Towards an integral framework for debt management: Lessons from Latin America to Europe (Part I)

Remarks delivered at the Plan B Conference in Madrid, 20th of February 2016.

1 April 2016 by Daniel Munevar

Part II

A brief survey of the history of South America would reveal that one of the landmark spots of historical traditions is reserved, besides soccer and corruption, to debt crisis. As such the region has one or two words of wisdom it could give to countries undergoing this type of ordeal. This discussion is organized around the notion that, as the historical experience of Latin America clearly shows, debt crisis can only be resolved once insolvency is recognized and dealt with. Attempts to delay this process, in order to shifts economic costs between debtors and creditors, result in actively harmful economic decisions and policies. Thus, the presentation is organized as follows. The first section will discuss a set of parallels between the Latin American debt crisis of the 1980’s and the current crisis in Europe. The second section will attempt to develop a series of ideas on how to think of an integral framework for debt management in the context of the discussions of DiEM and Plan B.

Even though the debt crisis of Latin America and Europe are 30 years and an ocean apart from each other, there are remarkable similarities between the two of them. To examine the characteristics of the first can help to think more clearly about the possible choices and outcomes of the latter. In that respect, there are a series of key areas that is worth discussing briefly: the origins of the crisis, the structure of creditors and debtors, as well as the official response and outcome of the crisis.

Concerning the origins of the crisis, the main culprit in both cases was the temporary suspension of logic that came as a result of surges of liquidity Liquidity The facility with which a financial instrument can be bought or sold without a significant change in price. in international financial markets. Off course, that can also be said of every single financial crisis in history. More to the point, the suspension of logic is embodied in the notion that bankruptcy and insolvency are a thing of the past. In the case of Latin America, the justification for this absurd notion was a result of the sustained increase in commodity prices that took place in the 70s. The euphoria surrounding sovereign lending in the region led the then head of Citigroup, Walter Wriston, to famously proclaim that countries don’t go bust. He ended up being disabused from this concept, and his position at Citi, early on in the debt crisis. In Europe, the introduction of the Euro led markets and policy makers to believe that the risk of default belonged, alongside national currencies, to the history books. Debts in Greece and Spain began to be valued the same way than debts in Germany. In the eyes of the supporters of the common currency, this was precisely the evidence that the Euro was doing its job at promoting convergence. In that regard, the process of disabusing policy makers from the notion that all debts will be repaid is taking a bit longer in Europe than it did in Latin America.

In the case of the structure of creditors, the main lenders in both regions were banks. Nonetheless, the geography of the crisis and the lending mechanisms were different. In the case of Latin America, banks from the US organized themselves in groups to provide syndicated loans to the region. The rapid growth of these loans, which were kept in the balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. sheets of the banks, created serious problems in terms of exposure and concentrations of risk to specific sovereign borrowers, which eventually ended up materializing. In the case of Europe, banks in the core countries of the Eurozone mainly bought bonds from banks in the south of Europe. The later then proceeded to use these funds to provide loans that funded an unsustainable consumption and real estate bubble in countries like Spain or Ireland. The financial crisis of 2008 obliterated the business model of European banks. With their balance sheets crumbling under the burden of bad loans, they are unable to provide new lending or to obtain funding in markets without the support, and subsidies, provided by the ECB ECB
European Central Bank
The European Central Bank is a European institution based in Frankfurt, founded in 1998, to which the countries of the Eurozone have transferred their monetary powers. Its official role is to ensure price stability by combating inflation within that Zone. Its three decision-making organs (the Executive Board, the Governing Council and the General Council) are composed of governors of the central banks of the member states and/or recognized specialists. According to its statutes, it is politically ‘independent’ but it is directly influenced by the world of finance.

The other side of this issue is the composition of borrowers. In Latin America, the large majority of the loans were provided to national governments. There was very little in the way of loans to private sector, and even in those cases, the credits included official guarantees Guarantees Acts that provide a creditor with security in complement to the debtor’s commitment. A distinction is made between real guarantees (lien, pledge, mortgage, prior charge) and personal guarantees (surety, aval, letter of intent, independent guarantee). from the government. Thus, went the crisis started in 1982, the losses were heavily concentrated in the balance sheets of the governments of the region. Once defaults started, this liability structure effectively blocked international credit flows to the private sector. As a result, it was able to emerge from the crisis, almost a decade later, with low levels of debt. This went on to become a key component of the recovery in the early 90’s, as the private sector was drew in new capital flows to the region. In Europe, the picture is the exact opposite. Most of the credit growth took place in the private sector. Before the crisis hit, public debt had actually gone down in countries like Spain or Ireland. But once the problems started in 2008, there was a massive process of socialization of debt, were the losses of private financial institutions were taken on by the public sector. Furthermore, the high levels of debt of households and corporations meant that, unlike Latin America, the process of private deleveraging actually intensified the severity of the crisis.

The origins and structure of lenders and borrowers is important to understand the approach taken to deal with the crisis. In this regard, it’s critical to appreciate that the process of dealing with insolvency can be narrowed down to an issue of recognizing and allocating losses between lenders and borrowers. From an inter-temporal perspective, the moment in which such losses are recognized plays a key role in how the burden is shifted among the parties. On the one hand, an early recognition shifts most of the costs to the lender who is forced to deal with the negative impact on its balance sheet. On the other hand, to delay the recognition of the losses implies a real transfer of resources from borrower to lender, which effectively transfers the costs of insolvency to the former. This is because there is a real transfer of resources on what is by definition an unpayable debt. Not surprisingly, in both Latin America and Europe, the lenders fought tooth and nail to delay for as long as possible the recognition of the problems of insolvency.

With this mind, it’s possible to better understand the official response taken by government officials on both sides of the Atlantic. In the case of US banks with exposure to Latin America, an assessment made by the FDIC in 1982 showed that 8 of the main 10 banks of the country could have faced insolvency if they would have been forced to recognize losses on sovereign lending. As such, the response from US government officials was to practice “regulatory forbearance”. This is just a fancy term for looking the other way around, and pretend the problems did not exist. Thus, US banks were allowed to continue carrying sovereign loans on their balance sheets at nominal value, despite the fact it was clear that it was unlikely those loans were ever going to be paid back. Furthermore, they underwent a painful process of consolidation to shore up their balance sheets that involved raising additional capital and increasing reserves. The Brady Plan allowed to recognize the losses almost a decade after the crisis had begun, and only once banks were in a position to absorb them without risking insolvency. Thus, from the perspective of US government authorities and banks, the policy response to the Latin American debt crisis was a resounding success.

Obviously, an entirely different picture emerges if one were to ask people in Latin America regarding their experience with the crisis. With it came the implementation of IMF IMF
International Monetary Fund
Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.

When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.

As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).

The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.
led adjustment plans. Government budgets were slashed across the board in a drive to create surpluses to service the debt. As a result, GDP GDP
Gross Domestic Product
Gross Domestic Product is an aggregate measure of total production within a given territory equal to the sum of the gross values added. The measure is notoriously incomplete; for example it does not take into account any activity that does not enter into a commercial exchange. The GDP takes into account both the production of goods and the production of services. Economic growth is defined as the variation of the GDP from one period to another.
per capita and living standards suffered a noticeable decline. Nonetheless, two elements separate the experience in the region with the current one in Europe. First, the US had no formal process of integration with Latin America. Thus, in order to save its banks it could afford to impose this decade long crisis on its “backyard” without having to worry too much about its economic or political impact. The same cannot be said of the EU, where tensions between borrowers and lenders are creating an enormous amount of resentment towards the integration process. Second, in Europe both public and private sectors have emerged from the crisis with high levels of debt. Thus, unlike Latin America, there is no immediate source of credit demand or aggregate final demand to foster the recovery. By extension the deflationary tensions experienced by Europe are bound to be much stronger than those observed in Latin America.

Unfortunately, European authorities, led by the ECB, followed the same approach of US authorities. Jean Claude Trichet, head of the ECB, made a point of ensuring that his aversion to debt restructuring became the official policy of the central bank Central Bank The establishment which in a given State is in charge of issuing bank notes and controlling the volume of currency and credit. In France, it is the Banque de France which assumes this role under the auspices of the European Central Bank (see ECB) while in the UK it is the Bank of England.

. The approach was simple enough. In the short run, the plan was to avoid a financial panic through regulatory forbearance and provision of official guarantees to banks creditors. To this end, Trichet became quite fond of sending letters to European heads of State threatening with exclusion from liquidity provision, and the facto expulsion of the currency area, if they refused to offer a blanket protection to bank creditors. In the long run, the objective was to give enough time for banks to rebuild their capital base and reserves so as to eventually be able to recognize the losses without risking insolvency, especially of Too Big To Fail (TBTF) financial institutions. The problems with this strategy were clear enough. First, the other side of the coin of bank consolidation was the implementation of austerity in debtor countries. As it happens, to force your neighbor to live on the streets in order to pay the bank might be a bad idea if you run into him everyday when you leave your home. Some animosity could be involved. Second, as the problem of indebtedness was widespread, involving both public and private sectors, the deleveraging process would end up with one of two outcomes. It either locks entire countries in a debt deflationary spiral or if it works, it would be on a very large time scale. Given enough time, the heated exchange of words with your homeless neighbor could escalate into nastier forms of interaction.

From this it follows that without a clear and comprehensive framework to deal with debt overhang in Europe it will not be possible to overcome the crisis. Furthermore, the longer it takes to arrive to a coordinated response, the more likely it will be that the debt wound would fester on killing its host by poisoning. The second part of this article will attempt to develop a series of ideas on how to think of an integral framework for debt management in the context of the discussions of DiEM and Plan B.

Daniel Munevar

is a post-Keynesian economist from Bogotá, Colombia. From March to July 2015, he worked as an assistant to former Greek Finance Minister Yanis Varoufakis, advising him on fiscal policy and debt sustainability.
Previously, he was an advisor to the Colombian Ministry of Finance. He has also worked at UNCTAD.
He is one of the leading figures in the study of public debt at the international level. He is a researcher at Eurodad.



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