CHAPTER 12 The Debt Crisis
- Harold James
- Published Date:
- June 1996
The simultaneous emergence of debt-servicing difficulties in a number of major borrowing countries, and a consequent threat to the solvency of many international banks, was the most traumatic international financial experience of the 1980s. The debt crisis also acted as a more general signal of misadjustments within the international system as a whole, as well as within individual national economies. It slowed or even halted growth in many developing countries. It brought home the consequences of the internationalization of finance: the vulnerability of producers in Latin America (and elsewhere) to interest changes decided by the Federal Reserve System in Washington and to alterations in sentiment in the banking community. But it also showed that bank depositors, bank customers, and, indeed, whole national economies in advanced industrial countries could be affected by policy shifts in Mexico City or Manila or Warsaw. For a time, a major banking crisis appeared imminent in industrial countries.
The debt crisis placed the IMF back at the center of the international financial system, first as a coordinator in a crisis, and then in a larger sense, as a source of information, advice, and warning on the mutual consistency of national economic policies. The imminent threat of a collapse of the world financial system demonstrated the dangers to national and individual welfare caused by the existence of large global imbalances. Tackling the debt question involved addressing the larger problems in the international order that had given rise to it. Sound national policies inevitably played a part in the search for a solution, but so too did an alteration of views about international movements of capital and the nature of risk. The general financial crisis threatened not only states that had pursued inappropriate policies, but also soundly managed debtors (such as Colombia), as bankers tried desperately to restore their own liquidity by not renewing outstanding credits. This chapter describes the story of a search for a better approach to global economic management. National politicians, but also international bankers, clearly could have benefited from both better information and a more global vision.
In finding an answer to the “debt crisis,” governments, international institutions, and banks encountered a classical dilemma of the kind encountered in any form of behavior modification: a major problem is most easily fixed if all those involved are convinced that they need to act, and this conviction is most likely to be generated by a sharp crisis. On the other hand, knowing the full magnitude of a difficulty may produce a mood of hopelessness and resignation, and present a barrier to effective action. Searching for a solution to the debt crisis involved moving between fear of its potential repercussions, the realization that large-scale action was required, and the acknowledgement that large shifts and large reforms could in practical terms probably only be accomplished in a piecemeal fashion. It took seven years after the outbreak of the initial crisis for creditors to be willing to adopt an approach that involved, on a country-by-country basis, any kind of debt reduction (the Brady Plan of 1989).
The recycling that took place after the second oil crisis had initially seemed less problematical than that following the earlier shock of 1973–74-Partly the new confidence arose from inappropriate lessons drawn from the earlier experience. It appeared in the late 1970s, with the benefit of a rather short-sighted hindsight, that the uncertainty and nervousness that had arisen originally in the immediate wake of the oil price increases had been misplaced, that the world financial system could handle the flows easily, unproblematically, and profitably, and that the outcome had allowed the pace of world development to proceed substantially unchecked. The result was a widespread feeling that global surveillance was not really very much needed. It became difficult in consequence for any institution to provide it.
The problems that arose as a result of the second wave of recycling of lending relate directly, on the one hand, to excessive confidence about the sustained nature, and the inevitability, of the development process; and on the other, to the working of private sector financial institutions. But they also reflect a global economic imbalance that made the aftermath of the second oil price shock even more destructive. After the first, many politicians had been shocked by the fragility of the system, and had attempted to postpone adjustment and maintain a relaxed monetary regime. The inflationary consequences had undermined stability still further. After the second shock, most countries tightened interest rates, following the example set by the United States, but many were still unwilling to make painful fiscal adjustments. As a result, real interest rates rose, and borrowing became more expensive and difficult to sustain. Countries that had started development programs, and built up political systems that depended on the rapid growth generated by low real interest rates, now needed to adjust very quickly.
Commentators have frequently been tempted to distribute responsibility for major malfunctions of the international system among the participants. Often this sort of exercise ignores the role played by misguided hopes and inappropriate expectations. Does the blame lie with politicians in developing countries who tried to preserve a precarious social stability (and perhaps also solidify their hold on office) by making a bet on short-term growth? Or with politicians and central bankers in developed countries, who came to the conclusion that the illusion was becoming destabilizing and could not be continued indefinitely? When national policies diverge dramatically, resulting capital flows pose a strain on the international financial system. How can that shock be absorbed? Should it be done through transfers made by international agencies, who have the responsibility of stabilizing and ensuring adjustment, or through the private sector? The critical question soon became: how long would the private sector be willing to make transfers between economies with unsustainably different performances? Looking back, Jesús Silva Herzog, Mexico’s Finance Minister, who had been at the center of the later crisis, concluded: “The whole world congratulated itself on the success, smoothness, and efficiency with which the recycling process was achieved. We all were responsible.”1 There is another, more convincing answer. Nobody knew enough—in particular about the extent of bank loans. The debt crisis reflected a failure to share and make available information: in effect a failure of the surveillance principle.
The origins of the debt crisis lie only partly in inappropriate short-term policies; they also involve longer-run developments in borrowing countries and on capital markets. In those countries where the debt crisis wreaked most havoc, the domestic financial system had been eroded by a history of instability. High fiscal deficits and inflation, often aggravated by external shocks, diminished the willingness of the private sector to save and to keep savings within the country. As a consequence, savings needed to be transferred from abroad, and borrowers hoped that foreign capital markets could make up for the inadequacies of their own past performance. The inflows contributed to the problem: short-term capital inflows were inherently volatile and unsuited to longer-term development finance; there was a risk of a sudden cessation of longer-term bank lending; and, in addition, the inflows of funds often contributed to an exchange rate appreciation that made exporting more difficult. A longer-term solution involved both the stabilization of the international financial system, and domestic measures to increase saving rates, and in general to make economies more competitive. The debt crisis sounded the death knell for a particular vision of economic development (see Chapter 5), as well as for the political systems fostered and sustained through an inward-looking and protected economy. Disseminating information about this policy adaptation, too, was a part of the IMF’s surveillance function.
The Confidence of Bankers
In the IMF Annual Report of 1982, which was published just as the major debt crisis erupted (but of course written sometime earlier), the Fund commented on the rise of interest rates in the major financial centers, and the “repercussions on many developing countries.” “Banks are becoming more selective in their lending policies, and there is increased focus on economic policies and conditions in individual countries.”2 Already in the previous year’s Annual Report there had been warnings about likely problems in payments financing.
Banks had initially been very confident about their ability to make correct judgments about risk and about future developments. They convinced themselves of their own infallibility during the course of the 1970s. The end of the par value system had created new opportunities for making gains from the greater flexibility of exchange rates (crises such as the 1974 Herstatt collapse, arising from forward exchange transactions, did not act as a deterrent to the development of this business). By 1982, some 600 to 700 banks throughout the world were engaged in international lending.3 New net bank lending to the non-oil developing countries, which had been around $26 billion in 1978 almost doubled in 1981 to $50 billion (in the next year it fell back abruptly).4 The internal structure and mentalities of banking changed. For the practitioners, the international side of banking turned from being a rather sleepy backwater into the turbulent rapids of career advancement. Bankers were by no means alone in being supremely confident about their actions. They were inevitably joined by many optimistic finance ministers in borrowing countries, and their actions rationalized by academic economists. In an article published in 1981, for instance, Jeffrey Sachs of Harvard wrote: “if my analysis is correct, much of the growth in LDC [less developed country] debt reflects increased investment and should not pose a problem of repayment. The major borrowers have accumulated debt in the context of rising of stable, but not falling, saving rates. This is particularly true for Brazil and Mexico, which together account for about 40 percent of the net bank liabilities of the LDCs.”5
After only a few additional years of hindsight, of course, an enormous amount of print was devoted to chronicling and ridiculing the limitations and follies of the brash young bankers who engaged in this exercise.6 If only, it was said, they had learnt their history better, and paid attention to the alternation of booms in international lending in the 1880s or 1920s, and busts in the 1890s and 1930s; if only they had looked at the experience of the defaults of interwar Central Europe or Latin America. The international lending of the 1970s differed only because of the extent of the direct exposure of banks. By the end of 1981, a calculation prepared by the IMF in mid-1982 showed that the exposure of U.S. banks to Latin American debt amounted to 97.3 percent of capital, and in many individual cases well above 100 percent. The exposure of U.S. bank capital was 33.7 percent to Mexico alone.7 Unlike the previous international tending boom of the 1920s, when the major part of the flow had taken the form of bonds bought by large numbers of private investors, whose fate might be personally tragic but macroeconomically irrelevant, the syndicated bank loans of the 1980s, with their concentration of risk, endangered the financial system of the world’s major economies.
In general, whenever a new form of financial intermediation is introduced, it is followed by a spate of semisensational accounts and eyewitness reports, depicting the hubris and then the nemesis of the opportunistic, shallow, and irresponsible innovators. This literature has a point. When a new activity is obviously successful, it attracts imitators who see an easy way of realizing gains. A herd mentality develops. Locked into a collective frenzy, bankers find that there exist sharp penalties for getting out, but none for staying in. Someone who advised a bank against further exposure to Mexican debt in early August 1982 might soon have looked very wise; someone who took the same stance in 1979 or 1980 would have been likely to find themselves without a job. The basis for this enormous expansion was provided by the belief most systematically and popularly expounded by Citicorp Chairman Walter Wriston and summarized in the often quoted phrase “countries don’t go bankrupt” (in fact, Wriston more usually said, “don’t go out of business”). “The infrastructure doesn’t go away, the productivity of the people doesn’t go away, the natural resources don’t go away. And so their assets always exceed their liabilities which is the technical reason for bankruptcy. And that’s very different from a company.”8 At least in a weaker sense, the Wriston proposition was certainly valid: even if countries were insolvent, there existed no legal mechanism analogous to bankruptcy for reducing or writing down a debtor’s liabilities to a creditor. They could only default and then invite their creditors to produce some kind of “work out.”
The result of the stronger version of the Wriston hypothesis that implied that insolvency could not be a problem for sovereign states was to make international lending enormously attractive for banks. No detailed credit investigations were needed of desired. In the 1970s, most banks had rejected proposals from the U.S. Federal Reserve Board, or (internationally) from the Bank for International Settlements (BIS), for a “checklist” of creditworthiness as had most borrowers. Instead for the banks, “country risk analysis,” based on measures such as the ratio between a country’s indebtedness or debt-service obligations and GNP of exports, turned merely into a way of satisfying bank supervisors and regulators that proper steps had been followed9 Lending officers were urged by New York headquarters to increase levels of exposure to foreign countries. The longer the debt boom went on, and the more positive experiences accumulated, the more secure the lenders felt. Two thirds of bankers questioned in 1982 stated that international lending was more profitable than domestic banking. In 1982, Latin America accounted for only 16 percent of Citibank’s assets, but 32 percent of overall net income.10 Looking at recent historical material, bankers found ample justification for their enthusiasm. The risks were low. Between 1971 and 1980 Citibank’s losses on outstanding foreign loans amounted to only 0.29 percent (compared with 0.70 percent for domestic loans).11 In addition, banks were pushed because of the decline of a part of their traditional business. In the course of the 1970s, particularly in the United States, corporations had begun a securitization of their liabilities, and as a result depended much less on bank credit. By 1980, bank loans accounted for only 33 percent of U.S. corporate liabilities. Commercial and industrial loans at this time amounted to less than a fourth of banks’ total loans and securities.12
How rational was the expansionist fervor of the banks? The answer is sometimes reduced to a simple relationship between the real interest rate and the growth of the borrower’s taxable base. On this depends the security of the loan. If economic growth is higher than the real interest rate, repayment of the outstanding borrowing will not be problematical, even though debt levels may rise. If, on the other hand, the real interest rate is higher than the rate of growth, debt levels will continue to rise even in the absence of any transfer of real resources, and servicing will come to be increasingly problematical as the mountain of debt grows. Establishing the behavior of the components of this relationship (growth and real interest rates) is more difficult than may at first appear. First, the sustainabilty of growth depends on the adoption of appropriate policies in borrowing countries. Too often loans were simply used to finance public expenditure that was not used for the creation of productive export-earning capacity. External circumstances—notably the behavior of commodity prices—will also profoundly affect growth rates. There is in general no simple formula that can simply predict the likely behavior of growth. At the height of the lending boom, a debate took place on the reliability of macroeconomic indicators as a guide for loan judgments. The proponents of country risk analysis admitted that “no single indicator or ratio can be relied upon to tell us what we wish to know, and some can be very misleading without thorough study of the reasons behind their behavior.” The critics complained that country risk analysis was “a quite amateurish exercise,” without any “coherent or systematic framework.” Second, the same caution needs to be applied to projections of interest rates. The leading theoretician of credit risk, Irving Friedman of Citicorp, in producing a long list of factors “exogenous to the country which may impact that country’s creditworthiness,” on the other hand, did not even list the level of interest.”13
Forecasting likely levels of real interest rates in the future is hard. The most reliable course appeared to be a simple extrapolation of the recent past. Much of the lending enthusiasm of the late 1970s was generated by the belief that real interest levels would continue to remain at the low of even negative values that had followed the acceleration of world inflation. The early 1980s in consequence brought a considerable shock. In the United States, real short-term interest rates had been negative in 1977 and 1978, rose to 1.3 percent in 1979, but then rose to an average 8.9 percent in 1981 and 8.1 percent in 1982. The long end of the U.S. market demonstrated the same behavior: long-term real interest rates in the second half of 1981 and the first three quarters of 1982 stood at high levels, between 8 percent and 10 percent.14 The climb of the critical rate for most international lending, the London Interbank Offered Rate (LIBOR) for dollars, began in 1978. From under 7 percent at the beginning of the year, three-month LIBOR rose to over 14 percent in November and remained at high levels for the next four years.
The Interest Rate Shock
For many of the borrowers and many of the lenders, interest rates (and the Federal Reserve Board Chairman who had put them up in October 1979) were the major villains who had caused the disasters of 1982, and the subsequently almost insuperable adjustment problems. The policy response to high levels of inflation in industrial countries, and especially in the United States, directly imposed a substantial cost on borrowers: because interest rates on bank loans were generally floating, and reflected U.S. rates; and because, in addition, the costs to non-U.S. borrowers were often higher than those faced by American borrowers (where interest payments were generally tax deductible). A turnaround in U.S. policy thus brought immediate global implications for sovereign credit.
Wriston thought Paul Volcker personally responsible for the debt crisis. The Brazilian Finance Minister, Mario Henrique Simonsen, explained later how there had been no policy mistakes in his country, except a failure to anticipate the developments on the capital markets. “The unorthodox blend of tight monetary and loose fiscal policy in the United States since 1981 was unanticipated,” he wrote in 1985.15 Higher interest rates obviously had an immediate effect in increasing the burden of debt service, as well as endangering the longer-term prospects for repayment. Of the total increase in current account deficits of the non-oil developing countries between 1978 and 1981 (some $66 billion), over a third was a result of the rise in net interest payments.16 Very high nominal rates also altered the distribution of service costs over the life of a loan, increasing the initial burden (and reducing that at the end).
The repercussions of the interest rate shock reached beyond the immediate service costs. Higher interest rates applied as part of a counterinflationary strategy in the developed countries, in association with the effects of higher energy prices on income, slowed down the rate of economic expansion. Real GDP in the industrial countries had grown by 3.5 percent in 1979, but only by 1.3 percent in 1980 and by 1.3 percent in 1981, and in 1982 it fell by 0.2 percent. As a result, their imports from nonindustrial countries fell. In addition, after 1981 the rise of the dollar on the exchange markets increased the real cost of servicing dollar loans.
For many borrowing countries, these effects of the sharp variations in interest rates were made more acute by the sustained slide in international commodity prices that occurred between 1980 and 1986 (with only a brief and slight recovery in 1982–83, which was followed by a new slump). (See Figure 12-1.) The effects of the recession on demand in the industrial countries affected the terms of trade of developing countries. Terms of trade of non-fuel exporters worsened hy 6.5 percent in 1980, 4.9 percent in 1981, and by 0.7 percent in 1982.17 About a third of the change in the trade balance of the non-oil developing countries was a consequence of the deterioration of the non-oil terms of trade.18 The fall in prices was particularly precipitate in metals and for some tropical commodities. Between 1980 and 1982, the international copper price fell by 32.2 percent, lead by 39.7 percent, and tin by 23.5 percent. The development in part represented a response to the recession in the industrial countries; in part it also was due to a structural change in demand. As many advanced economies moved away from heavy and chemical industries and toward increased activity in lighter manufacturing and services, they required fewer imports of metals. Some food prices also fell very sharply. Coffee prices between 1979 and 1982 declined by 25.9 percent, and cocoa by 47.1 percent.19 Attempts to stabilize these prices through buffer stock schemes ran into difficulties because of the extent of the collapse. An international Cocoa Agreement had been concluded in 1980, but made no purchases after 1982 because of the depletion of its funds. Quite substantial IMF resources under the buffer stock financing facility were used to support some of the stabilization attempts, most importantly the 1977 International Sugar Agreement, which was hacked to the tune of SDR 74 million ($94 million). The sugar price recovered rapidly between 1977 and 1980, then fell slightly, but remained very stable during the course of the 1980s. In addition, the amounts made available to national authorities under the compensatory financing facility increased through the world recession. In 1983, 29 percent of the Fund’s resources being used had been made available in this way.20
Figure 12-1.Real Non-Oil Primary Commodity Prices
Source: International Monetary Fund, World Economic Outlook.
High real interest rates and the depression in the industrial countries, together with the commodity slump, cast a shadow over the future of international flows of funds. The level of uncertainty about the prospects for the global economy increased. But there were also independent developments in many of the borrowing countries that radically changed the outlook. Levels of investment began to fall off in 1981, before the sudden reduction in net resource transfer (new drawings on loan commitments minus total debt-service payments, that is, principal plus interest) associated with the debt crisis. The fall in investment was greatest in countries that had relied most heavily on foreign financing.21 In part this was explained by the expansion of public sector deficits that had been facilitated by the lending boom, and which crowded out other would-be investors in the borrowing countries. Correcting this situation appeared almost impossible, and the consequent deterrent to private investment almost complete. If the adjustment were undertaken through attempts to increase government revenue, most obviously through increased taxation, it would depress the economy, lead to a fall in output, and thus affect the critical relation between real growth and real interest rates. Such an action might provide a shock sufficient to halt the lending process. On the other hand, expenditure cuts risked offending politically sensitive groups: businesses and farmers who depended on state subsidies, or voters, of the state’s own employees, of often also the army officers.
Falling investment was in part a consequence of increased levels of capital flight. As the long-term prospects grew bleaker, ever larger sums moved out. Particularly in those countries that had tried to maintain price stability through some form of fixed and overvalued exchange rate regime, the incentives to export capital were great. A second type of recycling occurred: the private recycling of funds into more secure foreign assets. Capital flight amounted to a vote of no-confidence in governments, or to use Albert Hirschman’s term, the use of the possibility of “exit” by economic agents. As that flight occurred, governments needed to compensate for the loss by generating their own ever larger inward capital movements. Increased borrowing and increased capital flight were mutual counterparts. In this way, greater borrowing in practice often served as an indicator of the bankruptcy of a particular policy approach, rather than as an endorsement by the international capital market of that policy’s success (as some borrowing countries tried to claim).
The movements involved were much more substantial than was generally realized at the time. A World Bank calculation of 1985 shows capital outflows from Argentina between 1979 and 1982 (where the problem of the overvalued exchange rate was acute) amounting to 65.1 percent of inflows. In Mexico, the equivalent figure was 47–8 percent. In Venezuela, outflows actually exceeded the volume of inflows.22 In 1985 U.S. Secretary of State George Shultz gave $100 billion as the figure for Latin American capital outflow since 1980.23 States faced with the problem of large-scale capital flight had an almost insoluble dilemma. The imposition of controls, of a threat of likelihood of such a measure, would only increase the rate of outflow as people tried to anticipate or circumvent the state’s control. Any initiative to increase levels of confidence through fiscal discipline encountered another sort of objection: it might provoke an economic downturn and undermine confidence even further.
How long could this state of affairs have continued ? The participants had every interest in convincing themselves that it might last, if not forever, at least a good deal longer. This was often nothing more than the banking equivalent of whistling in the dark. A senior bank economist, for instance, was quoted as stating in March 1982 that, “I don’t think Mexico’s need for financing will exceed the market’s willingness to lend.”24 Both the bankers and the borrowers needed to convince themselves that no systemic threat existed. There might of course be individual temporary difficulties, but they could be overcome. Those problems that might have been interpreted as danger signals were ignored, because as the extent of risk increased so also did the belief that a collapse of such a magnitude was impossible. As the lending boom continued, this calculation appeared to give ever greater confidence to the participants. Any breakdown would be on such a scale that it would wreck the international financial system and endanger world economic and political stability. For this reason, it could not possibly be allowed to happen. Someone would have to come to the rescue.
This calculation produced an assumption, which gradually became almost commonplace, of an implicit government guarantee on the part of creditor governments. This belief or expectation derived sustenance from further notions and assertions about the foreign policy background to international commercial lending, European governments, for instance, and in particular that of Germany, were eager for bankers to stabilize East-West politics, as well as to create additional export orders, by channeling resources to Eastern Europe. The U.S. government similarly was believed to back Latin American loans as a guarantee of economic growth and political stability in the western hemisphere.
As a consequence, although difficulties arose well before August 1982, in Jamaica, Nicaragua, Peru, Sudan, Turkey, and Zaïre, they were not treated as an indication of a major faultline in the international financial system25 Zaïre had accumulated debt arrears since 1976, and official debt was rescheduled through the Paris Club in 1976–77. Turkey had an outstanding private sector debt of between $8 billion and $12 billion at the end of 1978, as well as $5 billion publicly guaranteed debt. It had begun rescheduling in May 1978, and in 1979 bank debt was consolidated through a new syndicated loan. Sudanese debt was restructured in 1979. And what appears retrospectively as the first Latin American “banking crisis before the banking crisis” occurred in Peru (unless the analyst looks back further, to Argentina in the late 1950s, or to the general defaults of the interwar period).
In Peru, balance of payments difficulties and inflation had been building up through the 1970s. Peru used up its reserves, and at the same time borrowed heavily on international markets, but by the end of 1977 the confidence of international banks had begun to disappear. In December 1977, Peru requested an emergency loan of $100 million from the United States, but was turned down. In the next year, a sustained capital flight by private investors set in, and by the second quarter Peru was close to defaulting on its debts. In May 1978, it approached the IMF for a stand-by credit, which was approved in July. As part of the package, Peru agreed to reduce trade restrictions in 1979. In 1980, the military regime gave way to a centrist civilian government under the Presidency of Fernando Belaúnde Terry. There was little attempt to control public spending, inflation worsened, and the balance of payments deteriorated once more. In June 1982, Peru negotiated an EFF with the IMF, but quickly broke the performance criteria set for net indebtedness of the nonfinancial public sector, and for official reserves of the monetary authorities. In February 1984, eventually, the EFF was canceled and a stand-by arrangement requested in its place.
After the initial IMF operation of 1978, little new private money went to Peru. The lesson learnt by the international financial community from the Peruvian experience was not that international lending contained greater risks than had been foreseen, but rather that there existed two types of developing country. One type was growing healthily, and had access to private capital markets, which helped to finance further growth. In the other type, balance of payments problems were endemic, and attempts at adjustment did not lead to improvement or to an ability to draw on private capital. These cases would be permanently looked after by the multilateral financial institutions. There might be at the margins some movement between these camps: Peru in 1978, and Jamaica at almost the same time (see pages 330–33) had shown that they could not adjust satisfactorily, and would have to leave the international financial system (understood as a network of private sector capital flows). Countries of this type would henceforth be cared for by development agencies. According to this interpretation, the private sector would manage the healthy parts of the world financial system, while multilateral agencies would deal with the problems. Even some of the problem cases could be dealt with privately. When Nicaragua needed to negotiate a $600 million rescheduling agreement with 165 banks, the banks acted without insisting on a prior agreement with the IMF.
Bankers saw their own activities as quite separate from the IMF’s sphere of influence. Irving Friedman explained confidently that “because they depend upon full and prompt servicing of their loans for their financial profitability and viability, private banks (in contrast to the Fund and the Bank) understandably tend to focus their activities upon the best managed countries, and, within these countries, the best managed firms in the most advanced sectors of the economy.”26 Another prominent banker, Rimmer de Vries of Morgan Guaranty, in April 1982 formulated the new consensus among the private sector in the following terms: “in recent years Fund and commercial bank lending have evolved in different directions.” They had distinct and separate spheres of operation, and “thus, the Fund must not be viewed as a protective umbrella under which the international banking community can find shelter in times of trouble.”27 This view gained further support from politicians and commentators who feared that the private sector might at some time attempt to use international institutions to support their own operations. Already in 1978 the U.S. House of Representatives had debated an “anti-bailout” amendment of Congressman Jerry Patterson, aimed at prohibiting the use of IMF loans to pay off arrears owed to private banks.28
An East European Crisis
The problem of states leaving the “normal” financial system was posed in a very acute way in Eastern Europe in 1981 and 1982. In this case political rather than purely economic developments appeared to be responsible, and in consequence the result was not treated as a general warning (though these crises too were in large part a consequence of the interest rate shock, and the political crises that accompanied the debt crunch did have their economic origins: see Chapter 16). Poland had been a heavy international borrower in the 1970s, partly from commercial banks as well as from Western governments, as the regime of Edward Gierek tried to expand Poland’s infrastructure and at the same time raise consumer living standards. But by the summer of 1980 this policy had collapsed, and labor unrest in the shipyards and the formation of a large nonofficial trade union movement Solidarity marked the beginning of a mass revolution against the communist regime. The labor conflicts led to a collapse in industrial production, and intensified the balance of payments problems. At the beginning of March 1981, Poland requested a postponement of repayments.”29 On March 27, with total external debt standing at $27 billion (50 percent of GDP), Poland suspended principal payments on loans, and requested a rescheduling of its $ 12 billion bank debt.
Was this an isolated problem that arose out of Poland’s unique political crisis? Hungary too had borrowed heavily on Western markets, had begun a program of cautious economic liberalization, and had applied for membership in the IMF as a way of supporting its reformist course. (Hungary eventually joined in May 1982.) In 1981 and 1982 foreign demand fell as a result of the sharp recession in Western Europe, and the prices of Hungary’s major exports also collapsed. Nevertheless, the tone of policymakers during the premembership consultations with the IMF was cautiously optimistic. In December 1981, a Fund mission concluded that “notwithstanding some temporary financing difficulties linked to the situation in Poland and Romania, they [the Hungarian authorities] saw signs that Hungary’s realistic and competent economic management was restoring the banking community’s confidence in that country’s ability to service its debt.”30
By March 1982, however, the situation had deteriorated, and Hungary needed rapid short-term help. As it had not yet joined the IMF, and as in any case the negotiation of a stand-by arrangement would have taken too long to meet the needs of a sudden emergency, Hungary asked central banks and the BIS for a short-term credit. Initially, the Federal Reserve was hesitant and suspicious. Hungarian credit should be the concern of the Europeans, not of the United States, Paul Volcker claimed. It was “not on our turf.” In March a BIS line of $100 million was opened, in May a further $110 million was provided, and in September the short-term assistance was consolidated into a $300 million facility.31 In 1983, the BIS loan was repaid with the proceeds of a German commercial bank loan.
The Hungarian device of the BIS bridging loan eventually proved to be a crucial component of the solution worked out to deal with the generalized banking crisis. But for the moment, Hungary, like Poland or Peru, was treated as a special case.
Through 1981 and 1982 some hints about the extent of the general risk posed by the debt buildup began to circulate. U.S. Senator Bill Bradley in 1980 visited the Managing Director of the IMF and asked whether he was concerned about the volume of banking debt and whether the Fund had plans for dealing with a widespread debt crisis. In March 1982 international bank supervisors issued a statement through the BIS urging bankers to separate the functions of setting limits on exposure from the task of marketing loans.32 Banks themselves moved to shorten the maturities of loans, presumably in the belief that shorter loans were less risky and that in an emergency it would always be possible for the skillful banker to reduce his exposure. Reduced maturities clearly made the task of debt management much more difficult for borrowers. As the dangers rose, the debtor countries’ authorities tried to borrow more. A last-minute inflow might ward off the threat posed by the unavailability of funds. Respectively, it became clear that every country that was obliged in 1982 and 1983 to restructure bank debt showed an increase in bank lending in the period immediately prior to the difficulties.33 There were some signs of optimism in 1982. The three-month LIBOR fell from almost 16 at the beginning of the year to an average of 11.53 for August. The fall in rates gave some hope that countries might grow out of potential liquidity crisis.
The Emergence of a Mexican Problem
Mexico, whose problems eventually produced an awareness of a general banking and debt crisis, had led the way in expanded bank lending. At first the Mexican problems too appeared unique, and not characteristic of debtor countries in general. They seemed to stem from the peculiar circumstances of Mexico’s commodity production. The oil boom generated a euphoria, in which the President described Mexico’s fundamental economic problem as “the management of abundance.”34 In fact, abundance did have damaging implications for Mexico’s exchange rate policy. In the late 1970s, the peso had been held steady against the U.S. dollar. Since during the oil boom Mexican costs and prices rose quicker than in the United States, the result was a real appreciation, which damaged the competitive position of non-oil producing sectors. The growth of nonpetroleum exports slowed and virtually ceased in 1981. The oil bonanza had begun to produce in Mexico the symptoms of the “Dutch disease.” In late 1980, the government responded by allowing a peso depreciation relative to the dollar, but higher Mexican inflation levels meant that the real exchange rate still continued to climb. In 1981, the external account was further undermined by a weakening of international oil prices. When Mexico tried to defy the market and maintain prices for its products, oil exports fell dramatically, while prices of other major exports (coffee, copper, silver, cotton) also fell. At the same time, the interest rate burden on the external debt was increasing, as both interest rates and the total debt outstanding rose.
Despite attempts at fiscal stabilization, the budget became increasingly unbalanced, and by the summer of 1982 the projected fiscal deficit stood at around 11 percent of GDP. Correcting the overvalued exchange rate had fiscal implications, which helped to undermine the attempted adjustment by adding a new inflationary stimulus. Each depreciation of the peso was followed by special pay awards to public sector employees, and thus larger deficits. In February 1982, a new devaluation of the peso increased the nervousness of Mexicans, and the pace of capital flight quickened. Mexico appeared to have reached an impasse. The problems of the external sector might have been solved through a faster adjustment of the exchange rate, as an IMF mission recommended at the end of 1981, but this would also have affected the budget and created further nervousness and an accelerated flight of capital.35
In June 1982, the government concluded its largest ever commercial loan operation, a $2.5 billion “jumbo loan” syndicated by Bank of America, with a seven-year commitment, priced at 1½ percent above LIBOR. European and Japanese banks were reluctant to join the syndication, although Bank of America defended the operation enthusiastically: “We are confident that Mexico’s vast natural resources, its industrial labor force, its dynamic private initiative as well as the efficient public administration, will pull Mexico out of its current troubles.”36 In July 1982 there was a small ($100 million) Eurodollar loan from Merrill Lynch at a very high interest rate (18.5 percent, a spread of 4 percent over U.S. Treasury bonds). At this stage the problems were already quite apparent to the Mexican authorities. In early July, the Mexican government asked the IMF to give a “seal of approval” to Mexico, without a formal stand-by arrangement and without Mexican drawings. The absence of a formal Fund program would “be easier politically for the Mexican Government,” but the Fund’s support would “facilitate there efforts to raise money on the commercial markets.” The IMF replied to this suggestion that its imprimatur be used to reassure bankers by insisting that any program go before the Executive Board for discussion, and that the proposal would need to be “fully quantified” and capable of being monitored “in a meaningful way.”37 On July 23, 1982, the Finance Minister, Jesús Silva Herzog, asked the IMF to send an informal mission; and on the same day he dropped heavy hints to the U.S. Treasury that he might require emergency assistance. He hoped that the Fund mission would negotiate an extended facility. A larger amount than could be given in an IMF package might be needed, more quickly than the IMF could give it. All the warning signs were ignored by the U.S. Treasury Secretary, Donald Regan. He was “asleep at the switch,” as the chronicler of the Mexican debt crisis, Joseph Kraft, wrote.38 On August 10, Regan still viewed the issue as primarily a domestic concern: he stated that he was concerned about “reactions to some recent banking difficulties in the United States and the possibility that international lending of [U.S.I banks would tend to fall off because of these and other aspects of the current climate of opinion.”39 Even in his memoirs, Regan’s only reference to the major international event of his tenure as Treasury Secretary was the rather passive and helpless (as well as incorrect) lament that “Third World debt, as well as our own budget deficit, was always with us.”40 Already on August 9, in fact, the IMF’s Deputy Managing Director had noted that “this is clearly an emergency situation that calls for very rapid action.”
Mexican hinting about possible problems soon became superfluous. The disaster had arrived. On August 12, 1982, Silva Herzog called Regan as well as Paul Volcker and the IMF’s Managing Director Jacques de Larosière to say that Mexico’s reserves were exhausted, the debt could not be paid, and that he was on his way to Washington. His interlocutors were all astonished, Regan was unaware of the extent of Mexico’s difficulties, de Larosiète later stated that “I was not expecting such a statement,” and Volcker was on holiday.”41
The personal discussions took place the next day. Jacques de Larosiète insisted that Mexico should issue a public announcement about its debt difficulties, but not make any unilateral move, should maintain its commitment to a liberal exchange rate regime, and should involve the commercial banks in the discussion of a solution to the payments problem. An adjustment program with the Fund should be a part of the solution, and a new IMF mission left Washington immediately. The Managing Director argued, that a severe adjustment program would be needed, in order to “convince the outside world, particularly the banks, that the Mexican economy would indeed soon be set on the path of return to order and stability. This was the role the Fund could play, rather that through the provision of short-term finance.”
The Mexican payments difficulties threatened to bring about a worldwide financial crisis, as banks with frozen assets might find themselves unable to make payments to other banks; a number of Mexican banks with New York or London offices might set off a chain reaction by failing to make payments. The immediate task of monetary authorities lay in keeping the interbank market functioning. Volcker suggested an emergency BIS facility, on the lines worked out in the Hungarian case. On August 18, 1982, the BIS approved a $1.85 billion credit. The U.S. Treasury prepared to buy oil from Mexico (at a price 20 percent below that on the world market) as a way of providing immediate funds. It paid $1 billion as an advance, and an additional $1 billion came from the Commodity Credit Corporation.
On August 18, Mexico issued a public statement that foreign currency debt would no Longer be serviced. Two days later, on August 20, Silva Herzog spoke with representatives of 100 commercial banks in New York. He gave details of the emergency credits arranged with the U.S. Treasury, the swaps with the Bank of France, the Bank of Spain, and the Bank of Israel, as well as of the package he hoped to arrange with the IMF, and then asked the banks to agree to a temporary rollover on all amortization payments due on bank loans to the public sector (all interest payments on loans to the public sector would, he promised, continue to be settled fully and on schedule). But even at this time, some of the banks were aware that Mexico could only make a successful adjustment if banks provided additional money (Citibank suggested that the banks could provide $4 billion in 1983).42 Potentially Mexico had a powerful leverage. Any Mexican action threatened banks’ solvency, since if there were to be no agreement, and interest payments on loans were to be suspended, the loans would have to be reclassified as nonaccruing. The lenders had every interest in avoiding such a step, and could in consequence be coerced into being compliant over additional lending. The banks agreed as a first measure on a 90-day moratorium of standstill on the amortization of the principal, which was announced on August 20. On the same day, the leading banks involved in the Mexican crisis formed an Advisory Committee. For a few weeks, the Mexican problems seemed to be singular. Then they appeared as a pan of a general debt crisis. Mexico became a model of that crisis. Then, gradually, it became also a model of crisis management, and of a strategy for recovery.
Tackling the Mexican Crisis
There was, in Mexico and in New York, a general hope chat the crisis could be handled by some external agency: the IMF. In some respects, however, the IMF was quite ill-prepared to act as a lender of last resort. Usually the lender of last resort needs to act very quickly and decisively in the face of a sudden crisis. The IMF makes decisions in its Executive Board, subject to voting by Executive Directors who consult their national authorities (and, in the case of the elected Executive Directors, often a substantial number of national governments). These decisions, as in the Mexican case, depend on an often lengthy negotiation of a reform program with the borrowing country. On the other hand, central banks, with their traditions of secrecy and clear operational guidelines, are able to provide speedy short-term support; and, in the Mexican crisis, both the U.S. Federal Reserve and the central bankers’ central bank, the BIS, did act extremely promptly. But they wanted assurance that they would not be left on their own, and that their short-term assistance would be used to galvanize the rest of the financial community. This was the task that the IMF set itself. The Managing Director of the IMF, Jacques de Larosière, put his own prestige on the table—committing the Executive Board, in effect, to follow his advice. In an emergency, the Board had to act in a different and more expeditious way than that to which it was not only accustomed but also committed through the Articles of Agreement.
The major mission involved in this exercise lay in building bridges—within the international financial community, and to Mexico and then other debtor countries, but also within the divided Mexican government.
Jacques de Larosière had from the outset emphasized the need for a broad political consensus in Mexico on the response to the debt crisis. The incoming administration of the new President Miguel de la Madrid should he involved as well as the old Portillo regime. The uncertainty of the transition of power between presidencies still inevitably affected the course of the debt negotiations. At the end of August, the Mexican administration suddenly changed course, and attempted a break with the international financial community. On August 31, 1982 President Lopez Portillo imposed exchange control, and nationalized the Mexican banking system. He publicly attacked both the commercial bankers and the IMF: “The remedy of the witch doctors is to deprive the patient of food and subject him to compulsory test.”43 The new Governor of the central bank, Carlos Tello, a radical economist who had just replaced the much more stability oriented Miguel Mancera, proposed maintaining exchange controls and refusing to make cuts in either the Mexican budget of the level of Mexican wage settlements.
There were in consequence at least three different currents in Mexico City. The Finance Minister, Silva Herzog, wanted a relatively orthodox stabilization. The economic adviser of the new President, Carlos Salinas de Gortari, argued for a less restrictive approach to the public sector deficit. The central bank governor was wildly expansive. The differences could be put numerically: Silva Herzog wanted to aim at a public sector deficit of 8 percent of GDP for 1983, while the President-Elect’s advisers thought of 10 percent. The Fund mission, which originally worked on the basis of 6 percent, needed to work intensively at bringing the different Mexican parties to a common understanding. From the initial discussions on August 13, 1982 the Fund had insisted that the program would need a “seal of Mexican origin,” and Silva Herzog had also stated that “it would not in tact be possible to ‘sell’ an adjustment program in Mexico if the public believed it had been designed by the Fund.”
The radical kneejerk nationalism of late August, which was detrimental to Mexican economic and political stability, on the other hand paradoxically simplified the negotiating position for the creditors. From the standpoint of the Mexican economy, there can be little doubt that the bank nationalization was disastrous. The move destroyed the confidence of the private sector, and it took over half a decade for Mexico’s businessmen to recover their nerve. Capital flight from Mexico remained at high levels until after 1987. In 1983 alone it amounted to $9.2 billion.44 The major beneficiaries of a move intended as a gesture of defiant nationalism were not Mexicans. In nationalizing the banks, the Mexican state assumed responsibility for their liabilities, and thereby increased their credit ratings. Many of the foreign bankers were more of less openly relieved. Before September 1, 1982, it might have been possible for some of all of Mexico’s banks to request their own moratoriums and deal with their creditors individually. With a private banking system, the option existed of going bankrupt in compartments. Bank A might be in difficulties, but Bank B could go on paying. Bank nationalization broke down the barriers between the compartments and as a consequence added to the dimensions of a general “Mexican crisis.” Mexican public authorities had taken on a task that they could have escaped, and now had the responsibility of finding a solution.
Volcker and William Rhodes of Citibank, the influential co-chairman of the Banks’ Advisory Committee formed to handle the Mexican debt crisis, argued that there should be no new money unless Mexico could come to an agreement with the IMF. (The Mexican example came to be a model, in this as in many other regards. For each country, a separate bank committee of 12 to 14 banks was established to negotiate a new schedule of payments. Each bank on the committee had the task of keeping the other creditor banks in its country of region informed, and under pressure to agree.)
The IMF, instead of appearing, as many bankers had previously believed, a fringe institution in a world that could be quite adequately managed by the private financial sector, now took on the task of coordinating the global system. Its negotiations with Mexico represented a bracket that would hold the world of money and the world of sovereign states together.
The letter of intent for a three-year extended facility prepared by Mexico as a result of those negotiations was signed on November 10, 1982. It involved 450 percent of Mexico’s IMF quota, of around $3.7 billion. For its implementation, the Fund had to borrow substantial additional resources. Under the terms of the agreement, the budget deficit would be cut from 16.5 percent of GN.P in 1981 to 8.5 percent in 1983, 5,5 percent in 1984, and 3.5 percent by 1985. The current account deficit would be expected to fall from $13 billion in 1981 to $6.5 billion in 1982 and $4.25 billion in 1983. The agreement would, in addition, be dependent on a rescheduling accord with the commercial creditors.
The calculations of the IMF involved a substantial element of new money. On its own, the IMF could clearly nor provide all of it. Jacques de Larosière shocked bankers meeting in the New York Federal Reserve building on November 16 with a statement that the Fund’s arithmetic could not work without a sizable contribution from the banks. Instead of bailing out the banks, the IMF would be “bailing them in.” The Managing Director then explained the details of the Mexican and Argentine figures. For Mexico, a total of $8.3 billion would be required over the course of 1983, of which $1.3 billion would come from the IMF and $2 billion from the United States and other governments. Then de Larosière added that the rest, $5 billion, was to be the contribution of the bankers, in order to “make the amortization schedule compatible with the orderly execution of the Fund program.” The banks would have to agree to this additional funding, which amounted to a 7-8 percent increase in their exposure, by December 15, 1982, one week before the Executive Board vote on the Mexican extended Fund facility, (The Managing Director pointed out that, in 1981, bank exposure to Mexico had been increased by 46 percent.) In addition, the banks might have to deal with interest arrears.45 The procedure of providing new funds was known by a variety of names, most politely “concerted lending,” more clearly as “involuntary lending,” and mostly (by the bankers) as “forced lending.”
During the meeting, at which no representative of the U.S. administration was present, the President of the Federal Reserve Bank of New York, Anthony Solomon, explained the consequences for banking regulation. He added that “there is always a question of political will of the borrowing nations but the IMF has considerable experience in these matters.” When loans accompanied and depended on an agreed Fund program and when they “facilitated the adjustment process,” bank supervisors would raise no objections. On the same evening, Paul Volcker made the same point in a speech in Boston in which he urged both banks and the “relevant authorities and financial institutions” to deal more effectively with a threat “essentially without precedent in the postwar world.” “In such cases, where new loans facilitate the adjustment process and enable a country to strengthen its economy and service its international debt in an orderly manner, new credits shouldn’t be subject to supervisory criticism.”46
In effect, here was a triangular conflation of the functions of an international arbiter, a domestic regulator, and the market. First, the IMF had become for practical purposes a part of the domestic regulatory mechanism of U.S. banking. Linkage of loans with IMF programs could offer a way of avoiding the consequences of nonaccruing or nonperforming loans. Or, to put it another way, the definitions of what constituted sound banking were being rewritten in accordance with the requirements of the world financial system as a whole. Second, the banks themselves became part of the IMF’s international surveillance exercise. Their funds greatly enhanced the facilities that the IMF could hold out as the reward to a country for the successful completion of a program—in effect for rejoining the international financial system. An IMF program was supposed to have a “catalytic” effect on the private sector. And finally, the IMF would do the work that the banks had hitherto neglected to perform themselves: negotiate sound criteria for the use of funds, which would make economic stabilization and adjustment possible and would allow for banks to be repaid. In order to get this service, however, the banks would have to pay the price of putting up additional resources. By acting in this way, the IMF ensured that lending continued and that the cutting off of external credit did not produce a world depression of the type experienced in the past. In 1825, 1857, 1890, of most spectacularly and most damagingly in 1929, global depression followed the breakdown of credit markets. The year 1982 did not join this unhappy list of dates.
On November 30, 1982, the New York based Banks’ Advisory Committee agreed the proposed terms of the bank contribution. The 90-day emergency moratorium would be extended until the end of 1984 for 1983 and 1984 maturities, with repayment over eight years and a four-year grace period. In addition, banks would commit an additional 7 percent of their existing exposure (for six years, at a rate 2 ⅛ percent above U.S. prime rate).
The individual banks involved were subjected to great pressure to agree to the committee’s terms. Any single bank could have brought down the rather delicate structure by declaring a default, and thus triggering automatically a default for all the other bank credits through the cross-default clause that formed a standard part of loan agreements. In part, the pressure on banks not to extricate themselves was applied in the United States by the Federal Reserve, and in other countries by other central banks. The authorities might threaten increased regulatory attention to banks that did not comply.47 In Europe, the Governor of the Bank of England, a Gordon Richardson, arranged meetings for de Larosière with the leading figures of European commercial banking. Initially, many argued that “it will be a tough job to get new money” and that “the real job is to get official money.” One European banker complained that “normally a bank says ‘stop’ when it is stuck.”48 It required in consequence considerable persuasion to move the bankers. The advantage of the IMF appeared in its position as an international juridical institution created under the general international treaties that also governed the United Nations. In a situation in which many of the participants were acutely aware of the costs and risks involved, the IMF could give advice, persuade, encourage, and cajole, without running any risk that it could be sued by those who followed its advice. The major money center banks also took their own part in persuading other institutions, in particular the smaller regional banks which desperately wanted to extricate themselves from Latin American lending.
Jacques de Larosière announced that for the IMF Board to approve the program, a “critical mass” of 90 percent of the $5 billion would be required from the banks. When confronted by bankers with the argument that such an extent of compliance was impossible, he stated: “Because it’s impossible, you’re going to do it.” A crisis concentrates the mind. The bank package was indeed put in place by December 15, 1982, and in the following week the governments also made their $2 billion available through state expott banks (such as the U.S. Export-Import Bank, the Japanese Export-Import Bank, the Compagnie française pour l’assurance du commerce extérieur, Hermes in Germany, and the U.K. Export Credit Guarantees Department). The Fund extended arrangement was as a result approved by the Executive Board on December 23, 1982. By March 23, 1983, the commercial banks’ $5 billion had been fully achieved, with 526 banks across the world participating.
In December 1982 the Mexican domestic reform program associated with the international rescue operation was also launched by the new President Miguel de la Madrid. Known as the Programa Inmediato de Reordenación Económica (PIRE), it provided for a devaluation of both the “free” and the “controlled” exchange rates and an increase in taxation. It produced a dramatic improvement in the current account; but the short-term economic consequences of the PIRE were far harsher than had been anticipated by the Mexican government or by the Fund, in large part because inflation was difficult to control, and had been given a push by the increased import prices following the devaluation. It remained at much higher levels than had been foreseen in the program (an average of 80.8 percent in 1983 rather than 55 percent, and 59.2 percent in 1984 rather than 30 percent). As a consequence, the reduction in public sector borrowing had a more severe impact than intended. In 1983, real GDP declined by 4.2 percent rather than merely showing the zero growth that had been planned.49
A sharp drop in the price of oil (from an average of $26.98 a barrel in 1985 to $13.82 in 1986) provided the final shock that killed the first Mexican attempt at adjustment. Real GDP growth slowed in 1985 (2.6 percent growth) and GDP fell dramatically once again in 1986, by 3.8 percent.50 The collapse of the oil price destroyed the budget calculations, which had been built on the assumption of expensive oil. In the middle of 1985, Mexico could no longer draw on the Fund facility, as a result of the breaking of the fiscal performance criteria.51 Confidence collapsed, and a run on the peso and an acute balance of payments crisis ensued. The economic collapse was followed almost immediately by the tragedy of the Mexico City earthquake, which led to a catastrophic loss of life, and caused physical damage estimated at 2 percent of Mexican GDP.
The reaction to the renewed economic crisis differed significantly from that of 1982. The balance of payments problem was dealt with through an acceleration of the program of trade liberalization rather than by imposing restrictions. Already in July 1985 a large number of import categories were freed from the requirement of prior import permits, and the number of duty rate categories was reduced. Mexico applied to join the General Agreement on Tariffs and Trade (and became a member in 1986). The exchange rate was allowed to depreciate, so that at the end of 1985 the controlled and the free rates stood at the same level. The long-term effects of the liberalization included a dramatic growth of non traditional exports, which reduced the damaging extent of Mexico’s dependence on oil.52 There was thus an appropriate growth-oriented setting to the program of fiscal restraint.
In September 1986, a new IMF stand-by program (for $1.7 billion) included the novelty of a contingency financing clause, under which an additional amount (of up to $720 million) would be made available if the oil price were to fall below $9 a barrel. It thus minimized the potential effects of another commodity shock and generated much-needed reassurance. The balance of payments assistance package was followed up by a far-ranging domestic reform agreement, known as the Economic Solidarity Package (December 1987), negotiated by representatives of labor, business, and agricultural producers. There were further cuts in the fiscal deficit, a tighter monetary policy, an incomes policy to restrain wage-push inflation, and a commitment to further steps in trade liberalization. The stabilization of the exchange rate with the backing of a high level of reserves (which had recovered as a consequence of the 1986 program) helped to break the inflationary cycle.
At the same time a large-scale privatization program was launched, and the extensive state sector built up since the Mexican revolution dismantled quite quickly. The leading airlines Mexicana and Aeromexico, the copper producer Cananea, and a controlling stake in the telephone company Telmex were sold in 1989–90. Between 1982 and 1994, around 1,000 state enterprises were privatized, although many of the largest enterprises, including the oil monopoly, were still in state hands.
The reform and liberalization course was consolidated through the December 1988 Pact for Economic Solidarity and Growth drawn up by Finance Minister Carlos Salinas de Gortari (who became President on December 1, 1988), and in July 1989 supported through an agreement on debt reduction under the provisions of the newly announced Brady Plan (which constituted the first major initiative to solve the debt problem through debt reduction rather than new financing; see below, pages 401–402). Though the actual savings in debt repayments were lower than originally calculated, the program provided a major psychological stimulus and had a major effect in reducing the very high level of real domestic interest rates (which had been as much as 30 percent) as flight capital returned to Mexico. The effects on confidence thus far outweighed the numerical significance of debt relief. In August 1990, Mexico announced that it would negotiate a free trade agreement with the United States, which eventually came into effect in 1994 with the creation of the North American Free Trade Area. As this external setting locked in place the reform program, Mexicans and foreigners began to glimpse large investment opportunities. There were substantial capital inflows, including a return of much of the flight capital of the early 1980s. In the initial stages of the reform, many Mexicans were highly skeptical. In a deep crisis, it is often impossible to believe that there can be any recovery. An opinion poll carried our in late 1986, at the time of the new IMF program, showed 54 percent of the respondents believing that there would never be an end to the crisis, and another 30 percent thought recovery would take longer than ten years.53 Even while this poll was being conducted, recovery had begun, and the performance of the economy began to be widely described as miraculous. Like all so-called economic miracles, in reality it was the consequence of the formulation and implementation of sound policies.
The new miracle also raised very intricate problems of how the financial sector and the exchange rate should be managed. In particular, when the return of flight capital and the resumption of capital inflows brought upward pressure on the exchange rate, and the exchange rate was used as an antiinflationary instrument, a risk arose that the result might be a reappearance of the old problems of an external rate sufficiently high to serve as a deterrent to domestic activity and a disincentive to exporters. The political stakes attached to the maintenance of the exchange rate produced a tabu on discussion of the parity in the Mexican administration—a tabu that has often characterized pegged rate systems.
When the Mexican exchange rate overvaluation was corrected at the end of 1994 with an ill-prepared devaluation at the same time as a large quantity of public sector short-term instruments needed to be renewed, a new financial panic showed the extent of the instability of the financial system. However, Mexico’s fiscal position was much stronger than it had been in the crises of the 1980s. In addition, most importantly, a wide-ranging structural reform had already been implemented. The private character of much of the debt and of the capital inflows meant that the losses inevitably associated with adjustment were distributed more widely. A critical difference that made the new inflows less destabilizing than those of the big debt boom of the 1970s was the dispersion of risk produced as a consequence of privatization. Such diversification, and the consequent involvement of a greater number of actors, may have made the crisis of 1994–95 less transparent and a systematic solution harder to achieve than in the case of intrinsically graver problems 12 years earlier.
A General Crisis?
For a few weeks in 1982, at the outset of the Mexican crisis, optimists believed that the Mexican debt problems were as specific to that country as those of Hungary, and that no general crisis would break out. Even during the nervous IMF and World Bank Annual Meetings in Toronto, held (by coincidence) in the immediate aftermath of the Mexican declaration, Mexico’s Finance Minister was astonished by the apparent confidence of other Latin American finance ministers that they would not be touched by the Mexican debacle. Within a few weeks, however, similar crises broke out in Argentina and Brazil, and the world experienced a general debt crisis, and no longer isolated disturbances of a number of individual problem countries. Bankers then attempted to cut their exposure to the whole region, including to some of the smaller states with better managed economies.
Argentina’s rather different economic and political path appeared in the late summer of 1982 to be, quite fortuitously, converging with that of Mexico. If anything, Argentina provided an even more striking example of the lack of attention paid hy the international banking community to the early signs of financial distress. The international crisis followed years of abortive efforts at stabilization. Successive governments attempted to reduce fiscal deficits and to eliminate the inflationary dynamic, only to encounter a popular backlash against austerity policies too powerful for a weakened military authoritarian regime to resist. The most important single economic mistake—as in Chile at the same time—lay in the adoption of a mistaken approach to the exchange rate. An attempt between 1978 and 1981 to use a stable exchange rate (determined according to a pre-set tablita) as an instrument of anti-inflationary policy led to an overvalued rate.54 When this was combined with fiscal weakness, it prompted large-scale capital flight. The deficits of public enterprises and provincial governments increased and provided a potential source of instability. The effort to marketize the economy extended most effectively to the financial sector, where it produced a justification for the creation of a large number of unstable credit institutions.
Growth fell off earlier than in Mexico, where the oil price rises after 1979 had provided a powerful impetus to investment. Real GDP in Argentina had risen by 7.1 percent in 1979, but stagnated in 1980 with 0.7 percent growth. In March 1980 a domestic banking crisis broke out, and many of the major Argentine banks required emergency support from the Central Bank. In effect, at this point a nationalization of debt occurred. Attempts to correct the problem of balance of payments weakness and an overvalued currency (the peso) in the latter part of 1981 failed. The outbreak of the Malvinas/Falklands war with the United Kingdom in April 1982 destroyed any prospect of stabilization. The fiscal deficit soared, and monetary policy was relaxed further to accommodate the deficit. On June 17, 1982, immediately after the end of the war, the President, General Leopoldo Fortunato Galtieri, resigned, and a new military administration made a promise about a transition to civilian rule by “early 1984.”
In the long run, the transition to democracy would prove the only way of generating sufficient popular consent for a program of stabilization and liberalization. Political and economic liberalism went hand in hand. But the short-run consequences of democratization produced immense political instability, with rapidly changing ministries, in which the incumbents tried simply to extract the maximum advantages for their client groups as quickly as possible. Inflationary finance and economic nationalism with regard to trade policy and the debt issue offered almost irresistible attractions to politicians who saw populist politics as a key to electoral success in the new democracy.
In May 1982, permission to import most consumer goods was suspended; and then, on July 5, a full emergency program was implemented. The issue of peso overvaluation was tackled through a devaluation of 21 percent of the commercial rate and subsequent daily adjustments. Price controls were imposed on large industrial firms. The Central Bank tried to limit capital flight by making new lending by the banks almost impossible. Bank deposits outstanding on June 30 required 100 percent reserves. To prevent the credit stop affecting the domestic economy, existing personal and corporate loans could be refinanced through the Central Bank rediscounting at an interest rate of 6 percent monthly (which amounted to a highly negative rate in real terms). The effect was broadly to wipe out existing debts.
Predictably, the program rapidly disintegrated, as capital flight continued through other methods: exporters retained their proceeds, and imports were overinvoiced. The total short-term outflows from Argentina during 1982 were estimated at $5 billion. Already in August it became clear that Argentina could not sustain this radically inflationary course; the monthly cost of living increase was 160 percent; and, on August 25, 1982, the Treasury Minister directly responsible for the emergency program resigned. The course of inflation now proceeded without interruption. Indeed, some of the measures taken as part of a preparation for a transition to democracy, such as the lifting of restrictions on trade union activity, helped to perpetuate an inflationary momentum and a balance of payments crisis.
The ratio of scheduled debt service to exports exceeded 100 percent for 1982 as a result of the collapse of Argentine trade; and for 1983 and 1984 interest payments on the foreign debt involved an estimated 8 percent of GDP. These figures were based on the information then available, while in fact the total extent of the Argentine liabilities was very hard precisely to determine. Official figures gave the sum of public and private debt registered at the end of 1982 with the Central Bank as $37 billion. But it also became cleat in the course of 1982 that this was an underestimate and that the military regime had borrowed heavily between 1976 and 1982 through overseas branches of the Banco de la Nación.
At the November 16, 1982 meeting with bankers at the New York Federal Reserve, where the Mexican crisis undoubtedly provided the main theme, the IMF’s Managing Director also attempted to set out what would be the Argentine financing requirements. The current account deficit for the last quarter of 1982 and for 1983 would amount to some $2 billion. An amount of $1.8 billion would be available from the IMF; the bankers would have to put up $3 billion, of which de Larosière estimated that half could be financed through liquidating arrears and unwinding swaps involving Argentine businesses. There would be a short-term bridging loan from the banks of $1.1 billion, representing 5 percent of the banks’ exposure to Argentina, and the provision of new money amounting to 6.8 percent of exposure.
The program accompanying the SDR 1,500 million IMF stand-by arrangement approved on January 24, 1983 involved the reduction of the public sector net borrowing requirement to 8 percent of GDP in 1983 and 5 percent in 1984, with an increase in revenue financed through fuel taxes; and a reduction of the balance of payments current deficit from $5.5 billion in 1982 to $0.5 billion in 1983 and to an equilibrium by the first quarter of 1984.55 There was a very minor trade liberalization (automatic licensing for all permitted imports would be restored in place of case-by-case considerations). Wage indexation for government employees would be abandoned in the hope that this might affect the levels of private sector pay settlements.
This program had to be suspended already in March 1983, with only SDR 600.5 million ($662 million) drawn, as the government stopped payments on short-term loans altogether for an indefinite period. The agreement only became operational again on August 15, 1983, with the release of a further tranche of the stand-by arrangement, of the remaining part of the bridging loan, and the provision of the $1,500 million loan from 263 foreign banks: shortly before the elections that resulted in the civilian presidency of Raúl Alfonsín. A new stand-by arrangement was approved on December 28, 1984, for SDR 1,419 million ($1,391 million) at a time when inflation had reached around 1,100 percent on an annualized basis.
By 1985 a much more radical approach was required. The plan for currency stabilization involved the introduction of a new currency, the austral, which would he fixed in relation to the U.S. dollar. The new approach was described at the time as “heterodox,” in contrast to the “orthodox” packages developed in the first phase of the debt crisis in consultation with the IMF. It derived some of its appeal from the simultaneity of other experiments in “heterodoxy” (notably in Brazil) and from a current in international academic opinion—articulated for Argentina most effectively by Rudiger Dornbusch—that supported a more “growth-based” approach, and rejected the likely consequences of a stabilization shock.56 Its proponents recognized that the plan flew in the face of received economic opinion; in practice, as implemented it did not fly very well at all.
The anti-inflationary plan announced on June 14, 1985 involved a temporary wage-price freeze, a prohibition of new central bank credit to the economy, a cash deficit of the nonfinancial public sector that would not exceed 2.5 percent of GDP in the second half of 1985 and would subsequently fall still further, and the regulation of interest rates.57 The theory underlying the Austral plan was based on the primacy of a price and wage freeze (rather than monetary control) as an anti-inflationary weapon to break deeply entrenched inflationary expectations. Once prices had been corrected, the real economy could begin to operate again. Many of those involved in designing the plan felt that references to inflation as a monetary phenomenon were nothing more than acceptable gestures in the direction of a modish theory. The stabilization plan tan in parallel with an existing IMF program, which had already been approved in December 1984, but it brought no access to larger Fund support.
There was in fact an immediate and dramatic deflationary shock after the introduction of the austral, and in the third quarter of 1985, real GDP fell 8 percent below the level of one year earlier. The shock was too severe to be sustained by the unionized and well-organized Argentine labor force, and the inflationary mechanism began to crank up again. The fiscal problem had never adequately been resolved. By December 1985 prices were rising again. In January 1986, a general wage rise of only 5 percent was agreed; but at the same time, family allowances were increased by 50 percent. In the spring of 1985, an IMF mission visited Buenos Aires to discuss a further Fund drawing, but was skeptical of the government’s ability to maintain the financial policies that would be needed for price stability and a market liberalization. In particular, it had become cleat that the government was unable to make spending cuts. A large “quasi-fiscal” deficit had emerged in the public sector, financed directly by the Central Bank. The Fund’s staff also urged an end to state intervention in wage setting. Fundamentally, Argentina and the IMF were looking in different directions, and the 1984 stand-by arrangement expired in June 1986 without a renewal.
Privatization held out substantial attractions, not simply because of the hopes for efficiency and growth gains to be obtained from deregulating and liberating the economy, but also because of its potential contribution to a solution of the budget imbroglio. In 1986, an IMF mission examined privatization plans for the government-owned steel and petrochemical industries. It argued in general for an end to price controls, an end to state intervention in the determination of private sector wages, and the avoidance “at all costs [of] targeting real wage increases for the economy.”58
At the same time, the external debt position continued to be very uncertain. The ability of individual foreign banks to jeopardize the whole fragile credit structure represented a constant threat, requiring constant attention. for instance, in the spring of 1986, the Dutch Amro bank, involved in a dispute over claims against the state corporation Cogasco, threatened to release a notice of default, and needed to be dissuaded by a combination of pressures from the IMF and the Netherlands Finance Ministry.
The Austral experiment failed to produce any long-term economic stabilization. Fiscal deficits and inflation rose again, and attempts to impose a new stabilization plan (the Mini-Austral of March 1987 and the Austral II of October 1987) failed to deal with the budget deficit. Interest arrears to foreign banks mounted. In 1988, talks with the IMF about a stabilization program were resumed, but then broke down again. The World Bank nevertheless agreed to a controversial $1,250 million loan package in a move that led to a bitter public clash with the IMF,59 but in the event its release was suspended until appropriate macroeconomic conditions had been restored. In May 1989, the Argentine economy slid into hyperinflation.
Throughout the final years of the Alfonsín presidency, an unwillingness and inability to act to correct the problems in fiscal and monetary policymaking was continued with an increasing thetorical awareness of the desirability of change. At the same time as the budget deficit soared, the government talked about creating an open economy. This verbal concession to orthodoxy helped to convince the U.S. State Department and the World Bank that Argentina should be supported in 1988. By making such declarations, Argentina not only wooed the international financial community; it also at least prepared the intellectual ground for a more far-ranging reform program. For instance, Alfonsín told a U.S. audience in 1988 that Argentina would move more swiftly to trade liberalization, would end quantitative import restrictions, and would introduce a simplified tariff schedule with an average rate of only 30 percent. “In the past, and for some time, the Argentine economy was able to expand under the rules of the game of a semi-autarkic model. However, this kind of development was prolonged beyond a reasonable period. The time has come to settle accounts with the shortsightedness which relegated us to stagnation, while the world witnessed an expansion of markets and the technological revolution …. Either we begin a growth process more closely associated with private investment, relying less on state enterprises and the granting of fiscal and credit privileges to the private sector or we will quite simply be perpetuating inflation and stagnation.”60 But in practice, no substantive easing of quantitative restrictions took place, and there was no effective action on fiscal reform.
The administration elected in 1989, headed by President Carlos Menem, came much closer to bridging the gap between liberalizing thetoric and the world of economic practice. Almost immediately, Menem passed an Economic Emergency Act and a State Reform Law that provided for a splitting up and privatization of public enterprise (which had been hugely inefficient and responsible for losses costing 2 to 3 percent of GDP), for the suspension of almost all government subsidies, and for a prohibition of central bank financing of the public sector. In the past four decades, a major source of inflation and its debilitating effects on business activity had been the subsidies provided to the publicly owned sector: artificially low charges, which were intended to counteract the effects of inflation, in fact promoted inefficiency and through their effect on fiscal policy actually helped to promote and perpetuate inflation.61 New taxes would fill the previously intractable budget deficit. Military expenditure was cut (from 1988 to 1991 it fell from 3.25 percent of GDP to 2.5 percent of GDP). The large short-term debt, which had been a constant source of destabilization, was compulsorily transformed into ten-year certificates in U.S. dollars (Bonex). As a result, the possibility of a rush of conversion of short-term debt into foreign exchange no longer stood in the way of an adoption of exchange stabilization and convertibility. Unlike in the case of the Austral plan, some major domestic elements of stabilization were already in place before in November 1989 the government concluded a SDR 1,104 million ($1,420 million) stand-by arrangement with the IMF.62
The government also began a major program of privatization and deregulation. Nevertheless, the first stabilization initiative faltered. Already in November 1989, high wage settlements began to undermine the anti-inflationary program. An attempt to halt inflation through the adoption of fixed exchange rates in December failed, and in 1990 the return of high inflation was accompanied by a massive flight out of the currency. A new stabilization program in March 1990 did not deal with the fiscal position, and the high inflation continued. Only in 1991 did a new stabilization program, including a fixed exchange rate commitment and an expansion of the privatization effort, tackle the fiscal problem. The government’s reforms were supported in July 1991 by a stand-by arrangement of SDR 780 million ($1,067 million). As in other cases (for instance, Turkey after 1980), the experience showed that an original failure, or even an experience of multiple failures, did not mean the inevitability of a new disintegration of reform initiatives.
As a result, after 1991, Argentina, like Mexico, came to be regarded as a model for the management of reform. Many were surprised at the beginning of the new administration by the extent and the depth of the political commitment to the new economic course. A strategy that had been debated for a long time and that had found many theoretical proponents was now put into effect. The preceding period, in which the thetoric of liberalization clashed dramatically with the actual practice, had prepared the political public for a period in which theory was actually implemented.
In the last months of 1982, the international authorities had discussed the Mexican and Argentine cases in tandem in part to make the point that the Mexican problems were not unique but rather systemic. The critical meeting of November 16, 1982 in the New York Federal Reserve building had dealt with both countries. It was impossible that problems in as large a borrowing economy as Mexico should not have a demonstration effect that would lead to more generalized debt difficulties. In fact, within days rather than weeks, Brazil joined the list of problem cases. Brazil had attracted very large amounts of capital, and its gross external liabilities in 1982 were even higher than those of Mexico ($91,035.5 million compared with $85,830.3 million).63
Brazil had experienced very rapid growth in the late 1970s, with a peak in 1980 (real GDP growth of 9.1 percent). In 1981 the economy grew at a much reduced rate, and in 1982 the rise in real interest rates and conditions on the credit markets made new financing very hard. The outbreak of the Mexican crisis in August 1982 was immediately followed by a desperate attempt of the international banks, in which smaller banks played the leading role, to reduce their outstanding credit exposure to major debtor countries. In the end, the smaller foreign banks did substantially withdraw, leaving the large money center banks with a higher proportion of debt.64 Their behavior was a crucial factor in setting off large outflows as one country after another experienced the debt crisis. Between June 1982 and the beginning of 1983, foreign creditors withdrew some $4 billion from Brazilian banks, which in turn worsened conditions on the internal Brazilian market. The immediate restrictive effect on export financing and thus on trade made it substantially more difficult to improve Brazil’s payments balance.
Faced with these repercussions of the Mexican and then the Argentine crisis, Brazil summoned its own bankers’ meeting in New York on November 20, 1982, four days after the discussion of Mexico and Argentina. It was—unlike the earlier meeting—hosted by representatives of the debtor country, Minister of Planning Antônio Delfim Netto, Minister of Finance Emane Galvêas, and the Governor of the Central Bank, Carlos Geraldo Langoni. But otherwise, events unfolded rather similarly to the scenario acted out in the Mexican and Argentine cases four days previously. At the meeting, de Latosiére announced that an IMF program had been concluded for SDR 4.5 billion ($5 billion) over three years, together with SDR 0.6 billion under the compensatory and buffer stock facilities. The borrowing requirement of the nonfinancial public sector would fall from 14 percent of GDP in 1982 to below 8 percent in 1983 and would continue to decline in subsequent years. The current account deficit would also be reduced, from $15 billion in 1982 to $7 billion in 1983, $5 billion in 1984, and $4 billion in 1985, On the basis of these figures, a contribution by the foreign banks of $5.6 billion would be required.
The rescue operation was divided into several “projects,” of which the first (new money), the second (rollover of medium- and long-term debt), and the third (rollover of short-term debt) were relatively easily accomplished. Even new money posed no great difficulties. But the fourth part of the Brazilian program (money market facilities) led to major conflicts. Project four involved the restoration of “outstanding” banking facilities to the level of June 30 or December 31, 1982, whichever was higher. This coordination of additional lending required the most extreme pressure applied on banks in the story of the international debt crisis, and generated the most visible resentments on the part of the financial community at the attempt to manage the debt crisis globally. When banks, particularly in continental Europe, proved reluctant to restore Brazilian credit, the IMF’s Managing Director sent a very stern cable to the 42 commercial banks judged to be below their “fair share” (including 6 in Italy, 5 each in the United States and Germany, 4 in Kuwait and the United Kingdom, and 3 each in Austria and Japan), The text included the phrases: “In the absence of contrary indication, I must interpret the current situation of your bank as evidencing failure to cooperate in the effort to support Brazil. I permit myself to express the hope that you will cooperate fully by increasing current money market outstandings at once.”65 Even more embarrassingly, Brazil released a list of “uncooperative” banks to the Wall Street Journal. The banks protested at the IMF cable, and at the leaking of the list (which some of them blamed on the coordinating bank, Bankers Trust).66 The IMF also put pressure on industrial countries to supply trade financing through official export banks, and in 1984 the G-10 countries produced a sum of $2.5 billion.
The Brazilian adjustment program produced some unanticipated consequences. As in Argentina and Mexico, inflation rates were much higher than had been expected, A price readjustment in June 1983 eliminated a substantial range of subsidies (on steel, domestic petroleum, and in part also on wheat). Coupled with a poor agricultural performance in 1983, and the persistence of wage indexation, the price liberalization pushed up prices, and costs, and the government responded with a permissive monetary policy. Consumer prices rose by 142 percent in 1983, 197 percent in 1984, and 227 percent in 1985. Government revenue collection became more difficult:, with the result that the fiscal deficit increased, especially after late 1984. The central government deficit as a proportion of GDP had been 4.9 percent in 1984, and rose to 11.2 percent in 1985. A strong inflationary impetus had already preceded the transition to political democracy in 1985, with a civilian government under José Sarney (originally the candidate for the Vice-Presidency, who became President after the sudden death of President-elect Tancredo Neves). The new regime then pushed expansion even further in order to achieve political stabilization.
While inflation accelerated, Brazil’s external position had shown a dramatic improvement. The current account deficit had been $16,312 million in 1982 and fell to $6,837 million in 1983 (completely in line with the IMF program), and turned into a surplus in 1984 and only a very small deficit in 1985.
The strong current account performance made Brazil less immediately dependent on balance of payments assistance from multilateral institutions. In August 1985, Sarney replaced Finance Minister Francisco Dornelles, who had negotiated the IMF agreement, with an economist, Dilson Funaro, committed to a “developmentalist” (that is, expansionist) approach, Funaro broke off discussions with the IMF about a new program in late 1985, and prepared a nonrecessive and non-Fund “alternative” stabilization package for the introduction of a new currency which was launched in February 1986 as the “Cruzado plan.” (There were still some informal contacts with the Fund. In early 1986 Funaro, together with the Central Bank President met de Larosière in New York.67) Brazil, like Argentina, began to experiment with “heterodoxy,” a break with the “system,” and a rejection of advice coming from international financial institutions. Wage increases were included in the original scheme for making palatable the introduction of a new currency; while the government froze consumer prices and public charges. In July 1986 the Central Bank signed a Financing Plan for 1985/86 with the banks; at the ceremony the Governor explained that “the interest of each negotiating party cannot ignore the reality of a financial system that does not exist anymore.”68 Eventually, an increasingly radical approach to policy culminated in a partial debt default.
In November 1986, a second attempt at stabilization, the Cruzado II plan, increased public charges and attempted to modify the indexation process. Prices rose, and once again triggered wage increases in an inflationary spiral. As Brazil’s reserves dwindled, Funaro on February 20, 1987 turned to the “international financial community” with a radical statement sent by telex to the approximately 700 creditor banks. “A cornerstone of the Brazilian Government’s policy is its commitment to the promotion of economic growth and the consolidation of democracy. These objectives are not compatible with the massive outward transfer of resources required by the debt-rescheduling model applied up to now.” Inrerest payments on medium- and long-term debt would be halted and the money due deposited instead at the Central Bank of Brazil, Funaro added only a cursory conciliatory note to this moratorium on the $108 billion outstanding foreign debt. “The initiative taken by Brazil today must not be seen as a weakening of its ties with the international community, but rather as a first step in restoring the dynamics of the country’s external trade and foreign investment flows.” Funaro aimed at negotiating an agreed limit on debt service of $6.75 billion (about 2.5 percent of Brazil’s total output of goods and services). In a 15-minute public address explaining the debt moratorium, President Sarney added that “We want to negotiate a formula to meet our obligations without compromising our development, a formula that avoids the political instability that will inevitably follow a new recession, unemployment or social crisis.”69 It soon became clear, however, that this moratorium had achieved little, and after little more than a year the process of negotiating began again.
The moratorium succeeded only very partially in altering the climate of debt negotiations. In May 1988, a Fund mission went to Brazil again, and began to discuss a government program that would reduce the operational deficit of the public sector for 1988 to 4 percent of GDP (without the changes, the deficit would have been some 7.5 percent of GDP), There would be a privatization of public enterprises, new industrial incentives, a reform of the financial system, a simplification of the tariff schedule, and the elimination of prior control on a substantial number of exports. The Fund program would depend, however, on the willingness of the international banking community to “make every possible effort to secure in time the financing that is projected in the proportion envisaged for each participant.”70
In June 1988, Brazil released part of the interest that had accumulated at the Central Bank under the moratorium, and an IMF stand-by arrangement was approved; and in September after a meeting of the National Security Council, the debt moratorium was formally lifted. In January 1989 a disinflation program involving a temporary price freeze was begun, and in 1990 a four-year program launched to reduce tariffs and eliminate quantitative trade restrictions. Brazil, although for a long time politically paralyzed by the corruption scandal surrounding its President, was on the way to joining the new international consensus on policy reform—after a number of repeated false starts. In 1994, as the last of the major debtors, it agreed with the banks on a long-term rescheduling and debt-reduction plan, and introduced a new attempt at currency stabilization.
The Wider Crisis
The commercial bank debt crisis immediately affected a large number of middle-income debtors, and was not of course confined to Latin America. Some middle-income countries with heavy debt burdens escaped the long process of negotiating over debt through quick adjustment and policy reform, often with the help of Fund programs. The most striking example is Korea, whose external debt in 1982, at $38,338.8 million, stood only slightly below Argentina’s,71 but never experienced a bankers’ run. In other countries, generally poorer debtors, the crisis took a different turn because of the prominence of governmental and institutional debtors, rather than private bankers, and because of greater difficulties in achieving policy reform (these poorer countries are the subject of Chapter 14). In between these two extremes of quick adaptation and a slide into a protracted official debt crisis, stood a number of countries that came to be regarded as the “classical” cases of the debt emergency, and that were the subject of debt rescheduling plans in and after the mid-1980s, and eventually of debt-reduction proposals. These countries were neither so successful as Korea, nor so removed from access to the market as the lower-income cases. In each of these “classic” debtors, policy reform played a crucial role in overcoming the challenge.
A comparable debt crisis to that of Mexico erupted in 1983 in the Philippines. It had been preceded by a long sustained economic decline, the result of mismanagement and corruption as well as of inappropriate policy. The debt problem was managed as elsewhere through the linkage of negotiations with banks and the elaboration of an IMF program. The major elements of the IMF package included politically contentious measures such as tax reform, the reduction of the deficits of the nonfinancial sector, limiting central bank support of banks, and a reconstruction of the large state-owned banks, as well as Limits on fiscal deficits. In addition, the international bank package was very difficult to assemble, because of disputes about whether trade credits (particularly for oil imports) should fall under the terms of the rescheduling.72 All of these issues proved difficult for a government whose hold on power was increasingly tenuous, and President Ferdinand Marcos delayed the conclusion of the program (and thus also of the bank agreement, which was as usual dependent on a deal with the Fund) until after the parliamentary elections held in May 1985. The consequence of the delay and the uncertainty about whether the program would he implemented made foreign creditors more nervous. The new money element of the restructuring in May 1985 was substantially smaller than had originally been anticipated ($925 million rather than $1,600 million).
The stand-by program broke down during the campaigns for the presidential elections (February 1986). Immediately after the elections, and the victory of the opposition leader Corazon Aquino, foreign aid resumed, a new 18-month stand-by program was implemented (October 1986), and a major debt-rescheduling agreed (March 1987). Only the establishment of a government more secure and above all more legitimate made possible the carrying through of reform proposals long discussed between technocrats and the international financial institutions. Agrarian reform provided a basis on which a liberalization could command substantial popular support. All the features of the new course (abolition of monopolies, trade liberalization, tax reform) had been negotiated with the Marcos regime, but Marcos had consistently acted to obstruct their implementation. After 1986, a major privatization was implemented, which left only 37 of 291 public corporations under state control. Direct foreign investment, which had tailed off during the problem years of the early 1980s, now resumed, rising from $12 million in 1985 to $127 million in 1986 and $936 million in 1988.
The Philippine experience shows a number of general features characteristic of other countries in the midst of debt crises: the linking of the overcoming of a debt crisis to a change in political structure as well as in economic policymaking. The debt crisis itself was a signal of policy problems and a catalyst of change. Finding a way out of the crisis depended on a transformation in which increased economic openness was supported by political reform.
Chile’s course, like that of Argentina, followed from the adoption of an inappropriate exchange rare policy, in which a peg to the dollar had been used after June 1979 as an instrument of anti-inflationary policy. The consequences of the peso overvaluation were intensified by the increase in oil prices, and the collapse of copper prices (the major Chilean export at that time). This combination brought a severe economic downturn, and although in June 1982 the peso was devalued and in August Chile adopted a floating rate, the break with the peg took place too late. The years of the fixed parity had produced a major overvaluation and a dramatic monetary expansion based on foreign borrowing. Then came the additional shock of the repercussions of the Mexican crisis. A withdrawal of credits produced a general bank run and a banking collapse on January 13, 1983, which was managed through a renationalization of the banking system, and then a moratorium on principal repayments for foreign debt. At first, Chile tried to stabilize through a managed slow depreciation (calculated on the basis of the difference between consumer price behavior and international inflation), but this experiment soon reproduced the ills of the overvalued rate. A major element in negotiating a Fund program was the alteration of exchange rate policy. Supported by an extended facility from the Fund and three World Bank structural adjustment loans, Chile eventually adopted a better exchange rate regime. The peso was devalued in 1984, and the tariff increases of 1984 were later reversed. In 1985, Chile led the way with a series of debt conversions into equities and lower yielding paper, at the same time as a recovery of growth and living standards began. On the basis of an open economy, Chile provided the first clear example of an overcoming of the debt crisis, with annual real GDP growth of over 6 percent in the second half of the decade.
Another hopeful indication that there might be a way out of debt crisis, and a striking example of an effective monetary stabilization, was provided by Bolivia, which had suffered from a declining national income since 1979, again the result in part of the combination of oil price increases with unfavorable commodity (tin) prices. By 1985, the economy had reached the point of collapse, with a fiscal deficit of 28 percent of GDP, financed through hyperinflation (in August 1985 consumer prices were 24,000 percent higher than in the previous year). In an extreme situation, on the advice of U.S. economists (in particular Harvard’s Jeffrey Sachs), and with the prospect of an IMF stand-by arrangement and a debt renegotiation, the government introduced a shock stabilization program.73 The exchange rate was freed, and depreciated by 93.5 percent. Prices and interest rates were also liberalized, the subsidization of state sector stores ended, a hiring freeze imposed for public workers, and a fiscal austerity plan implemented, which reduced the public sector borrowing requirement to 4 percent in 1986. Restrictions on external trade were removed, and import Tariffs standardized at 20 percent. Despite poor conditions on the commodity markets in 1985–86, the program was successful. After an output fall in 1986 of 2.9 percent, growth resumed. Because of the extreme circumstances in which it was conducted, Bolivia’s stabilization had an exceptionally powerful demonstration effect. It showed not only that reforms could never come too late, but also that very farreaching and comprehensive measures stood a better chance of success than partial stabilization.
A Systemic Crisis and a Systemic Solution
An answer to the debt crisis depended of course in part on the discussion and then the adoption of sound policies, and the elaboration of a politically sustainable consensus on policy reform, in the debtor countries. But the widespread crisis of the early 1980s also raised systemic problems and required an international, as well as a series of national, responses. At first, the crisis appeared as one of insufficient liquidity and not as an insolvency. On this diagnosis, the solution involved a short-term injection of liquidity, rather than a writing-down of debt, which might only make the liquidity constraint worse because it would deter any new flows for a considerable period of time. The great attraction of this viewpoint, and one that served the whole international economy as well as merely the financial system of rich industrial countries, was that its adoption allowed lenders to keep on lending—or coerced them into lending more.74 There was no drying up of credit. Only rather later did the participants seriously contemplate the issue of solvency.
The emergence of problems in the large Latin American economies led to a generalization of the crisis, as international bankers tried to rescue their balance sheets by withdrawing credits from those countries that had not yet demanded a rescheduling. Such action forced countries into illiquidity, and also created an incentive for likely debt problem countries to suspend payments and renegotiate their credits as soon as possible. Countries that arrived later at the debt negotiating tables found their position more difficult than had their predecessors. Even Brazil, as number three in line in the 1982 debt crisis, found the generation of new money much harder than had Argentina or Mexico. The smaller countries had even greater problems. By the end of 1984, the only Latin American countries that had not rescheduled their external debt were Colombia and Paraguay. Altogether by this time, 30 countries had fallen into arrears and begun renegotiation of their commercial bank debt.
The story of attempted solutions to the debt crisis is not one in which any magic formula could be easily discovered and rapidly applied. It required in the case of debtor countries a period of acutely painful experimentation, over the course of which a gradual change in intellectual perceptions of the nature of the economic problem occurred. At the same time, the balance of social and political forces in debtor countries changed to accommodate the recognition that a single approach, focused on finding the “right solution” in terms of what was appropriate state policy simply did not exist. It would be more productive, and also more beneficial, to let a whole host of individual economic agents discover their own solutions. Often, the new recognition took place at first principally on a purely thetorical basis. Some debtor governments in the 1980s, as in Alfonsýn’s Argentina, may well have thought that the language of adjustment, liberalization, convertibility, decontrol of wages, fiscal consolidation, and privatization was simply what the international financial community wanted to hear. In addition, it is also always easier to arrive at a new theoretical insight, than to implement the conclusions derived from it in the midst of the rough and tumble of political life. Only a combination of the failures of “heterodox” approaches, and then the examples offered by the successful application of the new approach (and in particular the experiences of Chile and Mexico), convinced other states that large-scale policy adjustment might offer a way out of permanent crisis.
The criteria for adjustment and reform—fiscal stabilization accompanied by a reduction of inbuilt rigidities-—were fundamentally those that were also applied to industrial countries as part of the exercise of creating a more cooperative and better balanced world economy. The broadest and most systemic solution to the debt crisis in this way—one requiring a better mix of national policies—was also one that required implementation in the industrial and creditor countries. For the first part of the 1980s, however, there was little sign of any willingness to take corrective action here either. The United States, for instance, continued the mix of monetary restriction and fiscal laxity that led to continued high interest rates and in consequence also increased the real value of the largely dollar-denominated debt.
In the absence of any effective reform at this global level, a discussion began of what might be called “mid-level” solutions, involving reductions or write-downs of outstanding debt. Many political and academic observers found it infuriating that those chiefly responsible for dealing with the immediate “crisis” in 1982 seemed to deny the existence of a systemic crisis and provide only a half-hearted response to an urgent need. At the beginning of 1983, the BIS threatened to stop providing bridging loans to countries with balance of payments difficulties, as its resources had been strained by the eruption of a general debt crisis.75 Initially banks, particularly European banks, were reluctant to be pushed by international institutions to put up new money for small countries (such as Uruguay) whose collapse would not directly endanger the international financial system.76 Debt figured only peripherally in most G-7 summits in the early 1980s. The issue had been discussed secretly at the Williamsburg summit (1983), and was referred to in the communiqué of London (1984). But at Williamsburg, U.S. Treasury Secretary Regan had stated that while the debt situation was “dangerous,” it had “lost some of its urgency.” By the beginning of 1985, debt had disappeared from the agenda of summit sherpas.77 Debt issues were then brought explicitly to the G-5/G-7 setting after 1986 as a result of the initiative of the IMF’s Managing Director.
Why was there not a greater sense of urgency? Had not the debt crisis produced a general imbalance in the world economy in which the development in many countries had been halted? The natural process of the flow of capital from capital rich countries to capital poor countries (in which capital should find a higher marginal rate of return) had been reversed. After the outbreak of the debt crisis, the service of debt exceeded new credit flows, and the ensuing effects on growth and development prospects, was striking and depressing. (See Figure 12-2.)
Figure 12-2.Annual Net Resource Transfers: Argentina, Brazil, and Mexico
Source: World Bank, World Debt Tables.
The negative transfers corresponded to an adjustment of the current account—forced by the absence of financing—that was so rapid that it astonished most observers. In the early years of the debt crisis, the current account deficit for indebted developing countries fell precipitately (from $113 billion in 1981 to $38 billion in 1984). As late as 1984, the IMF forecasts for the combined deficit had been one and a half times higher ($53 billion).78 The result of the very speedy adjustment was felt in a sharp drop in economic activity.
Reduced living standards and betrayal of hopes about progress and improvement made the 1980s appear as a lost decade in the western hemisphere (as well as in much of Africa; see Chapter 14). The deterioration in living standards in Latin America was particularly acute in previously prosperous cities. In Argentina, for instance, the proportion of the rural population classified as poor remained approximately constant between 1980 and 1986, while the urban poor rose from 10.3 percent to 17.4 percent. The most severely affected were those without regular employment. For those in paid jobs in some countries (notably Argentina and Brazil), real average wages continued to increase during the mid-1980s.79
Many observers suggested their own solutions to the global problem. Some politicians devised debt-reduction plans. The U.S. Senator for New Jersey, Bill Bradley, argued that an international agency should buy up high-interest short-term debt and convert it to lower-interest long-term loans, and that banks should also make some write-offs as the price for support from the IMF. On occasion, he even called for a “Bretton Woods II” as part of an effort at hold systemic reform.80 Peter Kenen suggested that a newly created International Debt Discount Corporation should buy debt from banks at a 10 percent discount and convert country debt into long-term bonds with reduced interest rates. Allan Meltzer wanted banks to mark debt down to the market price and exchange it for minority equity holdings. The British financier and Labour Party economics expert, Harold Lever, proposed additional credit to debtor countries from the export financing agencies of industrial countries. And there were, of course, many other plans.81
These initiatives were studied, and their feasibility analyzed, in the IMF’s Research Department. There was some sympathy for the idea of debt reduction. In 1985, for instance, some staff members began to argue that the fact of heavy discounting of traded debt instruments deterred new lending and required a capital write-down before new lending could be expected to resume; but these suggestions were at first highly controversial.82 A wideranging proposal for debt reduction was also discussed by the Fund’s Executive Board, at the initiative of the Indian Executive Director, Arjun Sengupta.83 In May 1987, the new Managing Director of the Fund, Michel Camdessus, made a speech in which he pleaded for “a wider range of financing options… carefully designed so as to guard against an unintended reduction of resources available to the debtor country.”84 But there was, at this stage, no explicit call from the IMF for debt reduction.
Most discussants in the initial phase of the crisis saw more obstacles to the implementation of a general debt reduction than chances of success. How could the world’s banking system survive large write-offs without public sector support? Almost all the global schemes involved subsidies to banks or debtor countries from central banks, export credit agencies, or from governments via multilateral institutions. But this would amount to a “bailing out of the banks” or a “socialization of losses,” protecting the banks from the consequences of mistaken actions, and would almost certainly attract widespread populist political opposition in the creditor countries. David Lomax’s survey of the debt crisis of 1986 concludes that “1 see little chance of any global solution being adopted.” A rather different analysis from Tim Congdon produced the same answer in 1988: “If our analysis so far is accepted, the outlook for many of the debtor nations is hopeless.” Mario Henrique Simonsen concluded in 1985 that “a lesson from this crisis is that balance of payments finance involves too many externalities to be efficiently carried on by competitive credit markets.”85 Not all the diagnoses were quite so bleak. The more optimistic commentators reflected that the obstacles in the way of a general write-down of debt would not be a major impediment, since, as William Cline put it, “the resumption of international economic growth and the likely absence of new oil price explosions should go far towards resolution of the debt crisis,”86 But for many debtor countries, this prospect simply involved too long a wait.
White politicians and analysts searched for a global solution, it appeared for some time as if the debtor countries had a considerable incentive to form a global debtors’ cartel, sometimes colloquially referred to as “debtpec.” In May 1984, the presidents of Argentina, Brazil, Colombia, and Mexico issued a statement condemning the high level of world interest rates, and the increasing trend to protectionism that made it harder for debtors to export and service their debt. In June 1984, 11 Latin American states met at Cartagena, Colombia, and formulated a charter calling for lower interest rates, the reduction of loan spreads and the elimination of commissions, a new IMF facility to reduce the impact of high interest rates, and multiyear rescheduling of debts. The debtors thought that the IMF should concentrate its attention in adjustment programs on the behavior of production and employment indicators, and modify its monetary and fiscal targets if there was an unforeseen inflationary impact. The World Bank and the Inter-American Development Bank should increase their program lending.87
Some of the participants at Cartagena had pressed for a more radical solution, a concerted declaration of default by debtor states in order to put pressure on creditor governments to adopt a more systematic approach to writing down debt. At this time, versions of a famous Keynes quotation made the rounds: if you owe the bank a thousand dollars, you have a problem; if you owe the bank a thousand million dollars, then the bank has the problem. The more radical option was opposed by Mexico, which at the time seemed to have recovered from the worst part of the first adjustment shock. A default, it was argued, would lead to a suspension of trade, and to catastrophic consequences. Half of Mexico’s corn, Finance Minister Silva Herzog explained, came from imports. Depriving Mexicans of their daily tortilla would produce an explosion of rage and discontent. Breaking with the international system might be a pleasing political thetoric, but in sober reality could only lead to economic deterioration.
The creditors certainly took quite seriously the possibility of a general default. In 1984, U.S. Secretary of State George Shultz wanted to isolate what was then the worst case, Argentina, in order to stop the possibility of a “domino effect” of unilateral defaults.88
Some of the demands put in Cartagena by the moderate Latin American governments were also formulated by developing countries within the institutional context of the IMF, in the G-24. Already during the debt boom, there had been many skeptical and apprehensive discussions about the implications of the explosion of debt. In Belgrade in 1979, in a statement presented during the Fund/World Bank meetings, the G-24 had warned that “there is the possibility that commercial bank financing may not be forthcoming in the needed quantities or on suitable terms, so that the recycling mechanism may not operate as efficiently as in the past.” Its program included the creation of an “effective, symmetrical and equitable” adjustment process, in which surplus and deficit countries would be dealt with equally. International liquidity should be created through “truly collective international action in line with the requirements of an expanding world economy.” A greater transfer of real resources to developing countries would be desirable. Developing countries should play a greater role in the decision-making process in the inrernational financial system.89
The G-24 proposals of 1985 on “The Functioning and Improvement of the International Monetary System” restated some of the Belgrade proposals. The system needed greater exchange rate stability, and should move toward the adoption of “target zones.” There had been too much emphasis on adjustment, and not enough on growth out of crisis. “In determining misalignment, the focal point of concern should not be just the attainment of balance in international payments but achieving the objectives of expansion and balanced growth of international trade with high levels of employment and real income and a durable payments equilibrium.” In solving the debt crisis, relief needed to be associated with restructuring, in order to achieve “positive” adjustment with growth. The crisis had had many causes, and not just one single villain should be identified. “The debt crisis is a result of excessive lending by commercial banks, abrupt policy changes, and, in some cases, an unbalanced policy mix by industrial countries and other factors leading to historically high interest rates, excessive borrowing with inadequate policies by many debtor countries, and the failure of Fund programs in the case of many low-income countries.” One way of promoting greater levels of economic growth lay in not only a new issue of SDRs, but also a revival of the older “link” discussion. “A link between allocation of SDRs and development would not only meet the unfulfilled absorptive capacity of developing countries [the capacity to absorb capital from external sources] but also reduce the pressures on the industrial countries to accommodate an improvement in the current account balances of developing countries.”90
The report was right in pointing out that a solution to the systemic aspect of the debt crisis involved finding a way out of the international situation that had produced an alteration of the levels of savings and investment, and in consequence very high real interest rates. The U.S. fiscal deficit was a major culprit in this regard. In the mid-1980s, the World Economic Outlook exercise provided “worse policies” scenarios, in which the fiscal policies of the industrial countries continued to limit the potential for growth in the world economy, and with it the hope for a way out for the indebted countries.91 By the end of the decade, the global imbalance between savings and investment had become a common topic for international discussion.
Long before this situation could be addressed, let alone corrected, the need for a “mid-level” solution became ever more acute. The first practical move beyond an ad hoc approach to debt issues came as a result of the appreciation that since much of the debt contracted in the early 1980s had medium-term (five to seven year) maturities, there would be a “debt hump” in the mid-1980s as the maturities fell due. Particularly in the very difficult negotiations over the Brazilian case, bankers began to voice their impatience with the step-by-step approach to debt problems, the annual round of rescheduling negotiations, and the atmosphere of continual crisis that this generated. They appealed for a longer period of Fund control and surveillance.92 The solution, multiyear rescheduling agreements (MYRAs), developed out of a joint initiative in mid-1984 by Volcker and de Larosière and was laid out in a speech by de Larosière. A longer time frame for bank rescheduling “would be a way in which to reward good performers, while avoiding the necessity for repeated annual rescheduling: it would also help to restore the conditions needed for a return to market access and serve to rebuild confidence in the system.”93 This suggestion was accepted a few days later at the London G-7 summit. The communiqué referred to the “encouraging [of] more extended multi-year rescheduling of commercial debts” in cases “where debtor countries are themselves making successful efforts to improve their position.”94 The model of such an agreement was provided in the case of Mexican debt, where a 14-year rescheduling of all debt due until 1990 was agreed.95
Banks tried to argue that there should be similar concessions made by creditor governments in the case of official debt. Indeed, the London communiqué had also spoken of “standing ready where appropriate to negotiate similarly in respects of debts to governments and government agencies.”96 In the case of the Mexican MYRA, some banks had tried to make their agreement dependent on official rescheduling, bur eventually retreated.97
The longer duration of the MYRAs raised the issue of a performance guarantee.98 The response after August 1982 had linked Fund programs with bank agreements; but it was quite conceivable that Fund programs might no longer be needed for balance of payments purposes in the case of at least some debtor countries for the full period of the bank rescheduling. In an attempt to assure creditors of the reliability of debtor country policies, some debtors asked for IMF conditionality without a program (“enhanced surveillance”). This demand initially appeared awkward and even unacceptable for the IMF, because it seemed to tie Fund activity very explicitly to the working of the private capital market rather than being concerned primarily with a country’s approach to the balance of payments. But it amounted to a logical consequence of the close association of the banks and the Fund in dealing with the debt crisis, in which the banks had been brought in as part of the Fund’s surveillance operations, with the goal of maintaining the effective operation of the international financial system.
In the course of discussion of ways out of the debt crisis, criticism mounted that the IMF, which had previously, in the 1970s, been in competition with the commercial banks as institutions for financial recycling, had now become too close to them, too concerned with avoiding a banking collapse, and too untroubled by the growth implications in debtor countries. This was a view frequently expressed in some of the debtor countries, but it was also articulated forcefully by some economists in the creditor countries. Rudiger Dombusch, for instance, wrote that “it is increasingly perceived that poor performance is also due to a ‘system’ that enforces, with IMF assistance, the interests of foreign banks over domestic prosperity and stability.” In this view, the austerity entailed was neither necessary or acceptable. Harold Lever and Christopher Huhne drew from this argument the deduction that the IMF’s policy was unlikely to work. “It is more likely that the banks will not lend enough and that the debtors will not pay.”99
The test of whether the debt strategy coordinated since 1982 by the IMF was successful consists only in part of whether the world avoided a major financial and banking collapse. On that score, there can be no doubt that the IMF course “worked.” A more fundamental test—and the critics were right to raise this question—was how soon the consequences of adjustment and better macroeconomic policies would produce a return of confidence, a fresh inflow of investment, and growth. It would be unrealistic of anyone to expect such a fundamental reversal of expectations overnight; but it was equally clear that the longer it was delayed, the more painful would be the experience of the debt crisis.
The Baker Plan
The first systemic initiative that linked multilateral agencies, commercial banks, and the question of debtor country adjustment was announced by U.S. Treasury Secretary James Baker during the 1985 IMF-World Bank meetings, and then spelled out in more detail during U.S. Congressional hearings.100 All three sides should make concessions. First, banks should provide new money, amounting to $7 billion annually over the next three years, to 15 developing countries with debt difficulties (10 of the 15 were in Latin America: Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Uruguay, and Venezuela. The others were Côte d’lvoire, Morocco, Nigeria, the Philippines, and Yugoslavia. Two more Baker candidates, Costa Rica and Jamaica, were added later.) For some time, many assumed that the list of 15 was merely illustrative or indicative, but as the “Baker 15” it soon hardened into an analytical classification.101 Of the $21 billion to be supplied by private banks, $13 billion should come from banks outside the United States. Second, there should be new net loan disbursements on the part of multilateral development agencies of $3 billion annually over the same period; and if the results demonstrated success, the United States could agree to an increase in the capital of the World Bank, and multilateral assistance would rise to $20 billion. But new money alone could not solve the difficulties. As one of the architects of the Baker Plan, U.S. Assistant Treasury Secretary David Mulford, said, “one needs only to observe the pernicious problem of capital flight, which in recent years has been equivalent to virtually all new bank lending to Latin America, to see the futility of throwing more money at the problem.”102 Finally, therefore, the debtor countries should themselves make serious efforts to adjust. The plan was more of a guideline than an attempt to control the development of international debt; and it lacked any implementation mechanism.
Baker’s initial statement in the Annual Meetings was largely silent on the role of the IMF, except for a remark to the effect that the IMF was not a “development agency.” It ruled out the idea of an SDR issue as an internationally reflationary solution to the debt crisis; and it echoed the views of some European governments (in particular, of the Netherlands and Germany) that had insisted throughout the crisis on the Fund’s role as a “monetary institution.”103 According to this criticism, the Fund’s fundamental role as the administrator of a revolving credit scheme had been frustrated because its resources were tied for excessively long periods as a consequence of the linkage with bank workouts. The Fund had been forced to borrow from official lenders, and its liquidity had deteriorated. (This debate about the proper role of the Fund took an even more acute form with regard to lending to tow-income countries; see Chapter 14.) The IMF’s role in policing adjustment should be taken over, it was implicitly assumed, by the bankers and the World Bank. It was a way of sidestepping the central role played by the Fund in the first four years of the crisis.104
In the event, the flows to the Baker Plan countries were somewhat lower than envisaged by the Treasury Secretary. For the period 1986-88, they amounted to $28.6 billion rather than the $40 billion that might have been provided. Commercial banks responded rather skeptically at first, because they had pressed prior to the Baker announcement for creditor government guarantees to be linked with the provision of new money. The Baker Plan itself contained no mechanism for ensuring that banks complied with the suggested increases in lending. And, in fact, while in the first years of the debt crisis, the banks had been corralled into the provision of new money, in the second half of the 1980s, banks in practice disengaged from lending. This is evident from the composition of long-term debt of middle-income countries, and also from the figures available on net debt flows (net disbursements minus repayment of principal). The bank share of the net flows to severely indebted middle-income countries had been 55.1 percent in 1980, and in 1985 was still 34.2 percent. It fell and by the end of the decade was strongly negative (– 29.1 percent in 1990), although this figure also reflects the effect of debt-for-equity swaps that appear as a reduction of bank lending. At the same time, the flows from official creditors increased (24.3 percent of total flows in 1980, 54.6 percent in 1985, and 118.6 percent in 1990). The figures on the stock of debt owed to commercial banks also give a dramatic picture of the cessation of sovereign lending: in 1982 the stock was $282.7 billion and rose to $399.8 billion in 1988, but then fell, so that in 1991 it stood at only $314.7 billion.105 It is difficult to avoid the conclusion that at least in some cases, commercial banks were being repaid from resources made available by creditor governments and multilateral institutions.
At the outset of the Baker Plan experiment, the Fund indicated informally that it hoped countries would implement policies char allowed the Fund to undertake positive net lending; but the Fund also made it clear that it could not be expected to estimate its lending in advance.106 As the emergency IMF stand-by programs that had been such a prominent feature of the early years of the debt saga were repaid, IMF lending was reduced. Over the threeyear period 1986–89, the net flow of resources from the IMF was thus negative (-$2,667 million). Most of the debtor countries were disillusioned by the actual outcome of the Baker Plan. Critics claimed that the Baker Plan “managed to give the debt crisis a new life—another two years of don’t grow and don’t pay.”107 As the capital position of banks improved, many became unwilling to supply new money or to take part in concerted lending packages. In an informal session the IMF Interim Committee criticized “the reluctance of commercial banks to participate in new money packages.”108 The Baker Plan remained a fundamentally ad hoc solution.
A new wave of pessimism about the solubility of the debt issue was induced by the severity of the second wave of adjustment shocks in 1985 and 1986 (which was particularly traumatic in Mexico), combined with the slowing down of growth in the industrial countries and heightened nervousness about the economic future in the wake of the October 1987 stock marker collapse. The Baker Plan proposals had only piled additional liabilities onto a fragile and precarious base. The best that can be said is that it did not force deflation on indebted countries and that it resulted in no major bank failures. But this is a rather half-hearted defense. There were few signs of enhanced growth. The World Bank noted in 1988 that “most of the indebted countties are still no better off than in 1982.—when the crisis erupted. Debt disbursed and outstanding has doubled, and debt service payments on a cash basis ate one-third higher.”109
The fact that the Baker Plan worked less perfectly than intended, as well as the decreased likelihood of a systemic paralysis of the world’s financial markets, made for a greater willingness to contemplate a more general attempt at solving the debt crisis. In 1988 the IMF noted that “the existing market-oriented approach, which deals with the problem on a case-by-case basis, remains the appropriate way forward. There is a danger, however, that the cooperative approach of the various parties in recent years will be jeopardized if progress toward a sustainable solution is not accelerated.”110 The debate about new money from banks and the reasons for banks’ patchy response was one of the considerations that motivated a new approach to the debt issue.
More radical action seemed appropriate; and it could no longer do the systemic harm that might have resulted earlier. Since 1982, banks had tried to build up reserves against developing country debt. To the extent that national tax systems allowed write-offs to be offset against profits, the governments of creditor countries (or their taxpayers) slowly in fact helped to bail out the banks. Some banks also sold parts of their Third World portfolios at discounts on initially rather thin secondary markets. In 1985 the total sale of international debt was estimated at less than $5 billion, but in 1988 it amounted to some $30–40 billion.111 In some cases also debt was exchanged for equity participations. Chile in particular was an innovator in this kind of swap. The capital exposure (credits in relation to bank capital) of the nine largest U.S. banks to Latin America fell from the alarming 177 percent of 1982 to 84 percent by 1988.112 But even a default on this reduced figure would have clearly constituted a major threat to the U.S. banking system. By 1988, however, it had become clear that this was rather unlikely, Latin America would not move as a bloc, and there would be no debtors’ cartel or “debtpec.” The spirit of Cartagena disappeared. Two attempts in particular by debtor countries to alter the working of the system in the event actually underlined its new stability.
In Peru, Alan García Pérez had been elected President in 1985 on a nationalist economic platform. His government faced a clearly impossible situation. Debt interest and repayments due in 1985 amounted to $3.7 billion, more than Peru’s total anticipated exports ($3.1 billion).113 In his inaugural speech, the new President complained about the difficulty of exporting in view of the protectionism of the industrial countries, and then announced that he would limit debt service to 10 percent of export earnings. There would be no “intermediaries” in debt negotiations. “President Alan Gatcía is an elected President and must report only to 20 million Peruvians and not to the officials of an international organisation … At this time of difficulties and austerity, we will propose a policy that will require efforts for some time but that policy will no longer be imposed by the IMF.” He also appealed to other Latin American governments: “A united Latin American continent will succeed in making the wealthy countries recognise that they are also responsible for this crisis, and that they must lower interest rates, extend repayment periods, and maintain our exporrs’ prices … We welcome and support the consensus of Cartagena as a decisive step for unity.”“114 In fact, Peru’s action completely failed to shake the international system.
Brazil like Argentina had attempted a currency stabilization (the Cruzado plan); it failed to establish confidence, and in February 1987 President José Sarney announced a unilateral moratorium on interest payments on Brazil’s $108 billion outstanding debt. It produced no concessions, and it did not unduly harm the bankers. In 1988 Sarney admitted, “The fact is that we cannot destroy the international system.… We can scratch it, but it can destroy us.”115
Neither Brazil nor Peru seemed to hold out attractive models of the gains to be achieved by debtor default; and in this way, perhaps paradoxically, their actions increased rather than reduced the confidence of bankers in the operating and the permanence of the system. The Brazilian action in fact formed the backdrop to the announcement on May 20, 1987, by the new chairman of Citicorp, John Reed, that he had increased the bank’s loss-reserves by $2.5 billion, and that he hoped to sell one third of the bank’s developing country portfolio. Citicorp’s action was followed almost immediately by a number of smaller New England banks, as well as by appeals from bank regulators not to dispose of debt on the existent but weak and small secondary market.
Instead, banks began to work out new agreements that included an element of debt relief or reduction. The reform proposals could now emanate from bankers rather than from politicians and academics. In 1987, Mexico worked with Morgan Guaranty Trust on an exchange of bank debt at a discount for 20-year bonds collateralized with U.S. government zero-coupon bonds. In the fall of 1988 the Speaker of the Deutsche Bank, Alfred Herrhausen, publicly called for a partial cancellation of commercial debts,116 a course he had been advocating in private for over a year. The following year, the Deutsche Bank proposed debt relief through debt-equity conversions, as well as auction-style buybacks by debtor governments with funds made available by creditor governments and multilateral institutions, and concentrating on those sectors of the debtor economies whose financial rehabilitation was most needed in order to restore operational efficiency.117
In informal discussions in 1987, at the IMF and World Bank Annual Meetings, the Japanese Finance Minister Kiichi Miyazawa proposed the conversion of debt to equities and the establishment of a global “risk insurance” against noncommercial risk. The multilateral institutions would take on a role as clearing centers for debt-equity swaps.118
When Nicholas Brady, James Baker’s successor as U.S. Treasury Secretary, proposed in a speech of March 10, 1989 to the Bretton Woods Committee Conference a plan for voluntary debt reduction, he was systematizing but also extending initiatives that had in practice already been undertaken. According to his proposal, a quarter of IMF and World Bank policy-based lending was to be used for discounted debt buybacks. The Fund and the Bank together could provide $20–25 billion. An additional $10 billion would be provided by Japan. But, apart from this, the commercial banks and the Fund were to be disengaged from each others’ commitments. Banks would be given a variety of options, including accepting lower interest rates or selling claims to the debtor at a discount. As a result, the plan was usually described as “menu-based.” The IMF would “lend into arrears”: its lending need not be dependent on an agreement of the debtors with the commercial banks (although there would usually have been some negotiation). (In fact, already in October 1987 an IMF stand-by arrangement with Costa Rica had been concluded that did not include a requirement for an agreement over arrears to private bankers.) In effect, the linkages of 1982 were now partly undone. The Fund no longer was to act as a “policeman for the banks.” These proposals were formalized and accepted as a new debt strategy at the meetings of the IMF Interim and Development Committees in April 1989.
Three negotiations were concluded in 1989 under the revised debt strategy (for Mexico, the Philippines, and Costa Rica), another three in 1990 (for Morocco, Venezuela, and Uruguay). In 1992 another operation was conducted with Nigeria, and agreements concluded with Argentina and (in principle) with Brazil, as well as with Mozambique and Niger. The Brazil deal was only finalized in 1994. These conversions were conducted in conjunction with IMF programs. The IMF agreements were a condition for the sale of U.S. Treasury bonds to collateralize the long-term conversion bond option. Only in the Brazilian case was there no parallel IMF package. Brazil’s Brady deal as a result was interpreted as signaling the partial withdrawal of the Bretton Woods institutions and the “end of the debt crisis.”119
The largest so-called Brady deal, for Mexico, can be used as a model to illustrate the features and possibilities of negotiated debt reduction. The options for banks included swapping old debt for 15-year “discount bonds” at 100:65, or a 1:1 exchange for “par bonds” with a reduced interest rate of 6.25 percent. Banks that chose neither of these options would agree to provide “new money” in order to compensate for the increase in value of remaining debt as debtor countries became more creditworthy. The new bonds would be transferable, could not be rescheduled by the debtor, and the principal would be collateralized with U.S. zero-coupon bonds (that is, the Mexican authorities held the U.S. bonds in an amount corresponding to the principal due). The principal was guaranteed, along with 18 months of interest, through the use the special funds provided by the World Bank ($2.06 billion), Japan ($2.05 billion), and the IMF ($1.64 billion) together with a direct guarantee from the Mexican government. There was an additional provision for “value recovery,” involving higher payments on the bonds if Mexican oil revenue exceeded a threshold. Altogether $49 billion debt was rescheduled, with a total relief amounting to $12–13 billion, from which should be deducted the $7 billion cost of providing collateral for the new bonds. Measured as a proportion of Mexican GDP, this may not appear as a large amount of relief (2.7 percent of GDP).120
It helped, however, quite decisively in eliminating the phenomenon of “debt overhang,” in which the level of debt was so high as to discourage new capital inflows. This phenomenon was only widely recognized as an obstacle to recovery at a relatively late stage in the international debt crisis. At a certain point, debt becomes so large that much higher levels of taxation are required to make service payments. This reduces the likelihood of countries growing out of the debt crisis, and thus also lowers the incentives for debtors and creditors to reach agreement. A certain measure of debt forgiveness, as a result, could change the climate of negotiations completely. After negotiations on debt reduction had begun, paradoxically the value of debt on secondary markets rose dramatically.121 For the original 15 Baker Plan countries, it increased from an average of around 30 in 1989 to above 50 by the beginning of 1992.122 As a result of the return of confidence, capital markets revived, and new bond issues (but not new bank lending) began. Already in 1989, Mexico had raised $1.4 billion through bond issues; in 1991 it took $4.1 billion. For developing countries as a whole, capital raised on the bonds market increased from $25.1 billion to $40.8 billion over this period.123 Flight capital also began to return. An estimate for Mexico is $5.7 billion in 1989 and $5.8 billion in 1990.124 Direct investment responded to the establishment of a more favorable economic environment. An essential element in the new confidence was the market-based or choice-oriented debt reduction of the Brady Plan, and the absence of a compulsory write-off of the kind advocated by many analysts in the mid-1980s.
Such a possibility had indeed been held out as a route to the re-establishment of external viability even in the early stages of the debt crisis. At the end of 1983, de Larosière had explained that “foreign direct investment could play a far greater role in resource transfers than in the past. Not only does such investment avoid creating an overhang of debt, it often facilitates the transfer of technology and skills and is directly tied to productive capital formation.”125 In fact, for the major debtor countries, foreign direct investment had fallen off with the uncertainties surrounding the onset of the general debt crisis, and only revived again with policy reform in the late 1980s, with major inflows to countries that had pursued reform most vigorously. (See Figure 12-3.) At the same time, portfolio investment also surged after 1990, encouraged by the process of privatization in capital importing countries, and creating incentives for further and more radical privatization. Again, a relatively small number of countries accounted for the major part of the flows: from 1989 to 1993, two thirds went to five countries (Argentina, Brazil, Korea, Mexico, and Turkey). Roughly half of the private flows in the period 1990–94 took the form of portfolio investment, while half came as foreign direct investment. In this way, the risk shifted from a concentration in the public to a dispersion over the private sector, and the “de-accumulation” of risk has been a major factor in overcoming the debt crisis.126
Figure 12-3.Foreign Direct Investment: Argentina, Brazil, Korea, Mexico, and Turkey
Source: World Bank, World Debt Tables.
A further contribution to the solution of the debt crisis came from the lowering of international interest rates. In the late 1980s, it was estimated that a 2.5 percentage point drop in interest rates would save Latin America as a whole $6 billion a year, or a resource saving of 8 percent of imports. Such a change would clearly improve economic performance. Another calculation showed a 2.5 percent increase in LIBOR as reducing growth rates in developing countries by 0.5 percent.127 In practice, three-month LIBOR fell from an average of 10.25 percent in April 1989 to 3.19 percent by May 1993 (after which date it began once more to rise). This reduction was less a result of any calculated plan designed with the debt issue in mind, or even of the greatly improved international policy coordination of the later 1980s, than a consequence of world economic circumstances. Discrepancies in national policies, such as existed at the beginning of the decade, are a cause of increased uncertainty, and can result in higher interest rates as governments attempt to compensate investors for that uncertainty. Increasing convergence, providing that it was accompanied by fiscal consolidation, might be expected to produce lower rates. Above all, it was the effect of the recession in the industrial countries that drove down interest rates, alleviated the debt crisis, and thereby paradoxically increased the prospects for faster development in the rest of the world.
By the beginning of the 1990s, the complete pessimism that had characterized the debt discussion as recently as 1987 and 1988 had faded. Countries had discovered that sound policies would eventually reopen international capital markets. The mechanism of the Brady Plan, with its offer of a multiplicity of choices, had helped to make it clear that there was no longer one single phenomenon of “developing country debt.” Instead, as in domestic lending, there existed a whole range of differing qualities of investment. The financial experience of the 1980s also made it clear that other forms of lending—for instance, against real estate in Texas, or New England, or California or New York, Tokyo, and London—could be quite as risky as lending to countries whose development potential held out at least a possibility of rapid growth. After the property fiasco of the early 1990s, the British property developer Martin Landau (whose collapsed firm required the largest single write-down in the history of banking) was quoted as saying: “Banks are very lazy. They won’t lend it to farmers, they don’t understand manufacturers, they won’t lend to the third world, so they come back to lending to property. Bankers are definitely not very bright people.”128 Then, by the mid-1990s, another public sector debt problem appeared. Persistent fiscal imbalances, analogous to those of Latin America 15 years earlier, and the scale of future liabilities as a consequence of social security, health, and pensions commitments to an aging population, led to worries about the stability of major industrial countries, and produced dramatic upheavals in the bond markets.
Banks indeed should have learned a new lesson by the end of the debt decade: anything could be risky. In fact, the developing country debt crisis—unlike the property boom and bust in the United States, the United Kingdom, Japan, and Scandinavia, and then, with a slight delay, in France and Germany—did not bring down a single major financial institution. New or alternative forms of capital movement offered a more stable alternative to short- or medium-term commercial bank credit. After the mid-1980s new financial flows began to developing countries. Direct investment, which had remained through the period of the debt boom and bust at rather low but constant levels, increased dramatically, year by year, after 1986.
Does this mean a return to the “anarchy of the market”? What can prevent a repetition of past harmful cycles of indiscriminate overlending followed by panic? Two sorts of solution can be offered: a regulatory one, dealing on an international level with commercial banking practice; and a systemic one, addressing the world economy as a system in which government policies, whether appropriate or inappropriate, are in constant interplay with a broad spectrum of commercial judgments.
The outbreak of the 1980s debt crisis encouraged a renewed interest in financial regulation across frontiers. One important U.S. initiative extended the regulatory debates that had taken place in the course of the 1970s. It was now thought that banking supervision should be carried out internationally in a more systematized and open way than the tentative, informal, and secret coordination and exchange of regulatory experience carried out in the framework of the Basle Committee on Banking Regulation and Supervisory Practices (which had begun functioning in 1974). Part of the pressure came from domestic opinion in the United States, and from the widespread fear that a solution to the international debt problem would involve a bailout of the banks. The consequent reluctance of the U.S. Congress in 1983 to increase IMF quotas (as part of the Eighth General Review) could only be overcome through a legislative measure that extended control of banking. The International Lending Supervision Act (November 1983) gave U.S. regulatory authorities the legal right and the obligation to “cause banking institutions to achieve and to maintain adequate capital by establishing minimum levels of capital.” It also included a request for American regulators to pursue a convergence of international bank capital standards. Subsequent negotiations, first with the United Kingdom, then with Japan and the other G-10 members, produced a set of standards embodied as the Basle Accord of 1988.129
The Accord required an 8 percent ratio of recognized capital to credit-weighted risk exposure by the end of 1992. Five different categories of relative riskiness were established: loans to official borrowers from the OECD, as well as to countries with an arrangement with the IMF through the General Arrangements to Borrow (which, in practice, added Saudi Arabia to the OECD list) were given a zero risk weight; loans to non-OECD governments had a 100 percent weight. Like any arbitrary categorization, this system encountered obvious objections: would it not, for instance, act as a deterrent to developing country borrowing, but also to borrowing by industrial corporations, and would it not make lending to industrial country governments too attractive? There exists both a scope and a demand for the evolution of a more sophisticated and sensitive system of standards.
In addition, by the early 1990s a new financial innovation came to play a part analogous to that of commercial bank lending in the late 1970s and early 1980s. At that time, the growth of international financial intermediation had been neglected by national regulators, in part out of fear of affecting the competitive position of their own banks in the international marketplace through over-tight control. Over a decade later, such bank lending constituted much less of a systemic risk; but the threat now came from the largely unregulated growth of derivatives markets. These involve a separation and sale of various components of risk; in this way they lower individual risk, and have been an important cause of the major growth of international capital movements. At the same time, many experts argued that they contain an increased systemic risk (it is possible to imagine a chain effect of defaults and bankruptcies).130 Unlike bank lending, this off-balance sheet activity has not in general been the concern of the BIS. The IMF, as part of its surveillance mission, produced the first major account of the systemic dangers posed by derivative markets.131 More effective action, however, depends on the willingness of national authorities to act together in concert in this area of supervision and regulation.
At the systemic level, a different kind of solution is required to the problems posed by the large movements of capital, which had been facilitated by financial innovation and which had become an intrinsic part of the process of economic growth and development. It is important to avoid sudden shocks, including those caused by a mismatch of policies in the world’s largest economies. Many of the problems of the early 1980s had arisen out of the radical instability of the whole international financial system as a consequence of an interest rate shock. Increased international stability played an important part in overcoming the debt crisis. Perhaps a policeman was required, not so much for the regulation of individual debt renegotiations as between 1982 and 1989, but for the maintenance of order in the international system as a whole.
The debt crisis of the 1980s showed how borrowing countries were affected by the general world economic environment. First, there exists a clear need for a cooperation in order to minimize the risk of sudden shocks (such as are created by abrupt changes in real interest rates, or by dramatic commodity price cycles). Second, the experience also indicated the importance of appropriate policy and prompt adjustment, and the dangers involved in trying to finance delayed adjustment on private markets. Third, it demonstrated that the private financial sector can develop herd-like instincts and can exacerbate rather than solve problems, and that private bankers too should contemplate their responsibilities in the adjustment process. Finally, it has shown the importance of the availability of correct information—about economic developments, and about debt management and exchange rate and fiscal policies. Providing such information, as well as emergency assistance, is one of the tasks of international institutions, and an essential part of their activity in facilitating the functioning of the international financial system.
All countries are affected by conditions in the world economy, and are vulnerable to shocks emanating from abrupt changes of policy. The goal of international cooperation, as reinforced by surveillance, should be to secure agreement on medium-term policy goals that reduce the need and the likelihood of dramatic policy reversals. The pursuit of national policies oriented toward stability—including the reduction of fiscal deficits and the limitation of monetary growth—is an essential part of such a move to global stabilization. The adoption of such policies required a fundamental rethinking in the debtor countries; but similar recommendations, also bringing major international benefits, could be and were also made for the major industrial countries (including and especially the United States).
It is still, however, possible that large imbalances may lead once again to sudden crises of confidence requiring the mobilization of international resources. The issue became acute once more in December 1994, as a result of the overvaluation of the Mexican peso, and an abrupt loss of confidence following a mismanaged devaluation. A major contribution of the IMF in the debt crisis of the 1980s had lain in the supply not only of its own funds, but also in marshalling additional amounts from the international banking community. In doing this it produced an outcome that was generally desirable, and whose beneficiaries included the banks as well as the debtor nations; but individual banks did not perceive their immediate interest as lying in the supply of additional credit. An international institution—supported in many cases by national bank regulators—was needed to “corral” the banks into acting in the general interest, and their own, in a way they would not have chosen had they been left by themselves. The experience of the debt crisis provided a demonstration that the size of the international private sector was such that it could not escape or evade its responsibilities. In pointing this out, the Fund acted to overcome the obstacles posed by the “logic of collective action.”
This was a particular instance of a general function of the Fund. Surveillance in the broadest terms means increasing the amount of economic knowledge available in order to improve the functioning of markets. In this particular case it meant extending knowledge about the likely effects and benefits of “concerted lending” to the banks, in order to prevent the harmful effects of an international panic and run. In the early 1980s, the Fund in consequence acted as the international lender of last resort. Only after the possibility of the panic had been eliminated did more radical action—such as debt reduction or buyback schemes—become possible. In an ideal world, perfectly informed and rational, this type of rescue operation would not be necessary. In the actual world, however, an institution would be needed to provide emergency assistance as the logical extension of the general principle of surveillance.