Latin American Debt Crisis of the 1980s

1982–1989

During the 1980s—a period often referred to as the "lost decade"—many Latin American countries
were unable to service their foreign debt.

by Jocelyn Sims, Federal Reserve Bank of Chicago, and Jessie Romero, Federal Reserve Bank of
Richmond

Sections

 The Origins of the Debt Crisis

 Working Toward a Resolution: IMF and Central Bank Involvement
 Lessons Learned

During the Latin American debt crisis of the 1980s—a period often referred to as the “lost
decade”—many Latin American countries became unable to service their foreign debt. The
Federal Reserve and other international institutions responded to the crisis with a number of
actions that ultimately helped alleviate the situation, albeit with some unintended
consequences.

The Origins of the Debt Crisis

During the 1970s, two large oil price shocks created current account deficits in many Latin
American countries. At the same time, these shocks created current account surpluses
among oil-exporting countries. With the encouragement of the US government, large US
money-center banks were willing intermediaries between the two groups, providing the
exporting countries with a safe, liquid place for their funds and then lending those funds to
Latin America (FDIC 1997).1

Latin American borrowing from US commercial banks and other creditors increased
dramatically during the 1970s. At the end of 1970, total outstanding debt from all sources
totaled only $29 billion, but by the end of 1978, that number had skyrocketed to $159 billion.
By 1982, the debt level reached $327 billion (FDIC 1997).

The potential risk of the growing involvement of US banks in Latin American and other less-
developed country (LDC) debt didn’t go unnoticed. 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).

The near-zero real rates of interest on short-term loans along with world economic expansion
made this situation tenable in the early part of the 1970s. By late in the decade, however, the
priority of the industrialized world was lowering inflation, which led to a tightening of monetary
policy in the United States and Europe. Nominal interest rates rose globally, and in 1981 the
world economy entered a recession. At the same time, commercial banks began to shorten
re-payment periods and charge higher interest rates for loans. The Latin American countries
soon found their debt burdens unsustainable (Devlin and Ffrench-Davis 1995).

The spark for the crisis occurred in August 1982, when Mexican Finance Minister Jesús Silva
Herzog informed the Federal Reserve chairman, the US Treasury secretary, and the
International Monetary Fund (IMF) managing director that Mexico would no longer be able to
service its debt, which at that point totaled $80 billion. Other countries quickly followed suit.
Ultimately, sixteen Latin American countries rescheduled their debts, as well as eleven LDCs
in other parts of the world (FDIC 1997).

In response, many banks stopped new overseas lending and tried to collect on and
restructure existing loan portfolios. The abrupt cut-off in bank financing plunged many Latin
American countries into deep recession and laid bare the shortcomings of previous economic
policies, described by former Federal Reserve Governor Roger W. Ferguson, Jr. as based on
“high domestic consumption, heavy borrowing from abroad, unsustainable currency levels,
and excessive intervention by government into the economy” (Ferguson 1999).

Working Toward a Resolution: IMF and Central Bank Involvement

As transcripts from the July 1982 Federal Open Market Committee (FOMC) meeting illustrate,
committee members felt it was necessary to take action (FOMC 1982). In August, the Fed
convened an emergency meeting of central bankers from around the world to provide a bridge
loan to Mexico. Fed officials also encouraged US banks to participate in a program to
reschedule Mexico’s loans (Aggarwal 2000).

As the crisis spread beyond Mexico, the United States took the lead in organizing an
“international lender of last resort,” a cooperative rescue effort among commercial banks,
central banks, and the IMF. Under the program, commercial banks agreed to restructure the
countries’ debt, and the IMF and other official agencies lent the LDCs sufficient funds to pay
the interest, but not principal, on their loans. In return, the LDCs agreed to undertake
structural reforms of their economies and to eliminate budget deficits. The hope was that
these reforms would enable the LDCs to increase exports and generate the trade surpluses
and dollars necessary to pay down their external debt (Devlin and Ffrench-Davis 1995).

Although this program averted an immediate crisis, it allowed the problem to fester. Instead of
eliminating subsidies to state-owned enterprises, many LDC countries instead cut spending
on infrastructure, health, and education, and froze wages or laid off state employees. The
result was high unemployment, steep declines in per capita income, and stagnant or negative
growth—hence the term the “lost decade” (Carrasco 1999).

US banking regulators allowed lenders to delay recognizing the full extent of the losses on
LDC lending in their loan loss provisions. This forbearance reflected a belief that had the
losses been fully recognized, the banks would have been deemed insolvent and faced
increased funding costs. After several years of negotiations with the debtor countries,
however, it became clear that most of the loans would not be repaid, and banks began to
establish loan loss provisions for their LDC debt. The first was Citibank, which in 1987
established a $3.3 billion loss provision, more than 30 percent of its total LDC exposure.
Other banks quickly followed Citibank’s example (FDIC 1997).

By 1989, it was also clear to the US government that the debtor nations could not repay their
loans, at least not while also rekindling economic growth. Secretary of the Treasury Nicholas
Brady thus proposed a plan that established permanent reductions in loan principal and
existing debt-servicing obligations. Between 1989 and 1994, private lenders forgave $61
billion in loans, about one third of the total outstanding debt. In exchange, the eighteen
countries that signed on to the Brady plan agreed to domestic economic reforms that would
enable them to service their remaining debt (FDIC 1997). Still, it would be years before the
scars of the 1980s began to fade.

Lessons Learned

Despite the many warning signs that the LDCs’ debt level was unsustainable and that US
banks were overexposed to that debt, market participants did not seem to recognize the
problem until it had already erupted. The result was a crisis that required a decade of
negotiations and multiple attempts at debt rescheduling to resolve, at considerable cost to the
citizens of Latin America and other LDC countries.

In the United States, the chief concern was the soundness and solvency of the financial
system. To that end, regulators weakened regulatory standards for large banks exposed to
LDC debt to prevent them from becoming insolvent. On one hand, this regulatory forbearance
was effective at forestalling a panic. On the other hand, forbearance allowed large banks to
avoid the consequences of their prior lending decisions (albeit decisions that were to some
extent officially encouraged in the mid-1970s). But allowing those institutions to delay the
recognition of losses set a precedent that may have weakened market discipline and
encouraged excess risk-taking in subsequent decades.