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SUBMITTED BY: KHURRAM SHABIR HISHAM AWAN SYED ASAD NABEEL KYANI FAIZAN AHMED
S UBMITTED TO :
S IR , A SHRAF
R ANA
TABLE OF CONTENTS
SUBMITTED BY:....................................................................................1 PROGRAMS..........................................................................................1 SUBMITTED TO:....................................................................................1 BACKGROUND......................................................................................4 INTRODUCTION....................................................................................4 CAUSES OF DEBT CRISES 1981-82.........................................................6 SOLUTIONS TAKEN TO OVERCOME DEBT CRISIS ...................................12 WHAT WERE THE EFFECTS OF THE DEBT CRISIS?..................................15 CONCLUSION......................................................................................17
B ACKGROUND
he debt crisis exploded into public view in August of 1982 when Mexico announced to the world that it was unable to pay what it owed to its international creditors. The rapid rise in large-scale loans to the Third World, especially to the largest and most rapidly growing countries such as Mexico, Brazil and Argentina, had occurred in the 1970s under conditions of rapid inflation and increasingly floating interest rates. In principle, as long as these loans could be repaid there was no crisis, just business as usual. The sudden onset of recession in 1980 and then again in 1981 in response to Paul Volcker and the Fed.s tightening of the money supply and rapid rise in interest rates dramatically changed the situation of the debtor countries. The engineered rise in interest rates aimed at inflation, raised the cost of the loans and the recession, by reducing world output and trade reduced the debtor countries ability to earn the foreign exchange necessary to repay the loans. These were the direct and obvious causes of the crisis announced by Mexico in 1982 and subsequent defaults and rescheduling by a great many other countries. But behind this bottom-line crisis lie a continuing series of social crisis in both the debtor in creditor countries. The international debt crisis has continued to worsen since it erupted in the early 1980s. Currently, developing countries as a whole in Latin America owe over $600 billion. In a world where 20 percent of the people hold 83 percent of the world wealth while the poorest 20 percent received only 1.4 percent of the total income, over one billion poor people in the worlds impoverished countries suffer because of the debt. The debt crisis is far from over. You will see the causes mainly a liquidity crunch as well as some of the measures that were taken to try to resolve this crisis. You will also see the players in this tragedy; the debtor countries, the creditor countries, the creditor banks along with other third party banks. In conclusion I will offer possible remedies to the debt crisis, a crisis that has been ongoing for two decades.
I NTRODUCTION
The debt crisis began in the mid-1970s when many of the Organizations of Petroleum Exporting Countries (OPEC) amassed wealth, and banks were eager to lend billions of dollars. Other developing countries around a world borrowed 4
large sums of money at low, but floating, interest rates. As a result of the irresponsibility of both creditor and debtor governments, the countries did not use the money for productive investment; rather, they spent these new dollars on immediate consumption. Consequently, these countries had no money to repay their loans. Aristocrats controlled the government while the poor had no voice in these loan matters, nor did they benefit from them. These adjustable interest loans skyrocketed in the early 1980s when the United States attempted to reduce inflation by enforcing stringent monetary policies while, at the same time, it also increased its military spending. The Reagan Administration did all of this while also cutting United States income tax rates. Around the Globe, raw material prices fell sharply, meaning poor countries had even less money to repay their debts. For example, both Brazil and Mexico nearly defaulted on their loans; and, according to international law, there was no option for these poor countries to declare bankruptcy. Commercial banks rescued their own situations and prevented default. However, many developing countries were left in great debt, and as a result, could no longer get loans. With nowhere else to turn, these nations have relied heavily on the World Bank or the International Monetary Fund. The IMF required structural adjustment programs in these countries. Debtor countries had to agree to impose very strict economic programs on their countries in order to reschedule their debts and/or borrow more money. Put simply, countries had to cut spending to decrease their debt and stabilize their currency. The governments limited their costs by slashing social spending; education, health, social services, etc.., devaluing the national currency via lowering export earnings and increasing import costs, creating strict limits on food subsidies, cutting workers jobs and wages, taking over small subsistence farms for large-scale export crop farming and promoting the privatization of public industries. Most countries have suffered a recession and often depression; and the poorest of the poor are most affected. It is not hard to find evidence showing that the poor, women, children and other groups suffered disproportionately as a result of structural adjustment programs during the 1980s. As Latin Americas economies stagnated, per capita income plummeted, poverty increased, and the already wide gap between the rich and the poor widened further. The debt crisis seriously eroded whatever gains had been made in reducing poverty through improved social welfare measures over the preceding three 5
decades. Poverty is 50 percent in growing; malnutrition is 40 percent in growing; children are increasingly recruited into the drug trade and prostitution; long-term unemployment and its adverse social effects are increasing; the weakening of local communities and networks of mutual support are being destroyed; and the growth of crime and an epidemic of homicides, are but a few of the many dilemmas that this debt crisis has caused. In August 1982 Mexico announced to the international financial community that it did not have enough external liquidity to fulfill its financial obligations and requested a 90 day rollover of the payments of the principal to prepare toward definite restructuring financial package. Just a few weeks later, the problem spread all throughout Latin America and to other debtor countries. The impact from Mexicos statement was far-reaching. This created an atmosphere that caused many people to issue dire forecasts, which thankfully were never realized. Most observers believe the petrodollar recycling of the 1970s gave rise to this debt crisis. During that period, the price of oil rose dramatically. As was stated before, oil-exporting countries in the Middle East deposited billions of dollars in profits they received from the price hike in United States and European banks. Commercial banks were eager to make profitable loans to governments and state-owned entities in developing countries, using the dollars flowing from the Middle Eastern countries. Developing countries, particularly in Latin America, were also eager to borrow relatively cheap money from the banks. Decreased exports and high interest rates in the early 1980s caused debtor countries to default on their foreign loans. The frenzied lending and borrowing came to a halt with the global recession in the early 1980s. The significant drop in debtor country exports, combined with a strong dollar and high global interest rates, depleted foreign exchange reserves that debtor countries relied upon for international financial transactions. Debtor countries consequently began to feel the strain of having to make timely payments on their foreign debt, which became much more expensive to pay off because the loans carried floating interest rates that increased along with global rates. These problems were compounded by massive capital flight of outward transfers of money by private individuals and entities in developing countries.
1. N ON - PRODUCTIVE I NVESTMENTS
An essential starting point of this analysis is the demand for credit by developing nations. This involves identifying pressures that compelled poor nations to accumulate borrowed capital. Technically, this involves examination of the uses to which borrowed funds were applied. The General Agreement on Tariffs and Trade (GATT) has attributed the third world debt problem to the fact that the loans contracted were not matched by a corresponding rise in real investment. This would seem to suggest that a large proportion of borrowed funds either went into the unproductive sector or by-passed economies of poor countries altogether. A common factor to the two arguments is that third world countries did not devote the funds towards increasing their own capacity to service loans.
consequences of which became embedded in their economic systems. Initially deterioration in the external account was mild as the deficit on current accounts of developing countries rose from $11 billion in 1973 to $37 billion in 1974. This was attributed to the relatively larger content of crude oil in oil imports of developing countries. In the absence of counteractive measures adopted by developed countries, third world countries resorted to foreign borrowing to meet obligations for expensive oil imports. In 1975 economic conditions among third world countries worsened as the slowdown in industrial country demand resulted in a decline in commodity prices by 19%. The combined impact of highenergy prices and adverse terms of trade was a major slow down in the growth of developing countries and a widening current account deficit to $46 billion. Although a relatively stable atmosphere emerged during 1976 and 1977 resulting in reduction of current account deficits of non-oil developing countries, economic conditions in the developing world worsened again in 1979 by a second round of energy price rises which took Saudi crude from $13 a barrel in 1978 to $32.50 in 1981. As a percentage of the total import bill among non-oil exporting developing countries, oil imports rose from 5.9% of GDP in 1973 to 21% of GDP in 1981.
borrowers was either to increase debt to keep inflationadjusted debt stock constant or borrow less to avoid high rates of interest and consequently experience a reduction in the real value of the inward transfer. This phenomenon was repeated from 1979 onwards as nominal interest rates in the developed world continued to rise to offset the effects of high inflation originating from the second round of the oil crisis. As a result, total outflows of dividends, profits and interest payments rose from $15 billion in 1978 to $44 billion in 1981 (Lever and Huhne, 1982). UNCTAD has calculated that between 1976-79 and 1980-82, the rise in interest rates added $41 billion to the stock of third world debt (Inter-American Development Bank, 1985).
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that banks in most of the developed world were reporting net average annual growth rates of deposits of between 2530%. Most such deposits originated from excess foreign assets of oil companies in the gulf region, a reflection of export price impacts of oil revenues on their balance of payments. The rapid increases in deposits in the banking systems is also notable for creating additional financial capacity that enabled Banks to commit higher amounts in loans to the borrowing public in the own countries most of whom deposited their money back in the banking system. At every stage of the lending process the banks created more deposits with the final result that the original loans were multiplied several time as lending continued. One characteristic of financial systems in most countries at the time was the existence of liquidity requirements for banks and other deposit taking institutions to hold a prescribed percentage of their deposits in liquid assets like cash or tradable government bills. There were also similar rules the ratio of lending to assets, the ratio lending to capital, which altogether had the effect of lowering the magnitude of each successive round of lending. However, the main weaknesses of financial systems in Europe at that time which was construed as an advantage by the lenders was the absence of regulations limiting the ability of banks to lend from deposits. The rate of credit expansion each bank would achieve depended upon the definition of capital and reserve requirement by each bank. For most banks that had confidence in their assets, the money-go-round continued unabated. The leading lenders were USA and UK. Both of them had a loose lending hand, of cash. They lend too much money to Mexico and other South American countries, without keeping restrictive measures, to see if whether the debt holders will pay the money on time or not.
7. P OLITICAL M ISCALCULATIONS
Speaking at the annual meeting of the IMF in September 1977, Mr Dennis Healey, and Britains Chancellor of the Exchequer also commended the commercial banking system for successfully financing deficits of the third world. At a 1979 annual meeting of the IMF, his conservative successor Sir Geoffrey Howe, also expressed the hope that flows from the commercial banking system to the less developed countries would continue to grow. The US Secretary of the Treasury Mr G William Miller made similar encouraging remarks at the 1979 annual meeting of the IMF. It cannot be denied therefore that the build up of Mexican and other 11
Latin American countries, debt had assent from the highest levels of policy making in the developed world.
S OLUTIONS TAKEN TO OVERCOME D EBT C RISIS 1. T HE B AKER P LAN G ROWTH , THE K EY TO B REAKING THE D EBT C RISIS .
The Baker Plan proposals begun in 1985 by then Secretary Treasurer Baker, in response to the mounting debt crisis that had started back in 1982. At Seoul in October 1985, U.S. Treasury Secretary James Baker reshaped the strategy for dealing with Third World debt. The Baker plan emphasized that the debt crisis could only be resolved through sustained growth by the debtor countries. To achieve the desired growth, the plan recommended programs of economic reform and structural adjustment for the debtor countries, including greater reliance on the private sector, curtailment of state subsidies and price controls, steps to stimulate both foreign and domestic investment, and export promotion and trade liberalization. Secretary Baker emphasized that the cornerstone of sustained growth must be greater domestic savings, and the investment of the savings at home. He stressed the importance of foreign investment as non-debtcreating. He also pointed out that equity investment has a high degree of permanence and is not debt-creating. Moreover he pointed out, it can have a compounding effect on growth, bring innovation and technology, and help to keep capital at home. The plan also called for private banks and multinational institutions to step up sharply their lending to the indebted countries. The banks were urged to provide new commercial credits of $20 billion over a three year period while World Bank and the Inter-American Development Bank would contribute an additional $9 billion in loans. The Baker plan called for an annual increase of around 2.5% in commercial lending. What did not change in Mr. Bakers proposals was the reliance on continuing accumulating debt to finance growth. However, bankers were uneasy with this request, mainly from their exposure to existing loans and from angry shareholders. At the time of this request, many banks were under severe pressure to cut loose their existing loans, even at a lose, rather than increase their exposure. Without strong assurances on the new loans, it would be very difficult if not impossible to justify increased international spending. 12
The Baker plan has had mixed results at best. A number of the worst indebted countries had made progress in adjusting their external sector during 1986-88 and the threat to the international banking system has subsided, for the time being. But external financing in support of adjustment programs remained scarce. Net resource flows to developing countries, particularly from commercial banks, continued to fall.
to equity swap programs, commercial banks should provide new money in the form of trade credits, project loans, as well as voluntary and concerted lending. And finally, creditor governments should continue to restructure their own claims through the Paris Club, provide additional financial support to debtors pursuing debt reduction, and maintain open and growing markets with sound policies. They should also ease existing regulatory, accounting, and tax impediments to debt reduction. There seems to be many flaws with the Brady plan. Countries that need debt reduction need it because they have too much debt to start with. A country can reduce its current resource transfer with new money from banks, but only at the expense of worsening its future capacity of paying off the debts. Its like throwing fuel on the fire.
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which caused much anger and hatred from the people towards the IMF. This caused the IMF to become a symbol that people came to dislike as more and more people began to reject the IMF's policies which imposed the power of international agencies over Latin America. The citizens of Latin America did not like the fact that their government was being controlled by "outsiders". Leaders and officials were ridiculed and some even discharged due to involvement and defending of the IMF. In the late 1980s Brazilian officials planned a debt negotiation meeting where they decided to "never again sign agreements with the IMF". The efforts of the IMF helped Latin America regain some balance after the debt crisis but was not able to resolve all of its issues.
F UTURE A FFECTS
Mexico Rocked the Financial World Again in 1994 With the Mexican Peso Crisis. Showing the World that The Financial Crisis is Far From Over. Mixed results characterized economic performance in the countries of Latin America in 1995. While the total regional economy grew by only .8%, sharp distinctions persisted among the countries of the region. The December 1994 peso crisis in Mexico led to a substantial 6.9% decline in GDP in 1995. In Argentina and Uruguay, the main countries affected by carryover from the Mexican crisis, their economies contracted by 4.4% and 2.5% respectfully. The crisis in 1994 underlined the significant fragility and vulnerability in many of the regions financial and banking systems, not only in Mexico but also in Argentina and a number of other countries. In both Mexico and Argentina, the weak position of the banking system contributed to the poor GDP performance. Investors, both international and domestic, feared that a collapse of important banks could result in major economic dislocations, massive and costly bailout programs, and a resurgence of inflation. Argentinas weakness in their banking system tested the convertibility program and, the exchange rate regime. In Brazil, the weakness of their banking system, and especially the state owned banks, has added significant uncertainty to the public deficit picture. Central bank moves to provide liquidity to private banks in distress and treasury obligations to recapitalize public banks will add significant amounts of public debt over the next few years. Today Mexico stands with the deftness of 274,800 million us dollars. 16
C ONCLUSION
The Mexican debt crisis 1982, still remain as one of the biggest debt crisis since the 1930 world crisis. It left many implications of the modern financial system. From the debt crisis no matter what type of reform is initiated, the fact remains you need sound economic policies that are sustained by all of the market participants. Just because the crisis is manageable today does not mean that it will not deteriorate into a full-blown crisis tomorrow. There have been many suggestions for reform or different types of reform. Some of these suggestions are: first, forgive countries debts; second, some recommend that governments and commercial banks cancel some of the debts; third, restructure the IMF demands on countries in debt; fourth, reduce trade restrictions on the products of poor nations; fifth, loans and grants to poor nations should be in smaller amounts and specifically applied; and sixth, create new ratios for the heavily indebted poor countries. Use debt to GDP and debt to budget expenditures instead of debt to exports and debt service to exports.
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