issue 168 - February 1987
6. The day
When the oil price increased dramatically, some of the producing countries finished up with more dollars than they could use. So they deposited them in international banks. The banks in turn lent the money to developing countries - and set the scene for today's crisis.
Here I am. It's almost time for bed. I've missed Dallas. And we haven't even got round to the debt crisis. What sort of trick is this?
No trick. I'm going as fast as I can. There are even some people who would have regarded the treatment so far as a trifle superficial.
Extraordinary, isn't it? But I can live with that, Of course if you don't want to go on.
I didn't say that.
I'm quite happy to stop here. You've got the reviews page and the Update section to look forward to.
All right. I'm sorry. No need to sulk. What's next?
This is where the excitement really starts. Eurodollars.
I wonder if I've still got time to catch the news ...
No, I'm not kidding. This was quite an extraordinary development that materialized out of nowhere - and it is this as much as anything that has led the banks to the brink. Legend has it that the Russians started it all.
No, a Russian-owned bank in Paris, the Banque Commercial pour L'Europe du Nord. The Russians had dollars which they didn't want to keep in American banks in case there was a political confrontation and their money was blocked The idea caught on and now hundreds of banks deal in dollars which never go anywhere near the US.
They can't all be Russians.
No, they're not. Mostly they are just the normal commercial banks. The reason why they like to take deposits and make loans all in a foreign currency is that they have discovered that this enables them to evade many forms of government control.
In most countries a bank cannot normally lend money in the local currency unless it is registered with the government - and it then has to play by certain rules. These include, for example, the requirement to keep a certain proportion of the money invested with them in the form of cash - not to be lent out again.
And the banks don't like that?
It restricts their volume of lending - and therefore potential profits. But there are advantages to working with government - and particularly the central bank. Banks know that if they get into trouble the government may well step in and make them a loan to tide them over.
The Bank of England could help British banks in London, for example. And if necessary could print more pounds to do so. This is called serving as a 'lender of last resort'. The Bank of England, however, has little say on what Midland or Barclays do with their dollars.
I don't quite see where these dollars could have come from? Don't they just go back to the US to buy American goods?
They could do. But what has been happening over the last 20 years is that the US has had a balance of payments deficit. So the foreign exchange markets have finished up with a lot of dollars. In other circumstances this would have depressed the value of the currency. But people are happy to hold on to American dollars. They think that the US Government is financially very solid. Other countries can then trade amongst each other in London using US dollars, knowing that it is a fairly stable currency.
I think I follow that... But I thought you said all this started in Paris?
So it did. And the name apparently derives from EUROBANK, the cable address of the original Russian bank in Paris. But London has become the biggest Euro-currency centre. And banks from all over the world have branches there to join in the fun, The Canadian banks are very heavily into it.
Eurocurrency mushroomed during the 1960s. But it got its biggest boost after the oil price hikes from 1973 onwards.
Don't tell me you're going to add 'petrodollars' to all this . I can't take much more.
No. I was just going to say that the richer oil producers finished up with more dollars than they could spend. Their answer was to put them in the banks. Some went to US banks, some were converted into deutschmarks and went to German banks, and some into other currencies and other countries. But a lot also finished up as Eurodollars.
With all these dollars sloshing around, the banks needed borrowers for them. So they turned to the developing countries. They seemed to have an almost insatiable demand for loans.
But I thought they were in trouble with the IMF. Why would the banks want to risk their money there?
They weren't necessarily going to lend it to the poorest countries - that would have been too high a risk. But there were richer developing countries, like Argentina and Brazil, whose future prospects looked a lot more rosy and there were others like Mexico and Nigeria, which were themselves oil exporters, but which didn't have the immediate funds for projects they wanted to undertake. These countries looked like very attractive clients for the bankers. And the fact that they were governments - rather than individuals or corporations - made them even more attractive.
I find people more attractive than governments myself.
You've obviously got some redeeming features we can work on. Banks, however, prefer countries. This is because a sovereign state can't go bankrupt. The land will always be there and all the resources that go with it. When the banks discovered 'sovereign lending' they thought it was a wonderful idea: very secure, and also very profitable since huge sums could be transferred at the touch of a button; much more efficient than making small loans with all their administrative hassle.
The banks were also swept along by a kind of herd instinct. One bank would take the lead and gather together a consortium of others to make a 'syndicated' loan. The proposal would be telexed around the world and back would come the acceptances - sometimes from hundreds of banks. No-one wanted to be left out of such a big game.
Finance ministers even started to complain that they were being chased around by bankers trying to press money into their hands.
Very nice for them. But what were they going to do with all this cash?
Difficult to say what happened to a lot of it. Some was undoubtedly invested in worthwhile programmes - Brazil was able to invest in some projects that are likely to prove financially very successful.
Others suffered from the traditional weaknesses of large projects anywhere - making little real contact with what local people want or can use. Impressive on paper, but unlikely to make much progress in practice. Along with this a lot of arms were purchased as well as many imports of luxury goods for the richer members of society. And undoubtedly there was corruption. Many of the wealthy individuals who got their hands on the dollars just sent them straight back overseas again.
How did they manage that?
Developing countries have always been susceptible to this 'capital flight'. People who get hold of foreign currency often feel (usually quite rightly) that it would be safer if kept out of the country. A Mexico City newspaper recently published a list of 575 Mexicans, each of whom has a million dollars or more deposited in foreign banks.
A New York banker could easily arrange an official loan to Mexico and simultaneously arrange for a private client to take the same money out. The result is merely a book- keeping entry - and the money need never leave New York at all.
So the banks knew some of the money was being wasted.
Certainly. But it did not matter to them at the time. As long as the interest was being paid and it looked as though the principal was going to be repaid they were happy. Most of the banks' 'sales' staff were judged on the volume of loans they generated. If they were based in a local branch in a developing country they would probably only stay there a year or two before moving on to another country or another bank. They were not concerned about the long-term soundness of the loans.
But how were the loans being repaid at all If they weren't being used productively?
By getting new and bigger loans. Providing the bank doing the lending believed that other banks would be making more loans in the future they thought they were safe.
That sounds like madness.
It might not be the way you or I would lend our money. But it did work for the banks for a few years - in which they made substantial profits.
Surely other people must have spotted what was going on. What about the IMF?
At this point - from 1973 to 1982 - the multilateral aid and financial organizations were very much on the sidelines. Private enterprise was becoming much more fashionable: this was what was supposed to give a new impetus to Third World development. And many Western governments were cheering from the sidelines - delighted to let the banks get on with it.
The bankers were happy to do so - jetting off to exotic locations and meeting their international peers, and making lots of money.
Developing countries for their part were able to operate without the official agencies and their repressive 'conditionality'. And many of them needed loans even more at this point because of the increased cost of oil imports. They were delighted to see the money 'recycled' back to them through the banks. And had the money been used more wisely this could have been very beneficial to everyone concerned.
What went wrong then?
Interest rates, for a start. When the official agencies like the World Bank had been lending the money they generally did so at a fixed rate of interest. But these new loans from the commercial banks were arranged so that the interest rate varied - floating along with the prevailing market rate. So loans which had been made when the rate was seven or eight per cent finished up as high as 15 per cent.
On top of this commodity prices were collapsing again because of the world recession - so their foreign exchange earnings dropped. Deep gloom all round.
And the loans couldn't be repaid?
It certainly made things more difficult. The bubble finally burst in 1982 when Mexico announced that it wasn't getting in sufficient new money to repay debts that were about to fall due.
At this point the herd of bankers took fright and stampeded in the other direction: nobody would lend money to Mexico. And the atmosphere changed for the other countries too. The banks lost confidence because they thought there would be a crisis, and so there was a crisis. Argentina, Brazil, and the Philippines all saw their sources of finance drying up.
So the banks had lost their money.
They might have done. But they couldn't officially admit it. Banks take in money with one hand and give it out with the other in a continuous flow. But underneath this flow, and serving as a guarantee for it, is the banks' capital, provided originally by the shareholders and added to over the years from the profits made by the banks.
If the flow of borrowing and lending is broken by a bad debt the bank has to dig into its capital to make up the difference. If the bad debts are greater than the capital then the bank is 'bankrupt': it cannot repay its depositors and must go into liquidation.
If you bank with Lloyds, Citibank, Manufacturers Hanover or Midland you should take a stiff drink before reading on.
Because their loans to the big Latin American debtors are all greater than their capital. Mexico, Brazil, Argentina and Venezuela are the chief borrowers. And the loans to these countries as a percentage of their capital at the end of 1984 were: Lloyds (165%); Midland (205%); Bank of Montreal (160%); Manufacturers Hanover (173%).
They are if they admit it. If they did write off these debts as bad they wouldn't have the capital to cover the losses. The answer is not to write them off. In normal companies the auditors would not let them get away with this - and would oblige the company to cease trading. But these are not ordinary companies: they are usually too important to be allowed to crash.
If you bank with anybody now, another drink would probably be advisable - or you could close your eyes.
If one bank goes, it is likely to topple dozens of others. This is because much of the money that banks use has been borrowed from other banks through the 'interbank market'. Some $2,000 billion dollars runs through this network every year. One bank may get offered the prospect of making a juicy and profitable loan but not quite have the funds to cover it - so it would top up with funds borrowed from another.
So even if your bank hasn't been lending directly to Latin America, the chances are that it has been lending money to another bank which has.
But you're beginning to look a little tired and sleepy: the questions not quite so penetrating. Maybe we should continue at some other time.
The Reagan administration in the US, for all it's injunctions to developing countries to keep their financial house in order shows no signs of doing so itself. The US budget deficit in 1986 is unlikely to be around $170 billion - mostly as a result of an enormous defence budget.
The deficit is met by selling US treasury bonds - an activity, which is drawing huge amounts of money into the US. This demand for capital has helped lift interest rates at similar levels otherwise capital will move to the US to get a better return.
In tandem with this the monetarist policies pursued particularly vigorously in the US and the UK have had a similar damaging effect in the Third World - quite apart from the devastation they have wrought in their own countries. Monetarists see inflation as one of the worst things that can happen to an economy. Restricting the amount of credit by keeping interest rates high is used as a method of controlling the money supply and therefore inflation. Though monetarism as an economic philosophy has largely been discredited, the high interest rates that it has helped produce are still with us.
The graph opposite shows the rise over recent years.
This has had a disastrous effect on developing countries, which borrowed at floating rates.
UNCTAD estimates that interest payments by developing countries in 1982 were double what they would have been had the rates remained at their 1976 - 79 average. These interest payments have come largely from export earnings. The ratio of interest payments to exports for a sample of 65 developing countries rose from eight per cent in 1978 to 15 per cent in 1983.1
1 Trade and Development Report, UNCTAD 1985
The bars show the average interest rate on new loans taken on that year.