John Reed, chairman of Citicorp, is no hero.

He's won loud plaudits for recognizing possible losses of $3 billion on his bank's loans to developing countries. Everything said in praise of Reed's move is true. It acknowledges the debtors' inability to repay in full and restores some honesty to bankers' bookkeeping. But what's only whispered is more important. His action doesn't improve the Third World debt situation and may make it worse.

Nothing in Citicorp's decision -- already emulated by Chase Manhattan and Security Pacific and likely to be followed by other banks -- enhances the ability of the major Latin debtors (Argentina, Brazil and Mexico) to resume sound economic growth. Reed provided no debt relief. He simply shifted $3 billion of his shareholders' funds to Citicorp's "loan-loss reserve." The switch was an accounting transaction. The debtor countries still owe Citicorp $14.8 billion, the same amount as before the announcement.

It's an absurdity that only bankers don't see. In one breath, the bankers say their debts aren't worth 100 cents on the dollar; the debtors can't afford to pay, and economic conditions have deteriorated. In the next breath, the same bankers self-righteously demand that the debtors pay interest on the full debt. Ever since the debt crisis began in 1982, the banks have tried to squeeze as much as possible from developing countries.

The Citicorp action confirms that the "strategy" for the debt problem has been one of drift. The idea was that, with modest new loans, borrowing countries could make reforms and achieve enough growth to handle their debts. But piling new loans atop the old hasn't worked. Economically, Latin America is moribund. Per capita incomes are 7.6 percent below 1981 levels. Debt negotiations lurch from one crisis to another. Since February, Brazil hasn't paid interest on $68 billion worth of bank loans.

Something else is needed: debt relief in exchange for economic reforms by debtor countries. Here's how it might work.

First, debtor countries and the International Monetary Fund or World Bank would negotiate economic reforms. These would include measures to reduce inflation, cut budget deficits and end subsidies and regulations that tend to protect inefficient companies and practices.

Second, a new international agency (preferably an adjunct to the IMF) would buy developing-country loans at a discount of, say, 20 to 30 percent. The banks' bookkeeping losses would become real losses, with the savings passed along to the borrowers. Banks would receive securities -- bonds or notes -- from the new agency. Debtor countries would pay the agency, which would use the funds to meet payments on its securities.

Debt relief is obviously no panacea. Even wiping out the debt wouldn't cure the economic mismanagement that has raised Brazil's inflation to about 1,000 percent. At most, debt relief would allow countries to grow a bit faster. Economic growth stimulates imports; the lower the debt burden, the smaller the trade surplus a country needs to meet its interest payments. But debt relief is as much a political as an economic act. It provides debtors a victory and makes it easier for them to agree to basic reforms.

Ideally, relief would be progressive: Countries would get more as they fulfilled reform promises. In the past, most debtors have adopted politically painful economic programs. Argentina, which cut inflation from 647 percent in 1985 to 80 percent in 1986, is enjoying a modest recovery. But gains have usually been squandered, in part because the debt negotiations didn't create an effective mechanism to reward success. Doing well allowed countries to borrow more, raising their debt burden.

No one should exaggerate the odds of success. Negotiations between the IMF and debtors are always strained. Nations never eagerly cede control over their affairs. More important, meaningful economic reforms threaten the distribution of wealth and power in debtor countries. All these societies are politically fragile. Brazil and Argentina are emerging from military dictatorships; Mexico's one-party rule is shaky; the Philippines (another big debtor) is trying to restore democracy. Perhaps these societies can't create the political stability and popular consensus needed for sustained economic growth.

But debt relief is a gamble worth taking because the alternative looks increasingly bleak and because the arguments against it are increasingly weak. Proposals for giving debtors a break -- suggested by Sen. Bill Bradley (D-N.J.), Rep. John LaFalce (D-N.Y.) and Rep. Charles Schumer (D-N.Y.) -- have been consistently opposed by the Treasury and the Federal Reserve. Now the Citicorp action undercuts the most important objection: that forcing banks to suffer losses on Third World debt will mean they won't lend in the future. Large losses are now inevitable.

John Reed's message is clear: The banks are slowly disengaging. They don't want to make new loans and won't provide much leadership in the debt crisis. Some new loans may occur, but these would (as in the past) be intended to enable debtors to continue payments on old loans so that the banks don't have to record even larger losses. Despite "new" loans in recent years, some smaller U.S. banks have reduced their exposure. Between the end of 1984 and 1986, total U.S. bank loans to 15 large debtor countries dropped $9 billion, or nearly 10 percent.

In fact, banks' new willingness to accept losses complicates debt negotiations. Brazil may reasonably ask why it should fully service loans on which banks have recorded a loss. The worsening economic outlook also darkens the picture. Interest rates are rising (adding to the debt burden), and world economic growth is falling (cutting potential export earnings). A negotiating stalemate could produce the worst of all results: more bank losses, no debt relief and no economic reforms.

It's true, as retiring Federal Reserve Chairman Paul A. Volcker says, that there's no magic wand to solve the debt crisis instantly. But a bad situation can be made worse. Doing nothing risks just that.