The supply of Eurocurrency to developing countries Until 1970, developing countries had few potential sources of private external financing for balance of payments or development purposes. Since then, the expanding Euromarkets have become increasingly involved in filling this need. This article is based on a study that examined the nature and the growth of this involvement and presented a hypothesis to explain how Euromarket bankers establish criteria for lending to the developing world. Ishan Kapur

During the past seven years, a growing income, high and rapidly increasing export loans with maturities of over three years number of developing countries have bor- earnings, and a reasonably high rate of (and up to ten years or more), two inno- rowed increasing amounts from the - overall growth. According to World Bank vations occurred in the market to mini- market. This is not to suggest sources, about 15 of these relatively mize the lender risk arising from longer that access has been easy for all these higher-income developing countries, which maturities. The first was the creation of countries, nor that finance from this are also among the largest economies in the roll-over credit which is based on an market has been either cheap or always this group, owed about 85 per cent of all that is adjusted every three most suitable for development purposes. the medium- and long-term recorded pub- or six months and therefore protects the While some developing countries have lic debt to foreign banks of developing lender (as well as the borrower) to a had access to international and foreign countries (excluding oil exporters) in 1973, larger extent than a fixed interest rate bond markets, as well as to bank loans, and this proportion has remained rela- loan. The second was the spreading of the overwhelming proportion of borrow- tively stable until now. default risk over a large number of banks ings have been through medium-term by syndicating a loan, which limited the syndicated credits with floating interest The market liability of any one bank in a large credit. rates. Conservative estimates made by the The term Eurocurrency market is a Partly as a result of the latter develop- Bank for International Settlements indi- broad catch-all for a number of specific cate that medium- and long-term lending markets separated by the type of trans- from banks in the Group of Ten countries action, institutional arrangements, by the and to developing countries use of various instruments for financial increased from about US$2 billion in 1971 dealings, sometimes geographical location, to $10 billion in 1973, and to $17 billion and even by the lack of standardization in 1975. Other tentative estimates indi- on the part of European central banks in cate that such lending was about $21 bil- their use of terminology. The largest seg- lion in 1976. ment of the Euromarket was, and is, the The substantial, and increasing, amounts interbank market, which is essentially being borrowed by developing countries short-term in nature and its dealings with through the Eurocurrency market have developing countries are not substantial. been largely concentrated among rela- Most of the transactions on the Eurocur- tively few high-income countries, such as rency market by developing countries Argentina, Brazil, Mexico, and Peru. have been through syndicated medium- There was a perceptible shift in favor of term credits. Such lending operations con- lending to middle-income countries during sist of credits syndicated among numer- 1973 and 1974. However, at least in the ous banks and usually based on the case of some of these countries with debt six-month London interbank offer rate management problems or those perceived (LIBOR) as a result of which the loan to be overextended in the markets, the rate is adjusted every six months until ability to raise large amounts of Euro- final maturity. In addition to the base rate, currency loans diminished somewhat a "spread" over LIBOR as well as various toward the end of 1975. Apart from the front-end fees are charged by the lending few developing countries that borrowed banks. regularly and substantially, other borrow- The syndicated credit market developed ings by developing countries have been during the late 1960s and was a major erratic and insubstantial. The few borrow- factor in facilitating the access of develop- ers have tended to consist of developing ing countries to Eurocurrency funds. As countries with a relatively high per capita the demand increased for medium-term 32

©International Monetary Fund. Not for Redistribution ment, the size of individual loans increased The Eurobanks, in 1974, were pre- considerations underlying the supply of substantially during the past eight years. occupied with a new set of problems: the Eurocurrency finance to developing coun- substantial short-term depositing of funds "Tolerance levels" tries. It has been difficult, until fairly by the oil exporting countries combined recently, to obtain reliable data on the An important factor that has often been with demands for medium- and long-term overall magnitude and specific share of missed in analyses of this expansion in funds from some industrial countries Eurocurrency finance going to individual medium-term lending is the changing financing their enlarged balance of pay- countries. International bankers, more- "tolerance level" of the banks in the Euro- ments deficits. As far as developing coun- over, have been on the whole reluctant to markets. During the 1960s, for example, tries were concerned, the nervousness and reveal the assumptions and factors that in the absence of a large syndicated mar- fear of overextension on the part of some determine the flow of such finance to ket, individual banks had to commit them- major banks—which had initially arisen individual countries. selves to very large amounts on loans to because of portfolio maladjustments and The reasoning in the study focused on any particular developing country. Per- currency speculation—were exacerbated by the lender's assessment of the probability formance indicators began to be viewed the publicized inability of certain coun- of default by the borrowers in repaying in a much less stringent light during the tries to meet their short-term obligations. the loans, given the diversity of borrowers 1970-73 period than they were some years Under such circumstances, it was inevita- and the inability of the lender to discrimi- earlier. This was due partly to the rapid ble that while banks were keen to main- nate perfectly between borrowers. The expansion of the syndicated medium-term tain or increase lending levels in a few argument runs as follows: first, if they market in the early 1970s which coincided countries, if for no other reason than to could, lenders would discriminate among with extremely high rates of increase of prevent immediate repayment problems, borrowers through interest and noninter- commodity prices and, as a consequence, on the whole there was considerable selec- est elements in the price of loans. And of exports of many developing countries. tivity in lending to most developing coun- second, under market conditions where (The index of export prices of products tries. perfect discrimination is not possible or from developing countries, excluding oil, Retrenchment, and the restructuring of necessary (for institutional or other rea- rose by an average of 15 per cent per loan activity and internal control mech- sons), while the interest and noninterest annum between 1971 and 1973. See the anisms characterized Euromarket banks price of loans will reflect only part of the article by L. Goreux in this issue.) As from mid-1974 to the first half of 1975. differences in creditworthiness among bor- familiarity with lending to developing The strong revival of interbank business rowers, the allocation of loans will be countries grew, the market was willing in during 1975 indicated an easing of tension based on a system of quantity rationing. later years to lend to borrowers with that had been initially caused by fears of Credit rationing would not occur if lend- higher debt-service ratios (debt service as bank insolvency. The high level of liquid- ers could demand from each borrower an a percentage of earnings from exports of ity in the market, combined with the interest rate (as well as noninterest terms) goods and nonfactor services) and lower appearance of new borrowers, and the perfectly commensurate with the risk levels of growth in gross national product lack of demand from industrial countries, attached to each loan, judged naturally on (GNP). Much of the rapid growth in lend- were responsible for a very large increase an ex ante basis. ing to developing countries resulted not in Eurocredits to developing countries. It was assumed that the lender would so much from an improvement in these While the share of medium-term lend- establish differences in the interest price countries' economic position, though that ing to developing countries has increased between borrowers on the basis of the was undoubtedly a major factor, as from since mid-1975 compared with the early amount of the loan, the objective probabil- changes within the Euromarkets them- 1970s (even though it is still concentrated ity of default, and a calculation of selves. heavily among a few countries), the expected profits. An increase in the loan The considerable increase in loanable maturities of such loans have considerably rate, therefore, implies for the bank an funds in the Euromarket banks (or Euro- shortened and base interest rates have increase in the probability of a default, banks) during the late 1960s and early declined. Credits of over ten years matu- and/or a decrease in the likelihood that a 1970s encouraged them to lend to bor- rity, which had accounted for about 15 given level of expected profits would rowers that may have previously been per cent of all bank credits to developing occur. Therefore, while lenders were assessed as marginal. Commitments of countries in 1973 and 1974, were virtually assumed to discriminate between borrow- new bank credits to developing countries nonexistent during 1975 and 1976; in ers through small differences in price, it increased by almost 60 per cent in 1972 addition, there was a significant decline in was not considered possible to raise the and 75 per cent in 1973, as the balance the proportion of credits of a maturity price for marginal borrowers without of payments situation and prospects of over six years. This substantial shortening increasing the probability of default these countries improved, although private of maturities has had serious repercus- beyond acceptable levels. bank credits replaced other sources of sions on the debt profiles of several devel- Beyond a certain point, however, bor- funds such as suppliers' credits and inter- oping countries and will be reflected in rowers will not be able to borrow further governmental in some countries. As the debt service payments they will have regardless of the interest rate they are the proportion of private bank credits in to make through the period 1977-80. willing to pay. This would be consistent overall debt increased, the rate of total with profit maximization on the part of disbursement went up substantially and The analytical framework banks since it would suggest equalization net capital flows showed a sharp increase of the profit/risk ratio over the entire between 1970 and 1973 of 36 per cent The preceding section gives the back- asset portfolio. In order to equalize the per annum. This rate fell back to 28 per ground against which a study was made, default risk for the marginal borrower, cent in 1974, when lenders became more during 1976, on how lending criteria are banks use quantitative limits, sometimes cautious and selective as a result of the determined within the market. There exist also referred to as exposure levels. The considerable expansion during 1972-73. serious lacunae in our knowledge of the limits themselves will be based on criteria 33

©International Monetary Fund. Not for Redistribution for judging the overall economic perform- that is, the ratio of future debt service on nomic performance and the initial level of ance of the borrower and will tend to existing debt to projected exports of goods bank lending. change as market supply conditions and services. This particular indicator has For analytical purposes, it is being sug- change or as perceptions of default risk been widely used historically and some- gested here that Euromarket banks make attached to various borrowers alter. The times out of context, and has come under perfectly targeted portfolio decisions at argument assumes that borrowers offering severe criticism in recent literature, but the beginning of a time period, which will to pay a higher interest price than the many bankers still tend to consider this lead to some clearly measurable allocation existing maximum rate will do so only ratio an important indicator of a country's among borrowers for that entire period. if they are not creditworthy at a lower vulnerability over the medium term. Ex- However, this hypothesis should not be interest price; under such circumstances, ports of goods and services in absolute taken to mean that the process of lending even above the maximum existing interest terms can be used to differentiate between is in actual fact either so simple or so price, bankers will limit the quantity sup- countries on the basis of economic size. clear-cut. plied to those borrowers on the grounds that the bounds of exposure have already Banks manipulate the quantity of credit supplied to an been reached for the existing level of individual borrower through an informal system of rationing based creditworthiness. The nominal expression of relative de- upon the banks' perceptions of borrower "creditworthiness." fault risk by the lending bank is the size of the spread and, to a lesser extent, There is, in addition, an a priori reason to The flow of Eurocurrency funds to a management fees. Other elements of the believe that relative export performance is country is expected to be inversely related total cost of funds, such as repayment a significant factor in explaining the abso- to the existing level of bank lending to terms and maturities, are not so much the lute flow of Eurocurrency finance to devel- that country at the beginning of the result of risk perception of the bank re- oping countries. period. The larger the proportion of total garding the individual borrowers but The study suggests that bankers base loans contracted with one (or two) bor- rather the overall state of the market. In their judgments about lending among rowers, the greater the probable vulner- 1974 and the first half of 1975, for exam- countries on the above criteria or on some ability of the bank concerned in terms of ple, when overall maturities shortened, the close variants. The hypothesis can be ex- default risk. Typically, Euromarket banks contraction within various categories of pressed as follows: the flow of Eurocredit (in the same manner as other lending loans was not directly related to the class to a country during a specific period is institutions) tend to derive rationing limits of borrower. related to the flow of exports; the average for countries by making conventional growth in GNP over the previous three portfolio decisions based on risk aversion. Creditworthiness and rationing years; the expected changes in the debt- Two factors are important here: first, the service ratio; the relative level of liquidity; degree to which a bank is willing to com- Banks manipulate the quantity of credit and the stock of claims outstanding at the mit itself heavily in one country or to supplied to an individual borrower through end of the previous period. Banks prob- one borrower will naturally change over an informal system of rationing based ably make initial portfolio decisions in time as economic conditions change, either upon the banks' perceptions of borrower terms of the proportion of total claims in the borrower's economy or in the Euro- "creditworthiness." Since creditworthiness outstanding that are divided up among currency market itself. Second, individual is far too broad and all-encompassing a individual borrowers. The proportion of banks will also make judgments about concept to be defined unambiguously, the claims on each country would be adjusted their own levels of vulnerability in specific study attempted to isolate certain major to reach a desired exposure level, over a countries. It is not necessarily true, how- elements that enter into bankers' assess- period of time, through fresh flows of ever, that the concept can be applied to ments of country risk. It was assumed credit on the basis of that country's eco- the Euromarket as a whole by presuming that quantifiable indicators affecting credit- that market exposure is simply the sum of worthiness would fall into at least five the exposure levels of individual banks; broad categories: liquidity, overall growth, Ishan Kapur the existence of externalities in lend- external debt, export performance, and the ing preclude such a clear conclusion. How- existing level of bank exposure. Specific ever, the analysis is not significantly indicators must not only reflect the over- affected by ignoring the possible differ- all conditions in the economy but also ences between market exposure and the directly indicate the possibilities of default. an Indian citizen, summation of individual bank exposure Estimates of creditworthiness made use joined the fund staff in for any particular borrower. Banks are of each of these five factors. The conven- 1973, and is an econo- often influenced in their lending behavior, tional method of measuring liquidity— mist in the External moreover, by the presence of large de- using the ratio of gross international re- Finance Division of the posits that the bank may be holding serves to imports of goods and services— Exchange and Trade from the borrowing country. A number of was adopted as a measure of relative Relations Department. He was educated at countries hold their exchange reserves as liquidity levels among countries. The rate the Universities of Oxford (U.K.), New Delhi deposits in the Eurocurrency market, and of growth of a country's real GNP aver- (India), and Columbia (U.S.A.). He has some borrowers such as Brazil have, on worked on research teams for the United aged over two or three years gave a proxy occasion, redeposited their borrowings in Nations Conference on Trade and Develop- for the past overall economic performance ment, Princeton University, and Oxford the market. of the country. As an important indicator University, and has published several papers As far as the debt-service ratio is con- of the debt burden, the study used the on international finance. cerned, conventional wisdom suggests that expected growth in the debt-service ratio, bankers would be unwilling to lend large 34

©International Monetary Fund. Not for Redistribution amounts to countries which have had high doubtedly becomes more important in as- tical estimation confirmed the significance debt-service ratios in the recent past since sessments of developing countries with of the current level and expected growth the latter is considered an important indi- systems which may not be totally familiar in exports as a major factor in determining cator of a country's ability to repay over to international bankers. A major North relative creditworthiness. In addition, the the medium term. Three assumptions were American bank, very active in the Euro- projected change in the debt burden over made in the study: (1) bankers are not as markets, uses standard data forms to the medium term showed a strong rela- concerned about a high but stable debt- make a preliminary assessment of credit- tionship between perceptions of credit- service ratio as they are about a sharply worthiness of borrowers and assigns a worthiness as influenced by bankers' as- increasing rate of growth in that ratio— weight of roughly 20 per cent to political sessments of what is likely to happen to even if it is from an initially low level; (2) factors. However, while recognizing the the debt-service ratio and increases in it is the possible changes over the near importance of this element, its impact on bank lending to those countries. As was future in the debt-service ratio (as a crude the flow of Eurocurrency lending was expected, the existing level of country ex- measure of the ability of the borrower to ignored in the study. posure came out negatively related to the repay the loan) that are crucial as indi- Lastly, there is the clear implication in flow of funds. There seemed to be little cators of creditworthiness; and (3) in gen- the study that banks are a homogeneous relationship between the liquidity posi- eral, partly due to the short- and medium- group; this proposition does not, how- tions of countries and the supply of fresh term nature of the Eurocurrency market, ever, suggest that there are no special fac- loans. The overall real rate of growth of the time horizon used by bankers tends to tors in a particular bank-customer rela- income, viewed as a proxy for the general be fairly short. The higher the relative tionship which influence the bank's judg- health of the economy and adjusted to increase in the debt-service ratio expected ment. However, in general, such special take account of relative inflation, seemed in the near future, therefore, the lower factors supplement rather than replace the to be an important element in the mar- will be the flow of funds from the Euro- basic criteria for judging the creditworthi- ket's determination of relative credit- banks to that country. It should be men- ness of a borrower. worthiness. This is a slightly different tioned, however, that in some cases in the argument from the oft-cited view that the past, bankers have tended to grant fresh Results of estimation determining factor for the largest segment loans or roll over existing loans when of Eurocurrency lending has been the debt-service ratios of large borrowers had The hypothesis explained above was high-income level of the developing coun- reached extremely high levels, in order to tested by cross-section regression analysis tries it has gone to. On the whole, it is prevent default by borrowers. on data from 25 developing countries the countries with relatively faster rates of In general, it may be expected that the which borrowed from, the Eurocurrency growth that have been supplied larger higher the overall average rate of growth market during the period 1972-74. The amounts of funds and not only (or neces- in real GNP for an economy over a period countries were Argentina, Bolivia, Brazil, sarily) the ones with high absolute income of time (usually greater than one year), Colombia, Costa Rica, Egypt, Gabon, levels. the better will be its creditworthiness as Greece, Indonesia, India, Ivory Coast, The foregoing is not intended to suggest perceived by the lender. The growth rate Jamaica, Korea, Malaysia, Mexico, Nica- that decisions made by bankers on pro- of income may be interpreted as a proxy ragua, Peru, Philippines, Spain, Sudan, posed lending to individual countries are for the condition of the economy as a Thailand, Trinidad and Tobago, Yugo- based on a purely mechanical assessment whole, and rapidly growing economies slavia, Zaire, and Zambia. The World of a few economic indicators. In the first would be perceived as having a lower Bank definition, used here, includes Spain place, considerable importance is attached default risk, ceteris paribus, since the and Greece as developing countries. These to political and institutional stability and ability to repay external debt obligations countries included some oil exporters and past experience with the borrowing coun- would improve over time. ranged from those that have borrowed try. In the second place, even with respect Exports of goods and services are a sig- very large amounts, such as Mexico and to economic considerations, it is the over- nificant factor in determining the flow of Brazil, to those that have borrowed only all thrust of the borrowing country's loanable funds from the lender's point of insubstantial amounts from banks, such as policies and the bankers' experience with view. The level and growth of exports in India. specific elements of those policies that any individual economy have a bearing on The dependent variable in the regres- provide the basic framework for lending its liquidity position, debt-service ratio, sion consisted of the flow of funds from decisions. In addition, in particular years growth in GNP, and, as a combined result the London Eurocurrency market to each there could be special factors, such as of these various factors, ultimately on the of the sample countries. The London movements in world trade, influencing perceived creditworthiness of the country market is almost 50 per cent of the Euro- lending decisions. The usefulness of the in terms of default risk. The higher the currency market as defined by the Bank analysis contained in the study is indica- rate of growth of exports, relative to other for International Settlements' "Inner Re- tive rather than definite. More information countries, historically as well as forecast porting Area" of eight European coun- and further work are needed before con- for the immediate future, the higher will tries. The flow of funds from London to crete conclusions can be drawn on what is be the amount of funds that the banks the developing countries is a little smaller essentially a highly complex subject. ED will be willing to supply. than the proportion of the London Euro- An important factor that is difficult to currency market to the total size of the assess in quantitative terms is the percep- market. tion by banks of political stability. It is It was presumed that differential flows The original study, containing the well known that bankers assign consider- between borrowing countries would reflect methodology and statistical results, may able weight to what they consider to be differences in creditworthiness. The re- be obtained by writing directly to the politically strong and stable governments sults of the cross-section analysis may be author. in borrowing countries. This factor un- summarized briefly as follows: the statis- 35

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