Malik Shehryar (20-10845)

The Latin American Debt Crisis

Analysis of Institutions

The decade of late 1970s/early 1980s was often referred to as the “lost decade” for Latin
America, as many Latin American countries were unable to service their foreign debt. A debt
crisis is a situation in which a government loses the ability of paying back its governmental debt.
In other words the foreign debt exceeded the country's earning power.

It started off during the 1970s, when two large oil price shocks created an account deficit in
many Latin American countries, where 16 Latin American countries and 11 other LDCs (Least
developed countries) were affected. Whereas in the oil-exporting countries, it created an account
surplus. With the encouragement of the US government, large US banks were willing to be
intermediaries between the two groups by providing the exporting countries with a safe, liquid
place for their funds and then lending those funds to Latin America. Now most Latin American
countries being importers of oil had to bear a huge increase in their import cost too. Three Latin
American countries: Argentina, Mexico and Brazil, borrowed money from international creditors
with the purpose of undertaking industrial projects of the 1970s. The amount being borrowed
was so high that by the year 1980, the external debt of these countries was almost 50% of their
GDP. As a result the debt service grew at a very high rate as global interest rates elevated,
reaching $66 billion in 1982, up from $12 billion in 1975.Now the risk of the growing
involvement of US banks in Latin American countries didn’t go unnoticed. Still by 1982, nine of
the largest US money-center banks held Latin American debt accounting to 176 percent of their
capital; their total LDC debt was nearly 290 percent of capital.

We might consider the fact that the Latin American countries must have predicted the risk and
the outcome of involving the US banks. In 1977, during a speech at the Columbia University
Graduate School of Business, then-Fed Chairman Arthur Burns criticized commercial banks for
assuming excessive risk in their Third World lending (FDIC 1997). Still, by 1982, the nine
largest US money-center banks held Latin American debt amounting to 176 percent of their
capital; their total LDC debt was nearly 290 percent of capital (Sachs 1988). These countries still
went forward with borrowing the loans because of many economic factors. The loan terms were
favorable at first, they were collateral free with zero interest rates and they had low entry barriers
and a rollover loan term.. Another reason was that they needed the loans to enhance economic
stability and to reduce poverty. The average real GDP growth was 6% in the late 1970s and it
reduced to 4%-5% in the early 1980s. These countries didn’t have a choice, especially after
finding themselves at a breaking point when the oil price skyrocketed; they had to ask for
external help to keep up with the higher oil payments and increased demand. Overall it was
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considered a white elephant project, since it didn’t do much to help the economy; all it did was
attract the interest groups.

The US banks invested in the Latin American countries because at the time, the economy of
these countries was stable and as creditors they felt confident enough to lend them loans for a
number of reasons. As we discussed earlier how the oil importer countries borrowed loans from
these banks, even the oil exporter countries took a huge amount of debt for their economic
development, hoping that the oil prices would stay high long enough for them to pay off their
debt. This new influx from oil exporters proved to be beneficial for these banks; it paved the road
for the banks to expand their services internationally. Growth of the Euro Dollar exchange/trade
gave greater access to the funds. These money centered banks profited so much from this debt
crisis that in the 70s 50% of their surplus came from Latin American sovereign debt.

Later in the decade, the priority of the industrialized world changed to reducing inflation, which
resulted in a strict monetary policy in the United States of America and Europe. The interest
rates grew abnormally to overcome inflation. In July 1980, federal funds rate increased from
10% to 20% which led to the global recession of the economy by 1981. The interest was charged
at much higher rates and the repayment period of the loans was shortened by these commercial
banks. Due to global recession, the output of the economy of these Latin American countries
decreased, which meant that the cost of their exports, which were mainly primary products, was
lowered greatly. This further lowered the demand of the exports of these countries internationally

The crisis was further worsened due to the depletion of foreign exchange reserves which was a
result of aggravation of current account deficit due to a major fall in exports. Another reason was
the massive capital flight where the private sector funneled money out of Latin American
countries in large sums, leaving little to nothing behind. Eventually in august 1982 came the
trigger point, the finance minister of Mexico came public about the fact that Mexico won’t be
able to pay back its debt (which totaled to 80 billion dollars) any time soon and asked for
extension and renewal of policy where a bit of leniency is applied. All the other 16 counties and
the remaining 13 LDCs followed suit and asked for reschedules of debts. Overexposure of the
debt threatened global financial collapse so the banks refused to give any extension to these
countries and with time they became less interested in the Latin American debt and changed their
direction towards local investments which at the time proved to be safer and more profitable.

The short term impact of this crisis on the affected countries was that the countries had no money
left behind to spend on infrastructure; most of the budget set aside was to pay off the debt
services and to invest in export led-industries. The quality of life was also greatly affected amidst
this crisis where the incomes of the people decreased and so did their standard of living, real
wage dropped 10%-20% in the coming ten years after the crisis. The creditors were now more
conscious than ever about lending money to the LDCs because of their inability to pay it back.
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The interest rates for the least developed countries were 4 times higher than the rich countries
which were unfair.

There were several stages of strategies to control and help the countries adjust to the debt crisis.
The United States took it upon itself to help control the crisis by organizing a cooperative rescue
effort by the commercial banks, central banks and the IMF. Under this strategy, the central bank
agreed to restructure the county’s debt while the IMF and other agencies will lend money to the
LDCs to pay back the interest but not the principal on their loans. The 4 stages of adjustment
were as following:

● The IMF austerity (1982-1984) : It offered rescheduling and new lending

● The baker plan (1985-1989) : it offered new lending and pro growth
● The Brady plan (1989) : it offered debt reduction
● HIPC (heavily indebted poor countries) (1996) : debt reduction

There were a set of long term impacts from the debt crisis. The focus on export led industries
was stressed more as they learned from their past experiences that the import substitution
industries are not beneficial for the economy especially in cases of crisis as was advised by the
IMF. Trade liberalization was stressed and the multinational corporations were pushed to set up
production units in countries like Mexico who were suffering a major economic crisis. The
country’s manufacturing sector faced deterioration as the producers opted out for low-cost
facilities overseas. Many of the Mexican laborers lost out to cheaper Asian labor. Greater focus
on free trade resulted in the commodity boom, the rise of emerging markets in developing
countries.