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debt crisis of the 1980s in Latin America

Page history last edited by PBworks 12 years ago


The "Lost Decade" of the 1980's


The Latin American debt crisis refers to a period in the early 1980s (and for some countries starting in the 1970s), often known as the "lost decade", where countries in the region reached a point where their foreign debt exceeded their earning power and they were not able to repay it.



In 1982, Mexico's suspended its debt repayments and triggered the "debt crisis".The following 10 years, the so-called "lost decade," were marked by capital leaving the region in annual sums equal to more than $20 billion in some years, while international capital markets were closed to borrowers.


The 80s are often referred to as the "lost decade" in latin america because of the period of low economic growth,  and depression, caused by the two oil crises of 1973 and 1979.


As a result of the oil crisis, inflation went up, interest rates went up, and the US went into recession.   The price of commodities plummeted, and Latin America went into recession, then depression. 


The supply of US dollars in the international debt markets fell, which pushed up interest rates on international debt.


A chain of events led to the debt crisis in  Latin American countries in the 1970s and 1980s.






In the 1960s and 1970s many Latin American countries, notably Brazil, Argentina, and Mexico, borrowed huge sums of money from international creditors for industrialization; especially infrastructure programs. These countries had soaring economies at the time so the creditors were happy to continue to provide loans. Between 1975 and 1982, Latin American debt to commercial banks increased at a cumulative annual rate of 20.4 percent. This heightened borrowing led Latin America to quadruple its external debt from $75 billion in 1975 to more than $315 billion in 1983, or 50 percent of the region's gross domestic product (GDP). Debt service (interest payments and the repayment of principal) grew even faster, reaching $66 billion in 1982, up from $12 billion in 1975.[1]



The World Economy was growing at a rapid rate in the early 1970’s, with the largest percentage gains made by oil exporting “less-developed” countries. As oil prices increased, following the Oil Crisis of 1973-1974, rapid growth continued in many of these countries, especially those in Latin America and any country that was exporting oil. The rate of economic growth was sufficient to attract foreign capital and investments, and US banks were aggressively providing and servicing overseas loans in order to seek out new profit sources, when domestic savings opportunities in the early 1970’s began to dwindle. The influx of money into an LDC also caused increased inflation, prompting the borrowing of more funds used to cover inflation-related debt. The creation and expansion of oil-backed “Eurodollars” provided the needed funding for further leveraging.





Oil Crisis


Oil prices in non-oil exporting countries rose to the point where the 1974-1975 world recession was triggered.  High oil prices led to inflation, recession and slow growth. 


When the world economy went into recession in the 1970s and 80s, and oil prices skyrocketed, it created a breaking point for most countries in Latin America.




Other commodity prices fell


As a result of recession, commodity prices collapsed. 


The second oil crisis of 1979 (after the Iranian revolution) coincided with a fall in prices of other raw materials.   At the end of 1979, two factors forced up the cost of the debt: a very sharp rise in interest rates and the appreciation of the dollar. Attempts from the South to revive negotiations for a New World Order failed and in Cancun in 1981, the dialogue between the North and the South fell through. Moreover, the United States did not apply the budget austerity they imposed on the countries of the South. Instead they reduced taxes, increased military spending and spent more on consumer goods.  The general about-turn towards what the World Bank called « structural adjustment » was announced in a speech made by Robert McNamara at the UNCTAD conference in Manila in May 1979.




Unable to pay the previous debts


With commodity prices falling, Latin American countries found themselves suddenly without income to pay off debts.


This caused a decline in world commodity values that left the developing countries with a debt burden that could not be met with their dwindling commodity values. Many of the LDC loans were medium to long-term contracts that included a floating rate contract, tied to the London Interbank Offering Rate (LIBOR). It was estimated that 2/3 of the LDC debt was tied to the floating LIBOR, which re-priced every six months. Despite this financial challenge, many of these countries continued to borrow. When the dollar strengthened in 1981-1982, these dollar-based loans could no longer be serviced by the borrowing countries.





Liquidity crunch


Developing countries also found themselves in a desperate liquidity crunch. 


Petroleum exporting countries – flush with cash after the oil price increases of 1973-74 – invested their money with international banks, which 'recycled' a major portion of the capital as loans to Latin American governments. As interest rates increased in the United States of America and in Europe in 1979, debt payments also increased making it harder for borrowing countries to pay back their debts 


While the dangerous accumulation of foreign debt occurred over a span of years, the debt crisis began when the international capital markets became aware that Latin America would not be able to pay back its loans. This occurred in August of 1982 when Mexico's Finance Minister, Jesus Silva-Herzog declared that Mexico would no longer be able to service its debt. In the wake of Mexico's default, most commercial banks reduced significantly or halted new lending to Latin America. As much of Latin America's loans were short-term, a crisis ensued when their refinancing was refused. Billions of dollars of loans that previously would have been refinanced, were now due immediately.



Effects on Latin America


In response to the crisis most nations abandoned their Import Substitution Industrialization (ISI) models of economy and adopted an export-oriented industrialization strategy, usually the neoliberal strategy encouraged by the IMF, though there are exceptions such as Chile and Costa Rica who adopted reformist strategies. A massive process of capital outflow, particularly to the United States, served to depreciate the exchange rates, thereby raising the real interest rate. Real GDP growth rate for the region was only 2.3 percent between 1980 and 1985, but in per capita terms Latin America experienced negative growth of almost 9 percent.


The debt crisis is one of the elements which contributed to the collapse of some authoritarian dictatorships in the region, such as Brazil's military regime and the Argentine bureaucratic-authoritarian regime.



How it was eventually solved



For those that could not service their debt, Secretary of the Treasury, Nicholas Brady, created a plan in 1989 that provided debt relief for the borrowing countries when these countries agreed to certain economic reforms.





The beginning of the next cycle....ready for a Mexican crisis in 1994


"The infrastructure needs - housing, roads, telecommunications - are an area of growth for a minimum of 10 years," said James Remington-Hobbs, a director at Baring Securities in London. "They are the backbone of any economy. In Mexico, they need to build 500,000 houses each year for the next 10 years to catch up with demand."


Mexico is, in fact, an anomaly compared with the rest of Latin America.The North American Free Trade Agreement means its economic ties to the United States are even stronger than before.Political upheavals have in any case been limited by its strategic location in the backyard of the United States.


Tom Priday, head of the Emerging Markets Group at Paribas Capital Markets in London, said: "Now that Mexico has its currency under control, reasonable inflation and the perspective of NAFTA, U.S. bond investors have been studying it more carefully. Low yields in the United States have made them look farther afield for higher yields.For example, in broad terms, Mexican government risk is 250-300 basis points over U.S. Treasuries, while top corporate risk is 400-500 basis points over Treasuries."


It is not only U.S. investors who are interested in Latin America. Europeans are being tempted as well by high yields and the general emerging-markets vogue, while flight capital is working its way back.







A.    An Overview of the Debt Crisis

Let's begin with a brief overview of the debt crisis and the measures taken to resolve it.
1.     Petrodollar Recycling by Commercial Banks to Developing Countries Gave Rise to the Debt Crisis.
Most observers believe the "petrodollar recycling" of the 1970s gave rise to the debt crisis. During that period, the price of oil rose dramatically. Oil-exporting countries in the Middle East deposited billions of dollars in profits they received from the price hike in U.S. and European banks. Commercial banks were eager to make profitable loans to governments and state-owned entities (as well as private companies) in developing countries, using the dollars flowing from the Middle Eastern countries. Developing countries, particularly in Latin America, were also eager to borrow relatively cheap money from the banks.
2.     Decreased Exports and High Interest Rates in the Early 1980s Caused Debtor Countries to Default on Their Foreign Loans.
The frenzied lending and borrowing came to a halt with the global recession in the early 1980s. The significant drop in debtor countries' exports, combined with a strong dollar, (i.e., the value of the dollar increased relative to the value of other currencies) and high global interest rates, depleted foreign exchange reserves that debtor countries relied upon for international financial transactions. Debtor countries consequently began to feel the strain of having to make timely payments on their foreign debt, which became much more expensive to pay off because the loans carried floating interest rates that increased along with global rates. These problems were compounded by massive capital flight - outward transfers of money by private individuals and entities in developing countries.
In August 1982, Mexico stunned the financial world by declaring that it could no longer continue to pay its foreign debt. Not long after Mexico's declaration came similar announcements from other Latin American debtor countries, such as Brazil, Venezuela, Argentina, and Chile. The prospect of massive defaults posed grave problems for creditor countries, such as the United States. Government regulators discovered that commercial bank creditors, particularly the big U.S. ("money center") banks, had dangerously low levels of capital that could be used to absorb losses resulting from massive loan defaults. Policymakers were also worried that there was no central authority or forum that could oversee an orderly resolution of the crisis, such as a global bankruptcy system.
3.     Case-by-Case Debt Restructuring Negotiations Saved the International Financial System from Collapse.
Yet the principal players in the crisis - governments, banks, the IMF and the World Bank - averted a collapse of the international financial system by resorting to case-by-case debt restructuring negotiations, popularly known as the "muddling through" approach. The approach entailed engaging in a series of work-outs with hundreds of commercial bank creditors throughout the world via Bank Advisory Committees or Steering Committees, which were composed of banks with the greatest exposures to debtor countries. (Work-outs for government-to-government lending took place under the auspices of the Paris Club, a forum open only to sovereign states.)
Under this approach, commercial banks agreed to (i) provide new loans to debtor countries, and (ii) stretch out external debt payments. In return, debtor countries agreed to abide by IMF and World Bank stabilization and structural adjustment programs intended to correct domestic economic problems that gave rise to the crisis. IMF stabilization programs typically included drastic reductions in government spending in order to reduce fiscal deficits, a tight monetary policy to curb inflation, and steep currency devaluations in order to increase exports. World Bank structural adjustment programs focused on longer-term and deeper "structural" reforms in debtor countries.
4.     "Debt Fatigue" Appeared in the Mid-1980s.
After a few years of repeated restructuring deals, "debt fatigue" began to appear. New loans to debtor countries plummeted as commercial bank creditors contemplated the possibility that debtor countries were facing insolvency rather than a temporary drop in their ability to pay back the foreign debt.
In October 1985, U.S. Treasury Secretary James Baker proposed a strategy, dubbed the Baker Plan, that attempted to alleviate the debt fatigue. The plan was designed to renew growth in fifteen highly indebted countries through $29 billion in new lending by commercial banks and multilateral institutions in return for structural economic reforms such as privatization of state-owned entities and deregulation of the economy. The strategy failed, however, because the projected financing did not materialize and, to the extent it did, the new lending merely added to debtor countries' already crushing debt burden. During this period, Latin American debtor countries were making massive net outward transfers of resources.
In light of what appeared to be an intractable problem, government officials, academics, and private entities began to propose plans that would provide debtor countries with debt relief rather than debt restructuring. In the meantime, various debtor countries suspended debt payments and fell out of compliance with, or otherwise refused to adopt, IMF adjustment programs. This eventually prompted the big creditor banks to admit publicly (by adding to "loan loss reserves") that many of the loans to debtor countries would not be repaid.
5.     The Brady Initiative in 1989 Focused on Debt Reduction Strategies.
The Brady Initiative, announced in March 1989 by U.S. Treasury Secretary Nicholas F. Brady, marked a change in U.S. policy towards the debt crisis. Given the persistently high levels of foreign debt, the Initiative shifted the focus of the strategy from increased lending to voluntary, market-based debt reduction (reduction of outstanding principal) and debt service reduction (reduction of interest payments) in exchange for continued economic reform by debtor countries.
Debtor countries obtained significant (but not massive) debt relief under the Brady Initiative through: (i) direct cash buybacks; (ii) exchange of existing debt for "discount bonds" (bonds issued by the debtor country with a reduced (discounted) face value but carrying a market rate of interest); (iii) exchange of existing debt for "par bonds" (bonds that carry the same face value as the old loans but carry a below-market interest rate); and (iv) interest rate reduction bonds (bonds that initially carry a below-market interest rate that rises eventually to the market rate). Commercial bank creditors that did not wish to participate in a debt or debt service reduction option could choose to give debtor countries new loans or receive bonds created from interest payments owed by debtor countries. Debtor countries sweetened the deals by providing "enhancements," such as principal and interest collateral (U.S. Treasury bonds).
6.     Brady Deals Combined with Economic Reforms and Increased Flows of Capital to Debtor Countries Led Some Observers in the Early 1990s to Declare that the Debt Crisis was Over.
Commercial bank creditors agreed to Brady deals with a good handful of countries, including Argentina, Costa Rica, Mexico, Nigeria, the Philippines, Venezuela, Uruguay and Brazil. In the meantime, Latin American countries implemented substantial economic reforms. In 1991, the region registered capital inflows that exceeded outflows for the first time since the onset of the debt crisis. This led some observers to proclaim that the debt crisis was over for major Latin American debtor countries.
B.    Stabilization and Adjustment Programs
Here we provide more detail regarding IMF stabilization programs and World Bank structural adjustment programs.
The IMF's stabilization programs applied short-term "emergency" measures intended to reduce domestic demand for goods and services (IMF stand-by arrangements). The World Bank engaged in policy-based lending through structural adjustment loans (SALs) and sector adjustment loans (SECALs), medium- to long-term loans that supported structural changes to improve supply and prevent the recurrence of a crisis. The distinction between IMF and Bank programs often blurred in practice, however, because of the close collaboration between the two institutions and the complementary nature of their programs. Both programs carried "conditionality," releasing funds in installments and requiring recipients to meet performance criteria for each installment.
1.     IMF Stabilization Measures Tried to Cool Down Overheated Economies.
The idea behind stabilization is that a drop in demand will result in a reduction of the current account deficit (more imports than exports), which the IMF believed was one of the major causes of the financial crises in debtor countries. In most cases, governments reduced demand by cutting public expenditures, devaluing the country's currency, and reducing the money supply. The expenditure-cutting included drastic cuts in infrastructure (e.g., roads, bridges, and dams), freezing state employees' wages or laying off state employees, reducing consumer subsidies, and cutting health and education expenditures. Central banks devalued the currency in part to reduce imports and increase exports. Authorities reduced the money supply to check inflation.
2.     World Bank Structural Adjustment Measures Promoted Market-Based Reforms to Increase Efficiency.
World Bank structural adjustment programs complemented stabilization efforts by seeking to increase economic efficiency, which, in turn, would increase the domestic supply of goods and services. Although such programs differed among countries, they shared two themes: liberalization of domestic and foreign trade, and privatization of often large and inefficient public enterprises. Domestic liberalizations included abolishing price controls, freeing interest rates, ending credit rationing, and establishing a capital market. Liberalization of external trade typically included reduction of high tariffs, elimination of quotas on imports and import licenses, abolition of export duties and licenses, devaluation of the currency, and product diversification. Public enterprises were also subject to market discipline via privatizations, reduction or abolition of subsidies, and other streamlining measures.
C.    The Social Costs of the Debt Crisis: The Lost Decade of Development
A great number of observers criticized the IMF and the World Bank for their handling of the debt crisis. Indeed, the criticisms of that crisis resemble much of what we have heard about the Asian financial crisis: the IMF and World Bank stabilization and structural adjustment programs (SSAPs) imposed great costs on the poor and vulnerable in developing countries while "bailing out" foreign players such as banks and investors.
1.     The Debt Crisis Brought Debtor Countries' Economies to a Halt and Wiped Out Gains in Social Welfare.
It is not hard to find evidence showing that the poor, women, children and other groups (indigenous peoples) suffered disproportionately as a result of structural adjustment programs during the 1980s. As Latin America's economies stagnated (experiencing zero or negative economic growth), per capita income plummeted, poverty increased, and the already wide gap between the rich and the poor widened further. The debt crisis seriously eroded whatever gains had been made in reducing poverty through improved social welfare measures over the preceding three decades. These developments led policymakers to label the 1980s "the lost decade of development."
2.     Post-Crisis Studies have Shown that Stabilization and Structural Adjustment Programs have had Mixed Effects on Poverty and Income Distribution.
Post-crisis studies of the impact of SSAPs have helped policymakers evaluate whether such programs have had a negative impact on poverty and income distribution. The studies show that SSAPs have had mixed effects. Some studies indicate that SSAPs have adversely affected the poor and increased the gap between the rich and the poor in developing countries. This is because SSAPs have resulted in lower wages for laborers and increased unemployment. Funds earmarked by governments or the World Bank for "social safety nets" have fallen short of the amount required to prevent overall increases in poverty.
As one might expect, other studies have shown that SSAPs are not as detrimental as critics have claimed. Some have pointed out that the impact of SSAPs varies from country to country--they are not uniformly detrimental across developing countries. Others have shown that the plight of the poor can be improved after the implementation of SSAPs. For example, an overvalued exchange rate can reduce agricultural exports by making them more expensive for foreign consumers, thereby impoverishing people in the agricultural sector. A devaluation may improve those exports by making them less expensive and may indirectly increase the income of the rural poor. Still other studies have shown that avoiding adjustment or implementing adjustment policies that depart from IMF/World Bank criteria have resulted in skyrocketing inflation, which disproportionately hurts the poor who use most of their income for consumption.











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