Latin American debt crisis

The Latin American debt crisis was a financial crisis in the early 1980s, when Latin American countries reached a point where their foreign debt exceeded their earning power and they were not able to repay it.

Background
The origin of the debt crisis lay partly in the international expansion of U.S. banking organizations during the 1950s and 1960s in conjunction with the rapid growth in the world economy, including the Third World countries. Their growth generated new U.S. corporate investment in these markets, and the international banks followed. This multinationalism in providing financial services contributed to the emergence of a new international financial system, the Eurodollar market, which gave U.S. banks access to funds with which they could undertake Third World loans on a large scale.

The sharp rise in crude oil prices that began in 1973 and continued for almost a decade accelerated this expansion in lending. In addition to generating inflationary pressures around the industrial world, these price movements caused serious balance of payments problems for developing nations by raising the cost of oil and of imported goods. Developing countries needed to finance these deficits, and many began to borrow large sums from banks on the international capital markets. The oil price rise also increased the quantity of funds for oil-exporting countries, thereby fueling the lending boom. In addition to having those effects, the rise of oil prices helped to bring on the world recession of 1974-75, which would eventually produce a decline in world commodity prices for minerals and agricultural goods, thereby further exacerbating the developing countries' debt burden.

In Latin America borrowing had increased steadily in the early 1970s, and after the 1973 oil embargo it escalated significantly. As of year-end 1970, total outstanding debt from all sources amounted to only approximately $29 billion. By year-end 1978, it had risen to approximately $159 billion - an annual compound growth rate of almost 24 percent. It was estimated that approximately 80 percent of this debt was sovereign. The range in the annual growth rate of outstandings went from a low of 12 percent for Argentina to a high of 42 percent for Venezuela. In absolute terms, however, Mexico and Brazil accounted for approximately $89 billion, or more than half of the total outstanding debt as of December 31, 1978.

The typical loan of these countries consisted of a syndicated medium- to long-term credit priced with a floating-rate contract. The variable rate was tied to the London Interbank Offering Rate (LIBOR), which repriced approximately every six months. It was estimated that approximately two-thirds of outstanding developing-country debt was tied to floating LIBOR rates. Thus, these credits were especially vulnerable to repricing risk driven by changes in the macroeconomic conditions of the creditor nations.

The largest portion of Latin American claims originated from U.S. banking organizations, primarily the money-center banks, which specialized in managing large syndicated Eurodollar loans. Their lending increased rapidly in the 1970s, and the eight largest money-center banks by year-end of 1978 held approximately $36 billion in outstanding credits to Latin America.

During the late 1970s, the signs of impending crisis began to become clearer and were more widely recognized. Capital flight was taking place because of fears of devaluation and added to liquidity problems. Nevertheless, Latin American nations continued their heavy borrowing during these years. Between the start of 1979 and the end of 1982 total Latin American debt more than doubled, increasing from $159 billion to $327 billion.

The crisis
The record-high interest rates of the early 1980s, caused by the Federal Reserve's efforts to curb the oil-based inflation of the 1970s, brought on a global recession and helped to trigger the overall crisis. Because most Third World credits were priced to LIBOR rates, debt-service costs grew progressively greater as these rates reached record levels. This situation, coupled with the slowdown in world growth and the drop in commodity prices for the second time in eight years, left exports stagnant and debt-service commitments hard to meet.

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 International Monetary Fund (IMF) managing director that Mexico would be unable to meet its August 16 obligation to service an $80 billion debt (mainly dollar denominated). The situation continued to worsen, and by October 1983, 27 countries owing $239 billion had rescheduled their debts to banks or were in the process of doing so. Others would soon follow. Sixteen of the nations were from Latin America, and the four largest - Mexico, Brazil, Venezuela, and Argentina - owed various commercial banks $176 billion. Roughly $37 billion was owed to the eight largest U.S. banks. As a consequence, several of the world's largest banks faced the prospect of major loan defaults and failure.

For the remainder of the decade bank lending declined significantly, as many banks refrained from new overseas lending and attempted to collect on and restructure existing loan portfolios. From the end of 1983 to 1989, money-center bank loans outstanding to Latin America decreased from $56 billion to $44 billion, a decline of more than 20 percent.

Unlike some European regulatory authorities, immediately after the Mexican crisis U.S. banking officials did not require that large reserves be set aside on the restructured loans or on the succeeding arrearages by other nations. Such a policy was not seen as feasible at the time and might have caused a financial panic because seven or eight of the ten largest banks in the U.S. might have been deemed insolvent. During this period no large U.S. banks failed because of delinquent or nonperforming loans.

The creation of a plan in 1989 by Nicholas Brady, secretary of the treasury in the Bush administration, was a recognition by the U.S. government that troubled debtors could not fully service their debts and restore growth at the same time; the plan therefore sought permanent reductions in principal and existing debt-servicing obligations. This recognition paved the way for negotiations between the creditor banks and debtor nations to shift primary focus from debt reschedulings to debt relief. As part of the process, substantial funds were raised from the IMF, the World Bank, and other sources to facilitate debt reduction. To qualify for borrowing privileges, debtor countries had to agree to introduce economic reforms within their domestic economies in order to promote growth and enhance debt-servicing capacity. It is estimated that under the Brady Plan agreements between 1989 and 1994, the forgiveness of existing debts by private lenders amounted to approximately 32 percent of the $191 billion in outstanding loans, or approximately $61 billion for the 18 nations that negotiated Brady Plan reductions. These losses accrued primarily to the shareholders of lending banks.