1. NS4540 Winter Term 2019 Latin American Debt Crisis and the Lost Decade
Amendarlz and Larrain Chapter 4

2. Overview I
After the defaults of the Great Depression, Latin America not able to return to the international capital markets for four decades
During the 1970s, Latin America could borrow again and borrowed quite heavily
These sovereign loans were defaulted upon in the 1980s
Some similarity between defaults in the 1930s and the 1980s.
In both cases contributing factors were
Macroeconomic policies and
Negative shocks in main financial centers of industrialized nations

3. Overview II
Sovereign defaults of the 1930s were largely due to the Great Depression started in the U.S.
Those in the 1980s due to
Sudden change in the world macroeconomic environment
Sharp interest rate changes and
Falling export revenues resulting from industrialized countries’ recessions
Compared with the 20th century defaults, Latin America much less affected by recent 21st century financial crisis also starting in the U.S.

4. Overview III Key questions
How vulnerable is contemporary Latin America to a sudden change in the world macroeconomy
What will be the long-term effects on Latin America of the recent slowdown in China

5. Background I
Typically 19th century loans contracted after 1824 (Monroe Doctrine) were
Long term bonds sold in London
Had a thirty-year maturity period
Contracted at an approximate 6.5% risk premium
High element of risk on Latin American bonds:
Return on relatively safe British bonds was 3% per annum
Return on Latin American bonds was approximately 9.5%

6. Background II Debt renegotiations were not new
Most Latin American countries defaulted on their nineteenth-century bonds because of
Political instability and
Internal wars
Defaults were negotiated on a case by case basis
Foreign creditors often lost up to 50% on face value of their loans
Remaining sovereign debt was repaid at a considerably lower interest rate

7. Background III
Once Latin American countries had repaid their restructured debts, they were able to return to the international capital markets
Most borrowed heavily during
Unlike previous loans which were used to finance internal wars, these were mostly used to investment in infrastructure.
Railway construction to connect hinterlands with seaports was often prioritized
Investments short-lived due to the outbreak of WWI in 1914
Major trade disruptions prompted a vast majority of Latin American countries to default on their foreign debt

8. Background IV
Latin America subsequently could borrow in the 1920s in the United States
Simultaneously all 1870 to 1914 were partially renegotiated -- led by the U.S. Department of State.
However restructured foreign obligations were defaulted upon at the onset of the Great Depression in 1929
Still some Latin American countries successfully negotiated sharp debt reductions.

9. 1930s Debt Crisis I Previous debt restructurings in the early 1920s
Involved debt reductions of up to 70% with
The remaining debt to be repaid at considerably lower interest rates.
Still foreign debt to export ratios grew from 1.4 in 1926 to 4.5 in 1932.
Only Costa Rica and Brazil agreed to renegotiations in the 1930s
Outbreak of WWII made it impossible for other Latin American countries to sign similar statements
Export surpluses during World War II enabled Latin American nations to renegotiate permanent repayments on restructured debt.

10. 1930s Debt Crisis II
Much debt was resolved by bondholders accepting offers from sovereign county borrowers involving debt reductions.
By 1957 only 11% of the total outstanding Latin American foreign debt remained in default
Most Latin American countries had a great deal of bargaining power
Due to multiplicity of foreign creditors/bondholders acting in uncoordinated manner
Chile, Colombia and Mexico – extended take-it-or-leave-it offers to their creditors. Bondholders accepted

11. 1930s Debt Crisis III
Not until the 1970s that Latin America could come back to the international capital markets
Much needed investments in infrastructure projects were delayed or staled as a result.
This was one of the most severe legacies of the Great Depression debt crisis on Latin America.
After WWII the World Bank and other multilateral institutions extended long-term loans for infrastructure, but the volume of such loans was comparatively small
At first the World Bank more involved with reconstruction of Europe

12. The 1980s Debt Crisis I
Onset of the debt crisis --- August 1982 when Mexico declared a moratorium on the servicing of external obligations.
Nature of sovereign obligations had changed from earlier crisis
Owners of most Latin American debt were mostly a dozen commercial banks in the industrialized world.
Mexican announcement there threatened the world financial system and
Marked the beginning of a decade of crisis for Latin America

13. The 1980s Debt Crisis II
Causes of the crisis are now understood. They fall into three categories
The oil shocks of the 1970s,
The sudden changes in the world macroeconomy in the early 1980s; and
The inappropriate policies the borrowing countries that had taken a protectionist stand under ISI
The connection between the oil shocks and debt accumulation of the 1970s in the markets for loans has supply and demand explanations.
On the supply side the oil price spikes of 1973 and 1979 caused current account surpluses in the oil producing countries -- petrodollars.

14. The 1980s Debt Crisis III
Petrodollars made available for financial intermediation by the industrialized countries’ commercial banks
On demand side, Latin American countries
Eager to borrow at low interest rates.
Non-oil exporters borrowed for consumption smoothing reasons – had been hard hit by oil price prices
As had occurred in 1930s abrupt changes in international macroeconomic environment in early 1980s
Latin America experienced
Sudden increase in interest rates due to tight monetary policy in the US -- much of the debt serviced by borrowing
A rapid fall in export revenues due to world’s 1980s recession.

15. The 1980s Debt Crisis IV
Two effects combined – higher interest rates and lower export revenues had a drastic impact on debt service costs of foreign – currency denominated debt.
Some Latin American countries more vulnerable than others.
Mexico and Venezuela had a higher percentage of their foreign debts contracted at “floating” or variable rates.
Interest payments to exports ratios were highest in Brazil and Chile because they had high debt to export ratios at the start of the crisis
These two countries also defaulted on their external obligations in the early 1980s.

16. The 1980s Debt Crisis V
The only major country that did not default was Colombia
The recession in the early 1980s evolved into a slow recovery but the 1980s are often called the “lost decade.”
In 1990 Latin America’s per capita GDP relative to that of
high income economies was 9% lower than in 1980, and
23% lower relative to the world average
Capital inflows during Latin America’s lost decade were half those of the previous decade.

17. The 1980s Debt Crisis VI
1980s debt crisis came to an end in the early 1990s when most countries in Latin America
Embraced market-oriented reforms and
Signed permanent agreements involving debt restructuring with a consortium of commercial banks
The IMF acted as the coordinating agency for debt rescheduling.
Debt resolutions involved
Debt rescheduling or
Postponed repayments at a reduced face value under the so- called Brady Plan – a debt forgiveness program.

18. The 1980s Debt Crisis VII
In parallel, a large number of countries bought back their debts at recued market prices via various schemes
direct buybacks to
debt-for-equity swaps.

19. Another Wave of Crisis I
One of the main legacies of the lost decade was a series of structural reforms.
These reforms swept the region with a wave of globalization characterized by growing
Trade flows,
Increased capital flows,
Technology transfer and
Private sector crowding in via mass privatization and deregulation
Once Latin American countries had returned to foreign borrowing in the early 1990s, the region simultaneously attempted to consolidate price stabilization via maintaining fixed or semifixed exchange rate systems.

20. Another Wave of Crisis II
Mexico – in the 1990s
Went through a period of
Massive privatization of large, small, and medium state-owned enterprises (SOEs) and
Deregulation
Trade liberalization
As part of trade liberalization joined NAFTA with the U.S. and Canada
Country had finalized debt-restructuring agreements with its foreign creditors.

21. Another Wave of Crisis III
As of 1991, foreign inflows had increased steadily
Mainly FDI and portfolio flows.
Much of these flows were foreign currency denominated debts to finance private firms’ expansion
Capital inflows found their way into the newly privatized banking sector – lacked adequate prudential regulation.
Prudential regulation needed to:
ensure government agencies protect the stability of the financial system and depositors.
limit risk taking and/or
setting limits on debt/equity ratios

22. Another Wave of Crisis IV
In Mexico and many other Latin American countries at the time prudential regulation was impaired
Weak accounting standards
Poor quality of financial information and
Severe shortages of qualified professionals who could assess risk.
Massive capital inflows and a weekly supervised banking system created considerable risk
NAFTA prospects increased capital inflows putting pressure on the country’s fixed exchange rate
The exchange rate became overvalued as inflation picked up

23. Another Wave of Crisis V
Overvalued exchange rate and a series of domestic events
Political unrest in Chiapas,
Assassination of PRI Presidential candidate
Caused
A run on the country’s foreign exchange reserves
Mexican peso had a sharp devaluation
Recently privatized banks became insolvent – most had to be liquidated and
Many taken over by foreign banks.

24. Another Wave of Crisis VI
Brazil
Brazil also enacted a series of market-friendly reforms
Under President Cardoso in 1994 Brazil
Tried to limit inflation with a crawling peg exchange rate system
Central Bank issued a new real and
High interest rates
All helped attract large inflows of FDI
Stabilization efforts successful
Inflation came down from 5,000% in 1994 to 1.7% in 1998

25. Another Wave of Crisis VII
However current account deficit remained high
Foreign reserves dropped considerably from to sustain an overvalued currency
Eventually investors lost confidence
Despite IMF efforts to sustain the value of the currency, Brazil suffered a major depreciation of its currency through reserve outflow
The new real depreciated by about 66%

26. Another Wave of Crisis VIII
Argentina also engaged in a series of market-friendly economic reforms.
In 1991 under Carlos Menem and Domingo Cavalo government established a currency board – fixed exchange rate system.
Principal objective of currency board was to lower inflation and keep it under control.
Inflation brought down from 3,000 in 1989 to 3.4% in 1994
System resisted contagion from
Mexican Tequila crisis (1994)
East Asian Crisis (1997),
Russian crisis (1998) and
Brazil crisis (1999)

27. Another Wave of Crisis IX
However GDP started to contract in 1999 with steep declines in investment and exports
Current account deficit experienced major deterioration.
Convertibility system collapsed in 2001.
Argentina peso depreciated by nearly 80%
Legacy of crisis drastic in terms of
GDP growth
Inflation,
Rampant unemployment and
Political instability

28. Another Wave of Crisis X
Causes of the crisis
In 1999
Investors feared that Argentine debt, which had been denominated in convertible pesos (and therefore dollars) could not be serviced
Export growth meager and
Argentine central bank lacked the reserves necessary to sustain convertibility
Foreign and domestic debts denominated in convertible Argentine pesos could not be honored in dollars
Central bank experienced a run on its foreign reserves
Could not prevent capital outflows and system collapsed.

29. Another Wave of Crisis XI
When compared with the 1980s debt crisis the crises in Mexico, Brazil and Argentina share four common characteristics
First there were fixed or semifixed exchange rate policies aimed at lowering and controlling inflation
Second governments were unable to control spiraling fiscal and current account deficits
Third two of the three crises were relatively short-lived in comparison to those of the Great Depression and the one in the 1980s
Economic recovery took about two years to revert to pre-crisis GDP levels
Full recovery to pre-crisis levels in Argentina took over six years.

30. Another Wave of Crisis XII
Fourth, contagion became evident
In an increasingly globalized world economy, emerging market economies were becoming more vulnerable to crises in similar low and middle income countries.

31. 21st Century Financial Crises I
21st century crisis include:
Dot-com crisis in the early 2000 and
The subprime crisis from
Dot-com crisis triggered by a spectacular appetite for investment in internet based start-ups.
When dot-com bubble burst in 2001 investors turned to mortgage-backed securities
When housing prices collapsed, the world’s financial system was severely shaken.

32. 21st Century Financial Crises II
Both crisis could be blamed on low
Interest rates, and
Low inflation rate environment of the 1990s and beyond
Declining trend in interest rates blamed on increases savings in emerging market economies particularly China.
China’s high savings a result of high and sustained Chinese economic growth
Another cause, the steady decline in investment in industrialized countries due to recessionary trends in these countries.

33. 21st Century Financial Crises III
Against this backdrop, Latin America’s economic performance has improved since 2004
From 1961 to 2008 the world average growth was 3.2% whereas Latin America expanded by 2.7%
If Latin America were to catch up, it would need to have far greater per annum GDP growth than the industrialized countries
Instead it was about 0.5% lower.
Relative to industrializing Asia, comparison is considerably worse
In the early 1960s Latin America’s per capita income was almost double that of Asia
By 2006 per capita income in Latin America one third that of Asia counterparts.

34. 21st Century Financial Crises IV
Latin America’s poor per performance relative to Asia largely due to low productivity throughout the region
Latin America has been largely unaffected by the 21st financial crisis because of steady growth in Asia, largely China
Chinese growth has increased Latin America’s terms of trade to unprecedented levels
The extraordinary growth of Latin American primary commodity exports has had a positive impact on region’s current account
Moved from an average deficit of 4.1% of GDP in 1998 to a surplus of 2.0% in 2006.

35. 21st Century Financial Crises V
However by 2013 Latin America had a current account deficit nearing 3.0% of GDP – largely due to a fall in the region’s gross domestic savings
Another by-product of the Chinese growth spurt is reflected in Latin American public finances
Both taxation and financial surpluses from SOEs are up.
External debt burdens have decreased considerably
Inflation rates have decreased from hundreds and thousands percentage points in the early 1990s to an average of 7.0% in 2013

36. 21st Century Financial Crises VI
However China’s recent deceleration is a major test for Latin America
It has already been felt in significant declines in
Commodity prices
Growth rates and
Fiscal balances
And Latin America’s slowdown can make some countries insolvent
In case of Venezuela, China’s investments and loans are estimated to be about $70 billion
Doubtful that this debt can be serviced.

37. Conclusions I
Latin American economies are still vulnerable to external events.
Impact of a significant slowdown in China’s growth rate has been devastating
Mostly because Latin America has not yet capitalized on the export-boom opportunity it enjoyed from 2004 until 2013 – to diversify production and exports away from primary commodities
On contrary growing demand for primary commodities has exacerbated Latin American reliance on natural resource exploitation
Productivity growth is still stagnant.

38. Conclusions II
Still market based reforms in aftermath of second debt crisis in 1980 opened the scope for more productive public and private sectors.
In the 21st century revenues of the most recent commodity boom have trickled down
A strong middle class has emerged
Latin American governments have been able to finance anti-poverty campaigns
These have mitigated to some extent the historical legacy and persistence of income inequalities.