Episode 2: The Latin American Debt Crisis

Jim Grenn: So many countries in Latin America seem to have it all: natural resources, tourism, beauty, culture, proximity to the US.  So why aren’t they wealthier?

It wasn’t long ago that Mexico and Brazil, and many other Latin American countries appeared posed for greatness.  But something happened.  Why are the 1980s are now referred to as the “Lost Decade” for Latin America?   

Hi, this is Jim Grenn and I’m the director of client relations at Raanes Capital Advisors.  Today we are going to examine the curious case of what happened in Latin America that lead to the lost decade of the 1980s.

In 1972, a commercial fisherman named Rudesindo Cantarell was 60 miles off the coast searching for big fish when he happened to notice something shiny in the water.  It looked like a boat had dumped some oil in the ocean, but it was far too large to be from a boat.  Perhaps it had capsized.  Cantarell alerted the Mexican government, who investigated the source and discovered the second largest oil reserve in the world behind Saudi Arabia, immediately changing Mexico’s fortune forever. 

By the 1970s oil had become an economic weapon, something to be manipulated in the political sphere.  Countries banded together to form oil cartels and set the price.  Price shocks could cripple an economy.  Without ample oil and gas supplies an economy fell into recession.  Countries around the world scrambled to search for oil reserves within their borders in hopes of striking it rich or at least minimizing their reliance on oil producing countries. 

A year after Cantarell found the second largest oil reserve in the world, the price of oil spiked and became a huge focus for the government. 

Kent Oliver: Here’s the thing with finding oil, it doesn’t mean you suddenly have a lot of money.  It means you have something very valuable that one day will produce wealth, but it isn’t instantaneous.  It takes a ton of money and time to become a mass producer of oil and gas.  So much so that the Mexican government spent more than 20% of total revenue to build out their oil and gas sector within their country. 

This wasn’t completely unchartered territory for Mexico.  In general, Latin American countries had begun producing oil commercially in the early 1900s and ramped up throughout World War I.  By the end of the war, Mexico was actually one of the top oil exporting countries in the world, but production fell dramatically following the Great Depression.  Mexico didn’t surpass their 1920s production until the mid-1970s.

Jim Grenn: that’s Kent Oliver, he’ll help us paint the big picture. 

Kent Oliver: The spike in oil prices really made Mexico sit up and take inventory of what they had and they made the strategic choice to make oil and gas a focus of their economy.  But, in order to make that dream a reality it took a lot of money.  They began sinking billions into the production of the industry.

Jim Grenn: So, what did Mexico do?

Kent Oliver: they borrowed.  I mean, what would you do it wanted to convert future wealth into prosperity now?  The obvious choice is that you borrow against it. 

Brady Raanes: By the late 1970s, lending to Latin American governments had become the biggest fad in banking.  Senior bankers, many of whom had never set foot in a Latin American country, found themselves scrambling to keep pace with the competition.  Leading banks hired brass young salesmen ready to travel to the far reaches of the world.  Soon every major bank had teams of jet setters in search of borrowers abroad.  Mexico is a great example, they borrowed so much money in the 1970s that their national debt rose 10 fold over the course of the decade.  I mean, they had to borrow to scale up the oil industry, but they went above and beyond.

Jim Grenn: that’s Brady Raanes, he’ll help fill in the details.  So, they borrowed a lot.  But wouldn’t the oil profits eventually pay for all the borrowing.

Brady Raanes: but Mexico wasn’t alone.  It was sort of this strange phenomena that all these Latin American countries, from Brazil to Mexico to Peru to Venezuela all began borrowing these excessive amounts of money from banks – mostly US banks.  It was a little different for each country, in some cases, they were borrowing money to build out infrastructure like roads and bridges in some cases they would borrow money to build out their oil and gas industry.   There was also a fair amount of “pet projects” from government leaders and just pure waste.  It was like this sudden access to bank loans triggered this massive desire to borrow money throughout the region.

Kent Oliver: Yeah, and these countries didn’t borrow like you and I would borrow.  I mean, if you or I wanted to borrow money to buy something we have about two options.  If we want to buy a house or a car, you’d go to the bank, they’d access the value of whatever you were buying and they’d loan you the money based on that value and they would most likely do so at a set interest rate.  Say 5%.

The other way you could borrow money would be to use something like a credit card.  Technically, the money your borrowing isn’t backed by anything.  There is no lender accessing the value of your purchases at Wal-Mart and saying you can or can’t borrow money for that.  They just extend you the credit and hope you make wise decisions.

Brady Raanes: True, and with the credit card routine, the interest rates generally changes with the prevailing rates in the economy, so you really don’t know exactly what your interest expenses will be from year to year, which can be pretty risky. 

Kent Oliver: So, anyway, in simplistic terms that’s what so many Latin American countries started doing.  They began borrowing money from banks at a floating interest rate to spend on whatever they wanted.

Jim Grenn: When you say “Latin American countries” who was really doing this?  Business? Governments? 

Brady Raanes: it was kind of everyone.  As the US banks expanded internationally, lending became more mainstream for everyone, but the governments were the big borrowers.  Like, in Mexico’s case, they knew they had this massive valuable oil reserve that would begin pouring money into the government so they borrowed. 

Jim Grenn: so there had to a pretty big risk that oil prices would tank, right?

Brady Raanes:  well that was a risk, but this wasn’t a short-term gamble, this was the kind of thing that could change the course of their economy and at first it seemed like a brilliant move because oil prices didn’t tank.  They skyrocketed.

Kent Oliver: Oil prices tripled in 1979.  At that price, the oil reserve was worth more than Mexico’s entire economic output over the previous year.  That’s a pretty massive windfall.  Basically, they discovered a new economy for the country. 

Brady Raanes: But something happened in 1979 that totally screwed things up for everyone in Latin America.  The US was battling inflation partially due to the rising oil and gas prices.  And the US appointed a new chairman of the Federal Reserve, a guy named Paul Volcker.  Volcker was quite a character, 6’8”, played basketball at Princeton, smoked big cigars, but that’s not relevant here.  What is important is that Volcker decided to start hiking interest rates to stop this spike in prices in the US.  At his first meeting as chairman of Fed, he actually hiked rates 4% in one day.  Can you believe that?

Jim Grenn: But when he did it totally changed interest rates on all these Latin Ameircan loans too, right?

Brady Raanes: exactly.  Interest rates shot up on all those loans too.  But another thing happens when one country hikes rates more than another.  The country with the higher interest rates begin to attract money from other countries.  Money is mobile, it can travel across boarders much easier than people can.  And in this case, foreign investors started buying the higher yielding bonds in the US.  Which made the US dollar stronger than other currencies… and in turn made other currencies less valuable. And here’s the thing: the vast majority of these loans to Latin America had to be repaid in US dollars not the local currency

Jim Grenn: it was like a double whammy.

Brady Raanes: big time.  Not only were interest rates shooting up, but it was going to take more of whatever the local currency was to buy dollars than before.  For example, Mexico can’t print dollars, they can only print pesos and then use those to go buy dollars.   

Kent Oliver: Meanwhile, sorry to interrupt.  Meanwhile, oil prices weren’t holding up.  The oil price shock of the 1970s was wearing off and prices were coming back down to earth and a lot of Latin American economies had come to rely on oil exports to fund their economy.

Jim Grenn: their cash cow wasn’t a valuable.   

Kent Oliver: yeah, not only that, but the debt burden was staggering.  Don’t forget as Brady said, Mexico had a ten-fold increase in public debt from 1973 to 1981.   But they weren’t alone. From 1979 to 1982 Brazil nearly doubled their national debt. 

Jim Grenn: So what you’re both saying is that Latin American countries borrowed a bunch of money at a floating interest rate, payable in a currency they didn’t have backed by an asset that could fall dramatically in value. 

Kent Oliver: not even really backed by it.  Remember, these are like credit card loans, there is nothing really backing it.

Jim Grenn: So, as the US starts hiking interest rates to end inflation in 1979, he was also inadvertently waging war on Latin American debt in the process. 

Brady Raanes: Yeah, Brazil’s situation had gotten so bad that they began to borrow money simply to make the interest payments on their mountain of debt.    Brazil’s Finance Minister resigned in frustration.    

Jim Grenn: Couldn’t these countries just print their own local currencies and convert that to dollars?

Brady Raanes: In theory, yes, but we’re hundreds of billions of dollars in loans.  I mean in the case of Mexico they owed $80 billion.  The debt was too great and the peso was too weak.  If Mexico had tried that they would tanked the value of the peso and set up massive inflation only making the debt situation worse.

Kent Oliver: And in most cases the local currencies were already really weak.  In Mexico’s case, the peso money was flowing out of Mexico almost as fast as the bank loans were flowing in. Mexicans had been converting pesos to dollars at a record clip.  The peso had fallen by nearly 50% since the start of 1982.  Twelve months earlier Mexico could swap 25 pesos for every dollar.  By August of 1982 they needed nearly 50 pesos for every dollar.  In terms of pesos, the debt burden has essentially doubled over the previous year. 

Jim Grenn: so…

Kent Oliver: So, Mexico essentially has to come clean and tell someone their problem.  So in August of 1982 the Mexican Finance Minister, a guy named Jesus Silva Herzog calls Paul Volcker, the chairman of the Fed and breaks the news to him.  And they start talking about possible solutions.  Three months later, the Mexican government announces that an agreement had been reached with the International Monetary Fund (IMF) to supply a credit line of $4 billion to be used as needed over the coming three years. 

Jim Grenn: more debt?

Kent Oliver: yeah, and Mexico wasn’t alone.  Throughout the following eighteen months, Colombia, Venezuela, Ecuador, Bolivia, Uruguay, the Dominican Republic, Chile and Peru all stepped forward to request help from the IMF.

Brady Raanes: This idea of solving a debt problem with more debt becomes this re-occurring theme throughout the story of Latin American.  These countries borrowed more money from the IMF so they didn’t default on their existing loans to banks.  It was just this crazy cycle of debt trying to mask the problems of debt.  Regardless, the banks breathed a sigh of relief and continued refinancing the loans.

Jim Grenn: So, the banks had to be sweating it through all of this.  They had made all these excessive loans ad it’s looking like they won’t be paid back.  What are the banks feeling during all of this?

Brady Raanes: So, you’d think that the banks would be worried, right?  I mean get this: more than half of the bank profits for Citi, Bank of America, Chase Manhatten, Bankers Trust and JP Morgan came from these Latin American loans in 1982.  The top nine banks in the US had loan more 100% of their combined capital base to Mexico, Brazil and Argentina alone.  So, yeah, they should have been worried, but the increased interest rates were just adding to their profit.  So these banks weren’t too concerned.

And get this… banking regulation stated that as long as these countries continued to make payments on their loans the banks could continue to book profits regardless of whether or not the loans would eventually default.  Only if the countries stopped making payments for a lengthy period of time would the loans be considered “value impaired” at which time the bank would have to write them down and show losses… but as long as the payments rolled it, the banks were happy.  So, what do you do in order to be sure the game continues? 

Jim Green: keep lending.

Brady Raanes: Yep, you just loan more money.  It didn’t take long before countries in Latin America were borrowing money just to make the interest payments.  You know you’re in trouble when you get to that point.     

But remember the IMF loan was enough to assure that the banks would be paid back. 

Kent Oliver: The IMF loans did one more thing other than just protect the bank.  One of the conditions for these IMF bailout loans was that each country had to agree to certain austerity measures aimed at reducing the country’s cash flow shortfall.  In other words, the government agreed to slash public spending, raise taxes, and cut imports.  In theory this should give the government more money to pay their loans.

Jim Grenn: ok, so let me call a timeout for a moment.  The IMF – the International Monetary Fund –Where do they come into all this?  Many of our listeners may not be as familiar with this. 

Brady Raanes: So, the International Monetary Fund (IMF) was created at the end of World War II.  The forty-four countries that attended the original conference established the IMF in an effort to insure the stability of the international monetary system.  The IMF was effectively designed to serve as an international credit union; offering small loans to member countries in need of short-term assistance or special financing.  At the same time, the IMF also served a watch guard to the international community, reviewing the finances of governments and warning of pending concerns.

Unlike central banks, the International Monetary Fund doesn’t have the ability to create money.  Instead, countries pay dues to be part of the IMF.  These membership dues are then made available to fund loans to countries in need.  In its simplest form, the IMF is tasked with loaning money from rich countries to poor countries as needed.  The supply of funds is limited, and generally doesn’t afford generosity.  Nor does it afford leniency. 

For practical purposes, the IMF doesn’t simply hand a billion-dollar check to a poor government.  Rather, they provide the government with a credit line they can use to access installments as needed.  However, the IMF generally places strict requirements on government spending that must be agreed upon before providing any credit.  The credit line may be withdrawn at any point if a country isn’t meeting the IMF conditions of the loan. 

Jim Grenn: what about oil at this point?

Kent Oliver: it’s kinda beyond that.  Oil prices were still low, but even if they had shot back up they couldn’t have offset the higher interest rates and weak peso.

Jim Grenn:  ok, gotcha.  So how are the people living in Latin America holding up?  Are they aware of all this drama or is strictly a government problem? 

Brady Raanes: Oh yeah, big time.  All these restrictions put in place as a condition of the IMF loans meant that governments had to start cutting basic programs like healthcare, education, and basic subsidies.  The currencies in most country weakened to the point that the rate of inflation surpassed 100%.  Plummeted exchange rates coupled with soaring inflation made pension and incomes far less valuable.  Here are some pretty wild statistics. 

At the start of the crisis, the average Mexican worker could purchase one pound of chicken with the wages earned from about 40 minutes of work.  By 1986, the same pound of chicken required more than 2 hours’ worth of wages.  One pound of onions could be purchased after a mere 7 minutes of work in 1982.  By January of 1986 it took a full hour of work at minimum wage pay.  Meat consumption fell dramatically throughout Mexico.  Malnutrition began to rise.

Kent Oliver: it’s not the government didn’t realize these problems had arisen, but they couldn’t really do much because they didn’t have the money.  Peru elected a new president in 1985.  A guy named Alan Garcia.  People duded this guy the “Latin American Kennedy”.  He was young, enthusiastic, and he campaigned on this idea that he would end the austerity and stand up to the IMF.  So he wins the election and he announces that Peru will only pay their creditors, including the IMF based on the strength of their exports.  They would pay, I believe no more 10% of their exports towards interest payments. 

Sure enough, 4 months later, the banks have to take some write offs because Peru stopped making payments, but Peru was too small to really worry the banks.  The real fear was the Brazil or Mexico would try the same trick.

Jim Grenn: Was any unified effort every taken? 

Brady Raanes: A series of meetings between the indebted countries did take place in Colombia in 1984, but no formal cartel was every created. 

In 1984, Argentina challenged creditors and the IMF, but Brazil and Mexico didn’t join the effort because it appeared their economies were improving.  In 1985, Peru’s attempt to tie debt payments to export earnings fell flat when other countries didn’t do the same.  In 1986, with Mexico’s economy in shambles, Mexico nearly suspended all debt repayments, but Brazil and Argentina felt they were improving and didn’t join forces.  Brazil tried to play hardball in 1987 but they couldn’t get anyone else on board. 

The banks had done a marvelous job of renegotiating small deals with each country throughout the process, careful to stagger out the incentives to each at different time in an effort to avoid a concerted plan amongst the countries.  Latin American countries eventually resigned to the fact that there was no way out of the crisis.  If they had successfully banned together they likely would have had negotiating power and could have restructured years earlier.

Kent Oliver: Peru had it bad.  They had to try something.  Nearly half of all Peruvians lived in poverty in 1985.  The average income had fallen to levels not seen for 20 years.  The ratio of doctors-per-person fell by more than one-third as health care professionals moved away from Peru or took higher paying jobs in the private sector.  The country’s total headcount of nurses was also cut in half from the previous decade.  Infant mortality spiked.  The rate of infectious diseases tripled from the previous decade.  Sadly, it became more common to die in infancy than of old age in Peru.

Brady Raanes: but don’t forget about the earthquakes in Mexico – that was pretty rough too

Jim Grenn: Earthquakes?

Brady Raanes: yeah, just when things couldn’t appear to get much worse, two massive earthquakes hit Mexico City on consecutive days registering 8.1 and 7.5 on the Richter scale in the fall of 1985.  The quakes killed 10,000 and left 100,000 more homeless.  The capital city was shell shocked.  The final tab for the quake’s destruction was more than $5 billion leaving the country with two equally poor choices: borrow more money abroad or increase the federal deficit; likely leading to even more inflation.  The IMF advised them to take on more debt and provided Mexico with a loan in the wake of the disaster.

The earthquakes dealt a swift blow the country’s fledging tourism industry as well.  Several major hotels in Mexico City were destroyed, and those that remained struggled to attract visitors.  Hotel occupancy in Mexico City fell to less than 10 percent of capacity.  The lack of demand for the peso led it’s value to plunge to nearly 500 peso /dollar by the end of the year.  Mexico’s debt had now ballooned an additional $16 billion from the time of the crisis and stood at an insurmountable $96 billion.

Jim Grenn: this is exhausting.  So, how could this possibly end?

Kent Oliver: well we aren’t there yet.  But there were attempts to solve the problem.  Shortly after the Mexican earthquakes, James Baker, the Treasury Secretary for the United States announced that he had a plan to solve the crisis.  He pitched an idea that called for an additional $29 billion in loans to the region over three years.  Although the countries were already strapped by debt, Baker reasoned that providing them more money would reignite their economies and allow them to grow out of their recessions. 

Brady Raanes: Needless to say, the additional debt didn’t help provide the relief intended.   The end result was simply more debt.

Kent Oliver: With virtually no available jobs, illegal immigration rose dramatically as Mexicans traveled across the border.  The immigration of affluent skilled businessmen, intellectuals and craftsman became so prevalent that the Mexican people coined a phrase to describe the phenomena

Brady Raanes: let me give it a try “la fuga de cerebros”, translated “the flight of brains.”

Kent Oliver: “la fuga de Cerebos”

Brady Raanes: that’s what I said

Kent Oliver: For those who stayed in Mexico, however, there was one booming industry: the drug trade.  With limited money to pay police, the illegal drug trade became the easiest source of income for many.  The industry directly employed an estimated 50,000 people at the time.   With more 10% of the US population partaking in recreational marijuana and cocaine, the DEA estimated total US drug consumption at $110 billion, roughly equal to Mexico’s entire national debt.  Although the numbers aren’t widely known, it is believed that the drug trade brought in nearly as much revenue to the Mexican economy as the entire country’s oil exports. 

With the economy in shambles, the narcotics industry attracted many of the best skilled laborers, including the country’s limited supply of biologists, botanists and geneticists.  The main players in the drug industry were perceived by many in Mexico as modern day ‘Robin Hood’ characters.  By mid-1986, Mexico was the largest supplier of marijuana and heroin to the United States.

Brady Raanes: Peru too.  So, Peru becomes the cocaine capital of the world.  There is this valley in Peru called the Huallaga Valley that become ground zero for Peru’s cocaine production.  By 1987 there were twice as many acres dedicated to cocaine than Napa Valley has acreage dedicated to grapes. 

Jim Grenn: so… did… anyone do anything about this?

Brady Raanes: yeah, it’s kind of funny in a sad way, but the US spent more than $4 billion trying to solve this problem. 

Jim Grenn: Was this during Ronald Reagan’s famous War on Drugs

Brady Raanes: yeah, this was kind of during the heart of it all.  So, there were these joint efforts between the US and Peru to try all sorts of stuff.  They paid pilots to fly crop dusters over the fields and drop herbicide, but they didn’t pay enough and there wasn’t adequate oversight so the drug producers would just pay more to swap the herbicide for water.  The government negotiated with Eli Lily to use chemicals in a large-scale eradication but Eli Lilly didn’t want the possible fallout from the environmental impact of dropping herbicide on 100,000 acres.  But the worst idea was this plan between the US government and Peruvian government to offer $25 million worth of small loans to farmers willing to voluntarily substitute their crops to something like rice, sugar or coffee.  The only problem was that rice, sugar and coffee net about 60-80% less revenue per acre than cocaine.  So, all these do-gooder farmers couldn’t repay the loans and they fell on even harder times and had to turn back to cocaine production to repay the loans.

Jim Grenn:  So, let me get this straight.  Oil prices skyrocket.  Latin America has oil, so they think they are going to be rich.   So, they borrow a bunch of money to speed up the process, but interest rates shoot up on their loans, and they can’t pay their loans anymore, so they borrow more money, cut public spending, the economy tanks further and people start selling drugs… then they can’t really stop selling drugs because they owe to much from the loans they took out.

Brady Raanes: don’t forget about the earthquakes

Jim Grenn: right…

Kent Oliver: But it does get better.  Nicholas Brady was appointed to the position of Secretary of the Treasury for the United States in the fall of 1988.   

Shortly after he gets appointed, George Bush, Sr., gets elected president.  Nicholas Brady and old George Bush were already well acquainted – like pretty close friends.  President Bush had a different view of Latin American than most politicians.  For years, Bush worked in the Texas oil business, building close ties with various Mexican officials. Closer to home, President Bush boasted of having “three Mexican grandchildren” curiosity of his son Jeb and daughter-in-law of Mexican descent. 

So anyway, Nicholas Brady pitches this idea that begins to solve the whole problem.  Two words “debt reduction”

Jim Grenn: and it worked?

Kent Oliver: enough.  Things weren’t fine after that but Mexico started to put the pieces together and rebuild their economy. 

Brady Raanes: it was a bit of a difficult sale, but the banks could see the writing on the wall that if they didn’t agree to the idea these countries would eventually default.

Jim Green: so, the banks agreed to provide a debt reduction and take some loses to avoid larger losses later.

Brady Raanes: Yeah, but they didn’t really take any big losses.  The government was able to work out a nice deal that allowed the banks to convert their Latin American loans into new loans backed by Treasury bonds at a lower interest rate.  So, in the end, it worked out pretty well for the banks all the way around. 

Kent Oliver:  Sadly, it didn’t work out so well for the Latin American people.  That time frame, 1980-1990 roughly is referred to as the ‘lost decade’ because the whole region was so much worse off at the end than they had been at the beginning.  All the malnutrition and lack of government fund towards education really set the country back.

Jim Grenn: but thank God we protected the banks.