Latin America’s Debt crisis

1980’s
Franko, Chapter 4
 The LATAM Debt Crisis of the 80’s
• Why the region accumulated an unmanageable external
debt?

• What factors precipitated the crisis?

• How sovereignties and international creditors responded to

the crisis?

• What was the most important outcome of the crisis resolution

and afterwards?

• Is Latin America vulnerable to new debt crises?

 Origins of the crisis
The debt buildup
A. External factors
• The collapse of the Bretton Woods system was accompanied by the
reemergence of international capital markets and an increase in the
activity of international commercial banks.
• In 1973 the OPEC quadrupled the prices of oil. Oil producers countries
deposited their surpluses of asses in international commercial banks.
• Oil-importing nations in Latin America increasingly needed capital, in
part to finance the external deficits associated with oil inflation. The so
called Petrodollar recycling program allowed lesser developed nations to
purchase oil even as its price skyrocketed, and it was actively promoted
by the United States.
• A drastic change in the source and composition of loans to Latin
American in the 1970s, from long-term official loans with low interest
rates to short-term commercial loans with variable high interest rates
was a major factor which led to the debt crisis of the 1980s.
 The debt buildup
B Internal factors
• A good part of Latin American debt went to finance the growing
trade imbalances.

• Many LATAM nations kept the real exchange rate strong as a

measure against inflation, worsening the current account.

• The continuous real exchange appreciation made international

interest rates (low in nominal terms) to be negative in real terms.
This exacerbated indebtedness.
 What factors precipitated the crisis?
External shocks
• Raising interest rates
• Developed countries recession

Capital flight
• Many LATAM countries allowed the liberalization of foreign trade,
domestic financial markets, and international capital flows. The latter
caused large private capital outflows or “capital flight” from the
region to developed countries.
 Responses to the debt crisis
1. The IMF Approach
• The absorption approach: A way of understanding the
determinants of the balance of trade, noting that it is equal to income
minus absorption Y – A = B.
• If Y- A > 0 implies X-IM > 0 and NX>0 Trade surplus
• A trade surplus, then, would help restore financial health by decreasing
the need to finance imports, leaving the balance to pay off the debt.
• The IMF recommended contractionary policies aimed to decrease fiscal
spending and money emission.
• Countries that signed agreements with IMF were signaling international
banks of their intentions to abide to the rules of the game. The notion of
conditionality emerged with its harsh consequences for the inhabitants
of the debtor countries.
• Lending from the IMF and international banks were used for servicing
the debt. Resulting in a non-resolution of the problem.
2. Markets reaction to the debt crisis
Secondary markets
 Debt-for-equity swaps
There are at least three parties to the transaction.
Example
1. Citibank recognizes $100m of bad debt in Mexico.
2. Chrysler wants to invest in Mexico. It needs the equivalent of $75m in
pesos. Chrysler could take US$75m and convert it to pesos at the
prevailing exchange rate.
3.The Mexican central bank wants to help Citibank recoup some of the
$100 m bad loan. That way Citibank will be willing to lend to other
Mexican clients in the future.
4.The Mexican central bank approaches Citibank and Chrysler and
arranges the deal. Let’s say it arranges for Citibank to sell the debt at
a 40% discount and agrees to purchase it from Chrysler at 75% of
face value.
5.Chrysler then gives Citibank $60 (40% discount off of $100m ) and is
given the $100m bad debt. Just a paper asset.
6. Chrysler immediately runs to the central bank and swaps the bad debt
for the equivalent of $75m in pesos.
7. Chrysler then invests the $75m in pesos in Mexico.
3. Beyond Muddling Through: The Baker Plan
• Countries could not continue to service their debt through
contractionary policies, growth must be reassumed.
• The Baker plan targeted fifteen less-developed countries for $29
billion of new money, $20 billion from commercial banks and $9
billion from the IMF and the World Bank.
• Debt came to be understood as a development problem, and the
World Bank was charged with assisting in the management of the
adjustment process.
• Too little too late. $29 billion will have no impact on obligations of
near one trillion dollars
• The consensus was that the banks were prepared to take a realistic
position on developing country debt: it would never be repaid in full.
• Jump-starting growth would not work until the debt burden was
reduced two years later under the Brady plan.
 The 1989 Brady Plan

• It was aimed to debt reduction throughout 3 options:

– decreasing the face value of debt
– extending the time period of obligations
– Infusion of new money

• Mexico restructured $48 billion of its liabilities. This debt

relief reduced net transfers by $4 billion per year, nearly
2 percent of the gross domestic product (GDP), from
1989 through 1994.
 Lessons from the debt crisis
• Recovery from crisis long and painful

• “Latin American debt crisis of the 1980s (as) a crucial dividing mark in
the area’s recent economic history” (Rodrik, 2003).

• Strong economic fundamentals matter; countries must put attention to

price stability and budget constrains.

• The burden of adjustment to the debt crisis may have fallen

disproportionately on women in particular andon the poorest people in
general.

• Rodrik’s (2003), sees the debt crisis as the explosive end of a period
of continued decline: the import substitution industrialization
development model.
 Is Latin America vulnerable to new debt crises?
• Many agree that the openness of the financial sector in emerging markets
triggered the financial crises of Mexico in 1994, East Asia, Russia and Brazil at
the end of the 1990’s.
• However, these financial crises did not caused sovereign debt crises.

• LATAM countries returned to the international markets, and many nations are
emerging as important players in the world’s debt and equity markets.
• The return to the markets has not reached the poorest countries in the region