Latin American Development Quiz #5

(T/F?) The Baker plan aimed at shifting toward policies more focused on growth. To do so, the Baker plan called for even stricter measures of austerity than the ones already in place.

False

(T/F?) The IMF recommended Latin America to reduce its domestic absorption. This includes measures like decreasing public spending, focusing on the international sector, privatizing SOEs and adopting an expansionary monetary policy to combat inflation.

False

(T/F?) The World Development Report of 1983 incorrectly diagnosed that Latin America's debt problems were due to illiquidity (that is, Latin America does not have the capacity to pay now nor in the future; they are bankrupt) and not due to insolvency (that is, Latin America was unable to pay when it was due, but could recover in the future).

False

(T/F?) The oil crisis of the 1970s reduced the international price of oil dramatically. As a result, real interest rates were negative, and this encouraged many Latin American countries to increase their debts.

False

(T/F?) Loans for long-term projects with short-term payments can lead to a debt trap if the returns to the investments are not received in the short term.

True

(T/F?) The HIPC initiative is a joint program by the World Bank and the IMF to relieve debt for the poorest countries. Under HIPC, countries receive debt relief contingent on the adoption of credible poverty reduction strategies.

True

(T/F?) The main goal of the Brady plan was to reduce the debt burden of developing countries, recognizing that it was important to achieve stable growth.

True

(T/F?) The term involuntary lending refers to loans that are made to honor previous debt rather than to finance new projects.

True

Explain similarities and differences between the Baker and Brady Plans, in terms of their assessment, solutions, and consequences on LAC's debt crises in the 1980s.

o Baker plan was "too little, too late," and represented a shift away from conditionality. New role given to world bank, focusing on structural adjustment § Premise: LA countries could not continue servicing its debt through contractionary policies -> it did not favor investment or democracy § Exports were perceived as the engine of growth -> switched from a short-term liquidity problem to a long-term problem of structural adjustment § Did not work because: · International commercial banks were not convinced that lending more money to someone in debt will gain them any money -> did not restore confidence or trust § Would impact future policies o Brady plan: § Asked international commercial banks: · Decreased the face value of debt · Extended the time period of obligations · Infused new money § To be eligible for the Brady plan debt reduction, a LAC should show credible political will and strong track record of economic performance (evidence based) § Brady bonds served as safeguards in the event of default § Implementation: · Buybacks: bought own debt at small fraction of its face value in foreign currency · Swapping long-term loans for treasury bonds with 30-35% discount face value at variable interest rate, and swapping loans without discount but at a fixed interest rate of 6.25% o Similarities: § Both wanted the commercial banks to either loan out more money, or reduce the payments -> either way they would favor the countries over the banks § Both wanted short term fixes for a long-term problem o Differences: § Baker was fiscal (government changing tax to try to change the demand) and Brady was more monetary (interest rates/money supply à the fed) § Brady focused on bonds whereas Baker focused on export growth as a sign of economic growth § Brady made it look more attractive for the international commercial banks o Debt in 1980 was 220 billion and in 1989 it was 414 billion... so it INCREASED!!!!!

What was the first reaction of the financial community to LAC's 1982 debt crisis?

o Debt problems of most major countries were caused by illiquidity, not by insolvency o Mexico responded and said they could no longer service their debt o They faced a debt crisis, which spread to all other LAC developing countries o Threatened the whole international financial crisis o Lack of liquidity meaning they couldn't make payments when they are due o Face quite a bit of capital flight in Mexico o Social unrest § Threat of communism during these times o Populism was a way to address the social unrest

What fueled the accumulation of LAC's external debt?

o Debt trap: § Unproductive investments or investments with very long-time horizons that do not generate returns in time to help service loans. There were also inconsistent economic policies that impede the success of projects, or external shocks that derail the domestic economy. § If a multiyear project doesn't create significant returns, or is incomplete, you will need to borrow even more to make payments · This creates the debt trap o Mismatched projects and returns: § The state-led investments required high capital for large-scale projects to develop needed infrastructure in energy, transportation, and telecommunications. The multiyear investments did not always line up with the terms of commercial lending § The government would take steps in the future for public lending § Debt started to accumulate to service past debt o Unsustainable domestic policies: § The intersection of politics and economics promoted debt-led development § Has been known for the use of political rhetoric to mobilize the masses § Economic populism emphasized growth and income redistribution · Whilst at the same time, they de-emphasized the risks of inflation and deficit finance, external constraints, and the reaction of economic agents to aggressive nonmarket policies § Populist culture encouraged spending, which was made possible by conditions in the international financial markets o External shocks: § Interest rates would change drastically § When it is changing so quickly, it made it hard to repay loans § They would want to lend to SOEs rather than small business or agricultural loans as they saw it as easier and more lucrative o Distinct patterns, same result: Crisis § Fiscal policy: overexpansion led to the debt § Monetary policy: low interest led to capital flight § Exchange rate policy: overvaluing the dollar/keeping fixed rates hurt them § Exogenous shocks: US monetary policy tightening o The crisis builds: External shocks and Capital Flight § LAC had to earn or buy US dollars in the late 70s which created a recession

Explain the Washington Consensus. What was it about? Its main objective? Explain two reforms LAC implemented based on the Washington Consensus.

o Gave 10 different neo-liberal policies that could end LACs debt. The debt-crises made it evident the unsustainability of ISI as implemented - market-based and export-led was praised o They were market-oriented economic reforms, trying to build confidence in the market. They also had the transformation from the SOEs to an export-driven growth strategy o 10 policies included: § 1. Macro stabilization programs promoting fiscal balance § 2. Deep tax reforms, decreasing tax evasion and increasing government revenue § 3. Modernize the financial sector by letting international banking compete with local markets § 4. Avoid artificially strong currencies § 5. Reduce trade protectionism -> trade liberalization § 6. Privatization of inefficient SOEs § 7. Encourage FDI § 8. State modernization, improving legal protection of property rights § 9. Deregulation of business transactions, including investment decisions § 10. Target public expenditures on the poorer groups in the population -> social safety nets

How did the debt-for-nature swap work? Explain two advantages and two disadvantages of using this mechanism to manage LAC's public debt.

o It was first proposed in 1984, and gave NGOs bargaining power to influence the creation of environmental measures § Countries would be able to create policies and environmentally sound projects in return for reduction in their external debt o They needed three requirements: § 1. An NGO from outside/a secondary market § 2. A central bank willing to accept the debt note § 3. Private/government must carry out the environmental programs o Advantages: § Engages a high level of government participation § Helped promote environmental sustainability o Disadvantages: § Reduce little debt § Conservation projects may take precedence where other critical sustainable development projects are needed

Explain two internal and two external factors explaining the debt crises in the early 1980s.

§ LAC needed to finance: · SOEs · Long term projects · Projects with late/ or no returns § Types of loans LAC governments made to finance ISI: · International commercial banks · In dollars/hard currency · Floating interest rates · Repayments required in the short run, which resulted in the debt trap o External: § 1974 increasing oil price (supply shock) · over-abundance of money supply led to an excess of money supply, which meant lower interest rates · Resulted in a world recession § Global recession: · Resulted in decreased demand for LAC goods · International prices of primary commodities fell · LAC's total revenue from exports fell · Ultimately, they couldn't make the money they needed to repay their loans abroad High money supply, low interest rates

Explain the assessment and solution proposed by the IMF's absorption approach to LAC's debt crises.

● Assessment: ○ They thought it was illiquidity, but it was actually insolvency ● The Solution proposed: ○ Consume less in domestic country for more exports: Y - A = B ○ If -B: ■ Increase Y, or decrease A, or both ○ Policies include: ■ Reduction of: ● Subsidies ● Public spending ● Privatization of SOEs ■ Contractionary monetary policy