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 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. Such an increase had not been seen previously. 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 U.S. commercial banks to sharply curtail 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. So long as real interest rates remain high, developing countries will remain in debt. There are two choices. Either the piecemeal approach continues, or some form of debt relief occurs. For years, developing countries have paid the price of low growth and significant falls in real wages while making cash transfers to service their debt. Citizens of developing countries are kept at low levels of income for the sake of capital gains for banks and their shareholders. With
sensible debt relief, developing countries and lending institutions can begin to formulate growth-oriented development policies. This should be possible without increasing burdens on
taxpayers in lender countries.
1. The primary purpose of this passage is to discuss
(A) the causes of the debt crisis and potential solutions to it
(B) the effects of rising interest rates
(C) American banking in the 1980s
(D) the future of banking in the U.S.
(E) economic conditions in developing countries
2. The passage provides information that helps to answer which of the following questions?
I. Did errors of economic management by developing countries contribute to the debt crisis?
II. Are steps currently being taken to alleviate the debt crisis?
III. Do taxpayers in lending countries support the notion of debt relief?
(A) I only
(B) II only
(C) I and II only
(D) II and III only
(E) I, II, and III
3. Which of the following characterized responses to the debt crisis in the 1980s?
(A) Increased pressure on debtor countries to pay interest due on loans
(B) An increase in the percentage of their total capital large banks devoted to foreign loans
(C) A decrease in the funds designated by banks to cover potential losses
(D) Reliance by banks on inflationary pressure to reduce debt levels
(E) A decline in bank lending and an increase in capital reserves