What Makes an Economy Creditworthy?

Forbes magazine defines a creditworthy borrower as one who “is able and responsible enough to repay their debts in a timely manner.” Creditors primary goal in offering loans is to turn a profit by charging a borrower interest. However, there is an intrinsic risk in this business model: what if the borrower is unable to pay the lender back? To guard against this possibility, creditors have created different ways of quantifying risk, such as credit scores. A potential borrower with a higher credit score has a history of financial responsibility, meaning they have a comparatively low risk of defaulting on their debts. Given the high likelihood that they will get a return on their investment, creditors will loan to these borrowers on better terms, offering low interest rates and higher credit limits. Alternatively, potential borrowers with low credit scores are riskier investments, so they will be offered less credit at worse terms, if they get a loan at all.

The same underlying logic that determines creditworthiness for individuals also extends to countries. There are a number of issues, ranging from wars to economic stimulus spending, which might cause budget shortfalls that force governments to take out loans. Creditors need to evaluate a country’s ability to pay back debts when they consider these loans, and that requires creating criteria that distinguish a country that is creditworthy from one that is not. But what are these criteria? Using the international debt crisis of 1982 and subsequent structural adjustment as a case study, this assignment will teach you what makes an economy creditworthy. After reading the primer text, you and your classmates will use data from the DemCap Analytics (DCA) tool to see whether the proposed determinants of a country’s creditworthiness match its official credit rating. Finally, you will consider whether intervention to rescue debtor countries is appropriate and whether policies that improve creditworthiness are harmful to economic growth.

Countries are under many of the same pressures as individuals when it comes to borrowing. They need to keep their spending at manageable levels and maintain steady earnings to avoid late payments or defaults. The 1982 International Debt Crisis and its aftermath illustrate what aspects of a country might make it a risky investment for creditors, as well as what remedial steps need to be taken to make debtor economies creditworthy.

In the 1960s, many developing countries in Latin America and Africa attempted to industrialize their economies to reduce their dependence on foreign imports. This strategy, known as import substitution industrialization, required substantial state intervention and protectionist trade policies to bolster fledgling industrial sectors. For a time these reforms yielded positive results. Countries borrowed money liberally throughout the 1960s and 70s to finance industrialization, and because they were seeing healthy GDP growth creditors were eager to provide loans. Indeed, less-developed countries (LDCs) saw their real domestic products increase by an average of 6% annually in the decade before 1973, and they saw more modest but respectable 4-5% growth through the end of the 1970s.

However, this topline growth obscured many warning signs that the developing world was a risky investment. Higher energy prices, caused by the 1973 oil crisis, put inflationary pressures on the global economy and increased the cost of imported goods for LDCs. LDCs started to borrow more money to finance their deficits. Total outstanding debts for across Latin American countries were $29 billion at the start of 1971; by year-end 1978, these debts totalled $159 billion. Most LDCs had debt-service ratios (debt service payments divided by export earnings) of well over 30%,with some countries like Brazil exceeding 60%. A debt-service ratio above 30% is typically considered unacceptable for lenders.

The United States raised its interest rates to curb domestic inflation in the early 1980s, and this had the downstream effect of increasing debt-servicing costs for developing countries. Most new loans LDCs took out between 1979 and 1982 were used to service existing debts rather than to promote economic development. An international recession in 1981 coupled with low commodity prices further exacerbated LDC’s payment problems. This crisis came to a head in August 1982, when Mexico alerted its creditors that it could no longer meet interest payments. Banks began credit rationing loans to the developing world, and several countries attempted to reschedule their existing debts to avoid default. To avoid a global financial catastrophe, banks and debtor countries needed to come to a mutually agreeable solution about repayment.

Structural adjustment programs (SAPs) were the international financial community’s solution to the repayment problem. Banks agreed to reschedule LDC’s debts and the International Monetary Fund (IMF) provided loans to pay the interest on those debts. However, this aid was conditional on LDCs enacting fiscal and monetary reforms to improve their long-term economic stability. These changes would ensure that developing countries could fulfill their financial obligations and repay their creditors going forward. 

But what exactly were these reforms? The defining feature of most SAPs was their neoliberal policy prescriptions. Developing countries that accepted conditional IMF loans were expected to eliminate protectionist barriers to trade, liberalize their domestic markets, privatize public services, and cut social spending. Additionally, most SAPs required countries to devalue their currencies to make their exports competitive on the international market. These reforms were collectively referred to as the ‘Washington Consensus’, since they were inspired by the United States’ economic policies. By promoting international trade and cutting budget deficits, LDCs could assuage creditors’ fears of nonpayment and improve their long-term creditworthiness. 

By and large, SAPs succeeded in stabilizing the economic situation in LDCs. Larry Summers and colleagues find that intensive-adjustment-lending counties, i.e. ones that took on multiple structural adjustment loans, “enjoyed faster growth, higher export and savings shares, and lower fiscal deficits in the second half of the 1980’s, both compared with other countries and compared with their own earlier performance.” Additionally, Brian Crisp and Michael Kelly find that structural adjustment was “negatively associated with both poverty and inequality.” If these scholars are correct, the Washington Consensus helped save the developing world from economic freefall and helped resurrect LDC’s creditworthiness.

While organizations like the IMF and international creditors see the aforementioned reforms as a necessary tool to ensure that LDCs become financially solvent, critics argue that SAPs require harsh austerity that harms the economic health of developing countries. The immediate effects of spending cuts are often recession, and most LDCs that enacted SAPs in the 1980s saw economic contraction before their economies stabilized. High unemployment created downward pressure on wages, and coupled with high inflation developing countries saw a significant decrease in real wages. By the end of the 1980s real wages had fallen by 25% across Africa, suggesting that structural adjustment may have harmed workers. Additionally, health outcomes such as neonatal mortality were often worse in countries that accepted structural adjustment loans.