Week 6: The 1980s Debt Crisis

The first civilian elections in 20 years take place. Political uncertainty leads to dramatic increase in spreads. Tancredo Neves, first civilian to be sworn in as President in January, 1985

(spread on Brazilian bonds timeline): What happens between July 1983 - January 1985?

contagion from Mexico's crisis: no major events affected Brazilian economy, however, its spread increased around 420 points

(spread on Brazilian bonds timeline): What happens during July - Oct 1982?

a tentative agreement with commercial banks is reached and Brazilian spread stabilized around 300 basis points

(spread on Brazilian bonds timeline): What happens during Oct 1982 - April 1983?

An agreement with IMF is reached ($5.4 billion stand-by loan)

(spread on Brazilian bonds timeline): What happens in July 1983?

An agreement to reschedule payments is concluded. Spreads continue to decrease.

(spread on Brazilian bonds timeline): What happens in the end (after January 1985)?

L ́opez Portillo nationalizes the banks, and announces that all payments of debt principal will be suspended until 1984. The market punished Mexico with a spread of more than 600 basis points.

(spread on Mexican bonds timeline): What happens in September of 1982?

1. During 1983, Mexico negotiates agreements with banks and the IMF. 2. IMF declares Mexico's economic performance is in line with the agreements, and Mexican spread declines for first time in 10 months: 152 basis points.

(spread on Mexican bonds timeline): 1. During 1983, what does Mexico do? 2. Then, what happens in May of 1983?

after months of continuous decreases in spread, it starts to increase given the rumors that Mexico might reschedule some payments. Govt reaffirms it will not reschedule more payments and spread decreases again.

(spread on Mexican bonds timeline): What happens in 1984?

August 1983: A final agreement between IMF and Mexico is signed: spread keeps falling.

(spread on Mexican bonds timeline): What happens in August of 1983?

- President de la Madrid is sworn in, and extreme austerity measures are undertaken - IMF gives a loan package of $4 billion to Mexico.

(spread on Mexican bonds timeline): What happens in December of 1982?

1. expenditure-switching policies 2. nominal devaluations and import restrictions (higher tariffs, broader coverage of non-tariff barriers, multiple exchange rates)

1. After August 1982, most Latin American countries relied on this type of policy to improve their current account balances. 2. what are the two economic areas in which this certain type of policy was employed?

1. it quadrupled ($45.2 billion to $176.4 billion) 2. This increase in indebtedness was made possible by liberal policies followed by the international financial community (and in particular commercial banks), that provided funds to the developing countries after the oil crisis of 1973. 3. its severity: instead of a slow reduction in loans, the flow of capitals came to a sudden stop.

1. Between 1975 and the beginning of 1982, what happened to Latin America's foreign debt? 2. How did this happen? 3. What was particularly incredible about this?

1. They thought that major debtors needed financing in the form of new money for about 5. Once the country is in a stronger shape, it would be able to start servicing its obligations. This view was a call for debt relief, restructuring and re- duction. 2. The Brady Plan became an official debt strategy in 1989, when the US unveiled it.

1. Eventually, what do some studies start to suggest an alternative view for how countries in major debt can succeed in achieving increases in real consumption and real income. What did they think needed to happen? 2. When was this view recognized? What was its name, and which country unveiled it?

1. in order to produce trade surpluses in short periods of time 2. the adjustments were painful: decreases in real incomes, increases in unemployment and inflation

1. Following the debt crisis, economic adjustments were implemented in order to do what? 2. What were the effects of these adjustments?

1. aggregate deficit of $2 billion 2. aggregate surplus of $39 billion 3. The dramatic adjustments Latin America made, after years of incurring deficits, to have a surplus so high

1. Latin American current account in 1981: 2. Latin American current account in 1984: 3. What does this illustrate?

1. nominal exchange rate policies that were inconsistent with expansive fiscal policies. 2. Argentina, Uruguay, Chile, and some central American countries

1. The tendency for overvaluation of currency in many Latin American countries at the time was caused by a combination of which to incongruent policies? 2. Name some countries that are examples of this

1. Countries tried to cut expenditures- particularly public investment and government wages 2. government payments of interest increased due to real devaluations of domestic currencies 3. mainly because of low tax revenues due to poor economic activity (and also due to very inefficient tax collection).

1. What strategy was employed by many countries to resolve the debt crisis? 2. Why did government interest payments increase, despite these efforts? 3. Why did fiscal deficits increase?

1. trick question- causes varied from country to country, but many countries had been using credit from commercial banks, which we know stopped slowing suddenly. 2. Brazil was financing their ISI policies 3. Mexico was financing massive amounts of government spending 4. Chile was financing the consumption of "durables"

1. What were the overall causes of Latin America's heavy debt? 2. Specifically, what caused severe debt in Brazil? 3. Specifically, what caused severe debt in Mexico? 4. Specifically, what caused severe debt in Chile?

1. the evolution of the bond yields in the international secondary markets 2. Increases in the probability of default are reflected in increases in the premium of sovereign bond yields over risk-free bonds of similar characteristics.

1. this data reflects the informed public perception of the sovereign risk associated with a particular country's sovereign debt- it is what we look at when considering how the public perceived the possibility of a crisis as the year 1982 progressed 2. how are increases in the probability of default reflected by this data?

These policies were successful in the short run, however as time passed, less so- the countries needed more and more exports to finance the transfers of resources to the rest of the world.

Adjustment strategies used to produce a current account surplus successful in the short run? In the long run?

- Spreads varied significantly during the period. - Basically zero form Oct 1980 until almost right before the crisis. - First major increase in early August 1982, just before Mexico's announcement. - This agrees with the beliefs that the Latin American countries' problems were liquidity (cash flow) but not sol- vency.

How does the spread on Mexican bonds illustrate public perception of economic health?

Initially, the adjustments in current account balance were achieved by contractions in imports and investment- this compression was obtained by reducing the imports of capital goods and intermediate inputs. However, this strategy seriously affected future growth.

How was Latin America able to produce such a large current account surplus in 1984? What was the negative effect that resulted from this strategy?

- helped separate real transactions from volatile capital movements. - yields the same result as a differentiated tariff schedule. - Some countries (Chile, Mexico, Venezuela, Ecuador) applied preferential exchange rates to private sector's repayment of foreign debt.

Imposing multiple exchange rates as a way to improve current account balances after the debt crisis served what three purposes?

the mid 1980s

Latin American countries started looking for ways to reduce their debt by _____________

Capital flight- residents of Latin American economies preferred to convert their holdings of domestic currency into dollars, and then deposit these dollars abroad

Overvalued currencies led to what problem? Explain how it happened.

The LIBOR (London Interbank Offered Rate). Deflated by inflation for the region's exports, it jumped from... .... an average of -3.4% in the 1970s and 1980.... ....to 19.9% in 1981.... ....to 27.5% in 1982.... and 17.4% in 1983

The fluctuations in this interest rate in the early 1980s illustrate the massive increase in interest payment amounts for Latin American countries at the beginning of the debt crisis

In mid-August 1982, a group of highly ranked Mexican officials flew to Washington, DC to inform the Department of Treasury that Mexico could no longer honor its international financial obligations (around $80 billion). Almost immediately, all credits for Latin America were suspended.

This event marked the beginning of the worst financial crisis since the Great Depression in the 1930s.

Not really- hard to find serious warnings of a crisis in the literature. As late as the first quarter of 1982, prominent analysts and institutions did not expect a major crisis

Was the debt crisis foreseeable?

Not really. Despite all efforts, exports proceeds systematically fell short of interest payments. The gaps were usually closed by negotiations with the banks or help packages from institutions.

Were the strategies used to improve current account balances successful?

- Governments turned to the inflation tax to finance deficits. In many countries, monetary expansion became the norm to finance deficits. Consequently, inflation became an- other problem. - Governments also used domestic borrowing as a way to finance deficits. This crowded out private borrowing, keeping interest rates high.

What (two things) did the government do in an effort to finance deficits that occurred after the crisis, and what were the consequences of those choices?

most of the countries that were immersed in the Debt Crisis had let their national currencies become seriously overvalued in the 1970s and early 1980s (recall ISI)

What domestic factor contributed to the Debt Crisis?

- Not good: most of the countries in Latin America were in arrears of interest and principal payments. - They faced a serious solvency problem, that initially was thought to be only a liquidity problem - After enjoying years of easy and cheap foreign financing, Latin America suffered a sudden cut in commercial bank credit, and was forced to transfer large amounts of financial resources to the industrialized countries.

What was the economic state that most Latin American countries found themselves in by the end of 1982 (3 major statements)?

- Between 1981 and 1983 the reduction in funds was about 40%. - The Latin American countries had to produce current account surpluses after years of incurring in deficits - and had to do it fast!

What were the consequences of the Debt Crisis?

- Sluggish growth of industrial economies - Increase in world real interest rates - Decline in commodity prices.

What were the external factors contributing to the Debt Crisis?

- fiscal policies weren't always tight - countries used "crawling pegs" after initial devaluations, which led to inflation

Why were nominal devaluations not a completely successful tool for improving current account balances?