During the Latin American debt crisis of the 1980s—a period often referred to as the “lost decade”—many Latin American countries found themselves unable to service their external debt. The Federal Reserve and other international institutions responded to the crisis with a series of actions that ultimately helped alleviate the situation, albeit with some unintended consequences.
Origins of the debt crisis
In the 1970s, two major oil price hikes led to current account deficits in many Latin American countries. At the same time, these shocks led to current account surpluses in oil-exporting countries. With the support of the US government, the major US financial centers acted as voluntary intermediaries between the two groups, providing exporting countries with a safe and liquid place for their funds and then lending those funds to Latin America
Latin American borrowing from US commercial banks and other lenders skyrocketed in the 1970s. At the end of 1970, total outstanding debt from all sources was only $29 billion, but by the end of 1978 that figure had risen sharply to $159 billion. By 1982, the level of debt had reached $327 billion
The potential risk of increased US bank involvement in Latin American and other less developed countries (LDC) debt has not gone unnoticed. In 1977, during a speech at the Graduate School of Business at Columbia University, then Fed Chairman Arthur Burns criticized commercial banks for taking on excessive risk in lending to third world countries (FDIC 1997). However, by 1982, the nine largest American financial centers held 176% of their capital in debt in Latin America; their total debt to the LDCs was almost 290 percent of capital .
Almost zero real interest rates on short-term loans, along with world economic growth, made this situation sustainable in the early 1970s. However, by the end of the decade, the priority of the industrialized countries was to reduce inflation, which led to a tightening of monetary policy in the United States and Europe. Nominal interest rates rose around the world, and in 1981 the world economy entered into recession. At the same time, commercial banks began to shorten repayment periods and charge higher interest rates on loans. Latin American countries soon found that their debt burden had become unsustainable .
The spark of the crisis began in August 1982, when Mexico’s Treasury Secretary Jesús Silva Herzog told the Federal Reserve Chairman, the US Treasury Secretary, and the Managing Director of the International Monetary Fund (IMF) that Mexico could no longer service its debt. which at the time was $80 billion. Other countries quickly followed suit. Ultimately, sixteen Latin American countries rescheduled their debts, as did eleven LDCs in other parts of the world .
In response, many banks stopped new foreign lending and tried to collect and restructure existing loan portfolios. The sudden cessation of bank financing plunged many Latin American countries into deep recession and exposed the shortcomings of previous economic policies,
As transcripts of the July 1982 meeting of the Federal Open Market Committee (FOMC) show, committee members felt it necessary to take action (FOMC 1982). In August, the Fed called an emergency meeting of central bankers from around the world to provide a bridge loan to Mexico. Fed officials also urged US banks to participate in Mexico’s loan restructuring program.
As the crisis spread beyond Mexico, the United States took the lead in setting up an “international lender of last resort,” a joint rescue effort by commercial banks, central banks, and the IMF. Under the program, commercial banks agreed to reschedule countries’ debt, and the IMF and other official agencies provided the LDCs with sufficient funds to pay the interest, but not the principal, on their loans. In return, the LDCs agreed to undertake structural reforms of their economies and eliminate the budget deficit. It was hoped that these reforms would allow the LDCs to increase their exports and create a trade surplus and the dollars needed to pay off their external debt.
While this program averted an immediate crisis, it allowed the problem to worsen. Instead of eliminating subsidies to state-owned enterprises, many least developed economies have cut spending on infrastructure, health care and education, frozen wages or laid off government employees. The result was high unemployment, a sharp decline in per capita income, and stagnation or negative growth—hence the term “lost decade.”
US banking regulators have allowed lenders to delay recognizing the full amount of losses on LDC loans in their loan loss reserves. This abstention reflected the belief that if the losses were fully admitted, the banks would be declared insolvent and face increased funding costs. However, after several years of negotiations with debtor countries, it became clear that most of the loans would not be repaid, and banks began to create reserves for possible loan losses to cover their debt to the LDCs. The first was Citibank, which set up a $3.3 billion loss provision in 1987, more than 30 percent of the total exposure to the LDCs. Other banks quickly followed Citibank’s lead.
By 1989, it also became clear to the US government that debtor countries could not repay their loans, at least not when economic growth resumed. Thus, Secretary of the Treasury Nicholas Brady proposed a plan to permanently reduce the principal amount of the loan and existing debt service obligations. Between 1989 and 1994, private lenders forgave $61 billion in loans, about a third of all outstanding debt. In return, the eighteen countries that signed the Brady plan agreed to domestic economic reforms that would allow them to service the remainder of the debt. However, years passed before the scars of the 1980s began to fade.
Lessons learned from Latin American Debt Crisis of the 1980s
Despite many worrying signs that LDC debt levels are unsustainable and that US banks are overly exposed to this debt, market participants did not seem to recognize the problem until after it surfaced. The result was a crisis that took a decade of negotiations and repeated debt restructuring attempts to resolve, at a significant cost to citizens of Latin America and other least developed countries.
In the United States, the main concern was the soundness and solvency of the financial system. To this end, regulators have relaxed regulatory standards for large banks holding LDC debt to prevent them from becoming insolvent. On the one hand, this normative restraint effectively prevented panic. On the other hand, restraint allowed the big banks to avoid the consequences of their previous lending decisions (though decisions that were officially encouraged to some extent in the mid-1970s). But allowing these institutions to delay recognizing losses set a precedent that may have weakened market discipline and encouraged excessive risk-taking in subsequent decades.