International Monetary Fund ; International finance ; Developing countries ; Debts, External

Hang-Sheng Cheng

English

Research Papers in Economics

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July 29,1983
Bailing Out Banks?
Congress is currently considering abill that
would authorize an $8.4 billion increase in
U.S. contributions to the International
Monetary Fund (IMF). President Reagan has
requested the legislation on the ground that
it is essential for averting an international
financial crisis that mightarise frorn large
defaults on banking debts ofthe less-
developed countries (LDCs). The bill has
encountered considerable opposition
because ofa widespread suspicion that its
real purpose is to bailoutbanks from their
past lending excesses. Although ithas
passed the Senate, a different version with
more stringent restrictions on future interna-
tional bank lending is being considered by
the House.
This Letter will examine four questions
related to the proposed legislation: (1) Is it
indeed for bailing out banks? (2) Should
there be conditions attached to itforguard-
ing against future lendingexcesses? (3) What
wouId be its cost to U.S. taxpayers and its
impacton U.s. financial markets? and (4)
Why should we spend money to help for-
eign nations instead ofourown economy?
Bank bail-out?
Like Damocles' sword, the threat of large
LDC-debt defaults has hung overthe inter-
national financial system since last summer.
Particularly worrisome is the extentofU.S.
banks' exposure to the threat. According to
Federal Reserve data, U.s. banking clairns
on the LDCs amounted to $99 billion at
mid-1982 and accounted for 149 percentof
the total capital ofall the banks that made
significant (exceeding $20 million) interna-
tionalloans. For the nine largest banks, the
total exposure arnounted to 222 percent of
their capital; their loans to Mexico, Brazil
and Argentina accounted for 112 percent.
Large exposure to LDCs are also common
among all the major banks outside the
United States. Thus, any large LDC-debt
defaults could seriously disrupt the U.S. and
world banking systems.
What has led to the current condition?
Broadly speaking, there are two schools of
thoughton this subject. Onemightbe called
the "solvency school," and the other the
"liquidity schooL" The former maintains
that the current distress is a result of
excessiveborrowingbythe LDCs abette(1by
banks' competition for loans. From this
viewpoint, the borrowing countries are not
unlike households or firms that have over-
extended themselves and are thus in a state
of "insolvency." The liquidityschool, on
the other hand, emphasizes the ternporary
nature ofthe borrowing countries' current
payment difficulties, stressing that they
arose from special factors duringthe last
three years: the prolonged world recession,
unprecedentedly high interest rates,and
banks' reluctance to roll over credits. From
this viewpoint, the present difficulties are
symptomaticofa"liquiditycrisis"thatarose
from a particularly severe world recession.
The truth may lie between these two polar
views. But wherever it lies, to try to pin
blame and fix responsibility now is perhaps
futile and pointless. When fighting a fire,
one cannot wait for adetermination of its
cause before deciding on a strategy for put-
ting itout. Fortunately for international
lending problems, a strategy has already
been developed and, thus far, successfully
implemented.
The strategy has five elements. First and
foremost, the commercial banks have been
induced, cajoled, orpressured to continue
lending to the hard-pressed debtor coun-
tries. From their individual Viewpoints, it
may not seem prudentto renew credits to
risky borrowers, and many banks have not
renewed loans. However, whatmight
appear to be individual prudence is collec-
tive folly, for afailure to renew loans is
precisely what would precipitate a financial
crisis. Second, in order to convince bankers
that they are notbeing asked to pour good
money after bad, public international finan-
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Ie=JOpinions expressed in tf'lLs newsletter do nol
necessarily retleet the vievv5 of tnp managernent
of the.' Federal Rl'serve Bank of San Frandsen,
or 01' the Board of Covernors of tfw federal
Reserve Svstem.
cial agencies, such as the IMF, musttake up
the slack in financing. Todothejob, the IMF
must have sufficient resources. The Admin-
istration's request is butthe U.S. share
in a proposed $43 billion increase in IMF
resources.
Third, as a part of IMF loan conditions, the
debtor countries must adopt and carry out
adjustment programs designed to reduce
their payments deficits. Fourth, since the
IMF loan packages take time to negotiate,
national governmentsand the Bankfor Inter-
national Settlements have provided large
emergency credits to debtor nations to tide
them over in the interim. Fifth, because
ultimatelythe debtornations' abilitiesto pay
depend on a worldwide economic recov-
ery, the industrial nations have agreed to
pursue economic policies that promote a
strong and sustainable recovery.
Thus, the proposed bill for authorizing an
increase in IMF resources is nota bail-outof
banks-the banks are being asked to con-
tinue lending-butan essential element in
the current strategy for safeguarding the
soundness ofthe international financial
system. As the world learned from theexper-
ience ofthe 1930s, a collapse ofthe world
financial system would have disastrous
effects on theworld economy, including
ourown.
Restrictions on future lending?
Underpublic pressure, Congress is attach-
ing conditions to the proposed bill intended
to avertfuture recurrences oflIexcessive"
lending. The version that has passed the
Senate is less stringent than that being con-
sidered by the House. The latter requires,
amongotherprovisions, thatbanks set aside
loan-loss reserves on foreign lending in
anticipation ofpotential repayment diffi-
cuIties. The total effect ofthe proposed
restrictions would be to make it more costly
and cumbersome for banks to make foreign
loans.
These proposed restrictions stem from a
valid concern overthe riskiness offoreign
2
lending. In addition to credit risk, foreign
lendingentails a "country risk" in that an
ordinarilysound loan mayturn sourbecause
ofunforeseen balance-of-payrnentsdifficul-
ties or political upheavals in the borrowing
country. This concern justifies extra caution
in assessing foreign lending risks, but itdoes
not warrant governrnent restrictions on for-
eign lending. After all, risk-taking is the
essence ofthe free-enterprise system, and it
is doubtful thatthe system would bewell
served by legislation that lirnits risk-taking.
Furthermore, there is little evidence that
governmentagencies are any wiserthan
marketparticipants in assessing risk.
Another legitimateconcern is the long run
advisabilityofrelyingon banks to finance
world paymentimbalances, thereby incur"
ringthe riskofrecurrent crises in the inter-
national financial system. However,this is a
long-run problem. Until a safer avenue is
found, there is noalternativebuttofollow
the same road and deal with crises as they
arise. In the rneantime, the currentstrategy
calls for banks notto reduce lendingto the
hard-pressed debtornations. To restrict
foreign lendingatthisjuncturewouldbe like
cuttingthewatersupplytofirefighters inthe
midstofa dangerous conflagration.
Budget cost and marketimpact
Thefund request comes ata timewhen
Congress is underpressure to trim govern-
mentspendingto reduce the budgetdeficit.
Would approval ofthe $8.4 billion bill not
increase the budgetdeficit?
Surprlsingly,theansweris no. Whathappens
after thebill is passed is thattheTreasury
wouldextenda standbycredittotheIMF; no
fundswould need to be madeavailableuntil
actual drawings occur. Upon a drawing, the
Treasury would raise funds from the market
byissuingsecurities. Thefund transfertothe
IMF would be a budgetoutlay, butunlike
other budgetoutlays, itwould be balanced
by an increaseofthe same amount in the
Treasury's reserve position atthe IMF.·
This reserve is an international liquid asset
available to the United States to drawupon,
without interestand without stringsattached, to finance U.S. payments deficits.
In fact, overthe past 19 years, the United
States has drawn on the IMF some 24 times
and, with acumulativetotal drawingof$6.5
billion, is the second largest user (after the
United Kingdom) ofIMF funds. Thus, bor-
rowingfrom the market and transferringthe
proceeds to the IMF is notunlike a house-
hold borrowing from an uncle and placing
thefunds in abankaccount. In nosense can
itbe interpreted as resulting in an increase in
thebudgetdeficit-eitherforahousehold or
for government.
Some mightargue thateven though the
analysis may be valid in budget accounting,
itnevertheless makes little economic sense
because the fund transfer implies that pur-
chasing powerwould be taken from the
market and transferred tothe debtor nations
through the IMF. This action presumably
would "crowd out" other marketborrowers
just as othertypes ofTreasury borrowing for
financing government spending would do.
This argument, though seemingly persua-
sive, failstocarrytheanalysisthroughtothe
end. Itcanbe shown that, unlikeothertypes
ofbudgetoutlays, fund transfers through the
IMF tothe debtor nations would raise U.s.
interest rates and crowd out U.s. domestic
spendingonly under certain circumstances.
There are only two types ofcases to con-
sider: onemay be called "purefinancial
transfers" and the other, "real transfers."
The former arises ifthe debtor nations used
IMF fundsto repay U.S. banks, thus restoring
the funds to the U.S. financial market. Ifthe
repayment were made to non-U.S. banks,
the same would result ifthe latter invested <
the funds by purchasing U.s. securities. In
eithercase, there would be no effecton U.S.
interest rates, no crowding-out, and zero
impact on the real economy.
Real transfers would arise only ifthe debtor
nations used the funds to increase their net
imports from the United States and not to
repay debts, or to repay debts to non-U.s.
banks and the lattertransferred the funds to
bank customers forthem to purchase goods
3
and services in the United States. In either
case, the funds would not be restored tothe
U.S. financial market, U.S. interest rates
would rise, and some U.S. expenditures
would be crowded out. Indeed, the rise in
interest rates would be the market mechan-
ism for makingthe resource transfers to
foreign nations.
In short, the Treasury financing would result
ina rise in U.S. interest rates onlyifthefunds
were used to finance a rise in U.s. exports.
Since underthe present circumstances the
IMF loans would be used almost entirely for
helping the LDCs repay theirexistingdebts
(nearly 40 percent ofwhich is owed to U.S.
banks), any "real transfer" effect would
likelybesmall relative tothetotal size ofthe
U.S. financial market ofmore than $400
billion net borrowing a year by domestic
non-financial sectors.
Foreign aid?
Lastly, thequestionofwhetherthe proposed
bill aids foreign nations or ourselves can be
answered quite simply: it aids both. As
stated, the proposed bill is an essential
elementin the existingstrategytoensurethe
stabilityofthe world financial system, one in
which the U.S. national interest is clearly at
stake.
A concrete case may help illustrate the
point. Mexico is ourthird largest trade
partner, after Canada and Japan. In 1982,
because ofits external debtproblem, itcut
its imports back drastically. As a result, our
exports to Mexicofell by a staggering 60
percent, and our $4 billion trade surplus
with Mexico in 1981 turned intoa$4 billion
deficit in 1982. Based on an estimate that
every $1 billion increase in U.s. exports
creates 24,000 new jobs in the U.S. econ-
omy, the Mexican debtproblem alone
appears to have cost the U.S. 200,000 jobs
in 1982. Clearly, in this case, anyaid to help
Mexico service its external debts will not
only help promote,world financial stability,
but will also benefitthe U.S. economy.
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Change from
year ago
Change
from
Amount
Outstanding
Selected Assets and Liabilities
Large Commercial Banks
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
7/13/83 716183 Dollar Percent
Loans (gross, adjusted) and investments" 162,235 - 878 1.562 1.0
loans (gross, adjusted) - total# 140,788 - 888 891 0.6
Commercial and industrial 43,932 - 329 36 0.1
Real estate 56,124 61 - 1,276 - 2.2
loans to individuals 23,944 25 594 2.5
Securities loans 2,504 - 108 261 11.7
U.S. Treasury securities* 8,392 17 1,765 26.6
Othersecurities* 13,053 - 7 - 1,094 - 7.7
Demand deposits - total# 41,937 -4,048 2,091 5.2
Demand deposits - adjusted 30,527 490 2,294 8..1
Savings deposits - totalt 66,794 - 474 36,052 117.3
Time deposits - total# 65,523 - 225 - 32,200 - 33.0
Individuals, part. & corp. 59,786 198 - 28,437 - 32.2
(large negotiable CD's) 18,912 - 234 - 17,524 - 48.1
Weekly Averages
of Dailv He:ures
Member Bank Reserve Position
Excess Reserves (+)/Oeficiency(-)
Borrowings
Net free reserves (+)/Net borrowed{-)
Weekended Weekended Comparable
7/13/83 7/6183 "ear-aoo neriod
122 141 56
ltl 807 10
42 - 666 46
*Excludes tradingaccountsecurities.
# Includes items notshown separately.
t IncludesMoney Market Deposit Accounts, Super-NOW accounts, and NOW accounts.
Editorial commentsmay beaddressed tothe editor(GregoryTong) ortotheauthor....Freecopies of
this and other Federal Reserve publicationscan be obti1iined by calling orwriting the Public Infor-
mation Section, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco 94120. Phone
(415) 974-2246.

Bailing out banks?

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Bailing out banks?

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