Gregory Ruggiero
Independent Study
Professor Pantos
March 15, 1999
The debt crisis exploded into public view in August of 1982 when Mexico announced to the world that it was unable to pay what it owed to its international creditors. The rapid rise in large-scale loans to the Third World, especially to the largest and most rapidly growing countries such as Mexico, Brazil and Argentina, had occurred in the 1970s under conditions of rapid inflation and increasingly floating interest rates. In principle, as long as these loans could be repaid there was no crisis, just business as usual. The sudden onset of recession in 1980 and then again in 1981 in response to Paul Volcker and the Fed.’s tightening of the money supply and rapid rise in interest rates dramatically changed the situation of the debtor countries. The engineered rise in interest rates aimed at inflation, raised the cost of the loans and the recession, by reducing world output and trade reduced the debtor countries ability to earn the foreign exchange necessary to repay the loans. These were the direct and obvious causes of the crisis announced by Mexico in 1982 and subsequent defaults and reschedulings by a great many other countries. But behind this bottom-line crisis lie a continuing series of social crisis in both the debtor in creditor countries. The international debt crisis has continued to worsen since it erupted in the early 1980s. Currently, developing countries as a whole in Latin America owe over $600 billion. In a world where 20 percent of the people hold 83 percent of the world wealth while the poorest 20 percent received only 1.4 percent of the total income, over one billion poor people in the world’s impoverished countries suffer because of the debt. The debt crisis is far from over. You will see the causes “mainly a liquidity crunch” as well as some of the measures that were taken to try to resolve this crisis. You will also see the players in this tragedy; the debtor countries, the creditor countries, the creditor banks along with other third party banks. In conclusion I will offer possible remedies to the debt crisis, a crisis that has been ongoing for two decades.
1. Introduction
The debt crisis began in the mid-1970s when many of the Organizations of Petroleum Exporting Countries (OPEC) amassed wealth, and banks were eager to lend billions of dollars. Other developing countries around a world borrowed large sums of money at low, but floating, interest rates. As a result of the irresponsibility of both creditor and debtor governments, the countries did not use the money for productive investment; rather, they spent these new dollars on immediate consumption. Consequently, these countries had no money to repay their loans. Aristocrats controlled the government while the poor had no voice in these loan matters, nor did they benefit from them.
These adjustable interest loans skyrocketed in the early 1980s when the United States attempted to reduce inflation by enforcing stringent monetary policies while, at the same time, it also increased its military spending. The Reagan Administration did all of this while also cutting United States income tax rates. Around the Globe, raw material prices fell sharply, meaning poor countries had even less money to repay their debts. For example, both Brazil and Mexico nearly defaulted on their loans; and, according to international law, there was no option for these poor countries to declare bankruptcy. Commercial banks rescued their own situations and prevented default. However, many developing countries were left in great debt, and as a result, could no longer get loans. With nowhere else to turn, these nations have relied heavily on the World Bank or the International Monetary Fund.
The IMF required structural adjustment programs in these countries. Debtor countries had to agree to impose very strict economic programs on their countries in order to reschedule their debts and/or borrow more money. Put simply, countries had to cut spending to decrease their debt and stabilize their currency. The governments limited their costs by slashing social spending; education, health, social services, etc.., devaluing the national currency via lowering export earnings and increasing import costs, creating strict limits on food subsidies, cutting workers jobs and wages, taking over small subsistence farms for large-scale export crop farming and promoting the privatization of public industries. Most countries have suffered a recession and often depression; and the poorest of the poor are most affected. It is not hard to find evidence showing that the poor, women, children and other groups suffered disproportionately as a result of structural adjustment programs during the 1980s. As Latin America’s economies stagnated, 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. Poverty is 50 percent in growing; malnutrition is 40 percent in growing; children are increasingly recruited into the drug trade and prostitution; long-term unemployment and its adverse social effects are increasing; the weakening of local communities and networks of mutual support are being destroyed; and the growth of crime and an epidemic of homicides, are but a few of the many dilemmas that this debt crisis has caused.
I believe the debt crisis stemmed from a liquidity squeeze. Consider the role of the official sector in the crisis prevention and management. I maintain that many explanations of the Mexican crisis give insufficient emphasis to financial vulnerabilities, particularly mounting maturity and currency mismatches in public debt and in the banking system that together rendered the Mexican government illiquid and produced not only a currency crisis but a debt crisis. In my view, both host countries and international surveillance exercises need to pay closer attention to such indicators of financial vulnerability. I am also in favor of the IMF publishing its appraisals of country policy, deepening its contacts with private capital markets, and conveying a frank view on appropriate exchange-rate policy to its members.
In August 1982 Mexico announced to the international financial community that it did not have enough external liquidity to fulfill its financial obligations and requested a 90 day rollover of the payments of the principal to prepare toward definite restructuring financial package. Just a few weeks later, the problem spread all throughout Latin America and to other debtor countries. The impact from Mexico’s statement was far-reaching. This created an atmosphere that caused many people to issue dire forecasts, which thankfully were never realized. Most observers believe the petrodollar recycling of the 1970s gave rise to this debt crisis. During that period, the price of oil rose dramatically. As was stated before, oil-exporting countries in the Middle East deposited billions of dollars in profits they received from the price hike in United States and European banks. Commercial banks were eager to make profitable loans to governments and state-owned entities 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.
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 country exports, combined with a strong dollar 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 of outward transfers of money by private individuals and entities in developing countries.
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 authority or forum that could oversee and orderly resolution of the crisis, such as a global bankruptcy system.
A case-by-case debt restructuring negotiations saved the international financial system from collapse. Yet the principal players in the crisis, mainly governments, banks, the IMF and the World Bank, averted a collapse of the international financial system by resorting to slow and cumbersome approaches. The approach entailed engaging in a series of workouts with hundreds of commercial bank creditors throughout the world via Bank Advisory Committees, which were composed of banks with the greatest exposures to debtor countries. Under this approach, commercial banks agreed: (I) to provide new loans to debtor countries, and (ii) to 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 devaluation’s in order to increase exports. World Bank structural adjustment programs focused on longer-term and deeper structural reforms in debtor countries.
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, which attempted to alleviate the debt fatigue. The plan was designed to renew growth in 15 highly indebted countries through 29 billion dollars 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. I will touch upon the Baker plan in greater detail later in my report.
In light of what appeared to be a non-correctable 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 that many of the loans to debtor countries would not be paid.
The Brady initiative in 1989 focused on debt reduction tragedies. 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 and debt service reduction in exchange for continued economic reform by debtor countries.
Debtor countries obtained significant debt relief under the Brady initiative through: (I) direct cash buy backs; (ii) exchange of existing debt for discount bonds, which are bonds issued by the debtor countries with a reduced face value but carrying a market rate of interest; (iii) exchange of existing debt for par bonds, which carry the same face value as the old loans but carry a below market interest rate; and (iv), interest rate reduction bonds, which 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. I will touch upon the Brady initiative in more detail later in a report.
The Brady deal combined with economic reforms and increased flows of capital to debtor countries led some people 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, 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. As we will see, my report will show that the debt crisis was far from over.
With the resolve and atmosphere that fears of financial collapse can generate, creditor governments and multilateral institutions offered loan guarantees, debt equity swaps and debt rescheduling to countries willing to rapidly privatize, deregulate and open their economies to world trade and investment. After these and other measures were done, the creditors were somewhat off the hook, the crisis was downgraded to a problem and quickly disappeared from view. Once the debt became serviceable again, it was no longer a crisis for the world. It turned out to only be a crisis for the debtors who could not pay and develop at the same time.
When the debt disappeared from the political agenda of creditor countries, it disappeared from the debtor’s agenda as well, illustrating the degree to which the creditors came to define and thus dominate the terms of discussion. Putting the debt on the agenda, would have meant calling the very relationship between the U.S. and Latin America into question. The reluctance to do so may very well reflect the disappearance of an effective radical opposition within Latin America. Back in 1997, in a sign that this reluctance may have been just a temporary break, a group of Latin American parliamentarians gathered some two thousand people together in Caracas, Venezuela with the aim of reinserting the debt in the debate about Latin American development. At the gathering it was quoted that the character of most of our economies, is today determined by debts incurred through the errors and economic misjudgments of our governments, as well as through creditor countries abuse of the conditions of negotiation. The political problem, is that the debt, limits the ability of the indebted governments to make their own decisions.
The combined foreign debt owed by Latin American nations now stands at somewhat over 600 billion, up from 425 billion at the height of the crisis in 1987. It is not only the absolute size that hurts but also the size relative to the ability to pay. The region pays just under 30 percent of its export earnings to service those debts, and owes about 45 percent of its combined gross domestic product to foreign creditors. It is this drain on resources that feeds the growing social dislocation of so much of the continent and eats away at the ability of Latin American countries to make their own decisions at home.
When doing my research for this paper I came across an interesting quote from Congresswoman Ifigenia Martinez of Mexico. She summed up the problem in an interesting way. She said, “to say that a debt is unpayable, is to say that one cannot pay and continue to generate the income necessary to make further payments. This is now the case in Latin America, she asserts to no one’s disagreement, where in 1982, the chief goal of economic policy ceased to be long-term growth, and instead became payment of the debt. What, then, is the real value of the debt? It is that value, she says, that permits a country to grow and continue paying. The debt, proposes the Mexican Deputy, should be adjusted precisely to that real value. If not, the U.S. will continue to be collecting tribute from the South rather than earning a return on its investment”.
For developed country creditor institutions, namely the ones who counted on timely debt service payments for at least a part of their duration, a massive Latin American default, or even a significant interruption of payments, would have constituted a major hardship, and perhaps even called the possibility for the end of the international financial system. For the debtors, servicing the debt has become an insurmountable obstacle to growth and development. Since the eruption of the debt crisis, there is no question that we have avoided a major international financial crisis and that we have gained time and breathing space. But the problem is far from being over. Debt service payments are still too high, and this is hindering the prospects of growth, and with growth and significant forgiveness of debt that has been recently talked about, the possibilities do exist for this crisis to once and for all come to a halt.
What was done to try to correct the problem?
1. The Baker Plan “Growth, the Key to Breaking the Debt Crisis”.
The Baker Plan proposals begun in 1985 by then Secretary Treasurer Baker, in response to the mounting debt crisis that had started back in 1982. At Seoul in October 1985, U.S. Treasury Secretary James Baker reshaped the strategy for dealing with Third World debt. The Baker plan emphasized that the debt crisis could only be resolved through sustained growth by the debtor countries. To achieve the desired growth, the plan recommended programs of economic reform and structural adjustment for the debtor countries, including greater reliance on the private sector, curtailment of state subsidies and price controls, steps to stimulate both foreign and domestic investment, and export promotion and trade liberalization. Secretary Baker emphasized that the cornerstone of sustained growth must be greater domestic savings, and the investment of the savings at home. He stressed the importance of foreign investment as non-debt-creating. He also pointed out that equity investment has a high degree of permanence and is not debt-creating. Moreover he pointed out, it can have a compounding effect on growth, bring innovation and technology, and help to keep capital at home. The plan also called for private banks and multinational institutions to step up sharply their lending to the indebted countries. The banks were urged to provide new commercial credits of $20 billion over a three year period while World Bank and the Inter-American Development Bank would contribute an additional $9 billion in loans. The Baker plan called for an annual increase of around 2.5% in commercial lending. What did not change in Mr. Baker’s proposals was the reliance on continuing accumulating debt to finance growth. However, bankers were uneasy with this request, mainly from their exposure to existing loans and from angry shareholders. At the time of this request, many banks were under severe pressure to cut loose their existing loans, even at a lose, rather than increase their exposure. Without strong assurances on the new loans, it would be very difficult if not impossible to justify increased international spending.
The global banking community carefully examined the proposal through meetings and briefings by all the players in this tragedy from a financing standpoint. Mainly; the Treasury, the IMF, the World Bank and other creditor governments. Many of the banks formed large cohesive groups in order to collectively protect or try to protect their interests. These groups were the Institute of International Finance (IIF); the G-14 group of major international commercial banks, and later, national banking groups.
The IIF is a non-profit bank-financed organization comprising more than 185 banks. Its function is mainly informative by providing country analysis on some 40 borrowing countries to its members and serves as a forum for discussing international lending issues. Because the IIF members hold more than 85% of all overseas lending, they were the first group to oversee the Baker plan. The other forum, the G-14, which consisted of the largest international banks, also looked over the plan, and not to many peoples surprise, they both came out with more questions than answers. They endorsed the concepts of the plan, but noted that each bank would have to formulate their own response. It’s not surprising why the crisis continued to linger.
The part to play by the IMF was still in doubt. Mr. Baker gave it a central role, but some countries have drawn up their IMF access limits, and will soon have to start repaying. The role of the IMF will be somewhat more subdued if those countries that are not borrowing more decide not to listen to the IMF demands. It will be harder to impose strict IMF conditions where countries are not drawing additional credits, but only rolling over and repaying existing lines of credit.
The Baker plan gives new importance to the World Bank and other Multilateral Development Banks (MDBs), mainly the Inter-American Development Bank, both by increasing their disbursements and, as a condition of this, by giving them a bigger share of policy formation. The World Bank will be expected to increase from 11% to about 20% of total credits its non-project lending, in the form of structural or sectoral adjustment loans, aimed at improving either the whole economy, or key sectors such as foreign trade. In the past these loans have been linked with IMF programs. But countries such as Brazil were anxious not to be tied to two sets of conditions, and may regard the World Bank as more sympathetic to their pleas for gradualism and flexibility than the IMF.
The World Bank and the other MDBs will have to increase their outstanding credits far more rapidly than the commercial banks, even though each group of institutions is expected to contribute $20 billion over the next three years.
Its also important to stress the role of non-U.S. banks in international lending. They hold two thirds of the outstanding paper, and their commitment to the Baker plan was essential for its success. Also, in the U.S., the pledge was not communicated by the American Bankers Association, the largest association of U.S. banks. It was quit obvious from the outset, that even though the plan was aimed right, “Latin American Growth”, it turned out to be a smoking gun, only adding more fuel to the fire and piling more debt on top of the already unmanageable levels of existing debt.
The basic idea, that Mr. Baker finally recognized the severity of the problem was great, but the fact of the matter was, the plan fell short of any substantive successes in alleviating the debt problem. The problems with the plan lie with the details. The amount of new lending proposed was insufficient. The recommended policy reforms were insensitive to the political and economic situation of each country. The debilitating effects of high interest rates and low commodity prices were not addressed. The plan was geared towards the 15 largest debtors and neglected the needs of smaller countries. And finally, the problems caused by the huge U.S. budget deficit were ignored.
In order for Mr. Baker’s plan to work, all participants needed to be actively involved. One of the problems with this assumption lies in the fact that creditor banks were not as interested in the problem as they were back in the early 1980’s. In the five years since the Mexican crisis in 1982, the capacity and resilience of the global banking system has been bolstered substantially. Something positive has been achieved, but on the side of the creditors and at great costs to the debtors. Developing country debt accounted for less than 7% of the total assets by 1986 in U.S. banks while in 1981 it accounted for over 10%. The equity capital of the U.S. banking system has increased from about $80 billion in 1981 to nearly $150 billion in 1986 while LDC’s assets have increased from $131 billion to $154 billion. Because of this, banks are in a much better position because of their writedowns and increased equity buildups in their portfolios, and as such, their willingness to participate in the Baker plan was not as intense as it would have been, if it were proposed back in 1983 for instance.
In the years that followed the Baker plan, there has not been one significant contribution that it has been shown that the plan has indeed alleviated debt or restored growth. The Baker plan was certainly motivated more by a growing threat to creditors than by a worsening of economic problems of the debtor countries. It does not seem, however, that the plan was a complete falsehood. It was not designed merely to quiet the restrictiveness of the borrowing countries and induce them to continue along a path they no longer found acceptable, even though it seems, that it has effectively done just that. The reasons that the Baker plan failed can be found within all the participants; the reluctant banks, the passive debtors, and the confused and nervous creditor governments. The plan does not offer any regulatory or tax incentives to banks to continue their lending. Nor does it promise borrowing countries new lending without the adherence to traditional economic adjustment policies. Unilateral approaches like the Baker plan is difficult to implement, no matter how well thought out. Only a strategy that is formulated, endorsed, and managed by both the debtor and creditor countries will have any hope of succeeding.
The Baker plan has had mixed results at best. A number of the worst indebted countries had made progress in adjusting their external sector during 1986-88 and the threat to the international banking system has subsided, for the time being. But external financing in support of adjustment programs remained scarce. Net resource flows to developing countries, particularly from commercial banks, continued to fall. More importantly, they were insufficient in meeting the investment needs of these countries and in helping them meet their debt obligations. Because of all these facts, indebted countries had to cut back on investment. Their growth did not resume and living standards either stagnated or fell. The heavy debt burden continued to obstruct the mobilization of domestic resources, discourage repatriation of flight capital and direct foreign investment, and undermined the credibility of adjustment programs. I give the overall grade of the Baker plan, C, at least it started the discussion about the mounting debt problem.
2. The Brady Plan. “The Key to The Crisis is Debt Reduction”
On March 10, 1989 the United States approach to managing the Third World debt took a dramatic turn. Treasury Secretary Nicholas F. Brady acknowledged that serious problems and impediments to a successful resolution of the debt crisis still remains. He declared that, the path toward greater creditworthiness and a return to the markets for many debtor countries needs to involve debt reduction.
The framework that Brady outlined in his speech is only a first step toward designing and implementing a more effective approach to dealing with the problem. The major elements of the Brady initiative are as follows. First, in order to qualify for debt reduction, debtor nations under the IMF and World Bank economic programs must undertake sound growth oriented policy measures to encourage foreign investment flows, strengthening domestic savings, and promote the return of flight of capital. Second, to accelerate the pace of voluntary market based debt reduction and pass the benefits directly to the qualifying debtor nations, commercial banks should negotiate a joint waiver of the sharing and the negative pledge clauses included in existing loan agreements for a three-year period. Third, the IMF and World Bank would provide financial support for two types of debt reduction transactions, which could be the form of converting the bank loans into new bonds with reduced principal or reduced interest rates, and debt buy backs with cash. Fourth, in order to provide more timely and more flexible financial support to the reforming debtors, the international financial institutions should not hold hostage initial disbursements to firm commitments of other creditors to fill the estimated financing gaps. Fifth, debtor nations should maintain reliable debt to equity swap programs and permit domestic investors to engage in such transactions to encourage the repatriation of flight of capital. Sixth, the return of the use of public funds to enhance the quality of their L. D.C. exposure and for being able to engage in debt to equity swap programs, commercial banks should provide new money in the form of trade credits, project loans, as well as voluntary and concerted lending. And finally, creditor governments should continue to restructure their own claims through the Paris Club, provide additional financial support to debtors pursuing debt reduction, and maintain open and growing markets with sound policies. They should also ease existing regulatory, accounting, and tax impediments to debt reduction.
There seems to be many flaws with the Brady plan. Countries that need debt reduction need it because they have too much debt to start with. A country can reduce its current resource transfer with new money from banks, but only at the expense of worsening its future capacity of paying off the debts. It’s like throwing fuel on the fire. The seeds of today’s debt problem were planted back in the 1970s when commercial banks were actively encouraged to finance the balance of payments deficits of Third World countries. Any new idea of debt reduction should encourage banks to reduce their claims so that the countries do not need new bank money to service old bank debts.
The Brady plan does not seem to share this same view on bank activities. Mr. Brady’s view seems not to be too much old bank debt, but too little new bank money. Looking at the plan, at this angle, one can see that the plan has not alleviated the debt problem, but only made it worse. Countries needed debt reduction even more because the commercial banks cut back on their loans and thus made it even harder for banks to pay their loans. By trying to force the banks and the debtor countries to remain in the debt trap that they got into during the irresponsible overborrowing and overlending of the 1970s, the new approach may increase the possibility of the counterproductive process of subjecting development finance to the distortions and imbalances of a historical accident that could have been avoided.
Another weakness of the plan lies in the fact that the proposal involves only a part of the total debt of the troubled nations, the part that is owed to commercial banks. But one must remember that the banks have, in large part, lowered their exposures to the debt balance outstanding by writedowns and equity inflows to their balance sheet. Also the spotlight of the proposals has been on debt reduction rather than interest rate reduction. If Mr. Brady wanted to help the cause, he should have proposed interest rate reductions rather than debt reductions for obvious reasons. Debt reduction that a country may get from a principal reduction can easily be offset by increases in international interest rates. For example, the 20 percent average debt reduction that the Treasury estimates the 39 debtor countries may receive under the plan, if provided in the form of principle reduction, is equilivant to a 2 percentage point reduction in their cost of borrowing. A much more substantive approach to the crisis that was mentioned involves, providing relief to countries to convert their variable rate loans into fixed-rate loans or bonds with market discount rates. It is very important that the interest rate be not only reduced below the market rate, but that the rates remain fixed during the life of the loan.
The Treasury suggests three major instruments for debt reduction: exchanges of loans for bonds with reduced principal or reduced interest, buybacks of loans with cash, and debt/equity swaps. The IMF and the World Bank are expected to support the first two types of reductions, to make them attractive for the banks. The third item, debt/equity swaps, do not need any sweeteners, because the constraint is not with the banks but with the debtor governments. In this type of swap, a foreign investor buys the debt at a discount, converts it to local currency, and invests it back into local business or property. These swaps reduce external debt of a country in a way that may not be desirable on the grounds of stabilization, efficiency, and equity. These swaps increase inflationary pressures, and they do not increase new capital inflows. While debt/equity swaps could be of limited use if carefully controlled, they do not represent stabilizing, efficient, and equitable debt reduction, and as such, should be dropped by the Brady plan. Cash buybacks make sense only if the following three conditions are met. First, the secondary market price must be very low. Second, the buyback applies to all longer-term bank debt where both the buyback price and full participation by all banks are negotiated rather than left to a market auction. And third, the resources to purchase debt are donated by third parties such as the creditor governments and the multilateral development banks.
The main goal of a new debt strategy should be to revive growth in the debtor countries by cutting their debt service burden substantially, and not to encourage large-scale bank lending to the developing countries for financing their balance of payment deficits. It is unrestrained lending and borrowing by the banks and the developing countries in the wake of the oil shock that led to the debt crisis in the first place. It would be a shame if that lesson is not heeded in meeting the future external financing needs of the developing countries as efforts are made to resolve the current crisis. In terms of total debt stock this plan has not helped debtor countries. As commercial debts have fallen, multilateral debts have risen. Resources continue to flow out of these countries to pay interest on Brady Bonds. Debt service was lowered to levels, which were already being paid, so no actual benefit accrued to the debtor country. The Brady plan was much more close the problem than was the Baker plan. Because of this, my overall grade for this initiative, B.
3. The Highly Indebted Poor Country Initiative (HIPC) “Debt Forgiveness is The Key”
After the Baker plan and its call for growth failed, and then the Brady plan and its call for debt reduction failed, HIPC came along and proposed the ever popular proposal for debt forgiveness. In October 1996, there was a major shift by the IMF and the World Bank when they produced a debt relief initiative, which contemplated for the first time the cancellation of debts, owed to them. The agreement also recommended a strategy to enable countries to exit from unsustainable debt burdens. Briton’s Chancellor proposed that the Initiative should be financed through the sale of IMF gold. The Initiative proposed 80% debt relief by the key creditor countries (Japan, U.S., Germany, France and Briton). The World Bank announced the establishment of a Trust Fund to finance the Initiative.
The World Bank has committed resources to the Trust Fund, while the IMF has not. Instead it will offer cheaper loans to pay off expensive loans. There has been no agreement to sell IMF gold. And the Paris Club of key creditor countries has been reluctant to give the necessary minimum 80% debt relief. In practice, HIPC has been very limited in effect.
While many believe that the dreaded forgiveness word, should never have been spoken, others believe that the actions over the past 17 years show that is precisely where we are headed. Look at what the banks have been consciously or unconsciously doing. They have been reserving billions of dollars in the face of potential mounting unpaid debts. They have been selling loans using debt/equity swaps in the tune of several billions of dollars. They have been outright selling and writing off bad performing portfolios of debt. This seems to be showing that, debt forgiveness is not only conceivable, it is also unavoidable.
Some feel that debt forgiveness is not necessary and could even be counterproductive. They bring up that defaults in Latin America in the 1930s locked countries out of the capital markets for 30 years, and they say that doing the same now, could possibly do the same thing. I for one do not believe that scenario. The facts are completely different than they are now. In the 1930s the whole world economy was in a deep depression, and it was very difficult for any financial institution to step in, and help them out. Also the financial system was not at all the same with regards to the world economies. The economies back in the 30s were tied to the gold standard, while today we come under the Bretton-Woods system of economic stability.
So far creditor governments have fiercely resisted making outright donations to LDCs or guaranteeing portions of their debt. But a growing number of debt consultants and bankers believe that this will have to change if the next stage of the debt crisis is to be manageable. Budget deficits are one major reason for the resistance, especially in the United States. But as Latin America continues to groan under the debt burden, more people are questioning whether the industrialized governments shouldn’t do more to ease the debt load. Bankers and debt experts point to West Germany and Japan as two surplus running countries that should be doing more, especially when the U.S. helped them rebuild their own economies after World War II ravaged their country. This is the closest idea thus far to attempt to end the debt crisis. At least the crisis is being looked at realistically, and because of that I give it the highest mark so far, B+.
Mexico Rocks the Financial World Again in 1994 With the Mexican Peso Crisis. Showing the World that The Financial Crisis Is Far From Over.
Mixed results characterized economic performance in the countries of Latin America in 1995. While the total regional economy grew by only .8%, sharp distinctions persisted among the countries of the region. The December 1994 peso crisis in Mexico led to a substantial 6.9% decline in GDP in 1995. In Argentina and Uruguay, the main countries affected by carryover from the Mexican crisis, their economies contracted by 4.4% and 2.5% respectfully.
The crisis in 1994 underlined the significant fragility and vulnerability in many of the region’s financial and banking systems, not only in Mexico but also in Argentina and a number of other countries. In both Mexico and Argentina, the weak position of the banking system contributed to the poor GDP performance. Investors, both international and domestic, feared that a collapse of important banks could result in major economic dislocations, massive and costly bailout programs, and a resurgence of inflation. Argentina’s weakness in their banking system tested the convertibility program and, the exchange rate regime. In Brazil, the weakness of their banking system, and especially the state owned banks, has added significant uncertainty to the public deficit picture. Central bank moves to provide liquidity to private banks in distress and treasury obligations to recapitalize public banks will add significant amounts of public debt over the next few years.
There are many problems that lie ahead for Latin America. The Latin American region is capable of achieving a growth rate of 6% by the turn of the century, under reasonable assumptions about the evolution of the external environment and of appropriate domestic policies. Increased domestic savings rates will be crucial for more robust growth to occur. One of the important lessons of the Mexican crisis is that domestic savings matter greatly. They are important because they help finance the accumulation of capital and, because of that, facilitate growth, and also because of high domestic savings are associated with lower current-account deficits. Latin America, however, has traditionally had very low saving rates. In 1980 the region saved on average only 19% of its GDP, by 1994 this ratio was basically unaltered. This contrasts sharply with fast growing regions of the world that save 35% or more of GDP.
On January 14, 1999, Financial markets plunged because Brazil devalued its currency. Still we see the financial difficulties facing this region. Brazil devalued the real by 7.5%. The action was followed by the resignation of the president of Brazil’s Central Bank, Gustavo Franco, a leading advocate of the harsh austerity policies which Brazil has pursued over the past four years. The devaluation was triggered by a political crisis within Brazil, arising from domestic opposition to the austerity measures demanded by the IMF as the price of the $42 billion loan package agreed on back in November 1998, to provide a financial cushion for the Brazilian markets and its currency. 1998 was Brazils worst economic performance in six years, pushing into a recession and the worst could be yet to come. Latin America’s biggest economy shrank by 1.89% in the fourth quarter 1998, from the same quarter a year earlier. For all of 1998, the economy grew just .15% after a 3.68% expansion in 1997. That showing was the weakest since growth of .54% in 1992. Brazil was affected by the crisis in Asia along with Russia, further depicting the interlocking of economies all over the world. This is an issue that is even more important now than it was back in 1982, because of the advancements in technology that has created an ever shrinking marketplace and creating a tighter global economy. JP Morgan predicts Brazil’s economy will shrink by 5.5% in 1999. That would represent Brazil’s worst recession in 30 years.
On March 12, 1999 it was reported in the Wall Street Journal that “Demonstrations in Ecuador Fade, But Nation’s Economic ills Persist”. In February 1999 Ecuador’s Central Bank devalued the nations currency for the third time in less than a year before ultimately abandoning the exchange-rate band system. In the beginning of March, Ecuadorians began to yank millions of dollars out of banks, pushing their currency down 26% in value compared with the U.S. dollar.
These are but a few incidents, that have materialized over the past few years, and show beyond a shadow of a doubt, that the financial crisis in Latin America, is alive and well. Unless something is done in earnest to deal with the problem, the whole world economy could one day be devastated.
Conclusion
No matter what type of reform is initiated, the fact remains you need sound economic policies that are sustained by all of the market participants. Just because the crisis is manageable today does not mean that it will not deteriorate into a full-blown crisis tomorrow. There have been many suggestions for reform, or different types of reform. Some of these suggestions are: first, forgive countries debts; second, some recommend that governments and commercial banks cancel some of the debts; third, restructure the IMF demands on countries in debt; fourth, reduce trade restrictions on the products of poor nations; fifth, loans and grants to poor nations should be in smaller amounts and specifically applied; and sixth, create new ratios for the heavily indebted poor countries. Use debt to GDP and debt to budget expenditures instead of debt to exports and debt service to exports.
I believe that future economic crises in developing countries should be handled on a case-by-case, market oriented basis, not by a predetermined arrangement supervised by international financial institutions. Reading in the Wall Street Journal a few weeks ago I noticed an interesting article that was in the Letters to the Editor section of the paper. An excerpt from the article is as follows: the IMF is a negative force. This isn’t a recent phenomenon, however. In the nearly three decades since the Bretton Woods system started, the IMF has developed into a negative force. Countries that have come under its sway see it as an agent of U.S. bankers and financiers. Since the early 1970s, the Fund has impoverished much of the developing world through its mindless formula of increasing taxes to balance budgets and depreciating currencies to promote going out of business export sales. Despite promises to reform, the IMF continues to inflict its damaging policies on countries already suffering from financial and economic collapse. The article goes on to say; who can deny that the IMF helped wipe out the savings of ordinary citizens and families in Mexico when it supported the devaluation of the peso for years ago? The hope that NAFTA would bring about a new era of prosperity that would raise the standard of living in such poor states was quickly dashed. Although I do not want to seem that I agree with this opinion, there does seem to be some elements of truth that one cannot idly sit back, and say or assume that everything the IMF does is automatically correct.
The major reason I give for recommending the case-by-case approach for future crises is the vast changes that have occurred in recent years in international markets that have strengthened and greatly diversified international financial flows. Some of these examples were discussed toward the end of the last section. As a result, crises that do arise are likely to be isolated and sporadic, rather than pervasive as in the late 1930s and 1980s. Today’s countries have more moderate debt, sounder economic policies and receive more of their capital in the more stable form of direct investment. Past approaches such as rescheduling long-term bank claims, so common in the debt crisis and 1980s, have lost much of their relevance, because of the great changes in capital markets. In 1988 rescheduling of bank claims would have eased Latin America’s cash flow by 25 percent of imports, but today it would ease the flow by roughly three percent. Equity flows, both as direct investment and the more volatile portfolio investment, now account for more than half of total net flows to emerging markets, with multinational corporations, mutual funds, insurance companies and pension funds all increasingly involved. Capital mobility has seemed to have grown dramatically.
It is important to try to avoid future crisis in advance rather than acting in a reactionary manner, as has been done in the past. Industrial countries should continue to reduce fiscal deficits, implement prudent monetary policy, and face up to structural challenges so that interest-rate shocks do not recur and sustained growth is realized. Emerging market economies should reinforce their commitment to fiscal balance, exchange-rate realism, and ongoing structural reforms, which have played the major role in the normalization of emerging capital markets in the 1990s. The IMF for its part should continue to improve its surveillance efforts by strengthening its dialogue with private market participants.
Latin American countries need to do a number of things in the future, to strengthen their financial position. They should allow higher priority to the safety and soundness of their banking systems. A weak banking system can seriously restrain as it did in Mexico. They should follow sound management policies. Trying to save on borrowing costs by relying on short term, foreign currency debt is a penny wise, pound-foolish strategy in today’s world of volatile international capital flows. Those countries should also maintain a healthy cushion of international reserves. Countries that let their international reserves become small relative to the stock of liquid short run liabilities of the government or banking system are playing with fire. These are but a few of many sound fiscal policy’s that Latin American countries need to do in order to take control of their mounting financial problems.
With increases in information technology, another crises could have even more dire results, than what was realized back in the 1980s. Back then, it was mainly contained to our side of the world, but any future problems will have a snowball effect all over the globe, as has been seen with the Asian contagion. Debt forgiveness sounds like a righteous thing to do, but from a financial standpoint, that is not the way to handle this problem. That would only invite more fiscal mismanagement, and the lending community would not be so free next time to give their money away to corrupt and immoral LDCs leaders.
The financial crisis is not over, although things seem to have been settling down. The debt problem must be handled, before substantive steps can be taken to bolster the international financial system. Even the slightest downturn in commodity prices or upticks in interest rates have recently touched off financial turmoil. We are not out of the woods yet.
Aaronson, Susan., The Marketing And Message Of The Baker Plan, The Bankers Magazine, July-August 1986.
Andrews, Suzanna., Debt Forgiveness Gains Ground, Banking, 1988
Cline, William R., International Debt: Progress and Strategy, June 1988
Husain, Ishrat., Recent Experience with Debt Strategy, Finance&Develeopment, September 1989.
Islam, Shafiqul., Going beyond the Brady Plan, 1989
Johnson, Christopher., Fleshing Out The Baker Plan For Third World Debt, 1985
Main, Jeremy., A Latin Debt Plan That Might Work., Fortune Magazine, April 24, 1989
McLaughlin, Martin., Financial markets plunge as Brazil devalues currency. 1/14/99
Still Paying Ten Years After The Debt Crisis,
http://nacla.org/english/lat_rec/debintro.htm.
Latin America Annual Report 1998, http://www.worldbank.org/html/extpb/annrep98/latin.htm
1996 Latin America Prospective,
http://www.worldbank.org/html/extpb/annrep96/wbar08d.htm
Private Capital Flows
http://www.iie.com/PRESS/cappress.htm
Links Dealing With The Latin America Debt Crisis
The World Bank Annual Report
Latin America Online: Best Databases for News, Business and Current Affairs
Solutions For The Debt Crisis
Financial Archives With A Digital Bias
