Transformation Of Developing Economy Debt Under Financial Capital: Effects Of Financial Growth On Developing Economies Since The 1970s

Transformation of Developing Economy Debt under Financial Capital Effects of financial growth on developing economies since the 1970s

Introduction This paper engages in the study of external debt structure in developing economies and their sustainable development based on foreign capital flows. Historically, debt has been a very important aspect for development of any society and has been an important social relation within different forms of economic and social organization at domestic as well as at an international level. An important change can be observed in the nature of debt and the way debt structures have formed between lenders and borrowers since the growth of finance in the 1970s. With debt being funded by financial capital and lenders largely consisting of market entities motivated by profit maximization on their investments, the borrowers in developing economies have repeatedly faced periods of crisis. These crises have often proved to be detrimental to the fundamental purpose of debt, i.e., supporting sustainable development and economic growth in the developing economies. When a debt structure based on financial capital inflows leads itself into a crisis there are particular aspects which throw light on the similarity in the inherent flaws in the lending-borrowing structures in the post-1970s period. For this purpose, the cases of Latin American crisis in 1982 and the Asian Crisis in 1997-98 have been examined to bring forth these flaws and the effect that they produce on indebtedness. Debt in the age of financial capital flows has become an imperative that starts to exist in a cycle in order to ensure future capital inflows and to create avenues for development within the debtor economies. Also, debt creates vulnerabilities in terms of the risk that is spread between the lenders and borrowers, which in an ideal case should be fostering growth and concretizing this debt structure, shifts the risk to the borrowers. This shifting of risk onto the borrowers highly increases the possibility of debt defaults that might occur should there be any divergence in the lender and borrower expectations and their perception towards sustainability of the particular debt model. The paper encompasses the change in vulnerability and externality associated with external debt over the period of financial developments from intermediation of the 1970s to the disintermediation and securitization of the late 1980s and the 1990s. These changes reflect the relationship between external debt and the process of development within the developing economies experiencing financial capital inflows. Most times the governments of these developing economies have found it extremely difficult to maintain macroeconomic stability in the face of growing financial capital inflows, thus resulting into a debt crisis, or with the changes discussed in the 1990s leading to a financial crisis. The effort is to articulate that external debt is not a neutral or natural process through which the developing economies stimulate growth and that the problem lies in the nature of debt within a global economy that is dependent on financial capital and, therefore, in 2

essence the focal point of the debate lies in the way debt structures form between lenders and borrowers in such a system.

External Debt and its Structures in Developing Economies Debt, in its most traditional structure, is understood as capital provided by a lender to a borrower, for the lender to earn a profit over the capital in the form of interest paid by the borrower. This understanding of the debt contract emphasizes the market transaction approach where debt can be considered a commodity, the price of which is based on the demand and supply forces in different markets. Considering debt a commodity is problematic because the debt contract differs in the nature of transaction, even though if it seems reasonable to analyze debt as a commodity being sold in a market. Debt contract is a promise to pay back a certain amount of capital, but in the future. A debt is the principal amount of capital that a lender gives away, thus, not being able to use this capital until the time the repayment is made, and on the other hand debt becomes the principal amount along with the interest over the principal that a borrower has to give back to the lender at a certain date in the future. The critical aspect of this promise to repay in the future is that this introduces uncertainty in the nature of transaction and fulfilment of lender’s future expectations. This uncertainty varies among different range of borrowers across different sections of an economy as well as within these sectional divisions. Key features of a debt contract have been discussed by E.P.Davis in his description of debt and some of these features bring out the sheer complexity of debt being a contract between two entities and its handling in domestic and international markets. The main features which remain within the interest of this paper are- interest payment on debt could be fixed or variable based on certain benchmark rate, collateral against a default, transferability of the debt, specification of circumstances under which a repayment transaction is categorized under debt default (Davis, 1992). All these features give a new dimension to factors which affect the uncertainty, transaction costs, risk assessment, and default handling for a particular instance of debt transaction. The fundamental problem with a debt transaction is the possibility of a borrower to default on the repayment of the debt. According to the theory of debt transactions, the lender holds the capability to seize control over the collateral against a default, but in practice the collateral might not hold a fixed value and there is a possibility of asset value depreciation as it depends on external factors beyond the control of the transaction. The default on debt repayment

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might reflect the macroeconomic conditions under which the borrower is situated and therefore would reflect the weakness of secondary markets for assets that the borrower loses as collateral. External debt is the money loaned to governments and corporations in foreign currency by agents like international private banks, foreign governments, foreign portfolio investors like mutual funds and pension funds, etc., over several years. Such forms of debt have been most prominent in the developing economies of the world. Domestic savings, trade surplus, and US dollar accumulation within developed economies are some of the factors which lead to investment in developing economies or emerging market economies. The investments by developed economies have historical precedence in terms of the preferential distribution of foreign capital lending. The investments that were made post-WWII comprised mostly of government aids and direct investment in developing economies. The account of capital flows in the 1950s and 1960s was in terms of the US government aid mainly. This aid was provided to the developing countries for economic development and social reform. Stephany Griffith-Jones and Osvald Sunkel put this form of aid in their own words – “The total level of gross US economic assistance to Latin America during the 1960s was rather impressive, exceeding US $10 billion for the period of 1961-9. However, net disbursements were substantially smaller. Over half of gross economic assistance was devoted to the repayments, amortization of previous loans, and interests. American official credits and aid were supposed to finance government investment programmes”. (Griffith-Jones and Sunkel, 1989) Although, there was a significant change in some of the developing countries in terms of economic growth social reform was still a neutral agenda. Many authors comment on this era of government aid as a form of political agenda of the US government to foster economic growth in new international markets, hold its own dominance in the international market shares, and to create new investment avenues by political democratization of the newly developing nations. With the reintroduction of the capital mobility framework in the post-Bretton Woods era of the 1970s, there was a visible structural shift in the form of lending and a change in the nature of borrowing by the developing countries, especially Latin American economies.

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Privatisation of the External Debt With participation of international financial institutions in foreign lending, all major investments were coming from the international private banks in terms of intermediated capital flows. At a later stage this paper will analyze how there has been a transition in forms of lending, i.e., from intermediation to disintermediation and securitization. But the important aspect to focus on is the introduction of new dimensions to traditional forms of lending and the introduction of unprecedented effects in the nature of debt contracts and the way debt structures form between the developed and developing nations. These lending patterns have something peculiar to themselves as these models of developed country investment and developing economy growth have often reached to an Private capital is allocated based on the risk assessment of the investment opportunities. The investment with higher risk provides an avenue for higher profit return. So the private capital outflows have always been diverted towards high growth rate countries. Emerging economies in each era have been hosts of large capital inflows, either by private international banks or by international investors. The growth rate dependent distribution of the foreign capital has been a detriment for low income economies as they have been deprived from resorts of private lending and their most important source of capital inflow has been the government aid, which unfortunately is very insignificant, when compared to the majority of capital flows in forms of private investment. Another important feature of the private capital flows has been the shorter maturity period for the debt repayment. The cost of borrowing private capital also becomes high as it reflects, in addition to other factors, the cost of lending which increases with increasing risk in the investments. Majority of this private capital has been in the form of financial flows which are conscious results of intermediation in the case of 70s and early 80s and disintermediation and securitization in the 90s (Eichengreen and Fishlow, 1998). Finance is assumed to effectively distribute the risk among the lenders and the borrowers by diffusing the risk from any single individual into an array of actors involved. In theory, the system of lending and borrowing in an international market should be much less vulnerable to shocks of default by some borrowers or the reduced supply of private capital by some lenders as the risk is spread on a broad transaction base. Practical observations of the past instances of financial private lending portray that financial flows have been mostly ineffective in the risk management of the whole borrower-lender system. The reason for this has been underlined by many authors that critique the various financial crises and they argue that financial flows in turn create greater risk for borrowers as interest rates on majority of the private capital has been variable. This variability adds a new dimension to uncertainty for 5

borrowers to plan their balance of payments which include the interest and principal payments. For lenders the increased interest rates lead to increased returns and higher credit risk, and this credit risk may or may not result in a debt default. Another risk which constitutes the overarching systemic risk in the foreign private capital flows is the contagion effect which can drastically reduce the supply of capital in times of distress, and therefore, can further fuel the problem of illiquidity which can sometimes result in problem of insolvency.

Indebtedness of Developing Countries An external debt is provided to a developing economy for the development of its economic, political, and social conditions. So, the external debt should make the host country able to repay the debt over the developments that have been made using the capital inflows that have been directed towards the above mentioned goals. But, international private capital is generally not based on any fundamentals of developments. As argued in a section above, the private capital flows always find avenues for maximization of profit over the investments, with a short-term view on the returns. Ironically, the external debt of the developing world has been increasing since the 1970s, even with ever increasing repayments the external debt has been accumulating increasingly over time. In essence the debt repayment has become a mode of debt expansion rather than lowering levels of debt for which the repayment is being made. A simple question arises- How can you owe more when you give your debt back? Well, in the private lending system, the variable interest rates are always a key to the structure of cycles of interest payments and amortization of previous debt. If the interest rates are increasing, gradually the debt repayment will become costlier in time as each successive repayment would become expensive than expected due to rise in interest payments, thus, leading to an increased cost of future borrowing for repayment of the current debt. This encourages increased borrowing within the developing countries, although majority of the borrowing is used for servicing previous debt contracts. So, the capital which can be used for the process of economic and social developments is a minority share of the total borrowed capital. Moreover, the incentives for the developing country governments and elites for pursing any developmental investments are overshadowed by the attractiveness of increasing foreign inflows. But in such a fragile framework, a sudden credit withdrawal by lenders can create structural problems for such governments and their economy to handle the pressures of debt obligations, often leading to monetary tightening and economic slowdown affecting the social and economic conditions of their population. 6

This enquiry into financial flows and their effects on developing country debt provides with certain insights into the privatization of the capital flows which render the indebtedness as a highly risky proposition for the developing economies. The private lending could take various forms like bank lending or portfolio investments-equity and debt financing, or securitization. The core of the problem with private capital flows has been the same all throughout the decades of 1970, 1980 and 1990. A further investigation into the nature of change that these private capital flows have brought about can be observed by imposition of the above characters of international financial capital onto incidences leading to financial crises in various developing economies at different times.

Private Capital Flows to Latin America The Euro-currency market consisted of international private banks which were located ‘offshore’ to wade away the regulations within the national banking system. This market saw a rapid growth from the mid 1960s and throughout the 1970s. Initially most capital flows from this Euro-currency market were towards the developed country multinational corporations for the purpose generating funds for their international projects, but there was a shift in the 1970s towards increased lending to the third world. This inclination of the International private banks to lend more to the developing economies was due to factors like increased competition and need for new borrowers for private capital investment, diversification of portfolio to spread the risk among different borrowers and to offset the low credit demand by developed countries, and sudden growth of demand within the developing countries due to trade balances and higher commodity prices. The two oil shocks proved to be backing this lending model by providing extreme levels of liquidity diverted towards the international banks due to petro-dollars from the OPEC nations and the heightened demand for foreign capital by developing nations, especially Latin American non-oil producing nations, due to a rise in commodity prices and a devaluation of the US dollar in the international market (Griffith-Jones and Sunkel, 1989). The developing countries in Latin America were experiencing increased public expenditure due to capital goods imports and thus there was a need to acquire foreign capital. Also, the governments in these economies found it easier to use private capital at their discretion because the international banks did not put conditionality on the disbursements of the loans. As compared to foreign direct investment or an official aid, the private capital inflows were less capable of creating transfer of ownership and thus remittances of profits and generated a lesser degree of dependence. The national governments seemed 7

to have more autonomy over policy and allocation of resources than compared to the traditional lending models. It is noteworthy to understand why there was a need to introduce variable interest rates for the long term loans provided by international banks as was the demand in developing economies of Latin America during the 1970s. The loans were extended for a longer maturity period as compared to the short term maturity of the inter-bank loans from where the credit for the large loans was generated. These inter-bank loans were dependent on LIBOR (London Inter-Bank Offer rate) or the US prime rate, which are interest rates for inter-bank lending. To avoid variance in the interest earned on the loans made to clients and the interest paid on the short term inter-bank loans, the interest rates for developing economy borrowers were maintained to float with a fixed reference rate like LIBOR or US prime rate. This hedged against the risk of any drop in profit returns of the international banks due to divergence of the two interest rates involved. Another risk spread strategy was to create syndicated loans for these developing economies, so that in case of a default the risk was spread among all the lenders- large and small banks, which together constituted the huge amount for these large loans. In this way, even the smaller banks could participate in the private lending model and thus there was a massive credit generation all through the 1970s.

Effects of Private Capital Flows on Latin America and its debt structures External debt in Latin America had serious impacts on the nature of being indebted and the structure of debt repayment. The majority of the funding to Latin America was coming from the international private banks, contracted at floating interest rate, and nearly all the funding was denominated in US dollars. The private capital flows stress on short-term gains on their capital investment, and therefore, create a need for repayment of the interest and the principal from the borrower in shorter maturities. Any change in the interest rate reflects in the contracted debt interest payments which would become hazardous for the borrowers if the increase in the interest rate makes it substantially high. All through the 1970s the interest rates in the US and around the world kept climbing up, only with a sudden upward spike in the 80s. Due to increasing interest rate, the debt repayments were more expensive as the interest on the debt was more than expected at the time of repayment. In effect the borrowing had to increase in order to accommodate for a larger capital increased interest payments, which brought developing economies of Latin America under a cycle of interest payment and amortization of previous debt. The way in which 8

the external debt was handled by the Latin American economies has been articulated by Marcus Arrudathrough exports and allowance for increased foreign investment, generating outward flows of profits and transfer of ownership. The first source generated foreign capital which was insufficient to cater to imports and debt repayment together, so new loans were inevitable to continue to serve the domestic spending and need for foreign capital for imports. So, there was a vicious circle of debt for the developing countries in Latin America, in which the financial capital played an important role in the origination, survival, and sustainability of this condition for the debtor nations. Cost of net transfer of capital from previous debts to new loans became unsustainable in the period of monetary tightening in since 1980, beyond which the interest rates in the US and in the rest of the world went soaring high. In an account of the interest rate appreciation during this period, Phil O’Brien says- “The vast bulk of Latin America’s debt had been contracted at a floating rate of interest. Between 1970 and 1973, the US prime rate averaged about 6.7 per cent in nominal terms. Between 1979 and 1982 this figure jumped to an average of 15.5 per cent, an all-time historical high. For Latin America debtors, the consequences were disastrous” (O’Brien, 1993). Such a drastic change was one of the factors which lead to the Latin American debt crisis, where the debtors found their debts swell to unexpected levels due to sudden interest rate hikes coupled with a withdrawal of international credit due to the increased fear of vey high credit risk among the creditors, i.e., the private international banks. The period of 1970s and early 1980s can be seen as a complex array of political and economic events and changes in the international financial system. An important observation made by O’Brien is that the elites in the society in the Latin American developing economies had a major role to play in the promotion of the structures of debt that existed before the crisis as they had their interests vested in the continuation of the private financial inflows. Also the government and large business houses in these economies were reluctant to change the model of funding. O’Brien stresses on the lack of a debtor cartel which could have solved the problem of continuing debt for previous debt repayments and other structural issues faced like the social cost and distress faced by these economies (1993). This explanation is negligent of the viewpoint of the creditors towards the debt crisis. Barbara Stallings proposes the view of creditors and debtors distinctively which can answer the question of the failure of a debtor cartel (Stallings, 1990). But these views are not sufficient to analyze or bring a change in the nature of debt that can break free the developing economies from the negative effects of the system of lending in place. In essence private financial capital flows create imperatives for the debtor nations to continue to receive financial flows or atleast attempt to acquire foreign capital while remaining in the loop of increasing loans to pay older debts whether the system be in crisis or not. 9

Private Capital Flows to Asian Economies and the new debt structures From the late 1980s the nature of international private capital investments went under a shift from the intermediation of the banks to disintermediation by financial institutions, and in response, the securitization of illiquid assets by private banks. All through the 1980s and in the 1990s the Asian economies experienced economic growth, while these economies were following a policy transition towards liberalization and privatization. This phase created a new form of debt structure for the corporations, the governments, and other actors in these developing economies in the form of debt financing through issue of standardized bonds which could be traded on the exchange. So, there was a surge in portfolio investments in these economies. Equity and debt financing became the major source of capital generation in these economies, which in a later phase became extremely dependent on such financial capital for economic development and social reform. Streams of capital inflows that followed the growth in Asian economies were inclined towards a new class of potential borrowers and new form of lender-borrower system, with new risk spreads that made borrowers distinctly vulnerable during a financial crisis. The movement of capital towards the Asian economies had other evident reasons like the stagnation of US equity-market and low interest rates in the US and around the world. Although portfolio equity is discussed a major problem in the origins of the Asian crisis, equity and debt markets have not been much apart in their function within these economies and the factors that affect these two markets are similar in nature. The link between the two markets is close because the corporations generate capital through their portfolio selection by either issuing shares in the equity market or bonds in the debt market. International investors face of a risk of devaluation due exposures in the domestic-currency assets and are vulnerable to exchange rate changes, macroeconomic stability of the developing economies, and movements of highly mobile foreign capital. All these factors in turn affect the borrowers in the financial markets as the withdrawal of high mobile financial capital from these emerging markets leads to drastic consequences for the real ‘developing’ economy, which is observed as rising debt repayment value for governments and corporations as the domestic interest rates rise to control the outflow of financial capital and in case of a devaluation of domestic currency makes the foreign capital is made still expensive.

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Debt Structures and Financial Crises Jeffery Sachs details three kinds of financial crises that can occur in emerging markets- fiscal crisis, exchange crisis, and banking crisis (Sachs, 1998). Often a financial crisis occurs in combination of these different forms as the underlying fundamentals causing these irregularities originate from a common base. Such systems of borrowing become extremely vulnerable to external shocks like oil price rise or change in dollar exchange rate or interest rate hikes, etc., often leading to a credit crisis a large movement of funds from domestic-currency assets into foreign-currency assets (Sachs, 1998). A very important aspect observed with the new innovations in the forms of lending is what Sachs calls a selffulfilling panic. “If a panic begins, and each creditor believes that the other creditors will withdraw their short-term claims, then individual creditors will also call their claims”. This panic can occur in a government bond market, or a financial market, or in the form loss of confidence in banks capability to serve all depositors due to lack of funds. This has a powerful impact on how the debtors will face the continuing cycle of debt and credit generation for sustaining development and amortization of previous debt. A sudden withdrawal of credit by lenders in any form of capital flows creates a kink in the debt structures of the developing country governments, corporations, and other debtor entities. The dependency, which is inherent to the debt raised within the realm of private capital lending, is a paradox in itself. The dependency creates growth within the economy and an increased public spending which further fuels economic growth in these economies, but at the same time it makes these developing economies extremely vulnerable to any divergence in the private capital lending patterns. Financial capital has a tendency to assume that external debt to developing economies is a sovereign debt, i.e., any outstanding debts, whether owed by private or public sector, in times of distress or macroeconomic instability within the economy making it unattractive for financial capital flows – is the responsibility of the government. Casting the importance of the discretionary authority of the state and consideration of this economy as a separate national economic unit having sovereign control over all actors within this economy creates an incentive for the creditors to put pressures for debt repayment or debt rescheduling at any cost as a government’s responsibility. Ankie Hoogvelt notes- “ The fiction of national sovereignty and independency and, above all, the illusion of a national currency must be constantly recreated and reproduced”. (Hoogvelt, 1994) The nature of risk that the new financial capital lending system carries with itself makes the developing economy debts much more vulnerable to shocks which can lead to self-fulfilling panics. In the equity

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markets, the risk associated with the domestic economy and industry is partly shifted to the lenders, foreign stockholders. As McCulloch and Petri put in their own words, “Analyses of capital flows to developing nations typically emphasize the total volume of flows and, in the light of Mexico and Southeast Asia, the volatility of those flows, rather than the particular channels flows happen to take. Yet the channel can be crucial to the effectiveness of foreign capital in achieving sustained development, as well as to the consequences should the lenders’ and borrowers’ expectations fail to be met. This is because the channels differ in the way lenders and borrowers interact both in shaping the productive activity and in sharing the risks and rewards”. In other words, they stress on the important distinction that the new form of financial capital makes to the condition of indebtedness for developing economies and creates disadvantage for the borrowers. Even the healthy borrowers, situated in a debt structure that arises with portfolio investments, suffer during a macroeconomic instability and face solvency issues due to investor dissatisfaction over certain factors within the economy. Another problem that exists with the short-term motives of portfolio flows is the large volumes of net capital flow relative to other balance of payment methods. McCulloch and Petri argue that this magnified dependency on one form of capital flows to maintain balance of payments puts pressure on the exchange rate in floating exchange rate regimes and domestic monetary base in regimes committed to fixed exchange rates. Increased portfolio flows, even when having a long term outlook towards investment in developing economies, produces disruptive effects in the macroeconomic stability and real exchange rate conducive to growth and development within these economies.

Conclusion External debt is an entity which can be seen as an orphaned construction that is driven by external factors like investor perceptions, changing interest rates and exchange rates, and changes in macroeconomic policies within the core countries of the world economy. The vulnerability of such debt structures has been observed in the different economic and financial crises since the 1970s. Borrowers have always been the larger bearers of the risk that is introduced by financial capital flows due to lenders continuous evaluation of the credit risk in emerging markets. A very difficult condition is imposed by external debt in terms of the efforts of developing economies to sustain foreign lending and amortization of previous debts. Systemic risk of contagion plagues the nature in which lenders respond 12

to future credit necessity of different actors in the developing economies, transforming corporate and government debts into financial liabilities. Financial debt values much more than social, political, and environmental debt within the developing economies due to the paradox of debt expansion (). In order to service previous debts the debtor economies further increase their debt levels at the cost of social spending and investment in production and development. As compared to bank loans portfolio investments are highly liquid in nature and are subject to rapid changes in expectations. So, the factors of vulnerability and externality of debt funded by financial capital become increasingly dominant in defining the debt structure and render drastic effects on the real economy and its development. Most explanations on the crisis by the neo-liberals ends in blaming government’s inability and bad policy for creating instability in the macroeconomic conditions of a developing economy. But as Miles Kahler writes- “The Bankruptcy analogy does not hold up, because in the case of a country there is no equivalent for the value of a firm, and, unlike incompetent mangers, governments cannot be removed by international means”. All the factors relating to debt that have been discussed above play a major role in defining the future of debt and its problematic relationship with the issues of international financial stability. An argument that can be drawn from the analysis of growth in developing markets is that rising prices and revaluation of domestic currency in times of rapid economic growth experienced by these economies makes the reduced the real value of the outstanding debt that gradually leads to a condition of overindebtedness (Rachel and Petri, 1998). In such a condition the debtors that find difficulty in servicing the debt can be forced by the creditors to liquidate their assets (collateral) and if the government becomes incompetent to support such events, they can become widespread and the condition can take the shape of a debt crisis forcing an economic slowdown.

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Arruda, Marcus (2000) “E(x)ternal Debt: Understanding Brazil’s Debt Crisis”, in Arruda, Marcus, External Debt: Brazil and in the International Financial Crisis, Pluto Press: 1-22

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