January 10, 2005
The Asian tsunami has refocused minds on Third World debt. Bono, politicians and aid workers have called for the cancellation of all debt and, in particular, the debts of tsunami-ravaged Indonesia, Thailand and Sri Lanka.
On the face of it, anything that might help these countries should be welcomed. However, the issue of Third World debt is not straightforward. It has a history and a geography, it is part and parcel of our financial system and whether we like to admit it or not, many thousands of Irish investors and pension fund holders are benefiting from the proceeds of Third World debt every day.
To get the full picture, we have to go back to where it all started in the mid-1970s. On October 3, 1973, the decision of Opec leaders to restrict oil production changed the world. 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.
More than anything else, the oil shock constituted the largest single peacetime transfer of wealth ever seen. Rich, oil-consuming countries transferred billions of dollars 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 likes of South Korea and Taiwan were still very much developing countries.
Traditional investment banking business had dried up and, unlike today, there was no western property boom or emerging China, with its voracious appetite for cash, 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 the 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. In the sub-continent and Asia, it lent to left-leaning India and to communist Vietnam. In response, US banks lent to ï¿½their’ï¿½ guys in the region – Thailand and Indonesia.
The assumption that ï¿½countries don’t go bust’ï¿½ (as Walter Wriston, long-time chief executive of Citibank had wrongly contended) 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 such as sugar, rubber, diamonds and wood.
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 and the like 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 were 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 reexamined. 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 to 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.
Thousands of investors have taken this bet and are owners of third world debt and even countries that are still technically in default have seen investors buy their debt at deep discounts.
With respect to Thailand and Indonesia, the situation is even more complicated because most of the debt of these countries is private sector debt, owed by and owned by private individuals and companies. Asian countries began to incur significant debt in the late 1980s.
In contrast to the African and Latin American affairs, Asian, particularly Thai and Indonesian, debt was geared towards the private sector and property specifically.
In the 1990s, the Asians borrowed billions to finance land speculation. Property prices in Bangkok and Jakarta soared. Time and Newsweek magazines spoke of the Asian Tigers.
Hype, hyperbole and greed prompted further foreign investment. The Thai baht rose dramatically. Most investors did not worry about the currencies rising as they miscalculated that the IMF would bail out the Asian countries. Having been bitten before, the savvy lads got out first. Later on, panic ensued and the initial trickle led to a deluge.
The resulting 1997Asian currency crisis caused massive dislocation, devaluations and, in the Indonesian case, debt rescheduling.
Since then, the economies have recovered and billions of dollars in pension fund money has poured back into Asia.
Today, many Irish pension fund holders have invested in South East Asian funds and have done very well out of Indonesian, Thai and possibly even Sri Lankan debt. Writing off these debts now would involve slashing Irish pensions.
This scattered ownership structure, the complex links and the predominance of private debt in the Asian countries at least, makes Bono’s job 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 has no legal right to write off debts without cutting a deal with debt holders and, in the main, powerful investment banks.