October 22, 2002

In the banks' global recycling game the poor lose every time

Posted in ·
Share 

What have Yasser Arafat, the Palestinians, Israel, oil-producing Arab states, Citibank, Bob Geldof and Bono got in common?

Third world debt of course. Why? Because the amazing story of how the world’s poorest nations found themselves up to their tonsils in debts that they still can’t repay begins and ends in Jerusalem.

Chapter 1: Before 1973, the west’s phenomenal post war growth rate was subsidised by cheap oil from the Arabs. As long as cheap oil flowed from the Gulf, the west could pump out goods at low prices, trousering the profits (obviously there were other factors at work but oil was one of the cornerstones). Western Europe and the US got very rich, built up a huge surplus of cash and generally made hay. Suddenly, the Yom Kippur War breaks out, Israel is attacked from all sides by Arabs intent on taking back East Jerusalem at best, “driving the Jews into the sea” at worst. Against the odds, the Israelis win and the rest is history.

Aggrieved, humiliated and sore, the defeated Arabs used oil as a weapon to make the west, particularly America, learn that militarily supporting Israel was not a zero cost option. Opec choked off supply, oil prices sky-rocketed, stagflation (a combination of high inflation and high unemployment) reigned in the west and the curse of long-term manufacturing unemployment emerged and still blights us today.

At this miserable juncture, contemporary economic history usually ends and, in the west at least, is not taken up again until the emergence of the Reagan/Thatcher coalition of the mid-1980s. But this is not the whole story because it does not tell us about the recycling of western taxpayers’ money.

Chapter 2: The oil crises of 1973 and 1979 saw the biggest ever peacetime transfer of assets from one part of the world to another. Literally overnight, billions of dollars drained away from the west, cascading into the Arab countries, particularly Saudi Arabia and the small Gulf states.

Even the most conspicuous of consumers eventually run out of things to buy and following a spending binge that drove up the price of luxury yachts and villas in the south of France, the Arabs realised that they still had tons of cash.

So what would they do with the stuff? At home, their own banking and financial systems were incapable of dealing with the inflow and, given the sparse population in the Gulf, the cost of infrastructure projects was pretty small beer. Enter the western banking system.

Chapter 3: As the Arabs banks were not big enough to absorb all the lolly, western banks persuaded the Arab sheiks to deposit the cash with them. Unbeknown to western taxpayers, they had just increased the potential profits of the world’s biggest investment banks via a recycling mechanism called the oil shock and the Gulf states.

The problem now for the bankers was where could they put this money to work. After all, the name of the banking game is to create as much margin between the interest paid out to lenders and the interest charged to borrowers.

Traditionally, the banks would have lent cash to corporate America or Europe, making a few quid, keeping the Arab depositors happy. However, the oil shock itself had driven corporate America and Europe into recession and landed millions of previously free spending workers on the dole. Bankers had to look elsewhere for business. Where else but the third or developing world?

Chapter 4: By 1976, besuited bankers were literally stuffing cash into the pockets of third world dictators. No loan was too big, no deluded presidential project too deluded.

When faced with zero profits, their relationship with their Arab clients souring and the possibility of redundancy, the world’s banking community did what it had to do to stay in silk ties. Investment banks lent hand over fist to despots on the assumption that, should things go pear-shaped, America’s Cold War obsession meant the US would bail out their client states in Latin America and Africa.

And so stage two of the great, global recycling game came into play. Western taxpayers’ cash went first to the Arabs via the oil shock, then to the western investment banks and finally to the pockets of despots. Every venture from Mobutu’s “Rumble in the Jungle” to the Argentinian junta’s 1978 World Cup became possible. The third world’s finances began to spin out of control.

Chapter 5: As late as 1980, bankers still believed that America would never allow its “friends” in the world to go under. This view prompted the chairman of Citibank (one of the biggest players in this game) to state infamously that “companies might, but countries don’t go bankrupt”.

In 1982, Mexico defaulted, followed by almost every other Latin American country. Washington did nothing.

The bankers panicked, called in their loans and a domino effect began. By 1988, almost all third world countries, crippled with huge debts, had defaulted. Credit dried up and economies began to choke.

Chapter 6: As the third world ground to an economic halt, the bankers faced bankruptcy and the US government risked losing control over its political lackeys.

Something had to be done. Nicholas Brady, the US Secretary of State, came up with a plan that saw all the original primary loans converted into 25-year bonds which would trade in the secondary market. At a stroke, the old debt was turned into a new, tradable asset.

In the 1990s, emerging markets (as the third world was now renamed) became the next great fad for the bankers. Defaulted debt trading was where the money could be made. Because these bonds traded at a huge discount to US bonds, if the countries showed any sign of economic recovery, the price of these bonds sky-rocketed.

Millions were made and are still being made in the City and in New York by highly paid emerging market debt traders. But the taxpayers of Brazil, Mexico and elsewhere are footing the bill. If, according to the IMF (yet another US institution), the country is doing all the right things, then the cost of servicing the debt will fall, if not it rises.

Chapter 7: As most of these bonds are held by investors expecting huge returns, they are very risky and very susceptible to changes in market sentiment. Re-enter Jerusalem. Every time there is a scare in the Middle East, oil prices go up. As the third world countries are largely oil importers, these bonds crash in value, increasing the cost of servicing old debt.

In the past few weeks, violence in the Middle East has caused the market to be hammered. Not only did the third world debt problem start in Jerusalem, it continues to be significantly affected by events in the biblical cradle of our civilisation.

With that sort of skewed, no-win logic flying around and with investment banks sticking to the rigid rule of never lending to someone who really needs the cash, it’s hard to see a way out of this financial cul-de-sac for the developing world.