From banks to bonds: a problem resolved? A perspective from the LDC debt literature

The anouncement in October 1995 of an agreement with Peru marked the concluding stages of the commercial bank debt crisis tirggered by Mexico in August 1982. With its completion all major Latin American nations will have succeeded in exchanging partially defaulted bank loans into marketed bonds therefore normalizing their external financial relations. After a lost decade'of great depression proportions for the continent, and stimulated by these post 1989 'Brady' agreements, the flow of net private funding to the developing countries approximately quadroupled in the present decade to reach almost $175 billion in 1994 (Sachs, 1990; World Bank, 1994) Recognizing that capital markets rather than the banks have been responsible for around half of the renewed flows, this survey assesses the contemporary relevance of the debt literature which was to mimic during the previous decade the earlier growth of commercial bank claims on LDCs. Although comprehensive surveys are available elsewhere, our intention is to review key arguments in the light of the securitization of finance during the present decade(see Eaton et al., 1986; Eaton and Taylor, 1986; Cohen, 1991; Eaton, 1993). The survey begins with theoretical aspects of the borrowing and lending decision, assuming optimizing agents, and noting the unavoidable complications introduced by sovereign risk which the literature has emphasized. Subsequently two key practical considerations are introduced, political exigency in the demand for loans and market derived instability in their supply. Difficulties in both of these areas were implicated in the financial crisis which culminated in the devaluation of the Mexican peso in December 1994. By offering the prospect that future crises could be contained without threats to the banking system necessitating official intervention, the revival of the capital market finance which favoured Mexico in the first half of the 1990s has been widely welcomed. Large-scale multilateral support in early 1995, however, was to cast doubt on this assumption and a final section therefore addresses changing perceptions of the role of the IMF in crisis management. If 'securitization' is seen as a return to the nineteenth-century norm in which bond issues, portfolio and direct investment dominated capital inflows to LDCs, comparitive studies suggest that a market panacea has not been rediscovered. Major loan expansions in the 1820s, 1880s 1900-14 and the 1920s all ended in default crises despite being dominated by bond finance (Eichengreen and Lindert, 1989). The fragile response of international investors to emerging market risk in general during early 1995 certainly suggests that the potential for systemic crises has not been eliminated by renewed reliance on marketed instruments. By distinguishing between problems which are general to international lending and those unique to bank intermediation, the survey attempts to highlight the basic requirements for sustainable capital inflows to LDCs. © 1997 by John Wiley & Sons, Ltd.