Government pressure on U.S. banks to renegotiate Mexico’s debt led to the development of a plan for debt reduction that emphasized forgiveness rather than new lending.
During the 1970’s, banks located in major financial centers of the world participated in an expansion of international lending. Loans to less developed countries (LDCs) constituted the fastest-growing category of international bank loans. A combination of sharply increased bills for oil imports and a recession in the industrial countries that cut into the LDCs’ export earnings, compounded by unrealistic exchange rate policies, sharply raised these countries’ aggregate balance-of-payments deficits from an annual average of about $7 billion in the 1970-1973 period to $21 billion in 1974 and $31 billion in 1975. Banks were replete with funds and faced declining domestic loan demand, so they were willing and able to provide financing in the form of direct government loans and development funding.
Bank lending to LDCs continued to grow rapidly during the early 1980’s. In the summer of 1982, however, international financial markets were shaken when a number of developing countries found themselves unable to meet payments to major banks around the world on debt amounting to several hundred billion dollars. With the onset of the debt crisis, lending to LDCs dried up rapidly.
Several developments set the stage for this situation. One of these was a growing trend in overseas lending to set interest rates on a floating basis rather than fixing an interest rate for the life of the loan. Floating-rate loans made borrowers vulnerable to increases in real interest rates as well as to increases in the real value of the dollar, because most of these loans were in dollars. A second development was the oil price increase implemented by the Organization of Petroleum Exporting Countries (OPEC) in 1979. In the absence of policies that promoted rapid adjustments to this new shock, the LDCs’ balance-of-payments deficits soared to $62 billion in 1980 and $67 billion in 1981. The deficits increased the LDCs’ need for external financing, and banks responded by increasing the flow of loans to the LDCs, to $39 billion in 1980 and to $40 billion in 1981. Interest rates increased at the same time. The variable interest rates of the loans, combined with increased indebtedness, boosted the LDCs’ net interest payments to banks from $11 billion in 1978 to $44 billion in 1982.
The final element setting the stage for the crisis was the onset of a recession in industrial countries. The recession reduced the demand for the LDCs’ products and thus the export earnings these nations needed to service their bank debt.
The first major blow to the international banking system came in August, 1982, when Mexico announced that it was unable to meet its regularly scheduled payments to international creditors. Shortly thereafter, Brazil and Argentina found themselves in similar situations. By the spring of 1983, about twenty-five LDCs were unable to meet their debt payments as scheduled and had entered into negotiations with creditor banks to reschedule their loans.
By late 1983, the intensity of the international debt crisis began to ease as the world’s economic activity picked up, boosting the LDCs’ export earnings. In October of 1985, the U.S. treasury secretary, James Baker, called on fifteen principal middle-income debtor LDCs to undertake growth-oriented structural reforms that would be supported by increased financing from the World Bank, continued modest lending from commercial banks, and a pledge by industrial nations to open their markets to LDC exports. By 1989, most of the fifteen nations were behind in delivering on promised policy changes and economic performance. Citicorp
During the late 1980’s, recognizing the deteriorating financial situation, Mexico’s president, Carlos Salinas de Gortari, undertook programs to turn his nation’s economy around. Mexico cut its budget deficit by 20 percent, to 13 percent of gross domestic product, in the period 1987-1988. The government also sold into private hands two-thirds of the twelve hundred businesses it owned and obtained concessions from labor and business to help control inflation. In 1989, the Mexican inflation rate was reduced to 20 percent, down from 160 percent in 1987. Mexico also opened its doors to foreign competition through trade liberalization policies.
These changes did not occur without costs. The Mexican infrastructure suffered, as cutbacks in investment in public services, roads, telecommunications, and electrical systems led to deterioration. The Mexican government needed both private and public sources to provide stable jobs to attack the country’s poverty level and develop infrastructure. Mexico could not make its loan payments of $10 billion per year and also finance growth. Repayments of principal and interest added up to 6.5 percent of the country’s gross domestic product. Something had to be done.
In 1989, Nicholas F. Brady, who succeeded Baker as U.S. secretary of the treasury, put forth a new plan to replace that instituted by his predecessor. The Brady Plan emphasized debt relief through forgiveness instead of new lending. It would cover $54 billion of Mexico’s $69 billion debt to foreign banks.
On July 23, 1989, an agreement was reached between Mexico and the fifteen-bank committee representing the country’s five hundred bank creditors. Under the terms of the agreement, banks could choose to swap old loans for thirty-year bonds at a 35 percent discount off face value. These bonds paid interest at the same rate as the old loans, 13/16 of a percentage point over the London Interbank Offered Rate. Another option was to swap old loans for thirty-year bonds with the same face value. These bonds would pay a fixed interest rate of 6.25 percent, much lower than the prevailing rate. The last option for the banks was to lend new money or reinvest interest received from Mexico for four years in an amount equal to one-fourth of their current medium- and long-term exposure. The interest on the new bonds would be guaranteed for at least eighteen months. The bonds’ principal would be secured by a zero-coupon U.S. Treasury bond financed by the International Monetary Fund, the World Bank, Mexico, and Japan. For the Brady Plan to work, commerical banks had to both make new loans and write off existing loans.
Banks accounting for only 10 percent of Mexico’s debt chose to make new loans—fewer banks than had been predicted. The designers of the plan also thought that most banks would prefer to cut the face value of the loans rather than reduce interest rates, but this was not the case. Instead, many banks used the Brady Plan as an opportunity to exit the LDC debt market. These outcomes led to a $300 million shortage and the need for Mexico to contribute an additional $100 million and renegotiate the loan terms. Originally, the banks required that cash be made available immediately to pay eighteen months’ worth of interest, but because of the shortfall, they agreed to take the money in eighteen months rather than immediately.
Although the plan did not completely resolve Mexico’s debt problems, it was a step in the right direction. It allowed President Salinas to begin programs to rebuild Mexico’s infrastructure and provided relief from interest payments that was necessary for the Mexican economy to stabilize and gain an economic footing.
If any country had earned the reduction in debt, it was Mexico. Salinas was committed to free market policies and to opening the economy. Even while asking for help from abroad, Mexico was working to solve its own problems. The message to other countries facing similar debt-servicing problems was that they should emulate Mexico by cutting government waste, liberalizing their economies, and joining the international trading system before asking about debt relief.
Mexico provides just one example of the extent of the debt problems experienced by Latin American countries in 1989. The hyperinflation existing in Argentina, Brazil, and Peru, and the political instability in Latin America in general, threatened already fragile political and economic conditions. Many countries found themselves far behind on their debt payments. Debtor nations such as Argentina, Bolivia, Costa Rica, the Dominican Republic, Ecuador, Brazil, Venezuela, Honduras, and Peru needed economic breathing room to impose reforms. Mexican relief was only the tip of the iceberg.
Latin America continued to account for the world’s biggest debt problems, but it also showed several of the most promising turnarounds. The sixteen major borrowers there owed a total of $420 billion in 1991, slightly more than half of that to banks. Brazil, the largest borrower in the developing world, remained a problem. Its debt came to $122.6 billion in 1991, $80 billion of it owed to banks. Brazil suspended all debt payments in 1989 and agreed reluctantly in March of 1991 to start paying back a portion of its $8 billion in arrears. In Peru, bankers virtually abandoned hope of getting back the $8.6 billion owed to them. In 1991, Peru’s debt certificates sold at 4 percent of their face value.
The good news was that some countries, notably Colombia, never rescheduled their payments. Chile, through the use of a creditor swap, cut its bank debt by 40 percent. Argentina, a slow payer, began a debt-equity swap program to help cut the cost on its $34 billion debt.
The Brady Plan proved to be helpful to several countries, Mexico being the first. It ended the game in which banks kept lending new money that countries used to pay interest on old debts. “Brady bonds” were thirty-year bonds guaranteed by a zero-coupon bond from the U.S. Treasury. The interest was backed by the World Bank. Brady bonds helped Mexico, Costa Rica, and Venezuela reduce their debt and proved to be easier to sell than the original bank loans. Trading in loans to LDCs climbed from $200 million in 1982 to more than $100 billion in 1990, showing that the market for Third World sovereign debt was becoming more liquid.
After years of problems from Latin American government debtors, U.S. banks finally got some return. Sounder economic policies in Mexico, Argentina, Venezuela, and some other Latin American countries bolstered the value of their outstanding debt, easing the pressure on banks holding loans. The market for LDC debt remained fragile, with buyers continuing to demand steep discounts from face value. The market could not absorb all the loans that banks wanted to sell, but the debt crisis of the 1970’s and 1980’s appeared to have lessened.
During the early 1980’s, a widespread fear was that countries that had piled up substantial international debt, such as those in Latin America, would find their economies crushed by the pressure of loan payments. Defaults on loans would bring down big banks and cause a financial crisis in lender nations. One by one, however, the Latin American countries negotiated agreements under which their creditors would accept smaller repayments while, in return, the countries enacted economic reforms. Steps were taken to control inflation and open up foreign investments. In July of 1992, Brazil, the biggest Third World debtor and a holdout on renegotiating, worked out an arrangement with nineteen banks representing private creditors. The Brady Plan and Mexico’s debt restructuring provided a beginning. Cooperation between banks and governments softened the debt crisis.
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Chambliss, Lauren, and James Srodes. “Mexico: How to Break the Mexican Debt Impasse Before It’s Too Late.” Financial World 158 (July 25, 1989): 18-21. Presents an excellent review of the changes that took place under President Salinas in Mexico. Discusses the various economic and political changes that led to the improved Mexican economy and finally to the willingness of banks to renegotiate the terms of Mexican debt. -
Finn, Edwin A., Jr. “Giving a Little to Save a Lot.” Forbes, March 6, 1989, 38-39. Discusses the plan proposed by James Baker and includes information on the Mexican government’s efforts to work on the debt relief proposal. Provides good background on the Brady Plan. -
Hughes, Jonathan, and Louis P. Cain. American Economic History. 6th ed. Boston: Addison-Wesley, 2002. Comprehensive volume on the economic history of the United States includes discussion of the Brady Plan. -
Lustig, Nora. Mexico: The Remaking of an Economy. 2d ed. Washington, D.C.: Brookings Institution, 1998. In-depth examination of Mexico’s economy and economic policy since 1982 includes discussion of the impacts of the Brady Plan. Bibliography and index. -
Main, Jeremy. “A Latin Debt Plan That Might Work.” Fortune, April 24, 1989, 205-212. Sets out the details of the Brady Plan, the history behind its development, and the reactions of the bankers involved and Mexico’s president. -
O’Reilly, Brian. “Cooling Down the World Debt Bomb.” Fortune, May 20, 1991, 122-124. Excellent discussion puts the Latin American debt crisis in perspective. Written long enough after Mexico’s debt restructuring to assess the results and impact of the Brady Plan. -
Sachs, Jeffrey. “Robbin’ Hoods.” The New Republic, March 13, 1989, 16. Discusses the various ways banks have approached the idea of restructuring debt in the past. Offers insights into how the Brady Plan differed from previous attempts at debt relief.
Lovejoy Proposes the Debt-for-Nature Swap
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