From Crisis to Renewed Growth - Essay Example

I. Introduction: The 1980’s Crisis The crisis in the 1980’s was a financial crisis in the Latin American countries where they came to a point that could no longer repay their foreign debts as the total amount that is payable to their loan exceeded their capacity to pay. This was caused by excessive and continous borrowings even at a negative interest rates and rising commodities which was aggravated by the the Organizationof Petroleum Exporting Countries (OPEC) decision to raise the price of fuel which drove the interest rate of repayment and made the Latin American countries, particularly Mexico unable to service its loans (Buerkle, 2007). II. Background In the 1960s and 1970s, Latin American countries likeArgentina, Brazil and Mexico was experiencing tremendous growth in their respective economies (Swan, 1992). They capitalized on this growth by embarking on an industrialization program and borrowed heavily from foreign creditors to finance their industrialization program particularly their infrastructure projects. Given the performance and the prospect of the economies of these Latin American countries, foreign creditors granted them loans. These loans continued that in the span of seven years (1975 to 1982) of continuous loans, it had a cumulative annual rate of 20.4 percent. This translated to the contiunous accumulation of debts. Latin American country’s loans which was only $75 in 1975 rose to a staggering amount of more than $315 in 1983. These loans already amounted half of the region’s GDP or Gross Domestic Product. As a consequence, debt payment, both on the principal and the interest, increased rapidly that it amounted to $66 billion in 1982 when debt service was only $12 billion back in 1975. The Oil Crisis When the Organizationof Petroleum Exporting Countries (OPEC) initiated in October of 1973 the increase of the world price of oil to as much as much as five times and backed by a selective embargo which was directed against the industrialized countries, Latin America and developing countries took the hit because of their vulnerability to external shocks (Street, 1978). Of the 19 countries that has to import oil, they have to pay OPEC’s increased price by an additional amount of $4.8 billion more in 1975 and added $5.2 billion in 1975 (Robichek, 1975:1). To make the matter worst, Latin American countries’ trade fell as a result of the global recession that was aggravated by the OPEC’s decision to increase the price of oil. As a result, the demand for Latin America’s primary products decreased while production cost increased because the price of imported materials from industrial nations also increased due to the increase of price in oil. This resulted to the region’s “deterioration of balance of payments current accounts of $2.5 billion above their expanded oil import costs in 1974, and of $2.9 billion in 1975” (Robichek, 1975:1). The Effect of the Oil Crisis OPEC’s decision to increase the price of oil contributed to the recession of the US economy in 1974 to 1975. This decreased the demand for loans in the domestic economy. These loans however was availed by Latin American countries which had a tremendous appetite for foreign loans (Hawkins And Maese, 1986). The global economy also slid into recession after the OPEC’s decision to increase its price in oil. The crisis that OPEC precipitated was however unusual as it transmitted even to countries that did not experience the “stagflation” of matured economies such as United States and Europe. “Until 1970, 15 Latin American countries enjoyed relative stability in the cost of living, and only 4 experienced price level increases in excess of 15 percent per year” (Inter-American Development Bank, 1977:6). Brazil which had always managed to decreased its inflation rate in the 1960s experienced an increase of 13% inflation in 1973 which increased further in 1976 to as much as 42% (International Financial Statistics, 1977:53). Its annual growth of over 10% from 1968 to 1974 fell dramatically to only 4.2% in 1975. The same thing happened with Mexico whose annual growth rate of 6.3% from 1970 to 1974 dropped to 4.2% in 1975 and further to 4% in 1976. Colombia who had been experiencing a 7.1% annual growth from 1971 to 1973 also dropped its growth rate to 4.6% in 1975 (Street, 1978). The Debt Burden Latin American countries debt build up in the 1970s is closely tied to OPEC’s recycling of petrodollars who was the main benefactor of its decision to increase the price of oil. “Within one year of the first oil price shock of 1973-74, the share of fuels in the value of world trade increased from 12 percent to 20 percent”(Hawkins and Maese, 1986:61). This aggravated Latin American countries current account deficits and took further toll on its foreign borrowings. “The combined current account deficits for 18 Latin American countries in the oil-importing group tripled from $3.9 billion in 1973 to $12.8 billion in 1974 and quadrupled in 1975 to $15.9 billion” (International Financial Statistics, 1976b: passim cited in Street, 1978:63). This resulted in the mounting of aggregate external borrowings of 21% in 1973 to $36.0 billion and by another 26 percent in 1974 to $45.3 billion, the sharpest increases ever recorded in the region (Inter-American Development Bank, 1976). By 1976, Brazil’s external debt amounted to $30.5 billion while Mexico at $22.7 billion both countries ranking third and fourth of the most indebted countries in the world (Silk, 1976:60, 1977b:43 cited in Street, 1978). III. The Financial Crisis At the end of 1970’s, some economies who were non-petroleum producers and exporters were experiencing a stagnant output coupled with a high inflation or an economic phenomenon known as “stagflation”. When 1980s came in, the global economy slid to recession. The Role of the Fed in the Crisis As a response to the US recession, the US Federal Reserve Board headed by its new appointed chairman, Paul Volcker, instituted an anti inflation campaign beginning in 1979. The Fed used its monetary tools to tighten the money supply as a counter measure against inflation. As a result, cost of money, or interests rate soared up sharply reaching to a high of 20% per annum (1978). This measure however was proven effective in the long run as global inflation rates eventually ebbed. This is not however without repercussion as the global economy slowed down. The worst casualty of this measure was the developing countries who were heavily indebted. This caused enormous financial strain to the developing countries particularly Latin American countries as the interest payments they have to pay on previously made loans dramatically increased. In addition, demand for their exports also fell with global economic slow down. August 1982 Latin American countries particularly Mexico are already feeling the brunt of these combined economic setbacks. The global economic slowdown diminished the demand of their exports thus decreasing their capacity to pay their loans. More importantly, the interest payments on their loans rose dramatically due to the increased interest rate imposed by the Fed to arrest the inflation. This measure took a toll on the economies of Latin American countries because of their heavy dependence on external loans. In August of 1982, Mexico, through its Finance Minister, Jesus Lava Hertzog declared that it cannot bear the crisis anymore and declared that it cannot pay its debt and asked for a 90 days moratorium. When he made this announcement, Mexico’s debt already exceeded $80 billion and “almost 30 percent of this debt was due within one year (Hawkins and Maese, 1986:62). He also requested a new loan to repay its existing loans and renegotiated for the due dates of their loans. This declaration of default on loans by Mexico precipitated a global financial crisis as other countries which has the same balance of payments problem like Mexico also declared its inability to pay its loan. Instead of a moratorium, Mexico’s loans became immediately due. The Foreign Commerical Banks The foreign commercial banks who lent money heavily on these countries scrambled on how to get their money back. Immediately, all pending loans were cancelled and the petroleum dollars that were supposed to be loaned were terminated. Under the condition that they will adjust their policies, refinancing loans were granted for these Latin American countries, particularly Mexico, to reschedule their debt payments. Paris Club, countries who lends to developing countries, pitched in with the condition that they will abide with the IMF-WB conditionalities. The IMF-WB Conditions The International Monetary Fund (IMF) and World Bank (WB) came in to extend their financial help. The rescue loans provided by the IMF-WB to Mexico and other Latin American countries were not however without conditions . These loans were extended on the condition that the beneficiary country will abide by the structural adjustments required by IMF-WB. This required “a sharp cut in government spending; the elimination of large projects for roads, ports, and new housing; and a reduction in subsidies for consumption goods” (Hawkins and Maese, 1986:62). This measure shot up the unemployment level of Mexico and standard of living deteriorated standard of living by as much as 30%”. Other countries which had similar problem followed suit under similar strict austerity conditions imposed by the IMF-WB to those Latin American countries who sought for their help (Hawkins and Maese, 1986). The Baker Plan The Baker Plan was the initiative of US Treasury Secretary James Baker in 1985 which assumed that the issue with Mexico and other Latin American countries inability to pay is illiquidity. It is an economic condition wherein “a debtor does not have the cash to meet debt payments (interest plus principal) when due, even though net worth is positive (Romans, 1990). His initiative recognizes that the Latin American financial crisis is closely tied up with US Banks who extended those loans (Hawkins and Maese, 1986). He knew that if the Latin American debt crisis will not be resolve, this will have a disastrous consequence on the United States banking system who had overexposed themselves to Latin American borrowings. The Plan assumed that this countries has capacity to pay in the future only that it is not liquid enough to pay its debt today. It hypothesized that by moving the due dates of these loans in the future, these affected countries may be able to pay their debts. The Brady program included reduced government spending, greater free market orientation, lower inflation and the disposal of unprofitable public sector business (Hawkins and Maese, 1986:63). It is basically hinged on austerity measures, liberalized trading and privatization. But due dates came and the indebted countries were not still able to pay. Their balance of payments worsened as the issue was not illiquidity but insolvency. Gradually, lenders were able to realize that the solution is not delaying the payment but reducing the debt itself. The Brady Plan The Brady Plan was an initiative of Senator William Bradley of New Jersey in 1986 who recognized that for these Latin American countries to pay to their debts, the debt in itself has to be reduced to a manageable level. He also recognized that IMF-WB conditions will not make Latin American countries’ economy to grow and being such, the debtors will never be able to pay its debt. So the Brady Plan deviced measures where bad debts can be bought by good debts (debt buy back) at a lesser amount so that the debts can be reduced. The Brady’s proposal, also known as the 3-3-3 Plan, posits that commercial would cut interest rates paid by Latin American countries for three years. In the process, the principal will also be reduced by three percent and industrial countries particularly United States, will extend credit up to three billion dollars a year (Hawkins and Maese, 1986). IV. Conclusion For the Latin American countries to pay their debts, it has be restructured to a manageable level and rehabilitate its economy. This was initiated after the August 1982 Mexico’s declaration of inability to pay its loan as the amount of debt reached at an intolerable level. Various tools were used to rehabilitate the Latin American economies and to enable it to pay its loan. Among those who came in to restructure the Latin American economies particularly Mexico, was the IMF-WB whose assistance imposed conditions of austerity, liberalization and privatization. US Treasury Secretary James Baker came in 1995 with a plan of delaying the payment of Latin American countries loans hoping that they eventually, they would be able to settle their debts. Secretary Baker knew that it is imperative for the US banking interest that the Latin American debt crisis be resolved to avert a banking crisis in America. The debts however were just too big for these Latin American countries to pay. Eventually, the creditors realized that the debt has to be reduced because the issue is not about illiquidity but already of insolvency. Then Senator Brady came in with his 3-3-3 plan which sought the reduction of the Latin American debt through debt swaps and the increased market orientation of its economy. From then on, the Latin American countries transformed from being in a crisis to a region of renewed growth (Feldstein, 1984). References: Anon., (1977). Annual Report 1976 (Washington; Inter-American Development Bank). Anon., (2008) Latin America: Just how resilient.Business Latin America, 9/29/2008, Vol. 43 Issue 37, p1-2, 2p. Buerkle, Tom (2007). When the World Fell Off the Wall.. Institutional Investor, May2007, Vol. 41 Issue 5, p164-167, 3p. Feldstein, Martin (1984). From Crisis to Renewed Growth. Challenge. Vol. 27 Issue 3, p27, 4p Hawkins, Clark A.; Maese, Judy E (1986). An Examination of the Latin American Debt Crisis.. Columbia Journal of World Business, Fall86, Vol. 21 Issue 3, p61-67, 7p. Robichek, E, W. 1975, "Demand and Balance of Payments Management in Latin America and the Caribbean," Paper presented at the annual meeting of the American Economic Association, Dallas, December, Romans, J. Thomas; Warren, Stanton (1990). A BALANCE OF PAYMENTS ANALYSIS OF THE LATIN AMERICAN DEBT CRISIS. A. Review of Income & Wealth, Jun90, Vol. 36 Issue 2, p207-213, 7. Street, James H. (1978). LATIN AMERICAN ADJUSTMENTS TO THE OPEC CRISIS AND THE WORLD RECESSION.By: Social Science Quarterly (University of Texas Press). Vol. 59 Issue 1, p60-76, 17p Swan, Philip L. (1992). Economic reform in Latin America.By:. Business Economics. Vol. 27 Issue 2, p18, 6p Read More