LATIN AMERICA’S 1980′s AND ASIA’S 1990′s DEBT CRISIS: A COMPARISON
Eufronio Carreño R
Kean University
I
Latin America’s Foreign Debt crisis of the 1980s has had profound repercussions that resulted in fundamental changes in the process of Economic Development and the economic structure of several Latin American countries. Asia’s Foreign Debt crisis of the 1990s has resulted in comparable repercussions that changed the economic development process and economic structure of several Asian countries. This paper compares the Mexican 1980s crisis with the South Korean 1990s crisis. It focuses on the characteristics of economic development strategies, international financial crisis, and the effects of the conditionality on their economic structures. Part II of the paper presents the economic development process and the strategies pursued by these two countries. Part III presents the genesis of the international liquidity crisis. Part IV presents the effects of the conditionality followed by our conclusions.
II
Mexico and Korea are amongst the few Developing countries to have attained the status of Newly Industrialized Countries (NIC’s). Their drive towards industrialization had similarities during their early stages of development, however, they pursued different strategies to attain higher stages of economic development.
Mexico’s drive toward industrialization became a conscious government policy with the Amendment to Article 28 of the Liberal Constitution in 1938. This Article demarcated the areas of economic activity that government and private entrepreneurs could enter. Industries such as Petroleum, Mining, Electricity and Banking were designed “strategic”, hence, they were reserved for the Government. What was considered nonstrategic was left to private entrepreneurship. The government pursued an Import substitution Industrialization policy. Domestic producers who could produce domestically goods so far imported were given protection from foreign competition in the form of tariffs and embargo; also, these producers had access to subsidized funds from the Government owned NAFINSA (Development Banks).
As a result, Mexico, by the 1950s had largely completed the import substitution of consumption goods. It was perceived that the development process was stalling in the 1960s. Mexico could not export manufactured goods to the US because it could not overcome the US barriers that protected US producers. Consequently, an aggressive policy to move the import substitution of durable goods was implemented. The government’s investment expanded into consumption, intermediate and durable goods industries producing goods such as sugar, steel, and trucks. Most of the output of government owned and private firms was for the domestic market.
The import substitution of consumption goods had been financed mainly with the earnings of traditional exports such as minerals; however, the production of durable goods required foreign expertise as well as funds. Thus, Mexico borrowed from abroad; in the process, it acquired a foreign debt. The discovery of vast oil reserves in the 1970s allowed Mexico to continue the import substitution of durable goods with reinvigorated impetus, which was financed in part with a large increase of the foreign debt.
Korea’s economy had been linked to the Japanese economy since pre WWII. After the war, Korea in an effort to reactivate its economy, initiated a drive to industrialize via import substitution. Korea used tariff protection, multiple foreign exchange and controls. The import substitution of consumption goods had been financed mainly with the proceeds of traditional exports, such as minerals that had been developed during the Japanese occupation. When the import substitution of consumption goods was completed, it could not continue with this strategy. Korea, a natural resource poor country, could not finance it.
The U.S. officials wanted to see Korea succeed in developing its economy. Korea was a product of the Cold War. The U.S. had soldiers stationed on Korean soil since the Korean War (1950-53). The US would not allow Korea to fail: it had to be a show case of success of the capitalist system. Consequently, the US fostered the Korean economic development in several ways.
The US provided Korea with grants not only for the basic administration of the government, but also to develop an industry that would export. Initially, Korea utilized its abundant labor to assemble imported parts for export. The US provided technical assistance and training to improve Korean productivity. Young Korean students were educated in American Universities. Most important, the US opened its large domestic market to the Korean producers of manufactured goods.1 In the process, Korean producers acquired the necessary experience to operate in foreign markets, hence, Korea’s change of strategy. It emphasized economic development towards the production of exportable goods.
The Korean Government policy on the economic development emulated the Japanese model of targeting firms for support. The Government intervened in economic development by supporting industries that were perceived to be promising to become successful. The support included access to credit. Also, the Government protected domestic producers by placing restrictions on foreign investment to selected industries; thus, it encouraged the development of an indigenous Korean entrepreneurial class. In order to insure their success, these entrepreneurs were encouraged to form large conglomerates called chaebols. These chaebols played an important role in the Korean economic development, as well as in the financial crisis of 1997.
III
The Mexican 1982 and Korean 1997 liquidity crisis that caused international financial crises in their respective regions had similar geneses. They were caused by large amounts of short term capital flows which at maturity could not be paid. The difference was the mechanism of these capital flows.
Mexico had traditionally relied on low interest, long term official loans from International organizations for its economic development effort. This changed in the 1970s when Commercial Banks from the More Developed Countries recycled the Oil Exporting Countries’ Deposits (Petrodollars). The US banks such as Citibank and Bank of America pursued an aggressive policy of lending abroad. Mexico, which had just announced discoveries of large amounts of Oil reserves, became an attractive place to make loans. Although these loans were short term and their interest was LIBOR rate linked, Mexican borrowers were eager to accept.
The Mexican borrowers were, mainly, Government owned (parastatals), privately owned firms, and Commercial Banks. Parastatals such as PEMEX (Mexican Petroleum) and CFE (Federal Electricity Commission) were the biggest borrowers accounting for one half of the government owed foreign debt. Parastatales had enjoyed autonomy in their finances, arguing the need of equipment to expand and/or modernize. They borrowed short term funds to finance investments whose maturities were in the long term. However, others such as CONASUPO (Popular consumption) borrowed funds to finance consumption. Also, privately owned conglomerates such as Grupo Alpha borrowed short term to finance long term investments. Finally, domestic commercial banks such as BANCOMER and BANAMEX intermediated seeking funds internationally and lending domestically. However, not all the incurred debt was used for investment, a large portion of it was used to finance capital flight.
Given the devaluation experience of the 1970′s liquid asset owners hedged. The overvalued peso and the high US interest rates made the dollar a better alternative. Hence, Mexicans purchased real estate in the US, and deposited their liquid assets in the US banks as a way to hedge a foreseeable devaluation at the end of the sexenio.2 Within the same time frame that its short term loans had matured, Mexico had nearly exhausted all its International reserves. The country was in a liquidity crisis by August 1982. It did not have ready access to liquid funds to satisfy the demand for dollars. Mexico had accumulated a foreign debt of about $85 billion. López Portillo, in a feat of demagoguery, accused the commercial banks of causing the Mexican financial crisis and nationalized them.
The Korean crisis of 1997 was also a case of International illiquidity caused by short term capital flows. The Japanese economy had entered into a recession when its “bubble” collapsed in the 1990s;3 The Bank of Japan, in an attempt of stimulating its domestic economy, had lowered its interest rates below 1 (one) percent. Foreign Banks took advantage and intermediated internationally large amounts of funds. These funds accounted for 35 percent of the liquidity supplied to the international financial markets in Asian region. This was the market where Korea was a major borrower.
Korea had relaxed its financial regulations in 1996 which allowed the creation of a new set of financial institutions. Small financial institutions had become Merchant Banks and entered the financial market to intermediate short terms funds into long term instruments. These Merchant Banks, although inexperienced in the international financial markets, acquired Internationally and domestically issued financial instruments. They lost large amounts in the International market due to their inexperience. The domestic instruments they had acquired were stated in the domestic currency (won), which they had assumed would remain stable. In doing so, by November 1997, Korea had accumulated a foreign debt of $157 billion, of which $80 billion was short term with maturity of less than a year.
The main final Korean borrowers were the large firms (chaebols), accounting for $30 billion since 1966. These conglomerates were supported by the government; their production was not restricted only to the domestic market but also produced for the international markets. Korean firms in general had been allowed to operate with 20 percent of equity borrowing at 4/1 ratio. The high savings of Koreans (35% of gross savings) were deposited in the Banks, which in turn Banks lent. Chaebols which had support of the government had access to credits. Creditworthiness was not determined so much by soundness of the firms, whose books were laxly examined, but by the Government’s political decision of supporting it. Hence, chaebols borrowed heavily and used large amounts of funds in their foreign markets ventures where their profitability was low.
The Asian international financial crisis started in July 1997 with the devaluation of the Thai baht. This affected other countries such as Indonesia, and, eventually, reached Korea. Speculation against the stability of the overvalued won had increased. Korea’s main exports of semiconductors, chemicals and steel had decreased which had decreased Korea’s export revenues. The Japanese banks unwilling to rollover their loans abroad any longer, called their Korean loans. Korea found itself illiquid, without enough international reserves to meet the demand and unable to access liquid assets on short notice to pay the matured debt. Thus, Korea had to ask IMF for assistance.
IV
The International Monetary Funds’ (IMF) program of assistance to countries with financial difficulties has been fundamentally that of Demand contraction. The Stabilization programs were similar for both countries. However, the conditionality had evolved to make structural changes mandatory.
Mexico’s financial crisis generated a serious concern about the stability of the international financial institutions and the solvency of several major US commercial banks that had Mexican exposure. Mexico, attempting to solve the crisis, sought assistance from the IMF and implemented a Stabilization program designed to reduced the demand in the early 1980′s. Mexico had been running Budget deficits internally and balance of payments deficits externally alongside an ongoing inflation. The program consisted of drastic decreases of Government expenditures, devaluation of the Peso, lowering the rates of tariff protection, and decreases of the money supply, which increased domestic interest rates. The result of these policies was a sharp recession and increased unemployment.
De la Madrid’s administration in the early years of the program attempted to stimulate the economy by resisting IMF’s demands for reductions in expenditure to decrease the government’s budget deficit. The Mexican government had little choice. It had sought assistance from the IMF to meet its financial obligations and to get relief from its international creditors. However, foreign creditors demanded that Mexico reach an agreement with the IMF in order to rollover their short term loans and to make new loans. This condition gave the IMF enough influence to force Mexico into compliance with the letter of intentions. At the same time the World Bank demanded that Mexico implement changes in the economic structure. Mexico, trying to placate its creditors, lowered the protection to the domestic producers by lowering the tariff rates and simplifying the tariff structure. These policies allowed Mexico to enter the World Trade Organization in 1986.
Further structural change came about as a result of decreases in the Government expenditure to lower the deficit, which in turn resulted in the privatization of the parastatales in the late 1980′s. A drop in the market price of oil to about $ 10.00 per barrel in the late 1980′s, reduced the revenues that the government received from exports. Mexico, which was under IMF pressure to achieve an agreed level of deficit, had to decrease expenditures by decreasing subsidy to parastatales.
An administrative reorganization of the early 1980s had brought the parastatales’ finances under closer government scrutiny. The subsidies, considered revenue by the parastatales, were used to cover their operating deficits as well as to finance investment. Parastatales’ deficits resulted from price controls on their output and the high costs of operation. Their high costs stemmed not only from the inefficient production of goods but also from additional costs incurred as they had to supply their workers social goods such as health service and housing. These firms were inefficient; they could not compete with imports either in price or quality. Hence, they were privatized.
The privatization was a sale of government owned firms to private domestic and/or foreign entrepreneurs. It started in the late 1980′s with the sale of firms that operated in the consumption goods industry such as textiles and soft drinks. Mexico, to satisfy the demands of the foreign creditors, had to make amendments to Articles 27 and 28 of the Constitution in order to allow private domestic and or foreign investment into industries that the constitution had previously barred, such as the case of petroleum, mining, banking, and communications. The government had to dismember its integrated monopolies to make room for private investment, such as the case of PEMEX whose ventures in the petrochemical industry have been privatized. In many cases the privatization created greater concentration of resources amongst few firms. It was argued that large private firms would be more successful competing internationally. Also, with the privatization of the commercial banks, a financial institutional framework to intermediate funds was developed. The process of privatization was accelerated during Salinas de Gortari’s administration. There were around 1155 government- owned firms in 1982; after the privatization, there were around 212 government owned firms by 1994. The sale of the firms had little effect on the foreign debt, which had increased to more than $130 billion by mid 1990s.
The Mexican economy had been restructured. It was done by decreasing the government’s scope of intervention in economic activity, by opening the Mexican market to wider international trade, (expanded with the NAFTA agreement), and by making it accessible to foreign investment. The stability of the restructured economy was illustrated when free flow of goods and services as well as free flow short term capital to the Mexican economy produced the 1994 crisis.
IMF assisted Korea also during the 1997 crisis, it did so with a $58 billion bailout package in December 1997. There was also concern that Korea would pose a threat to the international financial system. The stabilization program was designed to reduce demand. However, the conditionality made mandatory the restructure and institutional reforms of the Korean financial system. To reduce inflation, the program required a decrease in the current account deficit to below 1 (one) percent.4 A drastic decrease in the money supply increased interest rates. The results were predictable; unemployment increased and GDP decreased.
By 1998, high interest of over 30% increased the cost of funds; it strained Korean firms which were used to carry high debt/equity ratios. Also, the won’s depreciation increased the cost of raw materials that Korean industry was heavily dependant upon,5 hence the cost of production of the Korean firms increased. As some chaebols went into bankruptcy, so did their suppliers. By 1998, the number of the medium and small firms’ bankruptcies had increased by around 5200.
Government encouraged firms to restructure through mergers, asset swaps and sale. It negotiated separately with the largest chaebols such as Hyndai, Samsung, LG, Daewoo and SK that had globalized operations. The intent seems to have been to increase specialization and take advantage of economies of scale. Finally, the chaebols had agreed to restructure their high debt/equity ratios to bring them down to international standards. They would do so by selling off assets and subsidiaries, and by issuing stock abroad.
The provisions for the financial restructure included the establishment of an independent Central Bank, the enhancement of bank operations transparency, the creation of a supervisory body to oversee the corporate financial operations and their financial reporting statements. The scope of government intervention on the economic activity has been decreased by eliminating government initiated loans, and by the removal of all restrictions on foreign borrowing by domestic firms.
Korea’s regulations which used to restrict foreign investment in Korean firms to no more than 15 percent were set aside as part of the financial restructure. Consequently, Government sold 51 percent of its shares of The Korea First Bank to a US based consortium. With the steps to restructure the financial system and the freedom of capital flow, foreign investors will have access to assets and portfolio previously reserved for the Koreans.
V
We have seen that Mexico and Korea at first pursued industrialization via import substitution that started with consumption goods industries. The governments in both countries played active roles. In the Mexican case, the government not only protected the nascent industries, but the government itself entered into industries that were considered strategic. In the Korean case, the government protected the nascent industries, it targeted firms for support, and it encouraged the formation of chaebols.
The strategies they followed were results of specific domestic conditions. The Mexican strategy of inward development was a result of abundance of natural resources and the inability of Mexican producers of manufactured goods to access foreign markets. The Korean strategy of outward development, which may not be replicated, was a result of limited natural resources and the U.S. Cold War policy. The U.S. provided financial and technical assistance to Korea and opened the U.S. domestic market to Korean manufactured exports.
Mexico and Korea financed their initial import substitution drive with revenues from their traditional exports and long term low interest loans from international organizations. However, these countries switched their main source of international finance to short term, high interest loans from commercial banks. In doing so, they brought about international financial crisis.
The Mexican international financial crisis in 1982 and Korea’s in 1997 had their genesis in large flows of short term capital intermediated by commercial banks. In the Mexican case, these funds were borrowed mainly by government owned firms to finance long term maturity investment and to finance capital flight. In the Korean case, the liberalized financial institutions intermediated funds to chaebols to invest in long term maturity projects and to finance international speculation. When the short term loans matured, both countries were placed in an international financial illiquidity position.
Both countries sought assistance from the International Monetary Fund to meet their financial obligations towards their creditors. The IMF implemented a demand reduction stabilization policy in both countries, however, the conditionality differed. In the Mexican case, the World Bank had pressed for the structural change that would reduce government’s intervention in the economic activity. Mexico, trying to appease its creditors that demanded an agreement with the IMF, changed its economic structure. The structural change consisted in reducing the scope of the government in the economic activity by privatizing the government owned firms, and by opening industries to private domestic and foreign entrepreneurs. In doing so, Mexico made assets available to domestic and foreign private investment. In the Korean case, the conditionality became mandatory. The Korean Stabilization program forced the Government to decrease its influence on economic activity. Korea restructured its economy by decreasing Government intervention and support to chaebols, by forcing chaebols to lower their debt/equity ratios, by creating a financial institution that makes Korean firms’ reports more transparent and accessible to foreign scrutiny, and by allowing unrestricted foreign investment in the Korean economy.
Developing countries that attempt to finance their economic development with large amounts of short term capital and are placed in an international financial illiquidity position should be prepared for an imposed restructuring of their economies.
Notes
1. Carreño, E.R. (1998)
2.Carreño, E. R. (1989)
3. Kim, Y.S. (1999)
4. Kim, K.S. (1999)
5. Veneroso, F. Wade, R.
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