August 12, 2001
In 1977, the American comedienne Bette Midler demanded that she be paid $600,000 for a European tour in South African gold krugerrands. Back then, gold was presumed to be the only hedge against both inflation and a falling dollar.
Another famous 1970s presumption was made by Walter Wriston, longtime chief executive of Citibank who, when asked whether lending to the third world was risky, remarked that “countries never go bust”.
The banker was wrong, the joker was right. Had Midler held on to her gold, she would have seen the price rocket to $653 in January 1980, up from $43 per ounce in 1973 and $120 in 1977. In contrast, countries did go bust. In 1982 Mexico defaulted. Brazil and Argentina followed and by 1984, the third world was stuck in the debt quagmire that it remains in to this day. The common factor between Midler’s gold and Wriston’s third world debt was oil.
On 3 October 1973, the decision of Opec leaders to restrict oil production changed everything. The price of a barrel of oil rose from $2 per barrel to $10.50, inflation in Europe and the US took off and the price of gold rose dramatically as people went back to hoarding the precious metal as a hedge. By the mid 1980s, gold prices had fallen back steeply as inflation abated. However, the impact of the other great monetary shock (third world debt) that was sparked by the 1973 oil shock remains with us to this day.
One of the main themes of the global economic story from 1945-1973 was the rapid accumulation of wealth in the US and Europe. Trade, investment and growth rates all soared, people’s savings grew and Harold McMillan’s “you never had it so good” comments would have been as apt in the early 1970s as they were in the late 1950s. This all changed in October 1973 when the music stopped, the feel good factor disappeared and the world plunged into recession.
More than anything else, the oil shock constituted the largest single peacetime transfer of wealth ever seen. Rich, oil-consuming countries transferred billion of dollars literally overnight to relatively poor oil-producing Arab countries.
One of the biggest problems for the Arabs was what to do with all the cash. They had little choice but to put billions of dollars on deposit with the world’s biggest banks. The headache then for the banks was what to do with the cash. The recession in the US and Western Europe meant nobody in the rich world wanted to spend or invest, so the international banking system’s biggest and most reliable clients weren’t interested. Japan was hurting and the Asian Tigers were still very much developing countries. Traditional investment banking business had dried up and there were no dot.com startups or tech companies to fund.
The only place the cash could possibly be put to work was in the third world. Within a matter of months, Brazil, Argentina, Honduras and Mexico were awash with Arab dollars. By 1975, African countries such as Ivory Coast, Liberia, Mozambique and Tanzania had easy access to what appeared to be cheap credit. Another huge lender was Russia which, as an oil producer, benefited enormously from Opec’s actions and, as a superpower, lent money to prop up communist countries around the globe.
The assumption that “countries don’t go bust” was based on the understanding that the World Bank and IMF would not let their darlings in the third world go under. Private investment bankers believed that if the worst came to pass, the IMF, financed by western taxpayers’ money, would bail out the likes of Congo, Uganda and Angola. Bankers turned a blind eye to the sort of ludicrous projects that were often financed by this African credit bonanza. A mountain of debt built up.
Typically, poor countries based their ability to pay on revenue from the sale of commodities like sugar, rubber, diamonds, wood etc. Therefore, countries had to increase production of commodities in order to service their debts. The more supply, the lower the price.
So when the world went into its second, oil inspired recession in 1980-81, there were far too many commodities out there that nobody wanted to buy. The price of rubber, cocoa, sugar etc collapsed while at the same time — due to huge budget deficits in the US associated with the doctrine of Reaganomics — American interest rates and the dollar skyrocketed. Third world countries couldn’t pay their bills and began to default, led by Mexico in 1982.
The banks, particularly Citibank, took huge hits because most of these loans had to be written off, yet the Arabs still had to be paid interest on their deposits. So the banks refused to have anything more to do with the African and Latin American delinquents. By 1988, without as much as a cent flowing into the developing countries, the situation was precarious. Democratic movements in Latin America were in jeopardy due to lack of cash and American commercial interests were threatened.
Nicholas Brady, Ronald Reagan’s finance adviser, came up with an ingenious rescue plan. The old loans were re-examined. Part of the banks’ original principal would be written off and the remainder would be paid by the issue of new 30-year bonds called Brady bonds. The countries would have a five-year grace period to get back on their feet and those countries that started paying off some of the old interest would be allowed borrow again. Initially, because of the risk associated with former defaulters, the interest on the bonds was very high. However, as the country adopted economic policies sanctioned by the IMF and monitored by investment banks, the risk fell and consequently so did the interest rate. The price of the bond would rise accordingly.
Investors bought these new bonds. This solved the banks’ dilemma because, despite losing huge amounts on their initial loans, at least the books were now clean and the developing world’s debts became someone else’s problem. The investors were happy as long as the countries did what the IMF said, and the countries were happy because they now had access to new finance.
It is now assumed that the Brady bond blueprint will be used everywhere and this assumption has created its own market in pre-Brady deal debts. For example, Sudan has $30 billion of outstanding debt that has yet to be renegotiated. Today an investor can buy $1 of Sudanese debt for 2 cents — a 98 per cent discount. If Sudan begins to pay back its debts, the investor is sure to see the price of Sudanese debt jump to at least 10 cents. This is a huge killing. Similarly, the debts of Liberia, Congo, Sudan, Chad, Cuba, Iraq, Mozambique and many more are all being traded despite still being technically in default. Thousands of investors have taken this bet and are owners of third world debt.
This scattered ownership structure makes Bono’s job very difficult because it is no longer in the gift of the G8 leaders alone to solve the third world’s debt problem. The debt holders believe that it is their right, based on international law, to be repaid. Therefore, the G8 cannot just write off debts without cutting a deal with debt holders, in the main, powerful investment banks. Bono has to persuade the G8 to cough up the billions of dollars to repay the investors. By coughing up, George W is going to have to persuade the US taxpayer to dip into his pocket to bail out African countries.
With a US recession on the way, it is difficult to see how Bono, despite his enormously valuable and humanitarian work, can twist Mr Bush’s arm. If he pulls this off, he definitely deserves our thanks and admiration.