HITESH PATEL asked:


1. Introduction

The debt crisis and loan defaults have been a constant feature of the global economy, the present size of the world debt problem overwhelms the imagination. It is clear that the countries in the Third World are in an inherently disadvantageous position. As primary exporters, they are at the mercy of price and demand fluctuations in international markets. These fluctuations are beyond the sellers’ control as they reflect the economic health of client industries in the West.

The total world debt soared from approximately $100 billion in the early 1970s to nearly $900 billion dollars by the mid-1980s. Time Magazine stated, “Never in history have so many nations owed so much money with so little promise of repayment” .

This paper will explain the “origins” of the debt crisis problem and re-assess in detail the causes of the debt problem, and question whether the Third World Debt Crisis was a crisis of debt (i.e. the fault of the developing countries) or of credit (i.e. irresponsible lending by banks).

2. The “origins” of the Debt Crisis problem

There are so many books and articles that provide detailed descriptions to the origins of the debt problem . However in my opinion, the global debt problem stems from two periods:

• In particular, the forces dating to the mid-1970s, and the first oil price shock (1973-74)

• The beginning of the Reagan Administration

2. (A). The mid-1970s and the first oil price shock

The period 1974-80, played a huge part to the debt crisis, which can summarised as follows:

Firstly the most important oil-exporting countries, (not being able to utilise domestically the vast financial surpluses generated by oil price increases), made huge deposits in various financial institutions.

Secondly, at the same time, a good number of middle and high income oil exporting nations (especially those with a higher degree of industrialisation) decided to accelerate their rates of economic growth, not withstanding the increase in oil prices. That policy contrasted sharply with the “stagflation” situation prevailing in the OECD countries.

Thirdly, in order to carry out their economic expansion policies, many developing countries requested huge loans from OECD commercial banks, (in the form of Euro-dollars ), so they are able to make massive imports of all kinds of goods, (apart from oil: in particular chemical products, foodstuffs and capital goods).

Following upon this point, the OECD banks, with great liquidity and a weak domestic demand for funds started a wild competition to export capital to the more dynamic of the less-developed countries (LDC). This is a very critical moment, as for that very moment, the LDCs decided to apply to the international private banking system to obtain the money required to implement their expansive economic policies.

Finally, in order to decrease the risks of those operations, the international private banks, decided to “change the terms and conditions of the loans” shifting from the fixed of interest that had prevailed until then, to variable rates. The borrowing nations accepted such changes under the influence of the aggressive marketing techniques employed by the banks. This included attractive offers that appeared to be to the borrowing nation’s benefit, without realising the grave harm that they would suffer in the future. What appeared in the beginning appeared as a mere technical innovation that came to be a real trap, since any increase in the interest rate would apply to the total outstanding debt.

2. (B). The Reagan Administration

The second period started shortly after the Reagan Administration in the USA (January 1981). During this period, the situation of the mid-1970s changed completely. Alongside a world economic recession, inflation became increasingly intense in the US and other industrial nations, and rates of interest escalated. The economic recession in the central nations caused a sharp drop in prices of raw materials exported by Third World countries. This was precisely the moment, when the financial charges, due to interest payments became heavier, and when the flow of fresh capital to the Third World began to decrease.

Such was the case in Autumn 1982: Mexico was an oil exporter, (or was at least self-sufficient), declared that it could not repay its debts, and the crisis in Mexico caused the full attention of the entire industrial nations. The crisis became universal, and was followed by 30 other Latin American countries in 1983, (including Brazil and Argentina ). Latin American countries had to compress their imports in order to be able to continue paying their debt services, and for the first time, Latin America became an important “net capital exporter”.

The extreme problem in 1982 derived primarily from the effects of global recession from 1980 to 1982, combined with hostile mental shocks to credit markets caused by events in individual countries. To a traditional economist: “the problem is a consequence of the development from inflation to dis-inflation in the world economy. Funds that were borrowed when inflation was high, and real interest rates were low or negative, are no longer cheap in an environment of lower inflation and high interest rates”.

3. The causes of the Debt Crisis problem

Having examined the growth of debt during the 1970s, and having looked at the circumstances which led to crises for Latin Countries (Mexico in particular) during the early 1980s, the next question to be answered is “why did the debt grow so fast in the 1970s?”

3. (A) The rise in oil prices

One of the most important causes of debt growth was the rise in oil prices in 1973-4 and 1979-80. only a few debtor countries, such as Mexico, Indonesia, Venezuela and Ecuador, benefited from the rise in oil prices. The table below, shows the difference between what was paid for oil and what would have been paid for oil, had its price not increased more than the US inflation rate.

Impact of oil prices on the debt of non-oil developing countries

1973-1982 (billions of US dollars)

YEAR A B A-B

1973 4.8 4.8 0.0

1974 16.1 5.3 10.8

1975 17.3 5.7 11.6

1976 21.3 6.8 14.5

1977 23.8 7.5 16.3

1978 26.0 8.6 17.4

1979 39.0 10.9 28.1

1980 63.2 11.9 51.3

1981 66.7 12.1 54.6

1982 66.7 11.9 54.8

TOTAL 344.9 85.5 259.5

A= Actual cost of oil

B= Cost of oil if its price has not increased beyond US inflation rate

C= Additional cost of oil

The additional increasing cost of oil over the decade was therefore $260 billion. This massive transfer of resources between Third World countries could not have taken place without equally massive borrowing from Western banks.

3. (B) The Western Banks

The Western commercial banks would also have to take some of the blame and were only too happy to lend to sovereign states whose export performance looked promising. Such lending was more profitable than lending in the developed First World markets. The Third World was regarded as a growth area for new lending by Western banks.

The almost unlimited availability of bank loans very often persuaded a process of de-industrialisation. Increased debt led to increased interest payments, which (if the loans were not properly invested), led to further loans. Through these changes, many Third World countries became more vulnerable to developments in the world economy.

If this argument is taken into account, then the Western commercial banks themselves are responsible, for five reasons:

(i). The banks believed that countries could not go bankrupt, and that no real insolvency crisis could occur.

(ii). Many of the loans were organised through a syndicates of banks, and many of the participating banks felt no need for their own “risk assessments”.

(iii). Competition for a share of the market transformed many banks into virtual “loan-pushers”. The two main players being City Bank (US) and Natwest Bank (UK).

(iv). Lending at variable interest rates allowed the banks to transfer the risk associated with inflation to the borrowers.

(v). The absence of effective regulatory bodies in the international financial market made it easier for banks to follow their own short-term interests and instincts in their lending policy, and to ignore the medium and long term effects of their actions.

It must be remembered that in the financial business of lending money, loans are an element of a huge commercial market, where banks struggle for a share of the market. This is socially constructed capitalism in practice.

The intention of lending money to the Third World was a “new concept”, where banks relied on a “handful of simple credit-worthiness indicators”, that were not helpful in forecasting the likelihood of the crisis. Some banks even began to push their customers to accept higher loans, by offering customers more money than they had asked for, and by easing their credit conditions.

Another point to note, is that, the banks also needed to buy time to strengthen their capital base. Banks began to accept the rolling over of debts , the re-scheduling of debt repayments, and the supplying of new money. While agreeing to delay in the repayments of the loans, the banks opposed any reduction in the interest of the loans.

This was the structural weakness of the financial system. Once committed, it was practically impossible for banks to withdraw from the market.

3. (C) Interest Rates and Recession

If higher oil prices set the stage for a heavy debt burden for many countries in the 1970s, the global recession and high interest rates of 1980-82 added sufficiently to the burden indiscreetly.

Borrowers became accustomed to low real interest rates in the 1970s, it made sense to borrow in such conditions. In 1979-80, nominal interest rates were high, (LIBOR – London Interbank Offered rate – averaged 13.2%). Approximately two-thirds of developing country debt is indexed to LIBOR .

However, by 1981-82, inflation fell sharply, but nominal interest rates remained high. This meant very high real interest rates of 7.5% in 1981 and 11% in 1982. It did not make sense to borrow in such conditions, but by then most non-oil developing countries had no choice in the matter. They had to borrow more in order to pay-off old debts, and the interest rates had an immediate effect on debt growth.

Instead in an effort to reduce inflation, some Western Governments increased interest rates and adopted tight fiscal policies. The non-oil developing countries paid the price of that interest rise in 1981-82. For debtors, inflation is a good thing, as it erodes the debt they have to pay off. For creditors, who wanted to reduce inflation, increased interest rates were a worth-while price to pay for lower inflation.

The problem of this policy, was that higher interest rates tended to aggravate the world recession, that began in the 1979-80period. Growth rates in the OECD countries fell from an average of 3.2% during the 1973-9 period, to an average of 1.2% during 1980-81 periods. Falling demand in the OECD countries, especially for primary commodities, was responsible for a fall in export values. Demand for primary commodities is generally inelastic, and one reason being that there was already a surplus capacity in the OECD.

3. (D) The Domestic Policies of the Third World Countries

I must admit that, not all of the blame of the debt crisis should fall on the burden of the Western financial banks. Some blame has to go to the developing countries themselves. Domestic policy errors contributed to the deterioration of the debt situation.

In Mexico, for example, the government allowed the “Peso” to become seriously overvalued, and allowed budget deficits to surge to 16.5% of GNP in 1982, when the presidential election made authorities reluctant to carry out effective budget-cutting measures. The government stuck to a strategy of high growth (8.2% annual growth in 1978-81). The strategy was based on the assumption that oil prices will always keep rising. That probably exceeded capacity growth and failed to take adequate account of the substantial weakening of the oil market in 1981 .

In Brazil, domestic adjustment policies were stronger and indeed contributed to a severe recession that began in 1981 and continued into 1983. Even so, Brazil’s domestic policies bear substantial responsibility for the eventual crisis in 1982. Throughout the 1970s, after the oil shock, Brazil consciously followed a high-risk strategy of pursuing high growth rate based on rapid accumulation of external debt. The resulting legacy of large debt proved to be an oppressive burden when the international economy weakened and exports declined instead of continuing their earlier rapid growth . Matters were made worse by overvaluation the “Cruzeiro” after an ill-fated attempt to bring down domestic inflation by placing a 40% ceiling of devaluation in 1980. nevertheless, in 1981, the government was taking adjustment measures and was considered by the international financial community to be managing the economy well.

In Venezuela and Mexico, policies led to large capital flight abroad. The basic defect was maintenance of an overvalued exchange rate on a fully convertible basis, combined with domestic interest rate policy that failed to provide sufficient attraction to retail capital domestically. As a consequence, in 1982, the decline in Venezuela’s official external assets reached over $8 billion, although on current account its deficit was only $2.2 billion .

Similarly, in Mexico, errors and omissions showed outflows of $8.4 billion in 1981 and $6.6 billion in 1982, and short term capital outflows added $2.1 billion in 1982, for total capital flight of $17 billion . This is almost as much as Mexico had borrowed in the same period.

In Argentina, in 1980 and 1981, errors and omissions and short-term capital outflows registered total capital flight of $11.2 billion. To make things worse, Argentina had a very ineffective stabilisation policy with the collapse of the “Peso”, and extremely high inflation in 1981.

The hostile shock of the credit markets from the Falklands did not help! As this was associated with the mutual freeze of assets, between the United Kingdom and Argentina . Thus, the capital flight has contributed to nearly one-third of total debt in Argentina.

Another problem, with the Third World countries was their long-term development strategies. Such strategies included :

(i). Excessive protection in programs of industrialisation based on import substitution.

(ii). Inadequate pricing of capital

(iii) Over pricing of labour

(iv). Overly ambitious and ineffective development in many developing countries.

The damaging pressures from the global economy have made it more essential that distortions in basic development strategies be corrected. Such long-term developments strategies consequently made their goods less competitive on world markets.

A further problem was the growing reliance on short-term debts. This was very prevalent in Brazil, Mexico, Argentina and Venezuela. In 1982 :

• Brazil’s short-term debt stood at $21.3 billion, (total debt to banks $62.7 billion)

• Mexico’s short-term debt stood at $31.2 billion, (total debt to banks $62.7 billion)

• Argentina’s short-term debt stood at $13.5 billion, (total debt to banks 25.5 billion)

• Venezuela’s short-term debt stood at $15.3 billion, (total debt to banks $26.7 billion)

Over 50% of Mexican and Venezuelan debts to Western banks had maturities of one year or less. The assumption was that such short-term debt facilities would be always available: ye another incorrect assumption.

4. Conclusion

The global debt problem that has emerged in many developing countries in 1982, can be traced to higher oil prices in 1973-74 and 1979-80, high interest rates in 1980-82, declining export prices and volumes associated with global recession 1981-2, and with problems of domestic economic management.

The global debt problem has grown to large dimensions, and in 1981-82 that growth outpaced the growth of exports that sustain the debt. Due to the magnitude of this debt, and the widespread evidence of debt-servicing difficulties, the debt problem currently poses a considerable risk to the security of the international financial system. As, the debt crisis is likely to continue, and be an obstacle on the growth of international trade through lower exports, investment and employment.

ENDNOTES

Time Magazine, 10 January 1984, p42

Robert Gilpin, The Political Economy of International Relations, Prince town University Press, 1987, p317-185

The Economist, Is Anybody Paying, 14 March 1987.

Hitesh Patel has written many articles on the Euro-Dollar market. Further details can be obtained at: http://www.canopychannel.com/index.cfm/fa/member.detail/Customer_ID/358

Mario Marcel and Gabriel Palma, The Debt Crisis: the Third World and the British Banks, Fabian Society, Series number 350, May 1987, p1

IMF, World Economic Outlook and International Finance Statistics (Various issues) at the British Library

Mario Marcel and Gabriel Palma, The Debt Crises: The Third World and the British Banks, Fabian Society, Series number 350. May 1987

IMF International Financial Statistics Yearbook, 1982

William R Cline, “Mexico’s Crisis, The World’s Peril”, Foreign Policy, No 49 (Winter 1982-83), p 107-18

William R Cline, “Brazil’s Aggressive Response to External Shock”, World Inflation and the Developing Countries, William R Cline and Associates, (Washington: Brookings Institution, 1981), p102-35

UN Economic Commission for Latin America, Preliminary Balance of the Latin American Economy in 1982, Santiago, January 1983, p13

M.S. Mendelson, Commercial banks and the Restructuring of Cross-Border Debt, New york: Group of Thirty, 1983, p23

Banco De Mexico, Informe Annual, Mexico City, 1982, p230

IMF, International Financial Statistics, May 1983, p68

Word bank, World Development Report 1983, Part II, Washington, 1983

(Short-term debt data, by country): American Express International banking Corporation, International debt: Banks and the LDCs, AMEX Bank review Special Paper No 10, London (American Express International Banking Corporation), 1984.