(FORTUNE Magazine) – TREASURY SECRETARY Nicholas Brady has set U.S. policy toward the Third World's mountain of debt on the most promising course yet. Finally there's a chance -- slim but real -- that the rich and the poor countries can begin to work their way out of a monstrous problem. Yes, the scheme is short on details, but it gives both sides a reason to negotiate, sets limits on what they can expect, and gives everyone with a stake in the outcome freedom to devise creative approaches. The proposal Brady outlined pushes banks to accept lower payments on increasingly unsafe Latin loans that have been discounted in the money markets to a fraction of their original value. In exchange they would get assurances that the reduced amounts will be paid. Japan and other developed countries would provide fresh capital to the international lending agencies, as well as to the debtor countries. To Latin America the proposal offers the hope of relief from an economic decline that is pushing desperate people to the point of explosion, as it did in Venezuela in February. Make no mistake: The hard work is only beginning. The most crucial of the missing details is a plan to force economic reform on the debtors, who owe $1.3 trillion. Politicians south of the border like to blame their falling living standards on yanqui bankers, but worse damage comes from home-grown problems: overwhelming deficits and inflation, corrupt bureaucracies, and huge, inefficient state enterprises. Even if all the debts were wiped off the books tomorrow, Peru and Bolivia would certainly remain economic basket cases, Argentina probably, and Brazil perhaps. What makes the plan plausible nonetheless is that borrowers and lenders both have powerful reasons to heed the Brady call. The banks need to end uncertainty and collect what they can. The U.S. and the international agencies will push them to cooperate in giving the borrowers a break. The borrowers desperately need new capital to restart the growth of their economies. They will find it harder than before to resist the demands for reform that will be tied to any help they get. The alternative, the utter disaster of default, looms ever larger. Details will emerge on a case-by-case basis as rescue plans are framed for each country. Mexico will be the first up because it needs $4 billion quickly and because it is looked upon favorably by the world's bankers. The new government of President Carlos Salinas de Gortari is highly competent in economic matters, Mexico has done much to free up its economy and considerably more than the U.S. to cut its deficits, and investors find the country promising. Mexico would likely get the fast $4 billion it needs to cover the difference between interest due and its current account earnings under any circumstances. But the Brady plan gives it room to ask for much more. Salinas would like to halve his country's $65 billion in commercial bank loans. He certainly won't get that soon, but Mexico might be able to swap or buy back its loans at, say, a 35% discount or negotiate a reduction in interest rates that would have an equivalent effect. The banks, instead of holding increasingly unhealthy Mexican paper, will acquire new bonds backed with either guarantees or informal assurances by the World Bank or the International Monetary Fund. Under the old Baker plan, formulated in 1985 by Brady's predecessor, James A. Baker III, the $4 billion would have been financed by new loans simply added to Mexico's debt burden -- with the delusive hope that the Mexican economy could eventually grow big enough to cope with its debt. A PROTOTYPE of the bond scheme fell short last year when J.P. Morgan organized an auction to exchange debt for 20-year Mexican government bonds secured by zero-coupon U.S. government bonds. Mexico could have swapped up to $10 billion in debt at a 50% discount but exchanged only $3.7 billion at an average of 30%. The auction reduced debt by a disappointing $1.1 billion, not much for a country that owes $105 billion altogether. But a new auction offering guaranteed interest as well as principal could be more successful. The Brady plan, or something like it, was long overdue. When Mexico unleashed the crisis in 1982 by suspending its loan payments, both the overextended banks and the overborrowed developing countries were gravely threatened. The banks had not set aside reserves for their Third World debt, which amounted to nearly double their equity.

Now most banks are in better shape to take a hit. Over the past couple of years they have built up their reserves (see table, page 212). U.S. money- center banks on average have enough to cover about 30% of their Third World loans, while some European banks are 90% and even 100% reserved. Japanese banks are allowed to reserve no more than 15%, but they are eager to settle anyway so they can start to make major new loans in Latin America and create new export markets. At the same time the loans have become worth less in the world markets where debt paper is traded, mainly by the banks themselves. Mexican debt was recently going for 40 cents on the dollar, Brazilian 32, Argentine 18, Bolivian 9, and Peruvian 3. Chile and Uruguay, whose economies are the soundest, can sell their debt for nearly 60% of face value. Harvard professor Jeffrey Sachs, who has helped Latin American countries with their debt problems, believes that any American bank could survive a settlement of 50 cents on the dollar and that many would accept that figure to put the problem behind them. The most eager would be smaller banks, which just want to forget about Latin America. Brady offered a vague promise of help when he proposed reducing and streamlining regulations that hold up debt settlements. For example, U.S. banks can get credits only when an entire loan goes down the drain. European banks, by contrast, can take a tax deduction as soon as they set up a reserve against a shaky loan. L. William Seidman, chairman of the Federal Deposit Insurance Corp., advocates allowing U.S. banks to take tax deductions for partial loan write-offs. UNLIKE THE BANKS, the borrowers have mostly sunk into increasingly pitiful conditions since 1982. Starved of new capital, hopelessly mismanaged, mangled by inflation that often reached the three- and sometimes four-digit level, they have watched their GNPs and real wages drop. Over the past seven years Latin American countries made a net transfer of $160 billion to the industrialized countries -- not including the estimated $300 billion their own citizens have sent abroad for safety. The Bush Administration might have liked more time to work out the details of a new debt plan, but late last year events began pressing in. Other creditors were becoming impatient for a solution. For fear of losing face and leadership, the U.S. had to dissuade Japan from presenting a detailed debt plan at an economic summit in Toronto last year. (Brady's proposal bears more than a passing resemblance to it.) Then came the Venezuelan riots and the specter of democracy under fire throughout Latin America. The architect of the Brady plan, David Mulford, undersecretary designate for international affairs and a veteran of world banking in and outside the Treasury, shoved the plan through the short-staffed Administration without the usual exhaustive studies and approvals. Says Richard Medley, an international bank consultant in Washington: ''Brady pushed the bankers and the debtors off the cliff, hoping someone will put some water in the canyon below before they hit bottom.'' Providing the water will be a horrendously complicated task. In Mexico alone, 600 banks will be affected by any settlement. The hardest to persuade will be some of the bigger American banks that lent more aggressively -- most notably Citibank -- and intend to stay in Latin America in order to go where their customers go. But Brady has made it plain to the banks that reluctant ones may not have the power to veto deals as they have in the past. These and scores of other issues are the subject of intense and esoteric discussions couched in language so arcane even bankers find them hard to penetrate. Financial leaders speed around the world looking for money and solutions. Mexico's able MIT-trained finance minister, Pedro Aspe, begins a week in Washington negotiating terms of the Brady plan, goes on to Tokyo to line up new capital, and finishes the week in Amsterdam at an international bank meeting. As an intellectual exercise, says a senior World Bank official, dealing with Third World debt ''is the most fascinating and challenging thing I have ever done.'' WHILE the Brady proposal has laid out the principles of the rescue effort, it leaves room for many types of solutions. More than a score of plans and approaches are ready to be plucked from the brains of the world's bankers and economists. American Express Chairman James D. Robinson III, for example, has called for an Institute of International Debt and Development to buy up loans at discount rates. The agency -- Robinson would nickname it I2D2 -- would issue bonds backed by the industrial countries, and also preferred shares that would pay dividends if the borrowers' economies got stronger. The Japanese propose to provide up to $10 billion in ''parallel'' credits to go with funding from international agencies. Pedro-Pablo Kuczynski, chairman of First Boston International and author of a book on Latin debt, believes an equity kicker could get debt relief moving. He argues that loans should be converted at a discount fair to both sides -- somewhere between 35% and 45% -- but that if the debtors' exports grow to a certain level, then the creditors would be paid more. Debt-equity swaps add another dish to the menu of solutions. In this type of swap a foreign investor buys the debt at a discount, converts it to local currency, and plows it back into local business or property. That can be anything from a factory to a soccer player -- Philips NV acquired the rights to a Brazilian star, Romario Farias, to play for its team in the Netherlands. Chile has reduced its debt by more than 10% through swaps, partly because Chile's market-oriented economic policies make it attractive to investors. But other Latin Americans are turning against swaps because xenophobes see them as sellouts to foreigners, and governments call them inflationary -- which, of course, they are when a government pays for them by printing money, as Argentina and Brazil have done. After making $7.5 billion worth of swaps last - year, Brazil suspended the program, and Mexico has done the same. Swaps probably have a useful but limited future. Rising interest rates made the debtors' burden heavier in recent years, and lower rates would lighten it -- but no likely decline will get them off the hook. The possibility floated by the U.S. Treasury of a 20% reduction in debt doesn't excite Latin Americans. Say rates on most American bank loans to Mexico continue to be calculated by adding thirteen-sixteenths to the London Interbank Offered Rate (Libor). In the past year Libor rose nearly four points, to 11%. If Mexico's $65 billion debt to commercial banks was reduced 20% to $52 billion by the sale of bonds or some other swap, interest payments would fall from $7.7 billion to $6.1 billion, nowhere near enough to cover even Mexico's immediate needs. The debt would have to be cut in half to stop Mexico from falling behind. Its payments would also drop to a manageable level if the bankers took a cut in interest rates from the Libor formula to, say, 5% or 6%. Reductions on these scales are unlikely, at least in the first round. MANY STUDENTS of the debt problem feel the cuts will have to be even bigger. Kuczynski of First Boston argues that Latin American commercial bank debt would have to be sliced by a third just to bring interest payments back to their level of early 1988. That would be equivalent to some $86 billion. Business Environment Risk Information, an international consulting group in Washington, D.C., is even more bearish. Like some European banks, it suggests that real help means rates of only 2% or 3%, capitalized over 30 years for the worst cases. But U.S. taxpayers would probably just as soon see those countries go up in smoke as pay for such a giveaway. Whatever breaks the creditors give Latin America, the performance of the countries themselves will determine whether they get the new capital needed to help them grow out of their misery. Apart from its size and proximity to the U.S., Mexico is the Treasury's current favorite candidate because its economically savvy government is making the right moves. Argentina, on the other hand, offers little reason to attract a new deal. Its government is paralyzed by repeated failure, an election coming up May 14 may produce a demagogue President, and the country is $2 billion in arrears on debt payments.

Most Latin American republics can't even hold on to their own money. The estimated $300 billion in flight capital sent abroad by Latin Americans is more than the total bank credit owed by their countries, now $257 billion. Many of the borrowed dollars went right into hiding in Switzerland or the U.S. before they could make a mark. If the owners of these foreign deposits and investments would repatriate just the interest they earn, Latin America could meet most of its current bills. And if they repatriated the principal, the debtors could settle most of their accounts. But there's no way of forcing the money to come home to malfunctioning economies. No amount of debt reduction and relief will work unless the afflicted countries straighten themselves out.

CHART: NOT AVAILABLE CREDIT: SOURCES: DRI/McGRAW HILL CAPTION: A SAD SAGA OF BORROWING AND MISMANAGEMENT Latin America has been struggling since 1982 to cope with its debt, but the burden of paying interest has contributed to a big drop in personal incomes and slowed economic growth.

CHART: NOT AVAILABLE CREDIT: SOURCE: SALOMON BROTHERS CAPTION: BANKS ARE GETTING STRONGER By adding to reserves and equity, American banks have made themselves less vulnerable to loans that go sour.