A careful analysis of economic data and the policies that most Latin American countries followed over the past five or six years clearly shows that the region’s external debt crisis stems from two basic sets of causes. First, following the emergence of external imbalances that required internal adjustment measures, countries sought to avoid reducing total public and private expenditure to the level of available resources; and second, loans from international commercial banks and other lenders—both public and private—expanded at an extremely rapid rate. These factors are closely interrelated, but for purposes of analysis a clear distinction must be drawn between the first set of causes, originating domestically from national economic policies, and the second, of external origin and related primarily to international commercial bank financing.
Gravity of the debt problem
Before analyzing the factors mentioned above, it is important to recognize the scope and magnitude of the Latin American debt problem, and the fact that it is not a temporary crisis linked to a particular phase of the business cycle. On the contrary, it will take many years before most of the countries return to a normal situation in which markets resume their role as principal regulators of financial flows and international trade.
There is no single criterion by which to measure external debt or determine whether a given level of indebtedness may be considered excessive or reasonable, and there are considerable problems of definition and measurement. Nevertheless, in the case of Latin America, even though the gravity of the debt problems was not uniform among all countries, it seems abundantly clear that we have been faced with an unprecedented crisis, regardless of the indicator used. For instance, in 1983 the stock of external debt was equivalent to 120 percent of GDP in Costa Rica, 103 percent in Chile, 76 percent in Peru, 66 percent in Argentina, 63 percent in Uruguay, 47 percent in Venezuela, and 44 percent in both Mexico and Brazil.
It may be argued that it is not the size of the debt, either in absolute terms or relative to GDP, that matters but whether it can be serviced; this would imply a comparison of debt-service obligations (payments of principal and interest) with exports of goods and services. The resulting picture is no less dramatic: Brazil, for instance, would have required 89 percent of its exports of goods and services in 1982 to service its external debt; Argentina, 68 percent; Ecuador, 69 percent; Chile, 65 percent; and Mexico, 57 percent. Even if the assumption is made that debt principal is not normally repaid, but refinanced, the situation would still be very serious. In 1983 Argentina would have needed to earmark 54 percent of its exports of goods and services to pay the interest on its external debt; Brazil would have required 40 percent; Mexico, 35 percent; and Chile and Peru, about 33 percent.
Countries cannot suspend their imports or reduce them below a minimum consistent with the effective operation of their economies. In view of this the above-mentioned debt-service ratios explain why the situation had become unsustainable by late 1982. On the one hand, the commercial banks saw that they could not go on lending large amounts for ever-shorter periods. On the other hand, the countries were unable to meet their import payments as they had suffered large losses in their international reserves and were falling behind in their external payments. When commercial bank credit was suspended, the lack of confidence in domestic currencies precipitated exchange crises, and the gravity of the situation became clear. Latin America’s worst economic crisis of the century had begun.
The domestic causes of the debt crisis may be traced to the growing fiscal deficits that most countries incurred between 1978 and 1982 and the expansionary monetary and credit policies that were largely used to finance them. While other factors also contributed to the inconsistency of economic policies, the primary factor was a level of public—as well as private—expenditures that exceeded currently available resources or resources that could have been regarded as stable in the medium term. Thus, between 1978 and 1982 the ratio of fiscal deficit to GDP more than doubled in the three main debtor countries, Argentina, Brazil, and Mexico.
How were those deficits financed? And what were the comparative effects of the different means of financing? Generally speaking, a fiscal deficit can be financed in one of two ways, external credit (borrowing abroad or use of international reserves), and domestic credit. But—and this is of fundamental importance—there is a close and inseparable interdependence between internal and external credit: in the final analysis, the former determines the pattern of external financing.
Domestic credit for the public sector basically has two main sources: the central bank and the private sector. Opting for financing from the private financial system has important consequences—an upward pressure on interest rates as the government attempts to place its securities and, as a corollary of this, a decline in private investment as projects yielding less than the now higher interest rate cease to be profitable (the phenomenon known as “crowding out”).
This problem of high interest rates is a delicate one, not only because of its effect on investment or, more accurately, on the distribution of investment between the public and private sectors, but also because high interest rates tend to become a difficult political problem as the monetary authorities are pressured to lower them. The basic problem is not the level of interest rates, as such, but the consistency of economic policies. Resources are finite, and one cannot at the same time increase private investment and use private savings to finance major public sector investments or higher current expenditure by the public sector.
The other source of domestic financing is central bank credit. In theory, this has the advantage that the interest rate paid by the public sector can be lower than what would have to be paid if bonds were to be placed with the private sector. But this presumed advantage is neither real nor permanent and implies even greater problems and risks than a short-run increase in interest rates. Although interest rates may initially tend not to rise because of the unanticipated excess liquidity, the public will soon realize that the situation is not sustainable. If the public is not willing to demand or hold the additional liquidity, it will proceed to “mop it up” by exchanging domestic financial assets for real assets—domestic or imported—or for external financial assets. The excess liquidity will inevitably lead to higher inflation, increased external borrowing or greater losses of international reserves, or a combination of both. These, in turn, will lead to a devaluation of the currency.
This is the previously mentioned monetary link between a fiscal deficit financed with domestic credit and its impact on the balance of payments. Within this context, a loss of international reserves is equivalent to an increase in the external debt, or it can be viewed as a temporary substitute for either higher inflation or a devaluation of the exchange rate. Statistical data for the countries under study tend to lend support to the linkages outlined above: the fiscal deficits of most countries had, as their counterparts, first an expansion of domestic credit followed by a series of mounting deficits in the current account of the balance of payments; these deficits, in turn, were the counterpart of the external debt or of losses of international reserves.
Admittedly, the numerous factors at work make it impossible to predict, in all cases and with mathematical precision, the precise relationship between the fiscal deficit and monetary and credit policy, on the one hand, and the balance of payments, on the other; but the direction and closeness of the relationship is unquestionable. For instance, the current account deficit of the balance of payments will vary according to the degree of the economy’s openness to international trade, with smaller deficits where import restrictions are severe and larger deficits where the restrictions are milder. On the other hand, there will be higher inflation in the first case and lower inflation and greater economic efficiency in the second. In both cases the adjustment will bring aggregate expenditure to the level of the resources available—unless it is possible to postpone it. And this brings us to the second set of causes of Latin America’s external debt problem, namely, financing by international commercial banks.
The external factors underlying the debt crisis may be classified into three groups. The first includes those that precipitated the 1982 crisis: the rapid rise in real interest rates in international financial markets, the world recession, and the difficulties in expanding export markets. These factors precipitated the crisis and certainly aggravated it, but, important though they were (and continue to be), they did not produce the crisis. Had external debt levels not been what they were, these developments could not in themselves have brought on a crisis, although they could have created serious problems. As it happened, they coincided with a situation that was already precarious.
The second group includes factors of a more permanent nature, in contrast to the transient ones mentioned above, and involves what economists call real, as against purely monetary, factors. The principal factor in this category was the decline in the terms of trade experienced by most Latin American countries, mainly as a result of the oil price increases of 1973 and 1979.
The third—and very special—group consists of external financing flows, particularly those from international commercial banks. Were it not for financing from these sources, which was growing rapidly and with ever-shorter maturities, an external debt crisis of the proportions experienced could not have developed. But this does not mean that this type of financing was the cause of the crisis. What this financing did was to facilitate the postponement of the measures that, in any event, would have had to be taken to adjust the economies in question to the deterioration in their terms of trade, as well as to the strictly monetary developments that occurred in 1979 and thereafter.
This last point is of particular significance in that it places the economic crisis in a proper perspective and underscores something that has sometimes been overlooked in the debate on recent economic developments, namely, the adjustment that should in any event have taken place beginning in 1974-75. In other words, the current crisis must not be regarded as an unexpected and surprising event that occurred in late 1982. To be sure, it should be set not against some normal or ideal situation but against the difficulties that would have been experienced some time after 1973 or 1979, had it not proved possible to obtain external financing from the international commercial banks in sufficient amounts to postpone corrective measures.
Nature of external financing
The specialization that characterized the external financing of Latin American countries, simply put, was as follows: The countries obtained development credits and long-term loans from multilateral entities and official agencies of the industrial countries (for the financing of capital goods exports). On the other hand, short-term credit, connected mainly with commercial transactions, was provided by suppliers or by international commercial banks. Generally speaking, the first category of loans—development financing—was linked to the feasibility of specific investment projects and was guaranteed by the borrowing country’s government. The second category of credit was not government-guaranteed and pertained to commercial transactions between private sectors. This scheme of things began to undergo a rapid and fundamental change from 1975 onward. Although financing by multilateral entities and governments grew rapidly, credits from international commercial banks increased much faster. By the end of 1981, liabilities to international banks accounted for 63 percent of the total external debt of the 20 major borrowing countries. But it was not only the principal lender that had changed; the average maturity of loans had shortened to the point where in early 1982 some 25 percent of these countries’ debt was short term (that is, with an initial maturity of less than one year).
Other changes of no less importance were also occurring. An increasing proportion of the loans was no longer linked to the economic feasibility of investment projects. Most of them were being extended to public sectors for the purpose of financing fiscal deficits or investment programs in which the lender was no longer a direct participant in the project risk. This naturally led to a reduction in the application of strictness of project appraisal, while allowing the financing of a higher volume of government expenditure than could be sustained in the longer run. The fundamental role of the risk factor thus underwent a change.
The increase in international bank financing of the public sectors took place on the assumption that the loans involved little, if any, commercial or exchange risk, as a result of which commercial banks did not pay sufficient attention to the global risk represented by the quality of the debtor countries’ economic policies as a whole. At the same time, the growing international bank financing of the countries’ private sectors was also carried out on the assumption that the operation involved no risk for the public sectors of the debtor countries. This ignored the danger of a possible total and instantaneous suspension of external commercial financing.
It is now clear that all the protagonists were mistaken in their perception of the risk involved. Developments have confirmed at least three postulates: risk is a fundamental factor in market equilibrium; all private external credit involves a certain amount of risk for the public sector of the borrowing country; and private credit to the public sector involves certain risks for the lender. All in all, risk plays a stabilizing role in the maintenance of market equilibrium.
Effect on economic policy
In principle, although foreign credit represents a liability for the borrowing country, it also produces an asset. Unfortunately, this was often not the case in practice in Latin America. Loan proceeds were not always well invested or used to generate foreign exchange or supplement domestic savings. At times, indeed, borrowing financed consumption rather than investment. As a result, the ratio of external debt-service to exports of goods and services rose steeply. It is true that a large part of these increases represented rising interest rates in international markets, but interest rates were also rising for other borrowing countries (i.e., some East Asian countries) that followed different economic strategies and used the external financing to create and expand export industries.
One of the most surprising results of any analysis of Latin America’s external debt data is the lack of a direct correlation between the aggregate debt and the deficit on current account and changes in reserves. Theoretically, a country or a region taken as a whole cannot accumulate external debt in excess of the total of its deficits on current account and the changes in its international reserves. It is assumed that external liabilities cannot be greater than the amount of the deficit less the losses in reserves. In the case of Latin America, however, external liabilities exceeded estimated external financing needs. The reason is well known: capital flight.
In its latest Annual Report, the Bank for International Settlements estimates that capital flight from Latin America between 1978 and 1983 amounted to possibly $50 billion. These funds, and those previously transferred abroad, are obviously not “lost” and the region’s actual aggregate debt position is thus not as serious as it may appear. If the amounts relating to net external debt and net interest payments (received but not repatriated) were known, it could be seen that investment in activities that generate foreign exchange was higher than indicated by the figures for investment in the exporting sectors, but with an important difference: capital flight neither creates jobs nor pays taxes in the country of origin.
The thrust of the foregoing analysis is that the countries in question did not follow the correct policies to take advantage of the increase in external financing made available to them. The surprising fact is that in most of the cases the increased inflow of external funds was accompanied by a drop in domestic savings as a percentage of GDP. Thus, given the imbalance created between the growth of external debt and domestic capital accumulation, a debt crisis was virtually inevitable. In sum, the region lacked not funds but better policies for the use of these funds.
Lessons of the crisis
It is not easy to reach firm conclusions about the experience of the external debt crisis, and perhaps the perspective of a longer period is needed before we can draw the lessons of these events. Nevertheless, a number of broad conclusions are possible.
First, countries do not have an unlimited capacity to absorb external financing and to make proper use of all the funds they may be granted at a given moment. A situation in which a country’s absorption, measured in terms of consumption and investment, exceeds its income, must not be confused with the very different situation in which the absorptive capacity for investment limits the total amount of resources that can be economically used. In other words, if there is additional financing, total absorption can exceed income, but the mere availability of financing does not guarantee the economic use of funds. If the availability of the external financing is not contingent on the economic feasibility of specific investment projects, and, consequently, if the risk factor is not sufficiently taken into account, it is highly probable that some irrecoverable loans will be granted. On the other hand, if there is easy availability of finance, it is also highly likely that this will reduce the discipline on countries to adopt better economic policies.
Second, the public sectors of the countries in question had neither the needed taxing capacity nor the domestic savings required to service the external financing offered to them. Fiscal deficits thus rarely contribute to higher total investment. Neither domestic nor external credit can be permanent substitutes for, or alternatives to, fiscal discipline. Sooner or later total expenditure will have to be brought into line with total resources, and financing cannot postpone that adjustment indefinitely.
Third, since external loans must be repaid in foreign exchange, external borrowing decisions must be linked to a general economic policy framework that will guarantee both the profitability of the investment and the generation of sufficient foreign exchange for external debt service. The maintenance of a realistic exchange rate policy is essential to attain this objective.
If these general conclusions lead to a single recommendation, it is that countries must view their external financing policies in the framework of their global macroeconomic policies, and that, within such a framework, adequate financial programming must assure a minimum of consistency between objectives, resources, and instruments.