Chapter

16 Origins of the Debt Crisis and of the Fund’s Involvement

Author(s):
Margaret De Vries
Published Date:
June 1986
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The year 1979 is a good starting point for understanding the circumstances that precipitated the “world debt crisis.” As the year opened, output in the industrial countries had not fully recovered from the 1974–75 recession that had followed the oil price rise of late 1973, and unemployment remained notably higher than in the early 1970s. Inflation persisted, with average annual increases of domestic prices in industrial countries still in the range of 7–8 percent. “Stagflation” had become a common description of the prevailing economic environment.

Early in 1979 another surge of inflation swept through the industrial countries, even before all the second round of oil prices were announced. And by late 1979, as higher prices for oil—and for many foodstuffs and other primary commodities—were passed through to final product prices, consumer prices in many industrial countries were rising at the highest rates ever experienced in peacetime. The urgency of a determined effort to combat inflation became the central theme of the Annual Meetings in Belgrade in September 1979. Indeed, U.S. Federal Reserve Chairman Paul A. Volcker dashed home even before the meetings ended to initiate a major package of anti-inflation measures that, in effect, introduced short-term monetary targeting in the United States.

This monetary initiative marked the onset of a major shift in policy in industrial countries. Abatement of inflation became the prime objective of the authorities of virtually all industrial countries, despite the emergence of higher levels of unemployment as anti-inflationary measures were pursued. The priority of controlling inflation as a prerequisite for stimulating growth and employment on a sustainable basis was stressed repeatedly at meetings of the Interim Committee. To this end, monetary policies in the industrial countries became decidedly more restrictive after late 1979 and remained so through the middle of 1982. Interest rates rose substantially.

The rate of inflation did fall, especially by 1982, when consumer prices in the industrial countries as a group rose at an average annual rate of 7 percent, the lowest inflation rate in several years. Accordingly, nominal interest rates considerably exceeded the rate of inflation, although they fell somewhat by the end of 1982—especially in the United States after tight monetary policies were eased in August 1982. High positive interest rates were in sharp contrast to the relationship between nominal interest rates and the rate of inflation, that is, zero or negative interest rates, prevailing for several years prior to 1979. Also, by 1981–82 a recession more severe than that of 1974–75 had gripped the world economy; in fact, it was the deepest and longest in 50 years. The trough of this recession was reached in late 1982 as unemployment rates soared to their highest levels since the 1930s. The volume of world trade, which had continued to rise during the 1970s (except for 1975) despite the economic disruptions of the decade, actually fell in 1982.

IMPACT ON BORROWING COUNTRIES

Many non-oil developing countries had been borrowing heavily after 1973, especially from commercial banks, to finance their balance of payments deficits. By mid-1982, their aggregate external debt was over $600 billion, over half of which was on commercial terms. Readily available credit from private sources—at favorable interest rates for that period—had helped induce countries to borrow. And steadily rising deposits, particularly as oil exporting countries banked their vastly enlarged oil revenues, had induced creditors, especially commercial banks, to lend. As a result, many non-oil developing countries had delayed taking sufficient macroeconomic or exchange rate measures to adjust their balance of payments deficits to the higher prices for oil. They had opted to accumulate large external debts rather than to make adjustments that, in the short term, would in all likelihood have reduced their rates of growth.

In 1979, however, their situation began to deteriorate considerably. Weak demand in industrial economies from 1979 on—in combination with the inappropriate policies of the borrowing countries and their failure to adjust to the worsened circumstances after 1979—induced a sharp slowdown in the growth rates of debtor countries and weak export performance, capital flight, and excessive borrowing. The growth rate of non-oil developing countries as a whole dropped to 2½ percent in 1981 and 1½ percent in 1982, the lowest for several decades, and growth in the volume of their exports slowed from an annual average of 9 percent in 1976–80 to less than 2 percent in 1982. Economic growth in three large debtor countries, Argentina, Brazil, and Mexico—all of which had been enjoying vigorous growth until 1978—declined even more than the average. A weakening of primary commodity prices further reduced the export earnings of non-oil developing countries, and as prices for oil and for manufactured imports rose, their terms of trade worsened significantly. Stagnation of world trade and high rates of unemployment in industrial countries also provoked an intensification of protectionist pressures, making it more difficult for developing countries to export.

The resulting difficulties for many borrowing countries led to a reappraisal by commercial bank lenders of the capacity of borrowing countries to service their debt. In fact, the mounting concerns of creditors in 1980 and 1981 had already caused them to lend increasingly on short term. By early 1982 creditors had become very much exercised about the growing size of the total debt outstanding, the increasing proportion of short-term debt—which made many debtors highly vulnerable to any decline in credit—and the persistence of high interest rates.

As weakness in the export markets of indebted countries continued, debt-service ratios (the percentage that debt-service payments represent of export earnings) rose sharply, alarming creditors (see Table 1). Consequently, in the second and third quarters of 1982 private financing flows were abruptly and severely cut back.

Table 1.Developing Members: Debt-Service Payments and Ratios(In billions of U.S. dollars; ratios in percent)
19771978197919801981198219831984119851
All developing members
Value of debt-service payments39.857.775.489.6109.3124.1111.7121.3142.9
Interest payments15.421.932.345.860.671.465.171.580.7
Amortization224.435.843.143.848.752.746.749.862.2
Debt-service ratio315.119.119.017.420.224.422.121.523.0
Interest payments ratio5.97.38.18.911.214.112.912.713.0
Amortization ratio29.211.810.88.59.010.49.28.810.0
Of which, major borrowers
Value of debt-service payments17.026.335.740.052.061.653.355.165.7
Interest payments6.710.215.622.930.638.734.938.242.0
Amortization210.316.020.117.121.422.918.516.923.7
Debt-service ratio324.833.735.219.733.644.138.835.537.9
Interest payments ratio9.913.115.417.019.727.725.324.624.2
Amortization ratio215.020.619.812.713.816.413.410.913.7
Non-oil developing members
Value of debt-service payments35.851.866.677.498.1109.798.9107.2124.2
Interest payments13.719.227.539.455.263.959.064.771.7
Amortization222.132.639.038.142.945.839.942.552.5
Debt-service ratio316.119.819.718.121.425.022.321.722.7
Interest payments ratio6.27.38.29.212.114.613.313.113.1
Amortization ratio29.912.511.68.99.410.59.08.69.6

Projections by Fund staff.

On long-term debt only. Data for the period up to 1983 reflect actual amortization payments. The estimates and projections for 1984 and 1985 reflect scheduled payments, modified to take account of actual or pending rescheduling agreements.

Payments (interest, amortization, or both) as percentages of exports of goods and services.

Projections by Fund staff.

On long-term debt only. Data for the period up to 1983 reflect actual amortization payments. The estimates and projections for 1984 and 1985 reflect scheduled payments, modified to take account of actual or pending rescheduling agreements.

Payments (interest, amortization, or both) as percentages of exports of goods and services.

This was the setting in which the Finance Minister of Mexico advised monetary officials of creditor nations in mid-August 1982, just a few weeks before the Annual Meetings in Toronto, that Mexico could no longer meet its debt-service payments. The announcement had an immediate, dramatic impact. Financial officials were stunned and suddenly fearful. Mexico was a major borrower. What was more important, officials and bankers had regarded Mexico, itself an oil exporter, as among the least likely of the heavily indebted countries to “default.” The prospects for other developing countries being able to manage their huge debts looked dismal indeed. Moreover, not only had the payments positions of borrowing countries suddenly become extremely difficult, but the inability of some major borrowers to “roll over” maturing loans threatened a major crisis of confidence in the banking system and a cumulative contraction of credit-financed imports that could seriously reduce world trade and the prospects for world economic recovery. This was the “crisis” to which the Fund was asked to respond.

THE FUND’s RESPONSE

The Fund’s first response focused on Mexico. From 1977 to 1981, that nation, aided by greatly expanding petroleum production, had experienced economic growth rates of more than 8 percent a year and a rapid expansion of employment. But this growth had been accompanied by accelerating inflation and a weakening of the external situation.

The most important element behind the worsening trends was an expansion of the public sector. The overall public sector deficit in 1981 was equivalent to 15 percent of gross domestic product (GDP), as public spending sharply increased and the growth of revenues slowed. Petroleum export receipts had stopped rising, and the prices set for goods and services of publicly owned enterprises had lagged behind inflation.

To help finance the rising deficit, Mexico had contracted a substantial amount of external debt in 1981—much of it short term—at rising interest rates. By early 1982, as confidence eroded, capital flight began to occur, and Mexico’s exchange reserves were being rapidly depleted. The Mexican authorities allowed the peso to depreciate sharply, introduced some measures of fiscal restraint, imposed import restrictions, and received several large loans. But because of the widening public sector deficit, the situation continued to deteriorate. Then, in mid-1982, capital inflows virtually ceased.

In a rescue operation, the U.S. Treasury and the Federal Reserve announced on August 30 their participation in an arrangement—in cooperation with the central banks of the other Group of Ten countries, Spain, and Switzerland, under the aegis of the Bank for International Settlements (BIS)—to provide $1.85 billion in short-term financing to the Bank of Mexico. In addition, the U.S. Government lent the Government of Mexico $1 billion in credits for imports of agricultural products and provided $1 billion as advance payment for purchases of Mexican oil by the U.S. Strategic Petroleum Reserve. These “bridging” loans were to allow time for a program supported by the use of the Fund’s resources to be developed.

At the end of 1982, after a protracted negotiation, the Fund approved Mexico’s use of SDR 3.6 billion of its resources, of which SDR 0.2 billion was under the first credit tranche and the remainder under an extended arrangement to be drawn by the Mexican Government over three years to support a medium-term adjustment program. The program envisaged a reduction in the public sector deficit from about 17 percent of GDP in 1982 to 8.5 percent in 1983, 5.5 percent in 1984, and 3.5 percent in 1985. There were to be major efforts both to lower public sector expenditures and to increase revenues, a review of public investment as well as public enterprises’ spending and pricing policies, tighter monetary policy, and a flexible exchange rate. The strengthening of the fiscal and balance of payments situations was intended to lower Mexico’s reliance on external financing over the next few years and thereby to contribute to an easing of Mexico’s debt-servicing problems. The intent was also to lay the basis for renewed growth of output and employment.

It was clear that even after the Fund’s lending, there would still be a sizable gap in Mexico’s balance of payments, and it was not possible for the Managing Director to go to the Executive Board with an adjustment program for which financing was incomplete. Moreover, after a period of heavy foreign borrowing, a reasonably spaced and successful process of adjustment in a debtor country required some new net financing from commercial bank creditors. Reliance on commercial bank inflows had been so great that there was a distinct risk that the adjustment program would fail unless the Fund was assured that the financial assumptions on which the program was based were secured by explicit prior commitments from commercial banks.

Therefore, in an innovative and unusual move for the Fund, the Managing Director, J. de Larosiere, and staff played a central part in Mexico’s negotiations with the international banking community, both for additional net lending and for debt restructuring. Net new financing needed for 1983 was estimated at $7 billion, of which $5 billion was sought from commercial banks and the remainder from official sources. To encourage financing of this amount, the Fund insisted that commercial banks and official creditors commit themselves to providing the required financing before the Fund approved the country’s program and the associated use of its resources. This approach was a sharp departure from the Fund’s past practice, under which it approved a country’s program and the financial assistance requested from the Fund without explicit advance assurances from other creditors on their commitments. In the end, the financing for Mexico was arranged, with as many as 530 commercial banks lending a total of $5 billion.

The Case of Brazil In the next few months, other debtor countries, especially in Latin America, came to the Fund for assistance. The Brazilian case, for example, received worldwide attention. In February 1983, after much negotiation, the Fund approved nearly SDR 5 billion of its resources for use by the Government of Brazil, SDR 4.2 billion of which was under an extended arrangement to support a medium-term adjustment program. As in the Mexican case, the Brazilian program aimed at a reduction in external and internal imbalances and was designed to bring about important structural changes to set the stage for a resumption of growth. The program envisaged a halving of the financial requirement of the public sector from 1982 to 1983 and a further halving by 1985. Achievement of these targets was to be facilitated by exchange depreciation, by the implementation of substantial financial and pricing policies by state enterprises, and by a restrictive monetary policy.

As was true for Mexico, even after the Fund had made its resources available, a sizable gap would have remained in Brazil’s projected balance of payments. After much negotiation with government officials and private bankers, in which the Managing Director again played a central role, the necessary additional financing from private creditors and from other official sources was arranged. Now debtor countries could obtain new loan commitments, especially from private creditors, only as part of “financing packages.” Such a package had to be established in the context of a comprehensive Fund-supported program that had the objective of restoring to the debtor country a viable external payments position within a few years. Moreover, with demand in the industrial world sluggish, the terms of trade for primary producers weak, and access to some industrial markets restricted, the necessary improvement in developing countries’ current account positions had to be brought about primarily through import compression.

Adjustment and Financing Strategy The Fund thus adopted what it called a cooperative strategy. This was a country-by-country approach, in collaboration with all the interested parties, comprising the two elements of adjustment and financing.

Assisting members to design and implement adjustment programs was a central responsibility of the Fund. In helping members work out these programs, the Fund proceeded in part on the assumption that weak domestic policies and delays in adjustment measures had been made possible, at least in part, by relatively easy access to foreign borrowing under favorable conditions, at least until the middle of 1982. Domestic demand-management policies had been lax. In particular, fiscal deficits had mushroomed.

Through adjustment programs, policy weaknesses on the supply side, primarily pricing policies, could also be corrected. With high rates of inflation, prices set for goods and services by state enterprises frequently moved far out of line with market realities, leading to distortions, to excessive subsidies—which added to budgetary deficits—and to weakened incentives for producers, exporters, savers, and investors. In addition, many developing countries had not adjusted their nominal exchange rates when domestic rates of inflation had exceeded those abroad. Overvalued exchange rates sapped the prospects for the export sector and encouraged imports, weakening the trade account and resulting in restrictions on imports that distorted domestic production. Also, confidence of domestic currency holders had been undermined and led to massive capital flight from some countries. This drain on savings limited the capacity to import and also the scope for investment.

The objective of Fund-supported adjustment programs was to achieve a viable balance of payments in the medium term and a more efficient use of scarce resources by introducing a number of incentives and measures to generate more domestic savings, more investment, and more exports.

The second element of the strategy was to facilitate financial flows. From the middle of 1982 to the end of 1984 the Fund lent some $22 billion in support of adjustment programs for 66 members, many of which had debt problems. In addition to its own financing, the Fund helped arrange financing packages for debtor members from governments, central banks, private commercial banks, the BIS, and the World Bank. This additional financing was considered so essential by the Fund to the success of adjustment programs that, as in the instances of Mexico and Brazil, it continued to ask other creditors to make their commitments before approving the programs and providing its own financial assistance.

Consequently, the Fund had not only a certification role, as in the past, but also a catalytic role, by helping to mobilize funds from other lenders. A key aspect of the Fund’s role in facilitating what it termed “nonspontaneous lending” from commercial banks was explaining to private creditors the adjustment policies being taken by debtor countries and the need for additional private funds if adjustment programs were to succeed. With the Managing Director and Fund staff helping to make the necessary arrangements, net new lending from commercial banks on a much larger scale than had been thought possible in mid-1982 and a rescheduling of official and commercial debt for an unprecedented number of countries and on an unparalleled scale took place.

* * * *

In addition to pursuing this cooperative strategy, the Fund engaged in other activities to alleviate the debt problem. It acted to prevent future debt crises by strengthening its surveillance over the external debt policies of members. It launched a new technical assistance program to help members monitor their external borrowing. It expanded its work on compiling and publishing statistics on debt. And it broadened its consultations to include a more detailed review and analysis of external debt, especially over the medium term. These activities thrust the Fund into the forefront of the attack on the external debt problems of developing countries.

Note: This article was published earlier in a slightly different form in IMF Survey (Washington), Vol. 14 (January 7, 1985), pp. 2–5.

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