International Economic Relations - Latin American Nations - Essay Example

Introduction The Worlds debt crisis of the early 1980's was the culmination of a build up of external debt of developing countries), a large part of which was accounted by a progressively rising short-term debt. The debt of LDCs was triggered largely by demands from the balance of payments effects of the oil crisis that started in 1973/74. The debt build up became more apparent towards 1980 when third world borrowers resorted to rolling over their debts. (Stambuli 2002) A combination of very tight internal fiscal position and increasingly fragile balance of payments, most developing countries contracted new loans to liquidate maturing loans. In some cases, entirely new loans were contracted to service interest only. At the same time bankers in the western world ignored signals of an imminent debt crisis and remained more than willing to refinance maturing loans of developing countries, but with shorter maturities. In this process, third world debt snowballed from $130 billion in 1973 to about $612 billion in 1982. Between 1975 and 1980 four countries had to postpone amortization payments while servicing interest only. The spark that ignited the LDC debt crisis can be readily identified as Mexico's inability to service its outstanding debt to the U.S. commercial banks and other creditors. The crisis began on August 12, 1982, when Mexico's minister of finance informed the Federal Reserve chairman, the secretary of the treasury, and the IMF managing director that Mexico would be unable to meet its August 16 obligations to service an $80 billion debt. Then by 1983 the number of countries defaulting on their repayments reached twenty one, and some third world countries had instituted state criminal processes against public figures on account of alleged negligence and mishandling of public money. The fact that the 1982 crisis occurred when there was a steep rise in interest rates in the U.S. underscores the significance of the capital outflow element of a financial crisis. The appreciation of the dollar at that time also means that repayments magnified the capital outflow in domestic currency terms. At the same time, the accompanying drop in dollar prices of internationally traded commodities undermined inflows derived from exports. It is also necessary to mention that the satiation described above is also reflected in the 1994 financial crises in Mexico, Turkey and Venezuela equally attributed to dramatic reversal of large scale lending to emerging markets, as well as the experience of Argentina in 1995 and East Asian economies in 1997. There is the argument that most of that crises were characterized with large amounts of international loans to forestall default, hence the rebuke of Mexico at the onset of the 1982 crisis worsened a financial condition that was potentially manageable. 1. Balance of Payments During the second part of the 1970s, and partially as a result of the oil price shocks, most countries in the world experienced large swings in their current account balances. These developments generated significant concern among policy makers and analysts, and prompted a number of experts to analyze carefully the determinants of the current account. As Edwards (2000) writes, the departing point was based on the recognition on two interrelated facts. First, from a basic national accounting perspective the current account is to savings minus investment. Second, since both savings and investment decisions are based on intertemporal factors - such as life cycle considerations and expected returns on investment projects, the current account is necessarily an intertemporal phenomenon. The Balance of Payments (BOP) is an account of all transactions between one country and all other countries - transactions that are measured in terms of receipts and payments. A country's international transactions can be grouped into three categories: Current account: records net flow of money into a country resulting from trade in goods and services and transfer payments made from abroad. The current account itself comprises of 3 accounts: trade account, income account and transfers account. A trade deficit (or surplus) arises when there is a deficit (or surplus) in the balance of trade. Capital account: records net flow of money from purchases and sales of assets such as stocks, bonds and land. Capital account equals: + Exports Imports Increase of owned assets abroad + Increase of foreign-owned assets in the country (Money coming in (+), or leaving () here) Reserve account: Official reserve account includes official gold reserves, foreign exchange reserves, strategic defense reserves or SDRs (e.g. Strategic Petroleum Reserve) and IMF reserves. A country will have a negative balance of payments (i.e., there is to be a net flow of money out of the country) if the net of the current account and the capital account is a deficit. Similarly, there will be a positive balance of payments (i.e., a net flow of money into a country) if the net of the current and the capital account results in a surplus. Nevertheless current account reversals are quite common and, even if they do not always lead to crises, they are costly. Moreover, the evidence presented here suggests that, for some regions, a higher CA deficit will increase the probability of a currency crisis. When it is talked about most, the current account will be either in large surplus (export receipts exceeding import payments) or substantial deficit (import payments exceeding export receipts). Generally it is a significant current account deficit (rather than a surplus) that is perceived to be a problem requiring action, but the current (trading) and capital (largely financial) accounts are inter-related and a persistent capital surplus can cause a current account deficit by raising the exchange rate above the level it would otherwise reach. Faced with such a deficit, a country can take one or more of the following steps: It can seek to increase exports and reduce imports: it can seek to achieve this either by a devaluation or by the imposition of import tariffs or export subsidies - both of which are excluded under GATT rules It can seek to promote the domestic production of previously imported goods - again usually via a protective tariff. A country can seek to reduce the pressure of domestic demands - and thus reduce imports and increase exports via restrictive monetary (and fiscal) policies - it is so-called stabilization. Finally, it may turn to the IMF (and/or the World Bank) for assistance. Since such assistance is usually given on some condition. Since it involves agreement to modify domestic economic policy, so turning to the IMF is usually a last resort. In this case creditor country (or organization) restricts free trade with protectionism in which barriers to imports (tariffs and quotas) are established in order to protect their industries from foreign competition. Government regulations also protect the environment and the country's workers. The governments of the MDCs subsidize agriculture so much that farmers in the LDCs cannot compete. They do so because they are democracies and eliminating farm subsidies is to commit political suicide. 2. Causes of the Crisis There were a number of interrelated reasons for the debt crisis in the LDCs. Firstly, in the late 1970s developing countries had maturing credit liabilities, which their governments could not serve. Instead they were taking new credits to serve amount and interest of previously credits. But at that time way of lending by international banks has changed from long term to short term. Secondly, commodity prices decreased by 30%, that reduced income from export in the LDCs. Collapse in export earnings was a result of the slump in economic activity in developed world as a consequence of the global recession. Thirdly, in the late 1970s, oil prices remained low and real interest rates too were low or negative. LDCs were able to meet their debt-service obligations. But in 1979, the second OPEC price rise raised the cost of energy to LDCs. Also, sharp increase in interest rates was a result of the stabilization policies adopted by developed economies to cope with domestic inflation. Interest rate rose by 17%, so debt doubled every 4 years. Finally, developing countries lost confidence of international banks, so in 1980's lending was reduced. In addition, many LDCs also witnessed enormous capital flight. Because many of these countries' economies were then dependent on commercial bank financing, continued debt rescheduling and the resulting perception of uncreditworthiness led to a "lost decade" of economic stagnation, during which voluntary international credit and capital flows to these nations and their private sectors all but halted. 3. Crisis Adjustment In the early 1980s 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 (IMF). 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 and social services, 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 poor are most affected. The number of the poor in LDCs was growing, "Despite repeated promises of poverty reduction made over the last decade of the twentieth century, the actual number of people living in poverty has actually increased by almost 100 million. This occurred at the same time that total world income increased by an average of 2.5 percent annually." (Stiglitz, 2002, p.5) Faced with the rapidly increasing crisis, LDCs had two options. Either they could have attempted to curtail imports through restrictive monetary and fiscal policies, thus impeding their attempts to develop. Or they could attempt to finance their widening deficits through more external borrowing - with the objective of growing out of the crisis. Most countries adopted the second policy - often for domestic political reasons. But such a response was unsustainable. As a result financial transfers from developed to developing world declined and even turned negative in 1983-84. Therefore more and more countries were forced to turn to the IMF or the World Bank for assistance. The IMF typically offered financial assistance to such countries conditional on the government adopting a so-called stabilization program. It does this by using a "one size fits all" (Stiglitz. 2002) kind of process, in the mind set that the economic situation. Poverty has to get really worse, before it can get better. The four components of a typical stabilization programme are: 1. Removing tariff protections and increasing exports, to try and devalue the official foreign exchange rate. 2. Reduction in the exchange rate. The value of the pound would not be as strong in comparison to the value of other currencies. This would be so as to reduce demand for foreign imports, because they would be more expensive comparatively. 3. A stringent domestic anti-inflation program, consisting of: a) Less bank credit, raising interest rates, to control for inflation and attract foreign investment. This would increase the likelihood of bankruptcy, corruption and a worsening of the economic situation. b) Control of budget deficit, often through drastic reduction in Government spending, which proves to hit the lower to middle income people particularly. c) Either Control of wage increases or wage reduction; d) Dismantling various price controls and ensuring a freer market so big business can go to town exploiting the poor even further. 4. Encouragements of foreign investment, opening up the economy to international trade so multi-national corporations can crush them and developed country governments. Given that an IMF program is in place, countries have found it possible to restructure their debt deferring repayment or agreeing debt-for-equity swaps or other such arrangements. It is not clear that this has resolved the debt crisis since the loans will still have to be repaid sometime. Further, debt-for-equity swaps have placed (or run the risk of placing) much of the assets of third world countries in foreign hands creating a hostage for future economic nationalists to hold to ransom. For years the World Bank and IMF loaned money to LDCs and looked the other way as these countries practiced policies that the Bank now wisely criticizes. By allowing the LDC governments to avoid for so long the consequences of their actions, these policies continued and economic reform was impeded. The new World Development Report therefore is a welcome sign that the World Bank not only understands the disastrous mistakes of LDC financial policy but also has learned that lending to countries even as they continue such practices only throws good money after bad. Conclusion As it was reflected in both money-center bank equity prices and corporate bond ratings, the market apparently did not perceive a problem until the crisis actually broke out. Regulator's attempts to urge banks to limit LDC lending appeared to have had no significant effect on lending practices, even as evidence suggested that Latin American nations were having increasing difficulty meeting current debt obligations. The regulatory system therefore broke down and was unable to forecast the crisis. Finally, the realization that banks would not recover the full principal value of existing loans turned international efforts from debt rescheduling relief, and substantial funds were raised through the IMF and the World Bank to facilitate debt reduction. The shareholders of the world's largest banks assumed the losses under the Brady Plan, which ended the crisis after a decade of negotiations. The experience of lesser developed countries, as reflected in the regulators' handling of large banks after the crisis erupted, illustrates the high priority given by banking authorities to maintaining stability in the banking system. It also represents a case of regulatory tolerance with respect to certain supervisory rules and standards. In the 1979 interpretation of the loans-to-one-borrower rule allowed banks to continue lending, and the delay in recognizing loan losses avoided the effects that could have threatened the bank's solvency. Over time control and tolerance proved to be successful, however because loss reserves and charge-offs were greatly increased and no money-center bank failed because of LDC lending. References Edwards, S. (2000). Does the current account matter University of California, Los Angeles and National Bureau of Economic Research http://www.anderson.ucla.edu/documents/areas/fac/finance/currentaccount5.pdf Federal Deposit Insurance Corporation (2002). History of the 80s. Vol.1, Part 2, Section 5. http://www.fdic.gov/bank/historical/history/vol1.html Stambuli P.K. (1998). Causes and consequences of the 1982 Third World Debt Crisis. Pre-doctoral Research Paper. Department of Economics, University of Surrey, Guilford, UK http://econwpa.wustl.edu:8089/eps/if/papers/0211/0211005.pdf Stiglitz, J.E. (2003). Globalization and Its Discontents. W. W. Norton & Company; 1st edition Read More