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EMERGING MARKET DEBT DEFAULT CRISES
The debt crisis refers to the subsequent financial problems in liquidity- squeezed debtor countries all over the world. Although the debt crisis in sub-Saharan Africa wrought disastrous effects on those economies, it was smaller in scale, especially in terms of private debt, than the crisis in Latin America. At the other end of the spectrum, Asia generally recovered more quickly due to higher growth rates (as in the case of Korea), targeted state intervention, and capital controls. Latin America, with large amounts of privately funded debt and a sudden slowdown in growth, bore the brunt of the crisis.
The instability of the 1970s paved the way for the rise of conservatism in the United States (US) and the United Kingdom (UK). Americans had struggled with recession in the 1970s and were interested in earning a better living on the free market. Monetarists such as Milton Friedman believed that control over the money supply was all that was necessary to control the national economy, and promoted the free market ideals held by economists at the University of Chicago. Influential Western economists thus became less focused on social welfare and more trained on individual gain. This movement away from social needs toward the needs of the individual was reflected in creditor nations’ attitudes toward debtor nations.
Developing countries suffered not only as a result of the oil shocks, but also as a consequence of declining aid. Official development assistance to developing countries had already decreased in the early 1970s. There was a gap not only in funds to finance oil imports, but also to finance development. Commercial banks involved in petrodollar recycling rushed in to fill this gap, providing structured loans that extended risk to the developing countries. The banks put the onus of currency and interest rate risk on the borrowing countries by lending in dollars and using floating interest rates (Giddy 1994). Syndicated loans, put forth by a larger number of eurobanks, spread default risk over several banks (Griffith-Jones and Sunkel 1986). This, in combination with an expanding eurocurrency market, meant that more money could be lent abroad.
As developing country debt burdens became larger, banks lent on increasingly shorter terms to reduce their exit risk. Short-term debt expanded twice as fast as medium- and long-term debt in 1979 as Japanese and European banks accelerated their participation in lending to developing countries (Kahler 1985). As a result, external shocks from the oil crises gave way to overlending to oil importing developing nations, many of which did not have strong domestic policies. Banks, supported by Organisation for Economic Co-operation and Development (OECD) governments, had lent money to the developing nations without truly questioning it.
For their part, Latin American nations had turned from import substitution industrialization policies to export-oriented production, which generated foreign exchange, but in often sporadic flows. The export sector stagnated when developed countries’ demand for goods from Latin America diminished, and tax collected from the sector lagged as well. Tax reform to extend the tax base was necessary but difficult politically and administratively, and the deficit grew as exports shrank (Griffith-Jones and Sunkel 1986). Not only was the economic base, the export industry, procyclical, but so were international credit flows. These factors together exposed Latin American countries to external shocks. For these reasons, trade liberalization often (as in Chile, Argentina, and Uruguay) had a negative impact in the region in the 1980s.
Latin America was also dominated by authoritarian political regimes by the mid-1970s, except for Costa Rica, Colombia, and Venezuela (Dominguez 2008). These authoritarian governments made the decision to go into debt rather than to undergo structural economic adjustment. These governments also preserved institutions that created inequality, keeping much of the region poor and struggling to repay the sovereign debt.
In late 1979, and early 1980 and 1981, US Federal Reserve Chairman Paul Volker raised the federal funds rate to fight inflation in the US (Goodfriend 2005). The increase in interest rates caused recessions in the US in 1980 and 1981. The increase also strengthened the dollar and caused an increase in the London Interbank Offered Rate (LIBOR), to which most of the floating rate debt was tied. This made it extremely difficult for developing countries to repay and service their debts (Kahler 1985). In addition, the US recessions resulting from the Federal Reserve’s policy hurt the exports of Latin American countries, leaving them with reduced income from which to pay their increasing debt service. As the debt-to-export ratio plunged starting in 1980, banks stopped lending to developing countries. Developing countries faced a sudden stop in economic growth and in access to foreign exchange (Meissner 1984). International banks, particularly US banks, faced potentially enormous losses from the outstanding loans.
The debt crisis came to a head on August 12, 1982, when Mexican Finance Minister Silva Herzog announced that Mexico could not meet its upcoming interest payments on foreign debt. Mexico’s postponement of debt servicing was a surprise, since Mexico was an oil exporting, rather than an oil importing, nation. The debt, however, had been largely used for investment in infrastructure, economic development, and consumption. Reversals in oil earnings flowing into Mexico, triggered by a sharp drop in oil prices on the market just as Mexico tried to sell at higher prices (Trevino 1989), led to a sudden inability to service borrowings from abroad (da Costa 1991). In addition, interest rates that had been very low or negative in the 1970s suddenly increased and made debt servicing obligations for indebted countries unbearable.
The situation in other countries was similar: increasing interest rates, along with declines in commodity prices and a sharp reduction in foreign lending, produced shocks that rippled across the developing world (Sachs 1989b). Argentina, Brazil, and other countries soon followed with their own debt service moratoriums (Van Wijnbergen et al. 1991). Currencies were viewed as overvalued and a devaluation was expected to take place. Capital flight therefore represented not only the debt crisis but a speculative attack against local currencies, as domestic investors sought to move out of the local currency (Edwards 1989).
Economists had warned that this type of crisis could occur, as petrodollar recycling continued in the 1970s. The debt crisis as a phenomenon was not altogether a surprise, but the massive, systemic nature of the crisis was quite a shock. The Latin American debt crisis was viewed as a serious problem that could wreak havoc on the international financial system, and therefore developed nations’ governments had a stake in maintaining liquidity in the system and enforcing debt repayment. This is because the debt crisis threatened to stop trade and finance between developed and developing nations, and to throw into question the solvency of many banks (Kapstein 1994). Although many banks in developed countries had lent to Latin America, American banks were particularly at risk, since they had an exposure of 177 percent of capital to the four largest Latin American less-developed country debtors (Ferraro and Rosser 1994). Should the largest debtors default, American banks would be left with no remaining capital.
Investors both abroad and at home had lost confidence in the financial systems in developing nations, and capital flight from Latin America grew. Several countries faced a debt crisis, in which they were forced to reschedule payments due to an inability to pay on time. However, even rescheduled payments faced the danger of becoming onerous with an increase in prime interest rates (Meissner 1984).
The four most highly indebted countries included Mexico, Venezuela, Argentina, and Brazil, which held 75 percent of commercial bank debt; and the larger debtors thereafter were located in Latin America (Bolivia, Chile, Colombia, Costa Rica, Ecuador, Peru, and Uruguay), in the Caribbean (Jamaica), in Asia (the Philippines), in North Africa (Morocco), in sub-Saharan Africa (Nigeria and Ivory Coast), and in Eastern Europe (Yugoslavia) (da Costa 1991). Countries in sub-Saharan Africa, which had relatively smaller levels of debt, faced severe debt servicing problems due to their relative impoverishment. Official development assistance to sub-Saharan Africa comprised the largest part of their debt, and this proved burdensome to debtor nations despite the adjustment efforts through the Paris Club, International Development Association (IDA) adjustment lending, and the Enhanced Structural Adjustment Facility (Humphreys and Underwood 1989).
Highly indebted countries had grown at a rapid pace due to increasing global trade between 1965 and 1973, but were forced to borrow during the oil crises in order to maintain growth, and hence suffered as a result of the subsequent interest rate increases. The collapse of commodity prices in 1980-82 due to the recession in developed countries worsened matters (Griffith-Jones and Sunkel 1986). These highly indebted countries, which had run average annual trade deficits of $2 billion between 1973 and 1982, turned the deficits into a surplus of $32.7 billion during the period 1983 to 1986, but this turnaround was also reflected in falling growth of gross domestic product (GDP) per capita, which fell from 2.6 percent between 1973 to 1980 to -2.6 percent between 1980 and 1985 (da Costa 1991).
Latin American financial sectors faced difficulties, and the governments of debtor countries often assumed the external liabilities of the private sector (Easterly 1989). Central banks made emergency loans to Mexico, Argentina, and Brazil. Extensive government intervention was required in the case of Chile’s banking sector, in which foreign funds were suddenly reduced by more than 75 percent (Edwards 1989). Indebted countries such as South Korea, which cut budget deficits and devalued exchange rates, fared better than countries that did not implement these types of policy responses (Sachs 1989b).
In countries that performed worse during the debt crisis, fiscal conservatism was viewed as politically unpalatable. However, the type of spending was problematic. Although fiscal spending during a crisis can alleviate the impact of the downturn, fiscal spending in Latin America continued to favor social groups that were already better politically represented. Deficits increased. Deficits also grew as a result of reduced tax revenues (Edwards 1989). Government deficits were financed by printing money, which created inflation in the already weakened economies and subsequent devaluations. Hyperinflation resulted in Brazil and Mexico between 1980 and 1987 (da Costa 1991). Stabilizing the price level led to stabilizing the exchange rate by selling foreign exchange, running down central bank reserves.
Volatility of fiscal circumstances increased greatly in the 1980s throughout Latin America, as underlying macroeconomic indicators shifted (Gavin and Perotti 1997). This occurred both on the revenue and on the expenditure sides. Fiscal policy has been particularly procyclical during economic downturns. Monetary conditions were also volatile, with fluctuating currencies and high inflation. Argentina, Brazil, Peru, Uruguay, and Venezuela adopted several policies in attempts to stabilize their economies, with little to no success due to a lack of credibility arising from inconsistent policy mixes, lack of fiscal reform, and lack of structural reform. Attempts to improve economic stability by taxing financial and exchange transactions (as in Argentina and Brazil), instituting price and/or wage freezes (as in Brazil, Argentina, and Venezuela), and cutting public investment worked at times in the short run but not in the medium to long run. Countries with a more positive outcome were few, although Chile, Bolivia, and Mexico had some success in stabilizing their economies during the 1980s (Ter-Minassian and Schwartz 1997).
In response to the crisis, the US acted as lender of last resort to Mexico, providing $700 million at the beginning of 1982 (Kapstein 1994). Later that year, the Group of Ten (G-10) countries put together a $1.85 billion loan. The diagnosis of the crisis was that it was one of illiquidity rather than insolvency (Devlin 1989). Therefore, at the same time, banks were told that they had to continue lending to Mexico so that the country could make its interest payments. By contrast, increasing indebtedness was not viewed as a solution by the banks. Argentina and Brazil soon spiraled into crisis and received aid from the largest central banks. Rescheduling agreements were signed with the International Monetary Fund (IMF) and the banks.
Complicating matters was the fact that debt relief was not seen as sufficient unless it was linked to structural reform (Rotberg 1989). American political leaders insisted on austerity packages that would turn debtor countries away from what they viewed as bad economic management. Even given a commitment to structural reform, there was a view among some American bankers that political will would be key in determining whether countries could sustain long-t erm growth by giving up their “short-Sived consumption-based policies” in favor of “job-creating investment-oriented policies” (Rhodes 1989).
These “new, improved” policies were later dubbed “Washington Consensus” policies. These included fiscal discipline, reprioritizing public expenditures, tax reform, liberalization of interest rates, liberalization exchange rates, liberalization of trade, liberalization of inward foreign direct investment (FDI), privatization, deregulation, and increase in property rights (Williamson 2004). Most of these policies were punitive toward the country undergoing them.
As long as countries did not default or impose a payment moratorium on their debt, they were forced to bear the brunt of the crisis. The US Congress was not in favor of bailing out banks with large exposure to developing countries’ loans (Rotberg 1989). For the countries themselves, a current account deficit was no longer viable as foreign funds were unavailable to finance it. Even trade credit had evaporated. Hence, Latin American countries saw a sharp drop in imports, while exports fell somewhat (Edwards 1989). Countries were far from being able to increase exports to produce much-needed foreign exchange, dampening economic growth and worsening the ability of these nations to continue paying down debt. It was estimated that countries would require a 4 to 7 percent growth rate in order to repay debt without large net resource transfers, and this growth rate was, at least in the short run, unattainable (Meissner 1984).
There were real shocks as well, as income and employment in developing nations dropped and poverty soared. Real wages declined across Latin America (Edwards 1989). The lack of social security and unemployment benefits in developing countries translated into a shock, with no cushion, for developing country citizens (Griffith-Jones and Sunkel 1986). Many of those in developing countries were unable to pay for housing and public services such as water, sewage, and electricity. Loan repayment took precedence over economic well-being in developing countries. The time period in which indebted countries were expected to implement structural adjustment measures was about 18 months, a period too short to foment growth, especially when government officials who were supposed to oversee reforms were constantly in the process of negotiating with creditors (Collas-Monsod 1989). As a result of stringent loan repayment schedules, net resources did not remain in the country for the very investment required by the loans they repaid.
Devaluations occurred, varying by extent and timing from country to country, with most major debtors adopting some type of crawling peg regime as of July 1986 (Edwards 1989). Countries also adopted multiple exchange rate regimes, with different exchange rates on capital and current account transactions, to protect private sector repayment of foreign debt. In particular, a “preferential” exchange rate was provided for repayment of foreign debt. However, real devaluations were difficult to maintain for long periods of time due to the implementation of inconsistent macroeconomic policies, as domestic prices rose to combat the impact of devaluations.
The Reagan administration in 1983 obtained an $8.4 billion increase in funding to the IMF, on conditions, imposed by Congress, that international lending be improved in terms of risk evaluation, supervision, and regulation (Kapstein 1994). These agreements also required timely debt servicing of interest payments (an important element of international financial relations), rescheduling of existing bank claims, and co-l ending by the IMF and commercial banks. The IMF began to require that debtor countries accept an adjustment package, in which fiscal spending had to be reduced, taxes raised, and money supply tightened (Kapstein 1994). In addition, the IMF required that IMF funding be accompanied by simultaneous lending from commercial banks. But IMF policies did not work to contain the chain of crises, in part because adjustment programs were never accompanied by robust investment that would catalyze growth (Serven and Solimano 1993). As Devlin (1989) points out, in order for an adjustment process to be effective, a trade surplus must be generated naturally through an increase in savings and production of export goods, rather than through a reduction in investment and output. The latter strategy is unsustainable since it is anti-growth. Crises were perpetuated because external financing was greatly reduced, placing a large burden for debt repayment on the private sector. A string of debt crises arose, and the international financial community sought to ameliorate each situation in turn (Cohen 1992).
IMF packages were problematic in their formation. The IMF reached an agreement with debtor countries that had already secured a loan commitment from the banks. In a bit of backwards policy making, the IMF used the estimate of committed external resources based on discussion with the banks to determine what the current account deficit should be (Collas-Monsod 1989). The focus was not on the sustainability of the debt or on the sustainability of economic activity in the face of the debt, but on what indebted countries could afford to pay, based on external funding.
Loan rescheduling fees and commissions were 2 to 3 percent of the loan value, and interest rate spreads for the rescheduled loans increased by about 1 percent. All of the debtor nations were forced to guarantee previously unguaranteed loans to the private sector (Mohanty 1992). After two years of efforts less than one-third of the outstanding debt had been rescheduled. By 1985, the lack of progress on debt reduction was evident. Lending to Latin America had all but stopped. Growth and capital formation suffered setbacks as indebtedness increased (Ffrench-Davis 1987).
The declaration by President Alan Garcia in Peru in 1985 that the country’s responsibility to its citizens took precedence over its responsibility to creditors shocked the international community and prompted the implementation of the Baker Plan for debt relief (Collas-Monsod 1989). US Treasury Secretary James Baker further pushed “growth-oriented” structural adjustment, deregulation, and export promotion in developing nations. Mexico was the first to agree to a $12 billion rescue package under the Baker Plan, which included new loans and extended terms on existing loans (Bogdanowicz-Bindert 1986). As an alternative to participation in the restructuring cartel, commercial banks could trade their loans for an exit bond which paid a below-market interest rate, but allowed the banks to cap their losses and be released from calls for new loans (Mohanty 1992).
After two years, it was clear that the Baker Plan was not working, since the plan never abandoned the notion that all borrowing by the developing countries would ultimately be repaid in full. The economies continued to experience ongoing distress. The prices of non-tradeables in indebted countries collapsed and led to a profitability crisis in the production of non-traded goods. Banking systems in developing countries deteriorated and resulted in banking crises, resulting in government takeovers of banks (Sachs 1989a). The Baker Plan ultimately failed because commercial banks, which were to lend in tandem with the international organizations, failed to fulfill their end of the bargain since they had already suffered losses on previous loans (Mohanty 1992), and because the banks did not want debtor countries to repay other creditors before they were themselves repaid. (Collas-Monsod 1989). What is more, countries could not successfully marketize in time to “grow” out of their debt (Vasquez 1996).
In 1987, Brazil announced a suspension of interest payments in order to protect its diminishing supply of hard currency, while attempting to renegotiate its debt with commercial banks (Riding 1987). Banks did not want to continue making loans so that debtor nations could pay their debt interest. In response, Citicorp, the largest commercial bank at the time, added $3 billion to its loan loss reserves, signaling that it was willing to write off a large amount of its developing nation debt and stop making new loans (Kapstein 1994). Banks followed Citicorp’s lead and lending to the indebted nations dried up.
During this period, developing nations’ debt was sold on a secondary market at a discount, which allowed the banks to hold their loans on the books at full value while the loans themselves were actually worth less (Kapstein 1994). This period has been dubbed the “market-based menu approach” (Mohanty 1992). The logic was to provide options to the individual banks for restructuring and let each optimize their selection based on individual needs. Brazil’s 1988 financial package was the first specifically based on the market-based menu approach (Husain and Diwan 1989). The Brazilian creditor claims were consolidated in the hands of a multiyear deposit facility, with installments paid at close to the six-month LIBOR rate and deposits eligible for debt-equity conversions (Lamdany 1989). Brazil and Mexico accounted for more than 72 percent of reduced external debt transactions. Through mixed measures, banks did astonishingly well in terms of recovering debt. Innovative debt reduction structures began to be employed more frequently. Until this time, assets, much less distressed assets, had rarely been traded among banks (Newman 1989). Chile retired nearly 15 percent of its medium- and long-term liabilities to commercial banks through debt-equity swaps (Larrain and Velasco 1990). Bolivia used debt buy-backs to reduce its debt, buying its debt back at the market rate of 6 cents on the dollar (Mohanty 1992). Mexico used securitization to offer creditors the opportunity to exchange Mexican debt for a smaller amount of debt that would be backed by zero-coupon US Treasury bonds and carry a higher spread, thus canceling $1.1 billion of its debt (Newman 1989). By 1989, many banks had recovered up to 40 percent of their original loans in a very short period of time (Cohen 1992).
US Treasury Secretary Nicholas Brady then tried a new approach through debt reduction. In 1989, as part of the Brady Plan, Mexico then offered its creditors three options: to reduce the face value of the debt by 35 percent, to reduce the interest rate to 6.25 percent, or to keep both the face value and interest rate and to lend an additional 25 percent of the face value over the next three years (Cohen 1992). Most creditors chose the first or second option. Other nations, including Costa Rica, Venezuela, Uruguay, Argentina, and Brazil, followed suit (Vasquez 1996). The Brady Plan used the IMF and World Bank to collateralize debt-for-bond exchanges at large discounts, to replenish reserves after cash buy-backs of debt took place, and to underwrite payment of new and modified debt contracts (Mohanty
1992). Although some bankers loathed the Brady Plan for “forcing” debt forgiveness on banks, the secondary market responded well to the loan securitization offered by the plan.
Under Mexico’s plan for debt relief, Mexico worked on its official debt with the Paris Club, the IMF, the World Bank, and the EXIM Bank of Japan, then worked with a Bank Advisory Committee which represented the more than 600 banks involved in Mexico’s debt. The commercial creditors agreed to a $48.9 billion debt restructuring. The Brady Plan worked in Mexico since most of the debt was with commercial banks rather than official lenders (Van Wijnbergen et al. 1991).
Ultimately, neither the Baker Plan nor the Brady Plan was able to prevent a net transfer of resources from developing to developed nations (da Costa 1991). The 1980s have been referred to as the “lost decade” for Latin America. The impacts on the debtor countries were severe. Between 1981 and 1988 per capita income declined in almost every country in South America. Living standards fell and triple- and quadruple-digit inflation raged in many countries as seignorage was used to replace capital inflows (Sachs 1989b).
Monetary and fiscal policy over the 1980s was mostly unsuccessful, and it was not until the end of the decade that policies were able to bring about some stability. Monetary stabilization policies were implemented in the late 1980s and early 1990s to dampen monetary and exchange rate volatility. Some examples included Mexico’s pacto of 1988 and Argentina’s currency board of 1991. According to Belaisch et al. (2005), countries that had high inflation rates before taking stabilization measures focused on exchange rate-based stabilization plans, while those with moderate inflation rates adopted inflation objectives. Explicit exchange rate-based stabilization policies were more effective in bringing down inflation than inflation-targeting policies. While these latter-day policies experienced some success, it can generally be said that crisis resolution in Latin America over the 1980s may be used not as an example, but as a counterexample of best practices.