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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 Mexicos
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 growthhence 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 Citibanks 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.
Endnotes
1
Money-center banks are banks that borrow from and lend to governments,
large corporations, and other banks on national and international financial
markets.
Bibliography
Aggarwal, Vinod K. Exorcising Asian Debt: Lessons from Latin American
Rollovers, Workouts, and Writedowns. In Private Capital Flows in the Age of
Globalization: The Aftermath of the Asian Crisis, edited by Deepak Dasgupta, Uri
Dadush, and Marc Uzan, 105-39. Northhampton, MA: Edward Elgar Publishing,
2000.
Carrasco, Enrique R. The E-Book on International Finance and
Development. Transnational Law & Contemporary Problems 9, no. 1 (Spring
1999): 116-26.
Devlin, Robert, and Ricardo Ffrench-Davis. The Great Latin America Debt Crisis:
A Decade of Asymmetric Adjustment.Revista de Economia Politica 15, no. 3
(July-September 1995): 117-42.