Defusing the Debt Bomb

by Christopher L. Culp

The international debt bomb is ticking away. The leaders of the "G-7" major industrialized nations recently met in Montreal to draw up a plan to defuse the crisis. Their efforts failed, as have all attempts since the problem emerged into public view in 1982. The bomb is still ticking, and given the superficial proposals now under consideration, we might as well prepare for the explosion.

Japanese Finance Minister Miyazawa proposed at the G-7 summit that debtor nations, particularly in Latin America, be forced to transfer parts of their reserve currencies to the International Monetary Fund. In turn, the IMF would manage loan repayments. Alternatively, French President Francois Mitterrand has suggested simply forgiving the outstanding debt.

Neither of these alternatives is attractive. The Miyazawa and Mitterrand proposals wouldn't change the conditions in debtor nations that led to the crisis in the first place. Rather, both seek to place a curtain around the debt bomb, hoping somehow that it would defuse itself. In reality, a solution will require that we rebuild the entire international lending system.

To rebuild the lending system, developing countries must be encouraged to replace their centrally planned economies with market-oriented economies that emphasize secure property rights and contracts, a strong entrepreneurial spirit, and a vigorous private sector. Promoting real economic growth eventually will allow debtor nations to defuse the debt bomb themselves.

A strong private sector is vital to growth and development. But stagnant, inefficient state-owned enterprises dominate the economies of many Third World countries. Such government-owned enterprises must be transferred through privatization to those able to make them productive. This would eliminate the tax burden of these enterprises, as well as stimulate growth.

Privatization increases ownership possibilities in the debtor nation's economy, thereby strengthening -- indeed, often creating -- capital markets. Increased capital market liquidity then stimulates growth, both by allowing consumers to buy and sell assets more readily and by promoting debt-forequity swaps. Private firms encountering repayment problems often find it advisable to offer greater equity participation to secure additional financing. Greater exchange of foreign debt for local equity can play a key role in reversing one of the major obstacles to Third World economic development -- capital flight.

When the rates of return on investments in a debtor nation are so low that its own citizens, not to mention foreigners, invest their assets elsewhere, a net outflow of capital occurs. In Argentina, for example, rates of return are so low that development loans frequently are reinvested in U.S. banks, thereby doing little for Argentina except broadening its debt obligation.

Privatization and debt/equity swaps can be instrumental in reversing the flow of capital. In Chile, for example, privatizations and debt/equity swaps were important parts of the liberalizing plan that reduced the Chilean debt by approximately 11 percent of Gross Domestic Product from 1986 to 1987. Debt/equity swaps during that period totalled 977 million dollars, and other direct investments -- stimulated by improving rates of return -- totalled 340 million dollars. By 1987, Chile's real growth rate had reached 5.7 percent, up from a negative 14.1 percent in 1982.

Increasing the role of the market in developing countries will enhance their growth rates and improve their returns on capital. To get out of the debt crisis, we need to encourage Third World countries to make money the old-fashioned way -- earn it through private market growth.