Latin American Debt Crisis of the 1980s

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1982 - 1989
by Jocelyn Sims, Federal Reserve Bank of Chicago, and Jessie Romero,
Federal Reserve Bank of Richmond
During the Latin American debt crisis of the 1980sa period often referred to
as the lost decademany Latin American countries became unable to service
their foreign debt. The Federal Reserve and other international institutions
responded to the crisis with a number of actions that ultimately helped alleviate
the situation, albeit with some unintended consequences.
The Origins of the Debt Crisis
During the 1970s, two large oil price shocks created current account deficits
in many Latin American countries. At the same time, these shocks created
current account surpluses among oil-exporting countries. With the
encouragement of the US government, large US money-center banks were willing
intermediaries between the two groups, providing the exporting countries with a
safe, liquid place for their funds and then lending those funds to Latin America
(FDIC 1997).1
Latin American borrowing from US commercial banks and other creditors
increased dramatically during the 1970s. At the end of 1970, total outstanding
debt from all sources totaled only $29 billion, but by the end of 1978, that
number had skyrocketed to $159 billion. By 1982, the debt level reached $327
billion (FDIC 1997).
The potential risk of the growing involvement of US banks in Latin American
and other less-developed country (LDC) debt didnt go unnoticed. In 1977, during
a speech at the Columbia University Graduate School of Business, then-Fed
Chairman Arthur Burns criticized commercial banks for assuming excessive risk
in their Third World lending (FDIC 1997). Still, by 1982, the nine largest US
money-center banks held Latin American debt amounting to 176 percent of their
capital; their total LDC debt was nearly 290 percent of capital (Sachs 1988).
The near-zero real rates of interest on short-term loans along with world
economic expansion made this situation tenable in the early part of the 1970s.
By late in the decade, however, the priority of the industrialized world was
lowering inflation, which led to a tightening of monetary policy in the United
States and Europe. Nominal interest rates rose globally, and in 1981 the world
economy entered a recession. At the same time, commercial banks began to
shorten re-payment periods and charge higher interest rates for loans. The Latin
American countries soon found their debt burdens unsustainable (Devlin and
Ffrench-Davis 1995).
The spark for the crisis occurred in August 1982, when Mexican Finance
Minister Jess Silva Herzog informed the Federal Reserve chairman, the US
Treasury secretary, and the International Monetary Fund (IMF) managing director

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.

Federal Deposit Insurance Corporation, Division of Research and Statistics. The

LDC Debt Crisis. Chap. 5 in History of the Eighties--Lessons for the Future,
Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s.
Washington, DC: Federal Deposit Insurance Corporation, 1997.
Board of Governors of the Federal Reserve System. Meeting of the Federal Open
Market Committee. June 30-July 1,1982.
Ferguson, Roger W., Latin America: Lessons Learned from the Last Twenty
Years, Speech given to the Florida International Bankers Association, Inc., Miami,
FL, February 11, 1999.
Sachs, Jeffrey D. International Policy Coordination: The Case of the Developing
Country Debt Crisis. In International Economic Cooperation, edited by Martin
Feldstein, 233-78. Chicago: University of Chicago Press, 1988.
Written as of November 22, 2013. See disclaimer.