The debt crisis affecting many developing countries has had three causes: imprudent management and borrowing by debtor countries; imprudent lending by banks; and rising interest rates. The unprecedented rise in real interest rates to about 6 percent by 1982 increased the burden on borrowers and completely changed the nature of the debt problem. In past debt crises, when loans were made at fixed rates, real interest rates rose with deflation. But once price levels stabilized, the interest burden would be higher only to the extent of the proportional decline in price levels, and it remained quite possible that inflation would eventually reduce the burden. In this crisis, though, the real interest rate has risen and stayed high, and inflation has brought no relief.
During the 1980s, fear of financial loss led US commercial banks to curtail sharply their lending activity in debtor countries. In 1982, nine large banks had over 250 percent of their capital in loans to developing countries; by mid-1986, the nine banks had reduced their activities to the point where they had sufficient equity and reserves to withstand potential losses. Although banks have stabilized their positions, many continue to carry developing-country debt at face value.
Present bank strategies deal with the debt crisis by extending the effective maturity of loans. Although any method that reduces the flow of resources from debtor countries will help in the short run, further lending promises little relief to the debt problem. As long as real interest rates remain high, developing countries will remain in debt.
Q. The author suggests that methods currently in place for dealing with the debt crisis are inadequate because they.
- A. increase the upward pressure on real interest rates without allowing any opportunity for reduction.
- B. allow real wages to rise at the expense of economic growth in debtor countries.
- C. fail to address problems of mismanagement in debtor and creditor countries.
- D. do not promote long-term growth.
- E. sacrifice a reduction of real interest rates for a short-term increase in loan maturity.