(FORTUNE Magazine) – WHEN THE U.S. said it would help Lech Walesa reform Poland's economy by forgiving 70% of the debt his government owes Washington, you could practically hear the champagne corks popping in Warsaw. Then the Japanese weighed in angrily, complaining like stern schoolmarms that forgiving one debtor would make sluggards out of all. Who's right? Give this round to Washington. Third World debt no longer threatens the world financial system. The Japanese raise a valid question -- Why indeed should responsible lenders forgive profligate debtors? But they answer it myopically. Selective forgiveness, to borrowers like Poland who have changed their ways for the better, will make everybody better off in the long run. The hundreds of billions that developing countries borrowed in the 1970s and early 1980s financed all sorts of extravagant and profitless projects, from Amazon highways that go nowhere to highly automated steel mills in Africa. Now the Third World is discovering how market economies use capital to create new wealth. Once a country starts acting accordingly, lightening its debt may be not only appropriate but also essential for future growth. And the promise of forgiveness is a powerful incentive for nations hesitant to take the reform plunge. As for the lenders -- well, many Western banks and governments behaved foolishly too. Why should they be exempt from the pain? Genuine change is already under way. Mexico and Chile, hopelessly mired in debt a few years ago, have reformed their economies so thoroughly that they were able to borrow new money from capital markets last year on favorable terms. Some new Mexican government bonds won Ba2 safety ratings from Moody's -- higher than Chrysler's bonds. Sovereign debt has stabilized. According to the Institute for International Finance, a bank-sponsored research group in Washington, the total owed by the developing world's 50 biggest borrowers comes to $1.3 trillion. About half is due to commercial banks, and most of the rest is ''official'' debt, owed to another government or multilateral lending agency. The total is twice what it was ten years ago, but it hasn't changed much in the past three years. More important, debtor nations are becoming better able to pay. The 15 borrowers whose debt binges in the Seventies gave U.S. banks their biggest woes are still hung over. Altogether, they were obliged to pay out a stiff 22% of export revenues in 1990. Anything over 20% is considered a serious burden. But that is the lowest in more than ten years and well below the 30% to 35% they owed during much of the 1980s. Most, though not all, of the bankers who filled the punch bowl have adjusted to reality. U.S. banks accounted for about a third of private lending to developing nations. Few large regional or medium-size ones hold much LDC debt anymore, but earnings for four of America's money center banks remain highly vulnerable to a default by one or two huge overseas borrowers. Citicorp, which lent the most to developing nations, still had $7.6 billion in medium- and long-term loans outstanding at the end of 1990, including $2.7 billion to Brazil (see chart). Though Third World debt is trading on average at about 60% below face value, Citi and Manufacturers Hanover have taken reserves against possible losses on only a third of such debt. Increasing reserves to realistic levels (at Bankers Trust, for example, they are equal to 78%) wouldn't be devastating, says Mara Hilderman, a bank analyst at Moody's, but it would require a big hit to already thin earnings or capital. ''It's still a very unpleasant item that banks live with.'' Meantime, regulators have told banks to write down loans to Brazil by another 20%, and to Argentina by 10%.

LATIN AMERICA accounts for the biggest debt problems, as well as several of the most promising turnarounds. The 16 major borrowers there owe a total of $420 billion, with just over half due to banks. Brazil, the largest borrower in the developing world, remains a nightmare. Its IOUs come to $122.6 billion, $80 billion of it owed to banks. It suspended all debt payments two years ago and agreed only reluctantly last month to start paying back a portion of its $8 billion in arrears. A powerful legislature and strong state governments have thwarted many of President Fernando Collor de Mello's attempted reforms. Peru, alas, makes Brazil look as solid as Switzerland. Bankers have apparently abandoned hope of getting back the $8.6 billion it owes them. Peru's debt certificates go for just 4% of face value. And the good news? Some countries, notably Colombia, never rescheduled their payments. Chile, by letting creditors swap their debt for equity interests in businesses, has helped cut its bank debt by 40% since 1985, to $9 billion. * Argentina, a slow payer on its $34 billion, has begun a debt-equity swap program too. Citicorp and J.P. Morgan, two of its biggest creditors, each own large shares of Argentine telephone companies. To many people's surprise, the Brady Plan -- remember it? -- has proved helpful to a half-dozen countries, notably Mexico. Introduced by Treasury Secretary Nicholas Brady in 1989, it ended the charade in which banks kept lending new money so countries could pay interest on old debts. In return for accepting a 35% reduction in principal on Mexican loans, for instance, banks could exchange old paper for new, 30-year ''Brady bonds.'' The principal is guaranteed by a zero-coupon bond from the U.S. Treasury. The interest is backed by the World Bank. Mexico cut its $69 billion in bank debt by $7 billion last year, mostly by using Brady bonds. The bonds helped Costa Rica and Venezuela reduce their debt as well. Bradys are far easier to sell than the original bank paper. That has helped trading in LDC debt to climb from $200 million in 1982 to more the $100 billion last year, says Paul M. Sacks, president of Multinational Strategies, a New York City consulting firm that specializes in Third World debt. Sub-Saharan Africa is in the worst shape of any region, with a debt of $116 billion. Most of its 44 countries haven't got a prayer of catching up any time soon -- they are paying only half the interest due on loans. Their economies depend on commodities, and prices collapsed in the 1980s. Half the countries are struggling to move toward a market system, however slowly, says Ishrat Husain, chief of debt and international finance at the World Bank. Their efforts prompted Britain's then-Finance Minister John Major to propose that lenders to such countries write down substantial portions of their debts and stretch out payments on the balance. Eastern Europe's prospects for coping with its $134 billion debt are a hodgepodge. Relative to GNP, Hungary's $22 billion debt looks a bit worse than Poland's. But Hungary invested its borrowings in factories that make useful products and has never had to reschedule interest payments. Poland, which owed $48 billion at the start of this year, wasted money for decades by buying inefficient Eastern bloc machinery, which it used to make shoddy goods for export to the Soviets. The value of its $10 billion in bank debt among traders fell from 50 cents on the dollar in 1986 to 15 cents before the forgiveness (afterward it bounced back to 27 cents). Poland's case nonetheless illustrates the rationale for forgiveness. Big creditors applauded its commitment to reform, perhaps the boldest undertaken by any country in modern times, but recognized that its debt was scaring off badly needed help. Says Robert Hormats, former Assistant Secretary of State for Economic Affairs and now at Goldman Sachs: ''Poland was doing all the right things, but it wasn't getting any foreign investment.'' The U.S. government's gesture had little direct effect -- it amounts to a $2.7 billion saving. But Washington also pressured other Western governments, which agreed in March to cut Poland's $33 billion of official obligations in half. The largest borrower in the region may be in the worst shape. The Soviet Union owes about $57 billion -- nearly half to commercial banks. It's no concern of American banks, which are owed less than $200 million, but those in other countries have a lot to worry about. ''The Soviets will have a problem with their debt,'' says John Haseltine, director of banking at the Institute for International Finance. ''I don't see how it will get better in the near term.''

WITH A FEW glaring exceptions like the Soviet Union, the global debt problem now appears to be in its end game. Banks and governments have a common interest in giving relief to countries that have committed themselves to economic growth. Says Sacks of Multinational Strategies: ''The banks will not get paid off in full. But countries that don't come to some kind of agreement with their bankers will have a difficult time getting the trade credits and development loans they need.'' The message is becoming increasingly plain: Capitalism can be harsh, but the alternatives are unendurable. If that lesson sinks in, the next time bankers get excited about lending to the Third World, their enthusiasm could be justified.

CHART: NOT AVAILABLE CREDIT: SOURCES: INSTITUTE OF INTERNATIONAL FINANCE; INTRADOS GROUP; SALOMON BROTHERS CAPTION: THE HEAVY BORROWERS Some of the borrowers most burdened by debt in the early 1980s, such as Mexico and Chile, are now reforming their economies and paying off their loans conscientiously. Others, including Brazil and Peru, have been slow to pay, so their debt trades at big discounts on secondary markets.

CHART: NOT AVAILABLE CREDIT: KEEFE BRUYETTE & WOODS CAPTION:BIGGEST U.S. CREDITORS Though most U.S. banks have whittled down their less-developed-country loan ! portfolios, there's still potential pain for several big lenders.