Latin American Soverign Debt-crisis ( 1982-1989)-

Latin American Soverign Debt-crisis ( 1982-1989)

Period also referred as lost decade “many Latin American countries became unable to pay their foreign debt.”

o   The Origins of the Debt Crisis-

o   During the 1970s, two large oil price shocks created current account deficits in many Latin American countries. At the same time, these shocks created current account surpluses among oil-exporting countries.

o   With the encouragement of the US government, large US money-center banks were willing intermediaries between the two groups, providing the exporting countries with a safe, liquid place for their funds and then lending those funds to Latin America.

o    Latin American borrowing from US commercial banks and other creditors increased dramatically during the 1970s. At the end of 1970, total outstanding debt- $29 billion, 1978- $159 billion and 1982- $327 billion.

o   The nine largest US money-center banks held Latin American debt amounting to 176 percent of their capital; total less-developed country (LDC) debt was nearly 290 percent of capital.

o   Initially, the near-zero real rates of interest on short-term loans along with world economic expansion made this situation acceptable in the early part of the 1970s.

o   By late in the decade, however, the priority of the industrialized world was lowering inflation by tightening of monetary policy in the United States and Europe.

o   Nominal interest rates rose globally, and in 1981 the world economy entered a recession.

o   Commercial banks began to shorten re-payment periods and charge higher interest rates for loans. The Latin American countries soon found their debt burdens unsustainable.

o   August 1982, when Mexican Finance Minister informed the Federal Reserve chairman, the US Treasury secretary, and the International Monetary Fund (IMF) managing director that Mexico would no longer be able to service its debt, which at that point totaled $80 billion. Other countries quickly followed suit. Ultimately, sixteen Latin American countries rescheduled their debts, as well as eleven LDCs in other parts of the world.

o    In response, many banks stopped new overseas lending and tried to collect on and restructure existing loan portfolios. The abrupt cut-off in bank financing plunged many Latin American countries into deep recession and laid bare the shortcomings of previous economic policies based on “high domestic consumption, heavy borrowing from abroad, unsustainable currency levels, and excessive intervention by government into the economy”.

o   IMF and Central Bank Involvement- In August, the Fed convened an emergency meeting of central bankers from around the world to provide a bridge loan to Mexico. Fed officials also encouraged US banks to participate in a program to reschedule Mexico’s loans.

o    As the crisis spread beyond Mexico, the United States took the lead in organizing an “international lender of last resort,” a cooperative rescue effort among commercial banks, central banks, and the IMF. Under the program-

§  Commercial banks agreed to restructure the countries’ debt,

§  IMF and other official agencies lent the LDCs sufficient funds to pay the interest, but not principal, on their loans. In return, the LDCs agreed to undertake structural reforms of their economies and to eliminate budget deficits.

§  The hope was that these reforms would enable the LDCs to increase exports and generate the trade surpluses and dollars necessary to pay down their external debt.

o   Although this program prevented an immediate crisis, it allowed the problem to fester. As, many LDC countries, instead of eliminating subsidies to state-owned enterprises, instead cut spending on infrastructure, health, and education, and froze wages or laid off state employees. The result was high unemployment, steep declines in per capita income, and stagnant or negative growth—hence the term the “lost decade”.

o   US banking regulators allowed lenders to delay recognizing the full extent of the losses on LDC lending in their loan loss provisions. This forbearance reflected a belief that had the losses been fully recognized, the banks would have been deemed insolvent and faced increased funding costs.

o   After several years of negotiations with the debtor countries, however, it became clear that most of the loans would not be repaid, and banks began to establish loan loss provisions for their LDC debt. The first was Citibank, which in 1987 established a $3.3 billion loss provision, more than 30 percent of its total LDC exposure. Other banks quickly followed Citibank’s.

o   By 1989, it was also clear to the US government that the debtor nations could not repay their loans, at least not while also rekindling economic growth.

o   Secretary of the Treasury Nicholas Brady thus proposed a plan that established permanent reductions in loan principal and existing debt-servicing obligations.

o   Between 1989 and 1994, private lenders forgave $61 billion in loans, about one third of the total outstanding debt. In exchange, the eighteen countries that signed on to the Brady plan agreed to domestic economic reforms that would enable them to service their remaining debt.