Thursday, May 18, 2017

Money Matters: An IMF Exhibit -- The Importance of Global Cooperation. Debt and Transition (1981-1989)

Countries Don't Go Bankrupt
"If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has." - John Maynard Keynes
"If you owe your bank a billion pounds everybody has a problem." - The Economist
During the 1970s, Western commercial banks had loaned billions of recycled petrodollars to the developing countries, usually at variable, or floating, interest rates. So when interest rates began to soar in 1979, the floating rates on developing countries' loans also shot up:
  • Higher interest payments are estimated to have cost the non-oil-producing developing countries at least $22 billion during 1978-81. At the same time, the price of commodities from developing countries slumped because of the recession brought about by monetary policies.
The time bomb was set.

What Went Wrong?
grotesquely high interest rates

  • Between 1979 and 1982, interest rates more than doubled worldwide, dramatically raising the cost of loans.
  • The U.S. dollar exchange rate improved, making the dollars needed to repay loans more expensive.
  • Widespread recession dried up the markets for the exports of developing countries.
  • Real prices for the export commodities that were essential to the developing economies fell to their lowest levels since the Great Depression.
"The time bomb was the debt burden and grotesquely high interest rates being carried by the Third World to the profit of the Western banks." - Les Gibbard
"Countries don't go out of business....The infrastructure doesn't go away, the productivity of the people doesn't go away, the natural resources don’t go away. And so their assets always exceed their liabilities, which is the technical reason for bankruptcy. And that's very different from a company." - Walter Wriston, Citicorp Chairman

Who Was to Blame?

Why did Western banks loan so much money to the developing countries?

Many developing countries were good loan prospects in the 1970s:
  • Many produced raw materials, foodstuffs, or manufactured goods that were in demand.
  • Growth rates looked even better than for industrial countries.
  • From 1960 to 1980, Latin America's economic growth rate was nearly twice the U.S. rate.
  • Even Eastern European countries seemed a good risk, because of the climate of detente and growing East-West trade.
Why did developing nations borrow such huge amounts?

As long as interest rates were low and inflation was high, the loans fueled their economies at little cost:
  • With high inflation, by the time the dollars had to be repaid, their real value had decreased.
  • Meanwhile, the borrowers could invest the money in economic development.

It worked. Between 1973 and 1980, the economies of oil-importing developing countries grew an average of 4.6%, compared with 2.5% for the industrial world.

Time Bomb Explodes

Poland found itself unable to pay the interest or principal on its massive loans in 1981. In 1982, the Mexican government declared it could no longer make payments on its debts. Argentina, Brazil and others soon followed. Thirty countries had fallen into arrears by the end of 1984. Billions of dollars were at stake.

The global monetary system was under threat. How could the world solve the debt problem?

Developing Countries: Just Don’t Pay?

If countries simply defaulted, everybody would suffer from the resulting economic and political instability:
  • The lending banks and investors would lose their money. For some, bankruptcy might follow.
  • Once it defaulted, a country would be unable to obtain future loans or investment, slowing economic growth and encouraging political instability.
  • Industrial countries that traded heavily with the debtor countries would lose those markets.
An individual or company that defaults on a loan goes bankrupt. But what happens if a country defaults? No one knew the answer.

Industrial Countries: Just Ignore It?

The banks that loaned the billions of dollars should have known better:
  • Why should the world bail out banks and investors who had made poor loan decisions?
  • If it should, who was to pay for the bailouts?
Both developing countries and banks found themselves in a difficult position. But could industrial countries afford to disregard the plight of the debtor countries?

Solving the Problem

With the Mexican crisis in 1982, the IMF took on the coordination of a global response. It realized that nobody would benefit if country after country failed to pay its debts.

The IMF had no magic remedy. The resolution of the crisis involved concessions from all concerned, to help debtor countries get back on track:
  • Industrial Countries: An immediate infusion of cash from industrial country governments
  • The Banks: Further lending and rescheduling of current debts by commercial banks, or "bailing the banks in"
  • The Debtors: An adjustment program, usually with IMF financial assistance
The IMF’s initiatives calmed the initial panic and defused its explosive potential. However, a long road of painful reform in the debtor countries, and additional cooperative global measures, would be necessary to eliminate the problem.

"Bailing the Banks In"

When the Mexican crisis struck, Jacques de Larosiere, the IMF's managing director, told the banks that the IMF rescue plan would not work without a sizable contribution from them. Instead of bailing out the banks, the IMF would "bail them in."

Mexico would need $8.3 billion in 1983:
  • $1.3 billion from the IMF
  • $2 billion from governments
  • $5 billion from the banks
The banks regarded the program as "forced lending," but all 526 of them paid up within a month.

Conditionality for Debtor Countries

To qualify for IMF financial assistance, a debtor country had to set up an adjustment program, which usually included:
  • Setting realistic exchange rates
  • Reducing fiscal deficits
  • Reducing inflation by restricting the creation of credit
  • Limiting external borrowing to reasonable amounts for growth-oriented purposes.
Some countries, such as Chile and Bolivia, responded remarkably to the stabilization plan in only a few years. However, for many countries, the process was more painful and prolonged. Unemployment, inflation, and stagnant growth persisted into the 1990s.

The Baker PlanAttempted Rescue

The Baker Plan, proposed by U.S. Treasury Secretary James Baker in 1985, envisioned further concessions by all three parties involved: commercial banks and multilateral financial institutions would increase lending, while indebted countries would make greater efforts at fiscal, financial, and monetary reform.

Initial enthusiasm for the Plan quickly faded. The Baker Plan had only limited success because it merely delayed payment of the debt, rather than reducing it.

Reducing the Burden

More radical action was deemed appropriate. In 1989, US Treasury Secretary Nicholas Brady proposed writing off some of the debt principal, rather than merely rescheduling it as had been done since 1982.

The Brady Plan was hailed as the beginning of the end of the debt crisis, which had plagued financial markets for nearly a decade. Still, many developing countries thought it did not go far enough toward reducing their burden.

Regional Economic Integration

Although regional trading blocs are not new, the enormous increase in trade alliances among neighboring countries have resulted in higher tariffs and trade restrictions for countries outside the group. Such regional protectionist measures during the 1930s prolonged the economic malaise of the Great Depression. Hence, region blocs had been initially regarded with suspicion.

Since 1948, over 150 regional trading associations have been formed. Over 65 of those came into existence during the 1980s and 1990s.

Why the rapid rise in the number of trade alliances? What benefits are there for individual member countries? Will the increase in these alliances improve or threaten the growth of world trade?

Regional Trading Associations

The purpose of a regional trade association is to protect and expand trade among neighboring countries through agreements that range from reducing trade barriers to harmonizing internal policies. Overall world trade will also benefit if regional trading associations help members grow without instituting protectionist policies that inhibit trade with outside countries.

Although not all regional trade associations have had positive outcomes, some have certainly thrived. These successes encourage confidence that regional associations will promote trade - both internally, among members, and externally, throughout the world.

The 1980s witnessed huge advances in the most ambitious of all regional integration efforts–the European Community. In the following decade this progress would result in the formation of an economic union that would rival the economic and political might of the United States.

The longest-lived example of a monetary union is Africa’s fourteen member CFA franc zone, which has used a common currency pegged to the French franc since 1948. The zone helped to support Africa’s most successful market integration.
The Asian Tigers
The Asian Tigers

During the 1980s the so-called "Four Tigers" - Hong Kong, South Korea, Singapore, and Taiwan Province of China - achieved astonishing economic growth. In addition, Japan, which already boasted the world's second largest capitalist economy by the 1970s, continued its impressive economic expansion.

Although all are located in East Asia, these areas have acted independently and never formed a regional trading bloc.

The Power of Private Capital

By the 1990s, transfers of private capital from one country to another had reached thousands of billions of U.S. dollars each year. Largely unregulated by governments and transmitted through cyberspace, international capital flows sought profit wherever it could be found.

Is Anyone in Control?

Although incoming capital flows helped countries develop, the sudden reversal of flows, or "capital flight," could cause panic and financial crisis.

Fearing that control over money had been transferred from national authorities to the private sector, many called for better monitoring of international capital flows (by institutions like the IMF) or even restrictions on these transfers.

Growth of Capital Markets

By the end of the decade, international capital markets had grown to an extent unimagined in 1980:
  • In the United States, transfers of stocks and bonds between domestic and foreign residents rose from 10% of GDP in 1980 to 93% in 1990.
  • Japan's corresponding figures were 7% and 119% of GDP.
  • Gross international equity flows - $800 billion in 1986 - had by 1990 exceeded $1.44 trillion.
So great was the growth that some feared control of the monetary system was shifting from monetary authorities to the private sector.

Growth of Foreign Exchange Markets

As a result of the unprecedented growth of international capital markets, foreign exchange markets (where one national currency is sold for another) also experienced a surge in activity.

Thaw in the East

With remarkable speed and surprisingly little violence, the Iron Curtain fell in 1989, radically changing the political and economic conditions that had been in place in Europe since World War II.

For years, Communist countries had been plagued by stagnant economies, low productivity, inefficient industry, and constant shortages of consumer goods. One by one, the Communist regimes of Eastern Europe collapsed in 1989. Was this the end of the centrally planned economies?

1989 Year of Anti-Communist Revolutions

In April, Poland’s Communist government legalized the Solidarity party. After elections in June, the Polish Communist party became the first to allow itself to be turned out of office. Nobel Prize winner and Solidarity leader Lech Walesa later became the first freely elected president.

In November, massive demonstrations by almost a million Czech citizens culminated in democratic reforms and the resignation of the country's Communist leaders. Dissident liberal playwright Vaclav Havel became president after free elections were held at the end of December.

The first real breach of the Iron Curtain occurred in May, when Hungary dismantled barriers on its border with Austria. In October, the Hungarian Communist party dissolved, after instituting democratic and economic reforms.

On November 9th, East Germany opened its borders and dismantled the Berlin Wall. Over the next month, 133,000 people moved west. To stem the flow, West Germany issued a plan on November 28 for Germany’s reunification. After economic union took place in July 1990, East Germany ceased to exist.

On November 10th, after over 35 years in power, Todor Zhivkov was forced to resign his positions as Bulgaria’s head of state and Communist party leader. Shortly afterwards, protesters obtained democratic reforms, including free elections and the repeal of the Communist party’s monopoly of power.

By International Monetary Fund

Source: International Monetary Fund

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