ECON 4311: The Economy of Latin America. Debt Relief. Part 1: Early Initiatives

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1 ECON 4311: The Economy of Latin America Debt Relief Part 1: Early Initiatives

2 The Debt Crisis of 1982 severely hit the Latin American economies for many years to come. Balance of payments deficits and investment was virtually paralyzed. As we have argued before, financial analysts initially thought that this would be a transitory liquidity problem. By 1987, however, both debtors and creditors realized that this was a serious problem, and that deep measures should be undertaken (tax reforms, foreign debt relief, institutional reforms) to regain macroeconomic stability.

3 By the mid 1980s, the Latin American countries faced three big problems: - close the gap between expenditures and income - inflation - generate an adequate economic environment that would incentive economic growth The failure of the heterodox plans in Argentina, Brazil and Peru convinced policymakers that to overcome these problem would require important fiscal adjustments, including tax reforms.

4 Many Latin American countries faced a debt-overhang problem: since the politicians rarely perceived short-term direct benefits for their countries from macroeconomic and structural reforms, they often made only timid eæorts to undertake them. Without these structural reforms, however, the external accounts did not improve enough to solve the crisis.

5 The macroeconomic stabilization programs implemented in Latin America during the late 1980s dealt with four issues: (1) Reduction of burden of foreign debt (debt swaps, debt conversion, debt restructuring and voluntary debt elimination). (2) Fiscal adjustments to reduce public deficits (tax reforms, expenditure cuts and privatizations). (3) Consistent domestic credit policies (to relieve aggregate demand pressures and avoid crowding out). (4) Exchange rate policies consistent with anti-inflationary eæort.

6 Table 4-1: Inflation in Latin America ( ). Although some progress has been done in lowering inflation, by 1993 it was still high in many countries.

7 Latin America -- Inflation Rates Country Argentina Bolivia Brazil Chile Colombia Costa Rica Dominican Rep. Ecuador El Salvador Guatemala Haiti Honduras Jamaica Mexico Nicaragua Panama Paraguay Peru Trin. & Tobago Uruguay Venezuela Average , ,

8 Debt Relief and Debt Restructuring Due to the Debt Crisis of 1982 many countries in Latin America were forced to generate huge trade surpluses to finance debt payments. O±cial approach of the US, IMF and World Bank: temporary liquidity problem. Solution (under this approach): lend new money to the economies that engage in structural reforms. Between 1983 and 1988: Latin American countries engaged in 29 debt-restructuring programs with private banks.

9 Not much later than 1982, analysts and governments realized that the Latin American debt problem had been underestimated and was aæecting the ability of these nations to grow. In March 1989, the creditor nations and multilateral organizations recognized that it was in everyone s interest to give some debt forgiveness. These ideas were put into practice through the Brady Plan.

10 Since 1989, the o±cial approach combined two basic mechanisms for alleviating the debt burden: - Debt-reduction schemes based on secondary market operations was encouraged (for example, debt swaps). - Direct debt reduction programs between private banks and countries became more common after Brady Plan was introduced.

11 Chile s Debt Conversion Schemes Chile has pursued one of the most aggressive approaches to reduce its debt. By 1993, Chile had reduced around $11 bn (more than 40% of Chile s long-term bank debt). Two mechanisms: - Debt conversion (Chapter 18) - Debt-equity swap (Chapter 19)

12 Debt conversion (Chapter 18) Domestic debtors could buy their own foreign liabilities in the secondary market. In order to avoid pressure on exchange rate, Chilean authorities controlled access to Chapter 18 mechanism through licenses. Chilean residents captured most of the secondary market discount (sometimes close to 50% a big portion of the discount was assumed by the Central Bank).

13 Debt-equity swaps (Chapter 19) In a nutshell: foreign investors can buy Chilean private debt in the secondary market (at a discount) and convert it into domestic debt. This debt could be sold in the domestic secondary markets and proceeds could be used to buy productive assets (privatizations, investment projects). Investors could not repatriate profits for the first 4 years and could not repatriate the principal for the first 10 years.

14 Example: - Suppose Chilean firm A owes 500 dollars to Bank B. - If Investor C is allowed to participate, it could buy the bond at a discount, say 300 dollars. - Now, Investor C can sell the bond to the Chilean government, in exchange for domestic currency. Suppose for simplicity that exchange rate is 1 to 1.

15 - If Investor C sells the bond, gets 500 pesos and makes a profit of 200 dollars. The 500 pesos have to be invested in Chile. Benefits? - The debt of Firm A is now in domestic currency (pesos) - Instead of having to transfer 500 dollars abroad, those are kept in the economy. - Investor makes a profit.

16 Questions Does debt-equity swaps crowd foreign investment out? Investor C invests 300 dollars in Chile. What if it had wanted to invest the original 500 dollars anyways (even without this implicit subsidy)? Another drawback: to buy debt from Investor C, the government prints (domestic) money, and inflation could arise. To sterilize, it must increase the interest rate, and thus lowering the incentives to invest.

17 One curious example of debt-equity swap: case of Brazilian soccer player Romario. Debt-equity swap programs have been used to finance purchases of existing firms, to induce investment in new operations and to unload burdensome state corporations (for example Bell Atlantic and Telefónica in Argentina).

18 Debt Conversion in Chile (by Feb 1993) Operation Millions USD Chapter 18 3,280 Chapter 19 3,600 Capitalization DL Portfolio Adjustments 156 Other Operations 3,984 Total 11,323

19 The Mexican 2008 Bond In Dec 1987, Mexico announced that it was willing to exchange $10 bn of its debt for twenty-year collateralized bonds that carried a spread over LIBOR of % (this was a very large spread). Bonds would be amortized in one payment on maturity. Collateralized with nonmarketable, zero-coupon US Treasury bonds. Collateral was to be acquired with international reserves. Mexico initially expected a price of 50 cents per dollar.

20 Example - Suppose Mexico owes 100 dollars to Bank A. Suppose that the price of the debt of Mexico in the secondary market is 50 cents. - Mexico proposes to pay those 50 cents with a bond that pays a very high interest rate, and the principal would be back with very low risk bonds bought with international reserves. - Short-term debt transformed into long-term debt. - Collateral earns a given interest rate.

21 The problem was that there was still risk involved in the operation: the interest payments. That is why bids received by Mexico where in the range of 65 to 70 cents. At the end, only $1.1 bn of debt was reduced. The result of this program was not very beneficial for Mexico. As we will see later, the Brady Plan for Mexico resulted in a much better deal.

22 The Role of Multilateral Institutions Multilateral Institutions contributed with voluminous amount of resources to the debtor countries. In this way, Latin American countries reduced the size of net transfers to the rest of the world.

23 World Bank objectives: - Reduce macroeconomics instability - Restore growth, including a minimum increase in consumption - Reduce the degree of debt-overhang. Without the increase in consumption, countries would not have the political incentives to undertake reforms, and would stagnate. Selowsky and van der Talk (1986): the initial conditions are so severe, that the only way to reduce the debt/output ratio is through some debt forgiveness.

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