The International Debt Crisis - Essay Example

The International Debt Crisis INTRODUCTION The origin of the international debt crisis of 1980s in Latin America rooted to a shift from government borrowing to commercial borrowing. It is evident from the trend in the Latin American economies that a boom was followed by a slump or recession in the economy, adhering to the economic fact that neither recessions nor booms are long-lasting. The countries in Latin America were mostly third-world or developing nations and required huge amounts of capital to restructure its economy or improve its infrastructure and other facilities. There were certainly not enough resources available to them to generate such huge amounts of capital causing them to rely on foreign capital for development. Commercial borrowing increased sharply and was one of the main reasons behind the huge debt accumulation. The private sector was partly or mostly responsible for the debt crisis because of their extensive borrowing of short-term loans with higher interest rates from foreign countries and banks. THE BRETTON WOODS SYSTEM AND ITS DOWNFALLl After World War 2, the Bretton Woods system was established and followed by many nations for years till is collapse in 1971. The Bretton Woods system was related to fixed exchange rate; linked to the reserve of gold held by the country. The system operated as the value of the dollar was kept almost constant and any fluctuation in the exchange rates between the dollar and other currencies was accordingly countered by the central banks of the related countries. If the dollar experienced a decrease in value, the central bank of the country would act so as to counter the effects of this fall in value by selling more of its own currency to decrease its value and maintain the value of the dollar to its previous level. This system functioned because of the willingness and ability of other nations to help maintain the value of the dollar. However, in 1971 when the United States experienced a fall in the value of dollar the countries did not act to maintain the value of the dollar. They expected that the measures that were required to maintain the dollar exchange rate would negatively affect their own economies in the form of expensive exports. Finally the Bretton Woods system was abolished in 1971 and the floating exchange rate system was introduced where the value of the dollar was allowed to fluctuate in the money market. THE OIL PRICE HIKE AND ITS EFFECTS The increase in the prices oil in 1970s was massive enough to create a ruffle in the economies of many countries throughout the world. The oil-exporting nations experienced a huge capital inflow due to the increase in prices whereas the oil-importing countries (which included many developing nations) experienced noticeable capital outflow and oil inflation in their respective economies. The oil-exporting countries deposited their huge capital in commercial banks; most of these banks were focused in the United States and United Kingdom. On the other hand, the oil-importing countries, many of which were already under-developed or poverty stricken, suffered huge capital outflows and oil inflation from this increase in oil prices. They required more capital in order to purchase oil and keep their economies functioning. The need of the developing nations for the acquisition of capital gave way to Petrodollar Recycling. It refers to the deposit of the surplus capital earned by the oil exporting countries in the commercial banks (of foreign countries) through which they invested in developing nations especially in Latin America. The investment was made particularly in the form of short-term loans with high interest rates. The countries that borrowed the money adopted an aggressive policy which they believed would help in accelerating development. They terminated the import controls and restrictions on international capital flows accompanied by privatization of many state-owned industries. The increase in the strength of the private sector and the relaxation in the capital flows triggered a process of borrowing huge amounts of capital from foreign banks. Unlike the loans acquired in the past with lower interest rates, these loans were short-term and had relatively higher interest rates. The private-sector firms were also given a freehand in negotiating the interest rates, agreement and other features of the loans; the policies adopted were exploited by most private-sector firms and huge amounts of money were borrowed. The unmonitored trade policies adopted and the huge loans acquired by the firms later backfired as the countries and firms found it impossible to make the high interest payments. The countries borrowed more capital to make the regular and huge interest payments on the loans acquired before. After a few years the banks as well as the debtor countries realized that these developing nations were incapable to pay back the debts or even make the interest payments on the huge amounts of loan on these countries. THE DEBT CRISIS AND THE INABILITY OF COUNTRIES TO PAY BACK THE LOANS Many of the Latin American countries declared that they were unable to pay back the loans. In 1982, Mexico was the first country to declare its inability of making the interest payments. Though Mexico was an oil-exporting country and it did benefit from the oil price hike, it experienced a fall in its non-oil exports eventually resulting into a current account deficit. After Mexico many other countries followed suit and declared that they were not potent enough to make the repayments that were almost due by that time. In 1980s the oil prices began to decrease causing the prices of other goods to decrease as well. The developing nations were further stressed as they relied heavily on the export of raw materials or primary goods and this decrease in oil prices caused a decrease in the value of their exports. The banks were alarmed by this situation and refused to make any adjustments or restructuring of the loans resulting into a financial turmoil. The developing nations of Latin America were compelled to restructure its economic policies and adopt a tighter approach. Still, this move was not adequate enough to cover the debts accumulated and therefore they were left with no other option but to seek help from the International Monetary Fund (IMF) and the World Bank (WB). CONCLUSION There were mainly two reasons which led to what seemed to be inevitable debt crisis of Latin America; namely, the elimination of the Bretton Woods system and the oil price hike in the 1970s. These factors along with the liberal trade policies adopted by countries like Brazil, Mexico, Chile etc. provided a chance for private sector firms to acquire huge amounts of loans by commercial banks. The commercial banks which held the massive capital earnings of the oil-exporting countries issued the short-term loans on high interest rates. The countries continued to borrow more and more to finance the huge interest payments and their economies until they realized that they could no longer make the debt repayments. The banks refused to restructure the loans or provide any relaxation; this caused the IMF and the World Bank to intervene and make an attempt to clear off the economic instability. The IMF set policies which restricted the countries in setting up trade policies according to their own will; it compelled them to adopt contractionary economic policies. The IMF offered to provide assistance to these countries if they adhered to how the IMF wants their economies to operate; i.e. to adopt market oriented policies. The Latin American countries were left with no other option but to accept the terms of the IMF and World Bank, which formulated solutions and repayment methods to eliminate the debt crisis and help clear the financial turmoil present in the global economy. However, the policies adopted by the IMF were debated upon and were termed as controversial as many of the Latin American countries have not managed to come out of the financial crisis and are yet to achieve the state of economic stability that was eminent before this debt crisis. Some people even believe these policies as a hindrance in the way of the development of these countries and a major factor in widening the inequality gap between the rich and poor in these countries. BIBLIOGRAPHY BOOK: Stanlake, GF, and Grant, SJ. Introductory Economics. 7th. Harlow: Longman, 2000 INTERNET Carasco, Enrique R. "The 1980s: The Debt Crisis & The Lost Decade." www.uiowa.edu. 1999. The University of Iowa Center for International Finance & Development (UICIFD). 2 Oct 2007 . Theberge, Alexander. "The Latin American Debt Crisis of the 1980s." www.columbia.edu. 08 Apr 1999. Columbia University, New York. 2 Oct 2007 . Read More