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Debt Crises - Policy Solutions - Washington Consensus Class Notes 5

Terms in this set (5)

NEO-LIBERAL POLICIES
Privatization of SOEs selling national state owned
enterprises to international and local private entrepreneurs
Goals of privatization:
1) Stop public deficit
2) Attract foreign investment (bringing foreign currency
needed to honor public debt)
3)↑Competiveness of SOEs (firm level):
↑production , ↑efficiency x worker
↑profit oriented, ↑quality of prod

• Elimination of price subsidies: gov will stop setting up
prices of goods and services produced in SOEs. Objective
eliminating prices distortions
• Modernization of public sector:
• Goal public spending & reforming public investment
• Promoting exports: 1) lifting taxes to exports
• 2) promoting exports of manufacturing goods and
• 3) promoting agro diversification: production nontraditional
agro commodities

NEO-LIBERAL POLICIES CONSEQUENCES
• Elimination of price
subsidies via SOEs
• Cost of production
increased: inputs were
more expensive
• Higher domestic prices
of manufactured and
agro goods produced
locally.

NEO-LIBERAL POLICIES
• Privatization
of SOEs
• Short term: preparing SOEs for
privatization
CONSEQUENCES ↑unemployment
• ↑prices of utilities and key goods
& services: water, electricity,
telephone, public transportation,
basic food, etc

NEO-LIBERAL POLICIES
Modernization of
public sector:
CONSEQUENCES
• ↑ Unemployment
• Contracted
government capacity
to invest on social
welfare & infrastructure

OTHER POLICIES TO CONTRACT
AGGREGATE DEMAND
• Monetary Policy: to fight inflation tight
monetary policy: freezing public wages
decreasing real wages.

OTHER POLICIES TO CONTRACT
DOMESTIC CONSUMPTION
• Devaluation to adjust overvalued
exchange rates making:
•Imports more expensive & Exports
cheaper.
• Exacerbated local inflation &
deepen poverty

MORE NEO-LIBERAL POLICIES: INTERNATIONAL TRADE POLICIES
To improve industry efficiency, IMF proposed openup
domestic markets to international competition:
Trade liberalization
How: lower import tariffs of manufactured goods
produced at home
SR result: overprotected industries
• w/o price subsidies from SOEs, preferable ERs, and lower
import tariffs
• faced higher production costs and due to capital flight
also depressed investment

MORE NEO-LIBERAL POLICIES: INTERNATIONAL TRADE POLICIES
Trade liberalization
Consequences of import tariff overprotection: after trade
liberalization:
Local factories: could NOT face foreign competition
Massive # industrial firms shot down
Massive unemployment in the urban areas poverty in
the cities.

MAIN EFFECT OF ABSORPTION
APPROACH:
Unemployment and Inflation

IMPLEMENTATION OF IMF PROGRAM WAS
NECESSARY CONDITION FOR MORE LOANS
• To have access to more foreign loans, LAC
governments signed letter of intent to
modernize and follow market-based
policies.

IMPLEMENTATION OF IMF PROGRAM WAS
NECESSARY CONDITION FOR MORE LOANS
• Additional foreign loans did not bring fresh invest for
new projects.
• Additional loans provided capital to repay past
liabilities.
• Some loans were rolled over into longer term maturity
and higher but fixed interest rates.

IMF ASSUMPTION
By the time, new loans came due, the benefits
of neo-liberal market-based public policies
would let LAC countries regained liquidity
problem and service public debt.
MARKET TOOLS: INTERNATIONAL BANKS
1980s, financial sector reduced its exposure by engaging in
Secondary Market Operations:
Market tools where international banks offer LAC public debt as
assets, to a more risk-inclined buyers.
The purpose was to get rid of riskier assets selling LAC public debt to a
discounted amount. How to determine the discount pct?:
The riskier the assets cheaper value higher the discount

PRICE OF LAC DEBT
By 1987, the avg
face value of LAC
debt was LT 50%.
1987: Peru's debt
could be
purchased for up to
7 cents per dollar

Purchased
Debt
•Foreign firms (FF) wanted to invest and build a
factory in a LAC country would purchase some of
the country's debt to a discounted value.
Exchanged
• FF negotiated directly w/ international bank holding debt.
• FF negotiated w/ LAC central bank, selling value of debt in
foreign currency to a discounted value higher than what they
had paid for.
Monetize
public debts
•Debtor government agreed to purchase the loans in
local currency.

DEBT-FOR-EQUITY SWAPS
Objective:
• Ownership of LAC pubic debt would change hands:
from international commercial banks to firms interested on
investing in LAC.
• LAC central bank would repay public debt in domestic
currency instead of foreign currency.

DEBT SWAPS
Example:
In 1988, Philips (Dutch company) purchased in the secondary
market $5million Brazilian's debt at 80% face value, paying
$4million in cash.
Philips negotiated with Brazil's Central Bank and sold the $5m loan
in dollars at 94% face value, accepting the equivalent of $4.7
million in Cruzados.
Phillip got the equivalent of $4.7m in Cruzados (purchased at $4m)
and paid a previous obligation to an internal Brazilian Co.

MAIN ADVANTAGES OF DEBT-FOR-EQUITY SWAPS
• International commercial banks get rid off poor performing
loans.
• LAC governments:
• Reduced debt w/international commercial banks
• Investment in LAC countries: ↑jobs ↑production.
• Public debt is monetized: debt is converted to obligation in
local currency

ARE DEBT-FOR-EQUITY SWAPS A WIN DEAL?
Main Disadvantages: To paid in local currency, countries
could:
• Printing money inflationary impacts higher prices tax
the entire society impact of inflation is not equal
burden higher for vulnerable population
• Borrowing internally: indebtedness only changed hands
from internationals to domestic lenders lower the
capacity of local banks to finance local firms.

ARE DEBT-FOR-EQUITY SWAPS A WIN DEAL?
Other disadvantages:
• Foreign firms had access to LAC debt at lower prices while
competing against local firms.
• Possibility of constraining foreign investment that may have brought
foreign capital in the country anyway.

LA DEBT CONVERSION 1985-1989
Despite its
disadvanta
ges, the
appeal of
debt
swaps was
strong.

Debt-for-Nature Swaps
Purchased
Debt
•International environmental groups (IEG)
purchased LAC's debt at discounted price
Exchanged
•IEG offered LAC government to cancel or accept partial
payments in domestic currency.
National
Preserve
•Debtor government agreed to establish National preserve
i.e. national parks or protect national forest.
Objective: promote environmental sustainability in LAC

DEBT-FOR-NATURE SWAPS
• Thomas Lovejoy started this initiative in 1984 (then Vice-president of
World Wildlife Fund). 1987 Costa Rica, Ecuador, and Bolivia used
this form of debt reduction.
• LAC debt gave international environmental non-governmental
groups means to persuade LA governments to adopt sustainable
environmental-development policies and implement environment
projects in exchange for a debt deduction.

REQUIREMENTS FOR DEBT-FOR-NATURE SWAPS
• 1. Donor NGO buys
LAC country's debt from
secondary market
2. LAC country's Central
Bank should agree to
accept the debt note
and be willing to finance
the negotiated
environmental program.
3. A private or
governmental agency
must carry out the
environmental program.

DISADVANTAGES OF DEBT-FOR-NATURE SWAPS
Same disadvantages of debt-for-equity swaps.
• Switching country resources from more critical poverty
alleviation needs to environmental conservation projects.
• Foreign donors' could dictate national environmental agenda.
• Costa Rica used this instrument wisely by using the debt-for-nature swaps as an
extension of its national environmental policy. The government of Costa Rica used
this type of swaps, setting a ceiling on # of swaps allowed per year.

THE BAKER PLAN
IMF 1st period of debt crisis adjustments were largely unsuccessful. LAC
creditworthiness was NOT restore and economic growth plummeted.
1985, U.S. treasure secretary James A. Baker proposed a new adjustment
plan promoting economic growth

THE BAKER PLAN
• Premise: LA countries could not continue
servicing its debt through contractionary policies
it did not favor investment or democracy.
• It channel $29 billion of new fresh money, $20m from
commercial banks and $9 billion from the World Bank
and IMF.

CONTRIBUTION OF BAKER PLAN
• It shifted policy from austerity to growth.
• Exports were perceived as the engine of growth. Both were marketbased
away from planning economies.
• Switched from a short-term liquidity problem to a
long-term problem of structural adjustment.
• It gave the World Bank a role of assisting the management of the
structural adjustment process.

THE BAKER PLAN DID NOT GO FAR
Did it work? NO it did not
• International commercial banks were NOT convinced
that new lending to debtor countries made any sense.
• The Baker plan was too little in scope - did not restore confidence
or trust.
Main contribution of this plan:
Promoted a conceptual shift that years later would impact future
policies.

THE BRADY PLAN: VOLUNTARY DEBT REDUCTION
ALLOWING SUSTAINABLE GROWTH
In 1989, the U.S. treasure secretary Nicholas Brady offered a plan asking
international comm banks:
• To decrease the face value of the debt (forgiving a percent of the debt).
• To extent time period of the obligations
• Infuse new money to cover interest service in early years to smooth the
transition to market economy.

BRADY PLAN ELIGIBILITY CRITERIA
To be eligible for the Brady plan debt reduction
a LAC country should show credible political will
and strong track record of economic
performance (evidence based).

BRADY PLAN ELIGIBILITY CRITERIA
1) Debtor countries should undertake policies favoring private
investment.
2) Collateral was created: in exchange of debt reduction and
to attract international banks to negotiation table:
Debtor countries buy U.S. treasury bonds as guarantees
Brady bonds served as safeguards in the event of default
encouraging investors' confidence. World Bank and the IMF
financed these bonds.

IMPLEMENTATION OF BRADY PLAN
Implementation:
• Buybacks: LA debtor countries bought own debt at small
fraction of its face value in foreign currency. Costa Rica used
this alternative and reduced official debt by $1billion
(purchased at 16% face value).
• Swapping long-term loans for treasury bonds with a
• 30-35 % discount face value at variable interest rate or
• Swapping loans w/o discount but at a fixed interest rate of
6.25%

MEXICO AND THE BRADY PLAN
In 1989 Mexico restructured $48 billion of its debt:
• Banks swap: $21b old loans for new 30-yr bonds with a 35 % discount on face
value at variable interest rate.
• Banks swap: $22.4b at total value but fixed 6¼%
• $4.4 billion in new money at the London Interbank Offer Rate (LIBOR) plus 13-
16%.
• The IMF, WB, Japan and Mexico:$10b guarantee in Brady bonds.
• 1989-1994 via Brady Plan Mexico reduced its net transfers by $4b
per year, about 2% of GDP.

BY 1995 TOTAL DEBT SERVICE REACHED
MANAGEABLE LEVELS OF EXPORTS: Total Devt Service/Exports (%) went from 50% to 25%.

COMPOSITION OF
LAC PUBLIC
EXTERNAL DEBT
LAC public external debt fell from a
peak of 42% in 1987 to 25% of GDP in
2004.
After the Brady Plan, the composition
of LAC's public external debt
changed from commercial bank
loans in 1980s, to mostly bonds in the
1990s.

WASHINGTON CONSENSUS
• In 1989, John Willianson (econ Inst for International Economics)
summarized the commonly shared policies from Washington
institutions: IMF, WB, US Treasury Dpt.
• The debt-crises made it evident the unsustainability of ISI as
implemented in LAC.
• New paradigm: Market-based and export-led was praised based
on the experience of the four Asian tiger countries(South Korea,
Singapore, Hong Kong, and Taiwan).

WASHINGTON CONSENSUS - NEW PARADIGMA
1. Market-oriented economic reforms: confidence in the
market
2. Transformation of inward-oriented industry model based on
strong government (SOES) to an export-driven growth
strategy promoting trade liberalization, regional integration,
promote international competitiveness -labor relations, investment in
technology, infrastructure, education, & health.

WASHINGTON CONSENSUS: 10 NEO-LIBERAL POLICIES
1. Macro stabilization programs promoting fiscal balance: balancing public
spending & downsizing public sector reducing inflationary process.
2. Deep tax reforms : ↓tax evasion, ↑gov rev, eliminating perverse
incentives depressed production and investment.
3. Modernize financial sector: letting international banking competition
access to local markets.
4. Avoid artificially strong currencies that discouraged X.
5. Reduce trade protectionism trade liberalization
6. Privatization of inefficient SOEs.
7. Encourage FDI
8. State modernization: improve legal protection of property rights
in secure greater investment from foreigners and locals
9. Deregulation of business transactions, including investment
decisions.
10. Target public expenditures on the poorer groups in the
population social safety nets.

IS LAC DEBT CRISIS OVER?
• After 1990, the turnaround in the region was dramatic.
• Financing was mostly restricted to corporate private sector. Only key
SOE remained .
• LAC domestic markets were provided with large capital investment.
• Pension funds got privatized: managed $130b in capital stock and growing ~ $1b per
month.
• Financial trust in LAC increased as LAC's currencies maintain economic
credibility.