Current Legal Issues Affecting Central Banks, Volume III.
Chapter

Chapter 8 The Debt Crisis and Its Resolution

Author(s):
Robert Effros
Published Date:
August 1995
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Author(s)
EDWIN M. TRUMAN1

The great international debt crisis and the debt problems that erupted in 1982 in connection with the debt of developing countries have run their courses and are now effectively concluded. This paper addresses how these countries got from where they were ten years ago to where they are today and some of the implications of that journey.

Causes of the Debt Crisis

The proximate cause of the crisis, as it broke in 1982, was a massive change in the economic environment, which actually had begun some years earlier. There was a period of accelerating inflation around the world, and particularly in the major industrial countries. It came to an end, or was brought to an end by macroeconomic policies, and a period of disinflation began. This period brought with it a rapid rise in nominal and real interest rates with the result that the carrying costs of the debts that had been accumulated by developing countries in the late 1970s and early 1980s became overwhelming, and the process of their external financing broke down. However, in some sense, that environmental change was only the proximate, and not the fundamental, cause of the problem.

The more fundamental cause may be traced to the behavior of the borrowers and lenders and to the macroeconomic policies of both the industrial and developing countries in the period leading up to 1982. In short, the lenders lent too much. Oversimplifying somewhat, the lenders accepted the view that sovereign countries do not default. The borrowing countries, seduced in some respects by low or even negative real interest rates, did what any good borrower would do under those circumstances, borrow a lot. When there are negative real interest rates, then one may be able to get by with a negative return on the investment and still recover costs. This is very attractive for governments. However, it is somewhat imprudent if one contemplates the possibility that the world may change. The policies that accompanied this heavy borrowing were policies that, in general, were not conducive to managing on a rainy day, which must ultimately follow, although the precise circumstances are unpredictable.

Dealing with the Debt Problem

Early Stages

The crisis phase of the international debt problem began with the famous Mexican weekend in Washington, D.C., in August 1982. At that time, no one had a perspective on what was likely to happen. Although it is popular to view the debt problem as something that burst suddenly on the scene and caught the U.S. Government completely by surprise, that really is not true. Certainly all of its dimensions were not anticipated. Everybody at the Federal Reserve and the Treasury Department who had been working with Mexico since February of 1982 knew that there was a high probability that there was going to be a crunch at some point. They just did not know when it was going to come.

Case-by-Case Approach

A strategy was adopted that is now referred to as the case-by-case approach. As the borrowing countries have carefully pointed out, it is a misnomer. It was designed to suggest that countries did not have to be treated uniformly in order to resolve debt problems. Still there were certain common elements. Innovation came slowly and sometimes rather grudgingly.

The initial strategy addressed the indebtedness as a liquidity problem. Borrowing countries needed to adjust their policies by reducing their budget deficit, tightening up monetary policy, adopting more realistic exchange rates, and generally tightening their belts under the guidance of the International Monetary Fund. The commercial banks were encouraged to restructure their claims on countries whose debts were falling due and to participate in so-called concerted lending programs, which would provide new money. During the crisis phase, moral support was provided by national monetary authorities through bridge loans, largely designed to contain the situation until disbursements could be obtained from the International Monetary Fund and later from the World Bank, as well as from the Inter-American Development Bank and a few other sources. The last element of the strategy was to increase the resources of the International Monetary Fund through an increase in quotas.

There were central features of this general pattern. Although it was called a case-by-case approach, there was not much room for variation on the theme, at least not at first. There was a tendency to emphasize that everyone was in this together: the borrowing countries, the creditor countries, and the financial institutions, private and official. There was a remarkable degree of cohesion in the first year, some of which was forced. Under the “critical mass approach,” there had to be a critical mass of commercial banks involved in the process before the Fund would decide to make disbursements. There had to be financial assurances provided to the Fund that the financing of the program would be available before the Fund would move forward. Everything was tied together pretty much in lockstep. This made it difficult for countries that, for political or policy reasons, felt it difficult to subject themselves to the regimen that was being advanced.

Multi-Year Restructuring Agreements

The initial phase involved annual restructuring of debt. By 1984, a program of Multi-Year Restructuring Arrangements (MIRA) was accepted.2 That was a great breakthrough. It meant that the official sector had had to convince the commercial banks that they needed to look further ahead. There was resistance to the idea because it meant dealing with the debt problem in a larger dimension. There was a tendency on the part of the creditor institutions to keep debtor countries on a short leash. The MIRAs were designed to lengthen the leash and provide breathing room for countries as they worked through their problems.

Baker Plan

In September 1985, then-Secretary of the Treasury James Baker announced a Program for Sustained Growth, which came to be called the Baker Plan, at the IMF’s Annual Meeting in Seoul.3 This ushered in the second major phase of the debt problem. The crisis period was over, but the recovery process in the borrowing countries had stalled. There was growing frustration among all the participants. The attitudes of the first year, during which all admitted that they were in the crisis together, were breaking down; individual interests became dominant and were less congruent than they were in 1982. It had been clear in 1982 that if the system went down, everybody went down.

By 1985, the interests of the banks, the creditor countries, international financial institutions, and the borrowing countries were more divergent. Negotiations took longer because there was less pressure to reach agreement, both for the countries and for the lenders, including the Fund and World Bank. The parties concentrated on details and the process of negotiation accordingly took an excruciating length of time. The process was not producing the kind of overall positive results that people felt were necessary.

Secretary Baker attempted to breathe new life into this process with his proposals, which were a natural evolution of what had gone before. He emphasized in his Seoul speech a continued need for adjustment with greater emphasis on structural reforms.4 There was a growing realization that, from the standpoint of the borrowing countries, the achievement of macroeconomic stabilization was separate from the achievement of sustained creditworthiness, which was much more complicated and involved very difficult changes in the way those economies operated. A second element was that the World Bank expanded its role through longer-term lending with an emphasis on structural problems. Lastly, Secretary Baker exhorted the commercial banks to continue to play their role through “new money” exercises, and he laid out some targets for them to achieve.

The results of the Baker Plan were somewhat disappointing. One of the major reasons why was that the announcement of the Baker Plan coincided with the collapse of world oil prices. This had three effects on the borrowing countries as a group. On the one hand, the oil-importing countries suddenly enjoyed a bonanza so that the external financial pressure to do anything was removed and they were able to coast for a while. On the other hand, the oil-exporting countries (notably Mexico) experienced a collapse in their export revenues and had to review the plans that they had intended to follow under the Baker Plan framework. When the oil-exporting countries went back to the drawing board, it was not clear what they should use as an assumption for oil prices. A random assumption for oil prices was impossible, particularly for an economy like Mexico, which at that point derived more than 60 percent of its export revenues from oil. It was difficult to deal with the financial components of a program from this uncertain base, to say nothing of the more complex policy components, including those concerning structural policy. Thus, the oil-exporting countries were taken out of the loop as they regrouped.

That left a group of countries in the middle that were in a balanced position, but the group was so small that there was resistance to signing up for the Baker Plan. This was because it was unclear whether any other countries would sign up. Moreover, there was a natural reluctance to be the first and a lingering hope that a better solution would arise.

Consequently, there was a loss of momentum that extended through the first year of the Baker Plan. By the time a program got started, another year had passed, and many aspects did not go quite as well as expected. In many cases, reform efforts faltered. The World Bank had been expected to contribute about $20 billion gross over the period. It actually came close to that in terms of its disbursements, but, because the dollar depreciated during this period, net disbursements were substantially less than had been anticipated, approximately $12 million. The International Monetary Fund, for several years, was a net receiver of repayments from countries.

The commercial banks, while contributing something, fell substantially short of the lending effort that had been anticipated by Secretary Baker. While part of the explanation was that countries did not sign up or under-performed, the banks were also busy dealing with their own problems and beginning the process of extricating themselves from the debt problem.

For a number of commercial banks it was critical to their financial health that they participate in the Baker Plan. Many of them had the flexibility by that time to take losses. Differences not only in the financial situations of national banking systems but in the structures of national banking systems began to show. For example, in some countries, reserves against claims on foreign countries and other debtors essentially were not tax deductible, so that banks in those countries resisted setting up the appropriate reserves. On the other hand, in France and Germany, reserves were fully tax deductible so that the costs were easy to pass on to the taxpayer. In the United States, passing debt forgiveness on to the taxpayers became a sensitive political issue. The situation led to disagreements among banks from different countries.

These divisions became difficult to manage. The three-year period of the Baker Plan came to an end in the fall of 1988. There was a presidential election in the United States, and the new Secretary of the Treasury, Nicholas F. Brady, announced a new set of proposals in March of 1989.5 While they built on what had gone before, they also ushered in a new phase.

Brady Plan

By way of background, there was mounting frustration that something definitive needed to be done. It became popular to talk about the “debt overhang,” and a view developed that it was necessary to reduce the size of debt and debt-servicing obligations once and for all if there was going to be any hope of countries recovering. The view was that the threat of the need to repay debt discouraged investment in the borrowing countries because higher taxation might be needed to generate the revenues to service the debt. This is a proposition that is technically respectable but difficult to prove empirically.

During this period, the international debt problem was becoming an increasingly political issue, not just in the borrowing countries but among the creditor countries as well. In the latter countries, a competition for leadership on the international debt issue arose concerning some of the elements that were ultimately included in the Brady Plan.

As noted above, the banks were seeking to extricate themselves from the debt problem, and it was clear that the authorities were unable to turn them around. This gave rise to the consideration that if the banks were going to exit, it would be appropriate to extract something from them as they left. This philosophy did not appear in communiqués but made itself felt anyway. Moreover, there was concern in the international financial institutions that if the banks were getting out, and institutions like the Fund and the Bank were staying in, this would result in a shifting of obligations from the private sector to the public sector. Officials who were responsible for the public sector, particularly in the finance ministries, did not like this situation. They, too, felt that the banks should have to pay an exit fee.

In 1987, on an exchange rate-adjusted basis, there was a $7 billion reduction in claims on the so-called 15 Baker countries.6 In 1988, there was an $11 billion reduction in claims. This compares with 1985 and 1986, when, by contrast, there had been a $1 billion increase in claims each year.7 The effect was a big turnaround. While these numbers are difficult to interpret, because they involve writeoffs and writedowns, as well as reporting inaccuracies, they give a notion of what was occurring.

It is useful to recall the full extent of the Brady proposals because their approach tends to be associated only with debt reduction and debt-service reduction. This approach was only one part of Secretary Brady’s speech. He emphasized the importance of sound policies and commitments to structural reform as the elements needed to qualify for the benefits of the new proposals. In addition, he endorsed “voluntary” debt reduction and debt-service reduction schemes and suggested that the Fund and the Bank should lend them support.

Lastly, Secretary Brady emphasized that there were limited resources to support these debt reduction efforts. This implied that countries had to qualify for the program. It was not an entitlement. For the future, countries would have to rely more heavily on other sources of external finance including indirect investments, direct access to international capital markets, and the return of flight capital.

After Secretary Brady’s speech, there was a transformation from previous types of debt reduction (buybacks, debt-for-equity swaps, and so forth) to a situation in which debt reduction was officially supported by financial contributions from the official sector. While this tended to shift the risks to the Fund and the Bank inasmuch as they supplied the money, they believed the risks to be justified.

Many observers agree that the Brady proposals were largely successful. Otherwise, the debt problem would not be over, at least not for the commercial banks and for the major borrowing countries. However, if the Brady proposals are seen as essentially debt reduction and forgiveness, then the results are not very remarkable. There had been only six Brady packages by June 1992, and only five of those actually involved “Baker countries”: the Philippines in August 1989; Mexico in September 1989; Venezuela in June 1990; Uruguay in November 1990; and Nigeria in March 1991. In addition, Costa Rica was not an original Baker country, but it reached a Brady-style agreement in November of 1989. There was also an agreement in principle with Morocco, which was never consummated. By June 1992, a package was agreed in principle with Argentina, and Brazil was close to an agreement with its commercial banks.

Chile and Colombia had already gone their own way. Chile had engaged in debt reduction through debt-for-equity swaps even before the Brady Plan, and it did not have a Brady package per se. Colombians believed that their problem was largely due to their association with the wrong neighborhood; their problems, in terms of both financial and economic policy, were substantially less than those of other Latin American countries. Bolivia engaged in a buyback of its debt before the Brady Plan was announced, and it was in a different category in terms of its reform efforts. Other countries such as Morocco (already mentioned), Ecuador, Peru, Cote d’Ivoire, and the former Yugoslavia, for a variety of reasons, had not qualified under the Brady Plan.

Over the past several years, in many of these countries, there has been a resumption of growth. It has hardly been booming growth, but it is an improvement over the lost decade of the 1980s. Debt burdens, measured by interest payments as a percentage of exports of goods and services, have been reduced. The ratio for the affected countries was 31 percent of exports of goods and services in 1982. This ratio increased before it was brought down.8 While debt reduction helped reduce these ratios, there also has been a growth in exports, which boosted the denominator. Another factor that acted on the numerator is the fall in interest rates. For example, Mexico and Chile both had 45 percent debt-service ratios in 1982. In 1991, these ratios were down to 19 and 15 percent, respectively. Venezuela is an interesting case of a country that could have avoided its debt problems because it was much better off to start with. It had only an 18 percent debt ratio in 1982. With the collapse of oil revenues, this rose to 29 percent in 1986, but by 1991 it was down to 13 percent.

Many countries have experienced a resumption of capital inflows, which has been, importantly, a function of the policies in these countries. Those countries that have been able to attract capital have been the ones that have been most successful in their reform programs. Probably, the Brady packages have helped. The debt situation is better, debtors are better off, and new lenders have come onto the scene. There have been three sources of inflows: foreign direct investment, helped along by the fact that many of the countries have rethought their policies toward foreign direct investments; borrowing on the international capital markets, which has been facilitated by reducing the premiums that were required as compared with U.S. Treasury securities; and, as the situation stabilized, a return of flight capital.9

Banks have not been lending for their own accounts. On an exchange rate-adjusted basis, there was a net reduction in bank claims on the affected countries amounting to $5 billion in 1991.10 Two exceptions were Argentina, where there was a small increase in loans amounting to several hundred million dollars, and Mexico, where there was an increase in bank claims of $6 billion. If those two countries are excluded from the calculations, in 1991 there was an $11.5 billion reduction in bank claims on the other 13 countries in this group. The commercial banks are out of this type of lending, and it is unclear that they should ever have been in the business of making medium-term balance of payments loans.

Implications of the Debt Problem

What are the implications from this experience with the debt problem? As far as the commercial banks are concerned, the great debt problem of the 1980s is over. This is true, as well, for many of the middle-income countries. Some countries were able quickly to reestablish their international creditworthiness, while others were less successful and must now undergo mopping-up operations. With differences among these countries, their circumstances, their luck, and leadership, some will be out ahead, and some will be left behind. A number of the poorer countries have very serious problems, largely associated with debts to official institutions. Their solutions will depend more on the Paris Club than on the international financial institutions and the commercial banks.11

In retrospect, the resolution of the debt problem has been an evolution. If we had been prescient, the process could have been made easier. Initially, the question was whether the debt problem was a liquidity or a solvency problem. From today’s vantage point, it is clear that it was a solvency problem, but this was not clear at the inception. Automatically assuming that a situation is a solvency problem, when it may be a liquidity problem, has drawbacks because there are costs involved in solvency solutions that are not present in liquidity cases. Thus, one does not automatically throw an enterprise into bankruptcy because there are many costs associated with such proceedings. From a technical point of view, bankruptcy may produce certain benefits, but from a social point of view there may be heavy costs.

In 1982, the countries themselves were not prepared to admit that their debts were too large and had to be reduced. Moreover, the banks would not have participated in a program of debt reduction, and the official institutions would not have given their blessing to it. Brazil is a good example. When the Brazilians came to Washington in the fall of 1982, having just gone through a minor debt crisis in 1980–81, some Brazilian officials thought it enough to patch things up, get a little breathing space, and let everything return to normal. That was a perfectly rational position, but it failed to take account of the depth of Brazil’s problems and events in the general economic environment.

Neither the borrowers nor the lenders were ready for a more draconian solution at the beginning in 1982. Even if it could have been imposed, it is unclear that the costs could have been substantially reduced. The Brady Plan clearly was part of the evolutionary resolution of the debt problem. It was a necessary step and, as in the case of the Baker Plan, it was, to some extent, a codification of what had already happened. While debt reduction was already under way, it did not play a large role. For example, the debt-service gain to Mexico was only $1 billion to $1.5 billion. Nevertheless, in countries with Brady packages, debt reduction played an important catalytic role. The measures were symbolic of drawing a line and announcing that the problems had been addressed and that now the countries could go forward. The Brady Plan’s psychologic and symbolic value was stronger than its economic value. Countries that merited Brady packages gradually earned them, in terms of long records of policy performance, by the time the packages were implemented. Thus, in the Mexican case, the turning point occurred in July 1985 when Mexico decided to liberalize its trade regime and announced its intention of joining the General Agreement on Tariffs and Trade. That was the watershed event; everything else followed from it even though progress was not inevitable.

In some cases, the obligation to repay debt was collateralized. While it has not been necessary to resort to the collateral, the collateralization of interest payments added to the sense of confidence. If 18 months after the Mexican package had been put together there had been a collapse of world oil prices, and Mexico had been forced to draw on that insurance policy, both Mexico and its creditors would have been protected. This was an important feature of the Brady packages, but it did not involve debt reduction per se.

Lessons for the Borrowers

In general, the debtor countries did not get more financially from debt reduction or debt-service reduction than what they paid. Basically they received the same amount as if they had taken the money that they borrowed from the Fund, together with all of the reserves that they contributed, or borrowed from Japan and bought back a small sliver of their debt. The net reduction in debt-service obligations would have been about the same.

Economic policies are crucial, while the technical means employed in resolving the immediate debt problems are subordinate. The ways that Chile and Argentina arrived at their present positions are different. Chile did it through a market-based approach and substantially reduced its debt-service burden. Its debt was trading at 90 percent of par in June 1992. At the same time, Argentina’s debt was trading at 43 or 50 percent of par, depending on whether interest is added. Despite this difference, they are in similar circumstances. It is difficult to decide which country is better off today.

The Brady Plan was important in restoring confidence. It reduced uncertainty, and there was a reiteration of all of the elements of the general approach. One of the lessons for borrowing countries is that a country should not borrow money, even when the real interest rate is negative, and waste it. Policies are important; external funds need to be used effectively. Recovery, once major problems arise, is a difficult process.

Lessons for the Lenders

The lenders also learned an important lesson from the debt problem. Wilfried Guth, a member of the Board of Directors of the Deutsche Bank, said, “[i]f one reflects on lessons to be learned from past mistakes, banking does not seem to be very different from life. We recognize our mistakes, regret them, and try to avoid them henceforth—and then make new ones.”12 Banks are supposed to take risks, but, when they do so, they can make mistakes. It is a question of degree.

The banks and their supervisors probably should have recognized that key elements of the developing-country debt problem were not unique to lending. Later on similar problems in real estate lending around the world, driven by many of the same macroeconomic phenomena, appeared. Not all the problems are the same, but many of them are driven by similar factors. Lessons derived from the developing-country debt crisis have a more general significance.

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