CHAPTER 3: LATIN AMERICAN PUBLIC DEBT CRISIS IN THE 1980S
3.4. The reactions and solutions of Latin American countries to the crisis
3.4.2. The measures of Latin American countries to the crisis
a) Short-term measures
* Bridge loans
One of the first preventive measures taken by the commercial banks was the extension of bridge loans, which permitted countries to continue paying the interest on their loans, even though they were not able to pay the principal . Bridge loans were, in8 effect, new loans granted by the banks to allow sovereigns to pay the interest on their old loans. To ensure that no bank was paying a disproportionate share of the new loans, each bank was only responsible for contributing a specified percentage of its own outstanding loans to the debtor nation. By permitting this form of transaction, the banks were protecting themselves. Because the borrowing nations had not completely defaulted on their payments, the banks could still declare the loans as assets on their balance sheets .9 Without this provision banks were required by regulatory and accounting rules to declare a loan "nonperforming” if interest payments were more than ninety days late, an10 unfavorable prospect from the bank's financial perspective. It was especially vital that
8 Goldman, supra note 8, at166 9 Goldman, supra note 8, at 167
banks kept borrower nations from defaulting on their loans because many of the large banks had loaned out more money than they actually had to lend. In fact, when the debt crisis began in 1982, the nine largest commercial banks had loaned 250% of their capital to sovereign debtors. It was therefore imperative to the banks' own survival that the debtor nations continued to pay, at the very least, the interest on their loans. Thus, immediately following the announcement of the debt crisis, many large banks extended new loans in order to prevent complete default, in hopes of cutting their own losses.
* Debt restructuring
In the face of falling economic growth rates and rising inflation, the “Baker plan”
was implemented in 1982, proposed by US Treasury secretary Baker (Van Wijnbergen, 1991)11. In return for economic reforms, high-debt countries would get new access to medium-term new loans, in addition to rolling over of amortization of old loans. New loans had to come both from commercial creditors and the official lending institutions. In June 1983, the “Paris Club”, representing creditor governments, rescheduled Mexico’s sovereign debt owed to major creditor countries (World Bank, 2004). The Paris Club is an informal group of financial officials from most western economies, which provides financial services such as debt restructuring and debt relief. With access to capital markets restored, it was hoped that the economic reforms would allow the debtors to grow out of debt. However, capital outflows went up rather than down, inflation skyrocketed, investment fell and over the period 1982-1988, no economic growth took place in Mexico at all. Consequently, external debt rose to 78% of GDP in 1987, marking the failure of the
“Baker Plan”.
In September 1989, the “Brady plan” was agreed, legitimizing the concept of debt relief. By now, it was believed that US banks could withstand projected losses on Latin American debt (Tammen, 1990) . The “Brady Plan” forced them to do so. The basic idea12 was to make debt relief acceptable to commercial bank creditors by offering a smaller but
11 Van Wijnbergen (1991), Mexico and the Brady Plan, Economic Policy, World Bank.
12 Tammen, M.S. (1990), The Precarious Nature of Sovereign Lending: Implications for the Brady Plan, Cato Jounal
much safer payment stream in exchange for the original claim that clearly could not be serviced in full (FDIC). The Mexican government and the Bank Advisory Committee representing the commercial bank creditors reached an agreement on a financing package covering the period 1989-92, restructuring approximately USD 49.8bn of Mexico's external debt. As only long-term debt with commercial banks was restructured, roughly half of the debt was involved (Van Wijnbergen, 1991). Commercial banks involved had three options (Odubekun, 2005) : 13
1. Banks could exchange old loans for new bonds at a discount of 35% of their face value, keeping interest rates at market levels (equivalent to LIBOR + %)
2. Banks could exchange old debt for face-value new bonds (called par bonds) bearing fixed interest rates of 6.25%
3. Banks could provide additional loans over the next three years equivalent to 25% of the banks’ initial medium- and long-term loans, which implied no debt relief but the provision of new money
Most banks opted for the par bond (47%), implying interest rate reduction. Other banks chose to reduce the principal (40%), a few offered new loans (13%). Another agreement was reached with the Paris Club, representing creditor governments, covering USD 2.6bn of principal and interest payments falling due in the period 1989-1992 (Van Wijnbergen, 1991). The “Brady plan” substantially improved Mexico’s ability to service its external debt by reducing interest and principal payments (Dornbusch, 1994) .14
* Structural reforms
In December 1982, Mexico started far-reaching structural reforms, which were a condition for receiving the IMF loan. The reforms included: fiscal austerity, privatization of state-owned companies, reductions in trade barriers, industrial deregulation, and
13 Odubekun, F. (2005), Debt Restructuring and Rescheduling, US Treasury Department.
foreign investment liberalization. Owing to rigidly enforced fiscal discipline, the budget deficit halved from 17.6% in 1982 to 8.9% in 1983. Fiscal austerity was accompanied by stringent monetary policy.
With an extensive trade reform, Mexico opened up the economy. The percentage of domestic (non-oil) tradable production covered by import quotas was lowered from 100%
in 1984 to less than 20% in 1991. Also, maximum import tariffs were cut. As a result, non-oil merchandise exports doubled their share of total exports to two-thirds. In May 1989, foreign investment regulations were considerably relaxed and made more transparent.
Also the tax system underwent a number of reforms, encouraging capital inflows and raising sanctions for tax evasion. The government also initiated a process of financial market liberalization. Ceilings on commercial banks’ deposit interest rates were removed.
Forced allocation of commercial credit towards favored sectors had also been abolished and credits privatize the commercial banks, which were nationalized in 1982. However, banking sector reforms were delayed. Mexico still lacked inadequate banking sector supervision, although the government guaranteed both deposits and liabilities.
b) Long-term measures
Firstly, Latin American countries have had reasonable public debt treatment.
Developing countries which have debt develop rational economic structures, have focus on capital investment and have clear repayment plans. Especially, they must avoid borrowing to invest in inefficient projects, abuse excessively short-term borrowings. The flow of short-term investment flows into a country can quickly be withdrawn massively as investors see the risk, which will cause great imbalance to the economy, therefore being over-reliant on public debt is extremely dangerous.
Secondly, they improve foreign currency loans and inflexible exchange rate policy.
Most countries in crisis maintain a fixed exchange rate regime and anchor the local
currency to the US dollar. Maintaining a fixed exchange rate regime will cause the domestic currency to be overvalued because strong currencies such as the US dollar are flexibly floating. Consequently, the competitive power of country’s international trade is reduced. Moreover, when the domestic currency is devalued, the burden of foreign debt will increase that will cause difficulties in payment of this country.
Thirdly, building an effective financial and banking system and reserving foreign exchange reasonably for self-defense against crisis risks. We can see clearly that, with the potential financial resources of the world, it is impossible to avoid or eliminate financial crises completely. Each country must learn to protect itself, find ways to eliminate risks for the economy. It means that this nation must build a legally banking system which has abundant foreign exchange reserves, has flexible exchange rate regime, encourages long- term investment flows and limits short-term capital flows with high risks.
Finally, they establish international forums to handle economic crisis issues.
Today, due to the globalization of the world economy, crises occur globally, but the adjustment measures are only national. Therefore, during a meeting in Washington on October 3, 1998, Finance Ministers and Central Bank Governors of G7 countries asked Hans Tietmayer, the President of Bundes Bank to present advice regarding the measures to adjust international finance. Mr. Hans Tietmayer came up with the idea of establishing an "International Financial Stability Forum" and was agreed. In its first meeting held in15 April 1999, the Forum discussed two tasks: firstly, reducing the potential risks of financial institutions such as hedging funds; secondly, introducing measures to reduce the abnormal fluctuations of international capital flows. These are important measures to reduce the causes of the crisis that in fact emerging economies in the late twentieth century occurred.
3.5. Achieved result