International_Economics_Tenth_Edition (1)

count on credit from the fund should it be needed. It also saves the drawing nation from administrative time delays when the loans are actually made.

General Arrangements

to Borrow

During the early 1960s, the question was raised whether the IMF had sufficient amounts of foreign currencies to meet the exchange-stabilization needs of its deficit member nations. Owing to the possibility that large drawings by major nations might exhaust the fund's stocks of foreign currencies, the General Arrangements to Borrow were initiated in 1962. Ten leading industrial nations, called the Group of Ten, originally agreed to lend the fund up to a maximum of $6 billion. In 1964, the Group of Ten expanded when Switzerland joined the group. By serving as an intermediary and guarantor, the fund could use these reserves to offer compensatory financial assistance to one or more of the participating nations. Such credit arrangements were expected to be used only when the deficit nation's borrowing needs exceeded the amount of assistance that could be provided under the fund's own drawing facilities.

The General Arrangements to Borrow do not provide a permanent increase in the supply of world reserves once the loans are repaid and world reserves revert back to their original levels. However, these arrangements have made world reserves more flexible and adaptable to the needs of deficit nations.

Swap Arrangements

During the early 1960s, there occurred a wave of speculative attacks against the U.S. dollar, based on expectations that it would be devalued in terms of other currencies. To help offset the flow of short-term capital out of the dollar into stronger foreign currencies, the U.S. Federal Reserve agreed with several central banks in 1962 to initiate reciprocal currency arrangements, commonly referred to as swap arrangements. Today, the swap network on which the United States depends to finance its interventions in the foreign-exchange market includes the central banks of Canada and Mexico.'

Swap arrangements are bilateral agreements between central banks. Each government provides for an exchange, or swap,

of currencies to help finance temporary payments disequilibrium. If Mexico, for example, is short of dollars, it can ask the Federal

Reserve to supply them in exchange for pesos. A drawing on the swap network is usually initiated by telephone, followed by an exchange of wire messages specifying terms and conditions. The actual swap is in the form of a foreign-exchange contract calling for the sale of dollars by the Federal Reserve for the currency of a foreign central bank. The nation requesting the swap is expected to use the funds to help ease its payments deficits and discourage speculative capital outflows. Swaps are to be repaid (reversed) within a stipulated period of time, normally within 3 to 12 months.

IInternational Lending Risk

In many respects, the principles that apply to international lending are similar to those of domestic lending: The lender needs to determine the credit risk that the borrower will default. When making international loans, however, bankers face two additional risks: country risk and currency risk.

Credit risk is financial and refers to the probability that part or all of the interest or principal of a loan will not be repaid. The larger the potential for default on a loan, the higher the interest rate that the bank must charge the borrower.

Assessing credit risk on international loans tends to be more difficult than on domestic loans. U.S. banks are often less familiar with foreign business practices and economic conditions than those in the United States. Obtaining reliable information to evaluate foreign credit risk can be

'Because of the formation of the European Central Bank and in light of 15 years of disuse, the hilateral swap arrangements 01 the Federal Reserve with many European central banks, such as Austria, Germany, and Belgium, were jointly deemed no longer necessary in view of the well-established, present-day arrangements for international monetary cooperation. Accordingly, the respective parties to the arrangements mutually agreed to allow them to lapse in 1998.

500 International Banking: Reserves, Debt, and Risk

time-consuming and costly. Many U.S. banks, therefore, confine their international lending to major multinational corporations and financial institutions. To attract lending by U.S. banks, a foreign government may provide assurances against default by a local private borrower, thus reducing the credit risk of the loan.

Country risk is political and is closely related to political developments in a country, especially the government's views concerning international investments and loans. Some governments encourage the inflow of foreign funds to foster domestic economic development. Fearing loss of national sovereignty, other governments may discourage such inflows by enacting additional taxes, profit restrictions, and wage/price controls that can hinder the ability of local borrowers to repay loans. In the extreme, foreign governments can expropriate the assets of foreign investors or make foreign loan repayments illegal.

Currency risk is economic and is associated with currency depreciations and appreciations as well as exchange controls. Some loans of u.s. banks are denominated in foreign currency instead of dollars. If the currency in which the loan is made depreciates against the dollar during the period of the loan, the repayment will be worth fewer dollars. If the foreign currency has a well-developed forward market, the loan may be hedged. But many foreign currencies, especially of the developing nations, do not have such markets, and loans denominated in these currencies cannot always be hedged to decrease this type of currency risk. Another type of currency risk arises from exchange controls, which are common in developing nations. Exchange controls restrict the movement of funds across national borders or limit a currency's convertibility into dollars for repayment, thus adding to the risk of international lenders.

When lending overseas, bankers must evaluate credit risk, country risk, and currency risk. Evaluating risks in foreign lending often results in detailed analyses, compiled by a bank's research

t~onallende:s consider detailed analyses too expensrve, they often use reports and statistical indicators to help them determine the risk of lending.

The Problem of

International Debt

Much concern has been voiced over the volume of international lending in recent years. At times, the concern has been that international lending was insufficient. Such was the case after the oil shocks in 1974-1975 and 1979-1980, when it was feared that some oil-importing developing nations might not be able to obtain loans to finance trade deficits resulting from the huge increases in the price of oil. It so happened that many oil-importing nations were able to borrow dollars from commercial banks. They paid the dollars to OPEC nations who redeposited the money in commercial banks, ~hich then re-lent the money to oil importers, and so on. In the 1970s, the banks were part of the solution; if they had not lent large sums to the developing nations, the oil shocks would have done far more damage to the world economy.

By the 1980s, however, commercial banks were viewed as part of an international debt problem because they had lent so much to developing nations. Flush with OPEC money after the oil price increases of the 1970s, the banks actively sought borrowers and had no trouble finding them among the developing nations. Some nations borrowed to prop up consumption because their living standards were already low and hit hard by oil-price hikes. Most nations borrowed to avoid cuts in development programs and to invest in energy projects. It was generally recognized that banks were successful in ~ecycling their OPEC deposits to developing nations following the first round of oil-price hikes in 1974 and 1975. But the international lending mech- a~ism encountered increasing difficulties beginning ~Ith the global recession of the early 1980s. In particular, some developing nations were unable to pay their external debts on schedule.

Table 17.2 summarizes the magnitude of the international debt problem of the developing nations. As of 1997, the external debt of the non--oil-developing nations stood at $1,966.5 billion; this was a sharp increase from the $328 billion level of the late 1970s. Much of this debt was incu~red by Latin American nations, including MeXICO and Brazil. As a percentage of the gross

domestic product of developing nations, external debt stood at 37.9 percent in 1997. From 1997 to 2003, the external debt of the developing nations leveled off, amounting to 37.7 percent of gross domestic product in 2003.

Another indicator of debt burden is the debt service/export ratio, which refers to scheduled interest and principal payments as a percentage of export earnings. The debt service/export ratio permits one to focus on two key indicators of whether a reduction in the debt burden is possible in the short run: (1) the interest rate that the nation pays on its external debt and (2) the growth in its exports of goods and services. All else being constant, a rise in the interest rate increases the debt service/export ratio, while a rise in exports decreases the ratio. It is a well-known rule of international finance that a nation's debt burden rises if the interest rate on the debt exceeds the rate of growth of exports. From 1987 to 2003, the developing nations' debt service/export ratio fell from 9.1 percent to 5.6 percent, as seen in Table 17.2.

Dealing with Debt-

Servicing Difficulties

A nation may experience debt-servicing problems for a number of reasons: (1) it may have pursued

improper macroeconomic policies that contribute to large balance-of-payments deficits, (2) it may have borrowed excessively or on unfavorable terms, or (3) it may have been affected by adverse economic events that it could not control.

Several options are available to a nation facing debt-servicing difficulties. First, it can cease repayments on its debt. Such an action, however, undermines confidence in the nation, making it difficult (if not impossible) for it to borrow in the future. Furthermore, the nation might be declared in default, in which case its assets (such as ships and aircraft) might be confiscated and sold to discharge the debt. As a group, however, developing nations in debt may have considerable leverage in winning concessions from their lenders.

A second option is for the nation to try to service its debt at all costs. To do so may require the restriction of other foreign-exchange expenditures, a step that may be viewed as socially unacceptable.

Finally, a nation may seek debt rescheduling, which generally involves stretching out the original payment schedule of the debt. There is a cost because the debtor nation must pay interest on the amount outstanding until the debt has been repaid.

When a nation faces debt-servicingproblems, its creditors seek to reduce their exposure by collecting all interest and principal payments as they come

502 International Banking: Reserves, Debt, and Risk

due, while granting no new credit. But there is an old adage that goes as follows: When a man owes a bank $1,000, the bank owns him; but when a man owes the bank $1 million, he owns the bank. Banks with large amounts of international loans find it in their best interest to help the debtor recover financially. To deal with debt-servicing problems, therefore, debtor nations and their creditors generally attempt to negotiate rescheduling agreements. That is, creditors agree to lengthen the time period for repayment of the principal and sometimes part of the interest on existing loans. Banks have little option but to accommodate demands for debt rescheduling because they do not want the debtor to officially default on the loan. With default, the bank's assets become nonperforming and subject to markdowns by government regulators. This could lead to possible withdrawals of deposits and bank insolvency.

Besides rescheduling debt with commercial banks, developing nations may obtain emergency loans from the IMP. The IMF provides loans to nations experiencing balance-of-payments difficulties provided that the borrowers initiate programs to correct these difficulties. By insistingon conditionality, the IMF asks borrowers to adopt austerity programs to shore up their economies and put their muddled finances in order. Such measures have resulted in the slashing of public expenditures, private consumption, and, in some cases,capital investment. Borrowers must also cut imports and expand exports. The IMF views austerity programs as a necessity becausewith a sovereigndebtor, there is no other way to make it pay back its loans. The IMF faces a difficult situation in deciding how tough to get with borrowers. If it goes soft and offers money on easier terms, it sets a precedent for other debtor nations. But if it miscalculatesand requires excessive austerity measures, it risks triggering political turmoil and possibly a declaration of default.

The IMF has been criticized, notably by developing nations, for demanding austerity policies that excessively emphasize short-term improvements in the balance of payments rather than fostering longrun economic growth. Developing nations also contend that the IMF austerity programs promote downward pressure on economic activity in nations that are already exposed to recessionary forces. The

crucial issue faced by the IMF is how to resolve the economic problems of the debtor nations in a manner most advantageous to them, to their creditors, and to the world as a whole. The mutually advantageous solution is one that enables these nations to achieve sustainable, noninflationary economic growth, thus assuring creditors of repayment and benefitingthe world economy through expansion of trade and economic activity.

Reducing Bank Exposure to Developing-Nation Debt

When developing nations cannot meet their debt obligations to foreign banks, the stability of the international financial system is threatened. Banks may react to this threat by increasing their capital base, setting aside reserves to cover losses, and reducing new loans to debtor nations.

Banks have additional means to improve their financial position. One method is to liquidate developing-nation debt by engaging in outright loan sales to other banks in the secondary market. But if there occurs an unexpected increase in the default risk of such loans, their market value will be less than their face value. The selling bank thus absorbs costs because its loans must be sold at a discount. Following the sale, the bank must adjust its balance sheet to take account of any previously unrecorded difference between the face value of the loans and their market value. Many small and medium-sized Ll.S. banks, eager to dump their bad loans in the 1980s, were willing to sell them in the secondary market at discounts as high as 70 percent, or 30 cents on the dollar. But many banks could not afford such huge discounts. Even worse, if the banks all rushed to sell bad loans at once, prices would fall further. Sales of loans in the secondary market were often viewed as a last-resort measure.

Another debt-reduction technique is the debt buyback, in which the government of the debtor nation buys the loans from the commercial bank at a discount. Banks have also engaged in debt-for- debt swaps, in which a bank exchanges its loans for securities issued by the debtor nation's government at a lower interest rate or discount.

Brazil owes Manufacturers Hanover Trust (of New York) $1 billion. Manufacturers Hanover decides to swap some of the debt for ownership shares in Companhia Suzano del Papel e Celulose, a pulp- and-paper company. Here is what occurs:

•Manufacturers Hanover takes $115 million in Brazilian government-guaranteed loans to a Brazilian broker. The broker takes the loans to the Brazilian central bank'smonthly debt auction, where they are valued at an average of 87 cents on the dollar.

•Through the broker, Manufacturers Hanover exchanges the loans at the central bank for $100 million worth of Brazilian cruzados. The broker is paid a commission, and the central bank retires the loans.

•With its cruzados, Manufacturers Hanover purchases 12 percent of Suzano's stock, and Suzano usesthe bank's fundsto increase capacity and exports.

Cutting losses on developing-nation loans has sometimes involved banks in debt/equity swaps. Under this approach, a commercial bank sells its loans at a discount to the developing-nation government for local currency, which it then uses to finance an equity investment in the debtor nation. In the late 1980s, Citicorp converted some of its Chilean loans into pesos, which were used to purchase ownership shares in Chilean gold mines and pulp mills. Citicorp maintained that it could get better value by selling and swapping the loans without using the secondary market. In Chile, Citicorp typically converted debt at about 87 cents worth of local currency for each $1 of debt. Although debt/equity swaps enhance a bank's chances of selling developing-nation debt, they do not necessarily decrease its risk. Some equity investments in developing nations may be just as risky as the loans that were swapped for local factories or land. Moreover, banks that acquire an equity interest in developing-nation assets may not have the knowledge to manage those assets. Debtor nations also worry that debt/equity swaps will allow major companies to fall into foreign hands.

Debt Reduction and Debt

Forgiveness

Another method of coping with developing-nation debt involves programs enacted for debt reduction and debt forgiveness. Debt reduction refers to any

voluntary scheme that lessens the burden on the debtor nation to service its external debt. Debt reduction is accomplished through two main approaches. The first is the use of negotiated modifications in the terms and conditions of the contracted debt, such as debt reschedulings, retiming of interest payments, and improved borrowing terms. Debt reduction may also be achieved through measures such as debt/equity swaps and debt buybacks. The purpose of debt reduction is to foster comprehensive policies for economic growth by easing the ability of the debtor nation to service its debt, thus freeing resources that will be used for investment.

Some proponents of debt relief maintain that the lending nations should permit debt forgiveness. Debt forgiveness refers to any arrangement that reduces the value of contractual obligations of the debtor nation; it includes schemes such as markdowns or write-offs of developing-nation debt or the abrogation of existing obligations to pay interest.

Debt-forgiveness advocates maintain that the most heavily indebted developing nations are unable to servicetheir external debt and maintain an acceptable rate of per capita income growth because their debt burden is overwhelming. They contend that if some of this debt were forgiven, a debtor nation could use the freed-up foreign-exchange resources to increase its imports and invest domestically, thus increasing domestic economic growth rates. The release of the limitation on foreign exchange would

504 International Banking: Reserves, Debt, and Risk

provide the debtor nation additional incentive to invest because it would not have to share as much of the benefits of its increased growth and investment with its creditors in the form of interest payments. Moreover, debt forgiveness would allow the debtor nation to service its debt more easily; this would reduce the debt-load burden of a debtor nation and could potentially lead to greater inflows of foreign investment.

Debt-forgiveness critics question whether the amount of debt is a major limitation on developingnation growth and whether that growth would in fact resume if a large portion of that debt were forgiven. They contend that nations such as Indonesia and South Korea have experienced large amounts of external debt relative to national output but have not faced debt-servicing problems. Also, debt forgiveness does not guarantee that the freed-up foreign-exchange resources will be used productively-that is, invested in sectors that will ultimately generate additional foreign exchange.

I The Eurocurrency Market

One of the most widely misunderstood topics in international finance is the nature and operation of the eurocurrency market. This market operates as a financial intermediary, bringing together lenders and borrowers. It serves as one of the most important tools for moving short-term funds across national borders. When the eurocurrency market first came into existence in the 1950s, its volume was estimated to be approximately $1 billion. The size of the eurocurrency market in the mid-1990s was estimated to be more than $5 trillion.

Eurocurrencies are deposits, denominated and payable in dollars and other foreign currenciessuch as the Swiss franc-in banks outside the United States, primarily in London, the market's center. The term eurocurrency market is something of a misnomer because much eurocurrency trading occurs in non-European centers, such as Hong Kong and Singapore. Dollar deposits located in banks outside the United States are known as eurodollars, and banks that conduct trading in the markets for eurocurrencies (including the dollar) are designated eurobanks.

Eurocurrency depositors may be foreign exporters who have sold products in the United

States and have received dollars in payment. They may also be U.S. residents who have withdrawn funds from their accounts in the United States and put them in a bank overseas. Foreign-currency deposits in overseas banks are generally for a specified time period and bear a stated yield, because most eurocurrency deposits are held for investment rather than as transaction balances.

Borrowers go to eurocurrency banks for a variety of purposes. When the market was first developed, borrowers were primarily corporations that required financing for international trade. But other lending opportunities have evolved with the market's development. Borrowers currently include the British government and U.S. banks.

Development of the

Eurocurrency Market

Although several hundred banks currently issue eurocurrency deposits on investor demand, it was not until the late 1950s and early 1960s that the market began to gain prominence as a major source of short-term capital. Several factors contributed to the eurocurrency market's growth.

One factor was fear that deposits held in the United States would be frozen by the government in the event of an international conflict. The Eastern European countries, notably Russia, were among the first depositors of dollars in European banks, because during World War II the United States had impounded Russian dollar holdings located in U.S. banks. Russia was thus motivated to maintain dollar holdings free from U.S. regulation.

Ceilings on interest rates that U.S. banks could pay on savings deposits provided another reason for the eurocurrency market's growth. These ceilings limited the U.S. banks in competing with foreign banks for deposits. During the 1930s, the Federal Reservesystem under Regulation Q established ceiling rates to prevent banks from paying excessive interest rates on savings accounts and thus being forced to make risky loans to generate high earnings. By the late 1950s, when London was paying

interest rates on dollar deposits that exceeded the levels set by Regulation Q, it was profitable for u.s.

residents and foreigners to transfer their dollar balances to London. Large U.S. banks directed their foreign branches to bid for dollars by offering higher interest rates than those allowed in the United

States. The parent officesthen borrowed the money from their overseas branches. To limit such activity, the Federal Reserve in 1969 established high reserve requirements on head-office borrowings from abroad. In 1973, the Federal Reserve system made large-denomination certificates of deposit exempt from Regulation Q ceilings, further reducing the incentive to borrow funds from overseas branches.

In recent decades, the eurocurrency market has continued to grow. A major factor behind the sustained high growth of the market has been the risk-adjusted interest-rate advantage of eurocurrency deposits relative to domestic deposits, reflecting increases in the level of dollar interest rates and reductions in the perceived riskiness of euromarket deposits.

Financial Implications

Eurocurrencies have significant implications for international finance. By increasing the financial interdependence of nations involved in the market,

eurocurrencies facilitate the financing of international trade and investment. They may also reduce the need for official reserve financing, because a given quantity of dollars can support a large volume of international transactions. On the other hand, it is argued that eurocurrencies may undermine a nation's efforts to implement its monetary policy. Volatile movements of these balances into and out of a nation's banking system complicate a central bank's attempt to hit a monetary target.

Another concern is that the eurocurrency market does not face the same financial regulations as do the domestic banking systems of most industrialized nations. Should the eurocurrency banks not maintain sound reserve requirements or enact responsible policies, the pyramid of eurocurrency credit might collapse. Such fears became Widespread in 1974 with the failure of the Franklin National Bank in the United States and the Bankus Herstatt of Germany, both of which lost huge sums speculating in the foreign-exchange market.

1.The purpose of international reserves is to permit nations to bridge the gap between monetary receipts and payments. Deficit nations can use international reserves to buy time in order to postpone adjustment measures.

2.The demand for international reserves depends on two major factors: (a) the monetary value of international transactions and (b) the size and duration of balance-of-payments disequilibrium.

3.The need for international reserves tends to become less acute under a system of floating exchange rates than under a system of fixed rates. The more efficient the international adjustment mechanism and the greater the extent of international policy coordination, the smaller the need for international reserves.

4.The supply of international reserves consists of owned and borrowed reserves. Among the major sources of reserves are (a) foreign currencies, (b) monetary gold stocks, (c) special drawing rights, (d) IMF drawing positions,

(e)the General Arrangements to Borrow, and

(f)swap arrangements.

5.When making international loans, bankers face credit risk, country risk, and currency risk.

6.Among the indicators used to analyze a nation's external debt position are its debt-to- export ratio and debt service/export ratio.

7.A nation experiencing debt-servicing difficulties has several options: (a) cease repayment on its debt, (b) service its debt at all costs, or

(c) reschedule its debt. Debt rescheduling has been widely used by borrowing nations in recent years.

8.A bank can reduce its exposure to developingnation debt through outright loan sales in the secondary market, debt buybacks, debt-for- debt swaps, and debt/equity swaps.

9.Eurocurrencies are deposits, denominated and payable in dollars and other foreign currencies, in banks outside the United States. Dollar deposits located in banks outside the United States are called eurodollars, and banks that conduct trading in markets for eurocurrencies are known as eurobanks.

•Basket valuation (page 498)

•Conditionality (page 502)

•Country risk (page 500)

•Credit risk (page 499)

•Currency risk (page 500)

•Debt/equity swaps

(page 503)

•Debt forgiveness (page 503)

•Debt reduction (page 503)

•Debt service/export ratio

(page 501)

•Demand for international reserves (page 491)

•Demonetization of gold

(page 497)

•Eurocurrency market

(page 504)

•General Arrangements to Borrow (page 499)

•Gold exchange standard

(page 496)

•Gold standard (page 495)

•IMF drawings (page 498)

•International reserves

(page 491)

•Liquidity problem

(page 495)

•Special drawing rights (SDRs) (page 497)

•Supply of international reserves (page 494)

•Swap arrangements

(page 499)

1.A nation's need for international reserves is similar to an individual's desire to hold cash balances. Explain.

2.What are the major factors that determine a nation's demand for international reserves?

3.The total supply of international reserves consists of two categories: (a) owned reserves and (b) borrowed reserves. What do these categories include?

4.In terms of volume, which component of world reserves is currently most important? Which is currently least important?

5.What is meant by a reserve currency? Historically, which currencies have assumed this role?

6.What is the current role of gold in the international monetary system?

7.What advantages does a gold exchange standard have over a pure gold standard?

8.What are special drawing rights? Why were they created? How is their value determined?

9.What facilities exist for trading nations that wish to borrow international reserves?

10.What caused the international debt problem of the developing nations in the 1980s? Why did this debt problem threaten the stability of the international banking system?

11.What is a eurocurrency? How did the eurocurrency market develop?

12.What risks do bankers assume when making loans to foreign borrowers?

13.Distinguish between debt-to-export ratio and debt service/export ratio.

14.What options are available to a nation experiencing debt-servicing difficulties? What limitations apply to each option?

15.What methods do banks use to reduce their exposure to developing-nation debt?

16.How can debt/equity swaps help banks reduce losses on developing-nation loans?

17.1 The World Bank Group provides various forms of assistanceto developing countries in order to promote economic growth and investment in people. Learn more about the World Bank by setting your browser to this URL:

http://www.worldbank.org

17.2 The European Central Bank was formed in June 1998 with 11 member states. Information can be found at this home page:

http://www.ecb.int

17.3 The Stern School of Business at New York University maintains a Web site

that provides extensive information and articles relating to instability in Asian financial markets. Visit this site by setting your browser to this URL:

http://www.stern.nyu.edu

17.4 The NYU Salomon Center for Research in Financial Institutions and Markets, a center within New York University's Stern Schoolof Business, supports academic research for the study of problems and issues related to the U.S. and global financial structure. Log onto their Web page at this URL:

http://www.stern.nyu.edu/salomon