region significant portions of their portfolios. Then the crisis disappeared and the nineties brought a renewal of capital inflows. One of the reasons for this renewal was the Brady Plan—the ingenious renegotiations of sovereign debt that seemed to dissipate the debt overhang. The decline in U.S. interest rates was also partly responsible for the reawakened interest in the region. But perhaps the greatest incentive to renewed flows was the move in emerging markets towards deregulation, public sector downsizing, trade openness, and stabilization. Emerging markets and their private sectors were able to leverage those improvements into greater debt. Stock market capitalization in emerging market countries grew from only US$613 billion to US$2.1 trillion from 1990 to 1996. In the industrialized countries, the figure went from $8.8 trillion to US$18.1 trillion during the same period (Hale 1998). These data show the very significant change that allowed emerging markets to leverage their reforms and to acquire significant amounts of private debt. More recently, Mexico again created a crisis which had a major spillover effect. What were the causes of the 1994 crisis? We have to look again into the behavior of credit and the moral hazard that supported it. The main engine of a smart and sustained increase in demand from leading up to 1994 was a tremendous explosion of credit from development banks and commercial banks. This increase came from banks and from foreign sources. Credit to the private sector rose 270 percent in real terms, just from the local commercial banks in Mexico. But the same type of increase was evident in other sources of credit. A significant portion of that credit was unrecoverable, even without the crisis. The credit expansion did not bring about growth. Instead, the current account became unmanageable and, together with Mexico’s fixed exchange rate, culminated in the 1994 crash. In 1995, the U.S. and Canadian governments, the World Bank, the BIS, and the IMF provided emergency backing that allowed Mexico to emerge from the crisis. This funding led to several new developments in global debt markets. Public and private borrowers are now back in the world debt markets and are relying more on bonds instead of obtaining direct bank credits. Also, because of the lack of a common statistical framework, financial institutions have established research departments all over the world. I would say that in this regard, a serious problem exists in most emerging markets, and it is manifested in the commitments that arose after the recent Asian crisis. Part of this dilemma is that Pete Marwick and all the reputable accounting firms were using lower and differing standards for evaluating institutions in southeast Asian countries and in most of Latin America. So despite the fact that these international accounting firms were auditing and evaluating income statements and balance sheets, they did not provide the transparency and fullness of information or the quality and timely advice that one expects from such firms. International observers simply did not know what was going on in these countries. This lack of transparency and information would, of course, apply to Mexico and most of Latin America. This situation led international financial institutions to reevaluate their roles. To date, however, they have only proposed common standards and global supervision. Supervisory problems, the absence of accountability, and information problems have provoked international financial institutions, especially the IMF, to look into the definition of common standards and some kind of international supervision. Notwithstanding the vast and timely amount of new information, the weaning out of the crises, and a new awareness by international official institutions, a large degree of moral hazard remains. We have no indigenous capital markets, only short-term money markets. Panama, which has a dollar economy, is an exception in Latin America. Another one is Chile, where most banking liabilities are dominated in another currency that is neither the dollar nor the Chilean currency but, rather, indexed deposits. Furthermore, central banks unavoidably continue to be lenders of last resort and commercial banks know they can rely on them. They know they can expect central banks to come to the fore whenever they need them. Development and commercial banks continue to borrow abroad and to lend in the short term in local currency. Therefore a mismatch problem persists because of a lack of domestic capital markets. This has been well documented by Ricardo Hausmann at the Inter-American Development Bank (Hausmann and others 1999). Due to these imbalances and the knowledge that there is a local source of lending of last resort, governments continue to bear responsibility for a country’s total indebtedness—not just for the so-called public debt. In turn, governments confide in the ever-present supply of international lending of last resort, which brings us back to the original assertion: all emerging market debt is really public debt. One could question these concerns based on the ever-present potential for failure derived from moral hazard. After all, emerging market economies have undertaken substantial reforms and public finances have improved. So the question becomes, “Have these reforms solved the problem?” Unfortunately the answer is no, and the foundation for a sustained healthy development is still incomplete. A main reason for this shortcoming is that hidden public debt is substantial. There are several sources of hidden public debt or of public debt disguised as private debt. Pension liabilities are potentially enormous; not only do pension liabilities exist because of unfunded pension plans at the central government level but there are also huge, unaccounted liabilities. (This is at least true of most state governments in Mexico, and I suspect it is true elsewhere as well.) Though these liabilities are not transparent, they are going to create a tremendous drain on public finances in the next few years. Then there is the question of development bank debt. We did not follow the healthy example of Carlos Boloña in Peru: we maintained our development banks in Mexico. That is true for most of Latin America and other emerging market countries. All kinds of ruses or excuses have been given to maintain development banks. I remember that we took development bank debt out of the definition of public sector debt a few years ago. Incredibly, the IMF allowed this move, and we justified it by saying that we were capitalizing the development banks. But who was capitalizing the development banks? The government! Although government money was injected, evidently it was really just an accounting transaction. We invented the fiction that the development banks were capitalized and thus removed these growing debts from the definition of public sector deficit. I think this was a wrong decision. In the past few years, ironically, the government deficit has been shown to be greater than the stated figure because development banks’ net lending has been negative. But most of their loans remain unrecoverable. Hence it is inexplicable why we persist in leaving development banks out of the assessment of the deficit, but I think the hope is, unfortunately, that these banks will continue to be an instrument of policy in the future. Chart 4 illustrates that Mexican development banks have not been repaying their debts in recent years and thus represent a potential government liability. There is also public investment disguised as private investment. There are off-budget items that are turnkey projects and are supposed to be self-financed, but the credit risk of these projects ultimately is in the hands of the government. So there is no way to excuse or rationalize putting these items off the budget.
There are other institutional problems in Mexico, like rigid labor laws, which were established in order to have a corporate-type relationship between the labor movement and the government. Furthermore, the lack of regional political competition is a serious problem in most of our countries. Why? Because having a centralized type of government doesn’t allow the type of tax collection, expenditure, and regulation at the local level that provides competition among localities. Although this issue hardly ever commands attention, I believe it is one of the most serious forms of backwardness that afflicts us. General judicial malfunctioning is, of course, another indicator that we have yet to develop a solid base for sustained, healthy development. The courts just don’t work. The ability to enforce a contract can depend on connections, bribes, the case reaching the upper, cleaner levels of the courts—or because you are lucky. Or enough time has gone by and it does not really matter who wins because, by then, the contract is worth so little that the victory is pointless. All these problems may yet explain why Argentina, Brazil, Mexico, and others have not achieved an investment grade credit rating. The lack of local capital markets, the growth of private sector foreign debt, and the resulting asset and liability mismatch, all feed expectations of further pressures on public finances and sustain high real interest rates. Debt restructuring is becoming more complex, with direct lending decreasing and a growing number of new lenders. This complexity is becoming quite a problem for all the renegotiations; we faced such a problem in 1995. Dispersed lenders do not feel pressured to lend, so even debt rollover becomes complicated. Therein lies the renewed pressure on the official international financial institutions. Greater distance between borrowers and lenders, coupled with the active role of international financial institutions, may be increasing moral hazard instead of diminishing it. Finally, I would like to conclude by mentioning again that nominal public deficits may hide large debts. We have the central government deficit or the public sector borrowing requirement, but we also have huge off-budget (at least in the case of Mexico) liabilities in development banks. We have financial requirements outside the budget as well. We have the problem of local governments and the problem of financing credit pensions in the future. Countries that have not tackled their moral hazard problem will face more financing needs. In this environment, medium-sized and small firms will suffer the most because big firms have access to international markets. To overcome these problems, the development of a common database is necessary for the evaluation of financial instruments. The success of the privatization process and the development of markets will determine financing needs in each country. There is also a need for an enhanced international supervisory role, but it will have to be a private one, not one based on international financial institutions, if it is going to be credible. References BANCO DE MÉXICO. “Información Financiera y Económica.” Available at http://www.banxico.org.mx. HALE, DAVID. 1996. “Lessons from the Mexican Crisis of 1995 for the Post Cold War International Order.” In World Bank (1996). ———. 1998. “Will Emerging Markets Outperform Wall Street after 1998?” Zurich Group (December 9). ———. 1999. “Stock Market Growth and Privatization in Developing Countries.” United Nations Conference on Privatization and Regulation (February 16). HAUSMANN, RICARDO, ERNESTO STEIN, CARMEN PAGÉS-SERRA, AND MICHAEL GAVIN. 1999. “Financial Turmoil and Choice of Exchange Rate Regime.” Inter-American Development Bank (January). INTERNATIONAL MONETARY FUND. 1985–91. World Economic Outlook. Washington, D.C.: International Monetary Fund. UNITED NATIONS. 1999. Conference on Privatization and Regulation (February). WORLD BANK. 1996. The World Bank Report on Mexico (February). |
very much appreciate the invitation to this conference by the Atlanta Fed. After two years in the private sector in the phone business, it is refreshing to be invited again in my capacity as an economist.
