What Went Wrong in 1981
- The foreign debt crisis
- The oil crisis
- Foreign banks discontinue annual loans of US$ 15 billion
- Without financing, growth comes to a standstill
To grow for another one hundred years. This would have been our prognosis based on cheap foreign financing and the profitability it generated. Somewhere along the line, interest rates would have slowly increased and rates of return would have slowly decreased, but that would have taken decades.
Unfortunately, in mid-1981 every single American bank cut their credit lines to Brazil, Mexico, Argentina and the Philippines, thus bringing our growth cycle to a standstill. Most experts, among them IMF economists, attribute this cut to problems such as imbalance in our economy, over- indebtedness, monumental overspending in infrastructure projects, and government incompetence.
In order to pay for the Itaipu Hydroelectric loans, for example, it was first necessary to put it into operation; the energy generated would make production possible for companies whose exports would generate foreign currency to pay for the debt incurred for the building of the dam. Every banker knew that Itaipu by itself would not generate foreign currency. Not only the cut in financing stopped short completion of the damn, but Brazil lacked the capital to build the industries that would have generated the exports.
In 1981, the foreign bankers decided to cut loans to Brazil, Mexico, Chile, the Philippines, and 60 other countries. Which brings up another question: how can it be that all of these countries, recipients of loans in the international market, were doing the wrong thing, all at the same time? How was Brazil connected to the Philippines, a country with a totally different economic and political system?
Another interesting aspect is the fact that not a single banker was willing to go on lending money to those countries. In a free market society as the USA , there is always someone who will go against a trend. When the market falls, there is always some contrarian who will by stock. Why weren't there contrarian bankers? Not a single one?
Economists in general do not associate a country's performance to that of a company. If we looked at Brazil at that time as a business corporation, we would see that, for a net worth of US$ 3 trillion, the country had a US$ 180 billion foreign debt, that is, less than 4% of the country's equity. The average Brazilian company usually operates with a ratio of 50% debt to 100% equity. For U.S. companies, the ratio is even greater: for every US$ 100 of equity there is an average of US$ 280 of debt. This indebtedness of 4% of equity is, therefore, ridiculously low.
Brazil therefore was a country with a very low debt to equity ratio. Its problem was liquidity, since its foreign reserves had fallen to zero due to the rise in the US $ prime rate in the beginning 80's. An analogy would be the millionaire Scrooge McDuck shopping without a single coin in his pocket. Rich, but unable to pay for a single loaf of bread for lack of liquidity, not for excessive indebtedness. Any banker would loan Scrooge McDuck money under such circumstances, demanding of course a collateral in exchange of new loans.
Another question about which public opinion has not been properly informed is how Brazil could go broke when paying only 4.5% real interest per year. During that period, the first two years of the eighties, real interest rates were a little higher than the historic average of 3%, due to a surge in inflation taking place in the United States . It was, however, still a low interest rate, much lower than average rate of return of Brazilian companies. In 1990 internal interest rates soared to 22% per year, and even then few companies filed for bankruptcy or were forced into agreement with creditors. Why would Brazil go bankrupt at a time when interest rates were 4.5% per year on the international market?
Actually, it was neither the high Brazilian level of indebtedness nor the disorganization of our economy that were responsible for halting our growth; it was rather a minor error in the U.S. government banking regulations. The U.S. forbids its banks from lending over ten times the amount of their capital, a regulation which is adopted by all central banks in the world, including our own. This restriction is a measure of financial prudence to prevent private banks from lending above their capacity, thus jeopardizing the financial system.
U.S. banks' balance sheets are not adjusted for inflation and their equity; therefore, on the contrary they have inflation eroded capital adequacy rules, in spite of living with low inflation U.S. legislation does not allow for accounting adjusted for inflation, a problem well known to Brazilians. No foreign executive in Brazil would accept a salary in Brazilian currency, without an inflation adjustment clause, usually pegged to the dollar.
As a consequence of the extremely low annual inflation rates in the United States , the American financial system never realized the need to include inflation in its contracts and legislation. But over long periods of time this minor mistake is has damaging effects to the US banking system. Just imagine what has happened to the initial capital of the Bank of Boston, founded in 1776, with no inflation adjustment for over 200 years. The book value of its initial capital has been totally eroded by 200 years of inflation. So has its retained earnings of 1882, 1902, etc. So has Bank of Boston's lending capacity.
Because the Controller of the Currency does not allow US Banks to adjust upwards book values, they have consistently lost their lending capacity, which is one of the hidden causes of the decline of the US economy. The US economy has lost its lending ability due to a fluke in its banking regulation.
US banks have tried to circumvent these problems doing off-balance sheet lending, derivatives and you name it, everything that is fancy but does not generate loans. Even off balance sheet financing has become regulated. US Banks because of a simple banking regulation are playing around with the derivatives game, which come to think of it, has limited economic value, just because they cannot earn money the old fashioned way — lending.
The meteoric rise of Mike Milken and the Junk Bond movement was due not so much to his genius but to the fact he had no competition. Banks could not compete because their lending ability had been destroyed by two years of very high inflation, 1980 and 1981, and an average of 4% a year thereafter.
US Banks lost then their supremacy to Japanese banking, which not only had a low inflation rate at the time, but had a better bank regulation.
Brazilian banking legislation is more modern; it allows banks to lend up to 12 times their equity, adjusted yearly for the Brazilian inflation. Someone might argue that for accounting reasons the American bank is more profitable than the Brazilian. Since neither equity nor retained profits are adjusted for inflation, The American bank's profit is therefore overestimated. Following this reasoning, if the U.S. bank re-invested all the overestimated accounting profit, the effect would be neutral; the two mistakes would balance each other.
The unfortunate fact is that the U.S. Internal Revenue Service does not see it that way and demands 50% of the bank's "inflationary" profits; the shareholders, usually conservative people, demand another 50% of the balance, the so-called retained profit, as dividends. In practice,
U.S. banks cannot compensate for the inflation effect and what often seems to be an accounting profit is actually a loss.
The inflation effect in the U.S. , historically in the 4% range, used to be compensated for by the bank's high profitability, around 12% per year, a fact which assured the growth of its equity above inflation rates.
This equilibrium came to an end in 1981 when inflation got out of hand and reached 10%, and 12% the following year. Financial institution equities were eroded and they started to show a loss. Companies started defaulting and loan provisioning depressed profits; profits became negative, thus reducing equity even further. The effects of the
U.S. inflation could no longer be compensated by a high rate of return; all banks without exception exceeded their lending limits and all at once halted their loans to countries like Brazil, Mexico, Chile , the Philippines , and others.
This situation lasted until 1983 when U.S. banks started finding loopholes in these credit restrictions in the form of derivatives — kinds of loans not recorded in the accounting books — known as off balance financing. Banks started operating as guarantors, enabling loans granted by other organizations such as pension funds, which at the time were looking for profitable investment for their growing actuary needs for payment of benefits.
These loopholes, which stem from the U.S. banks being unable to lend money through traditional operations, later became the flourishing derivatives markets. Nearly ten years later the market has practically forgotten how to make a plain vanilla loan.
The abrupt halt of the bank loans in 1981 obviously caught Brazil by surprise, with neither inventory nor the necessary financial structure. The country was scheduled to receive US$ 15 billion; when these did not materialize, the country had to make adjustments.
The consequences affected practically all areas of the economy and caused the postponement of many plans. We ended up having an electric power surplus for nearly 15 years because there was no financing for new industries that would consume the energy generated by the Itaipu hydroelectric plant.
Brazil 's image during this period is of a country carrying too heavy a load of debts, poorly managed and financially incompetent; a country with no reserves, with an extremely high credit risk rate. Totally uncalled for given the previous analysis.
It was at this time that the IMF and the World Bank started their long-drawn-out story about
Brazil needing to make an adjustment, that it, we needed to develop a plan for economic stabilization. What should actually have been done was to make the necessary adjustment to the U.S. banking legislation to require banks to record U.S. inflation in their books. That would have benefited the Brazilian and the American economy.
It is unfortunate that, as a result of this, the U.S. banks cut their loans to Brazil , not because the country's economy was a shambles, not because its economic framework was in disrepair, not because the country's level of indebtedness was too high, but because of a mistake in the U.S. Central Bank regulations.
This crisis profoundly altered the relationship of the international financial system with the so-called emerging economies. In 1986, the government of the wealthy countries ratified the Basel agreement, whereby new loans to the Latin American where discouraged, as well as the U.S. real estate market, another large-scale financial scandal of that time.
The only way for Brazil to regain access to external savings is through foreign pension funds.
Loans started to be weighted according to a risk based criteria. Thus, a loan to Latin America could cost 120% of the Banks equity, unlike financing to U.S. companies, which would cost only 100% of the company's equity. Which is the wrong solution to the wrong problem.
The U.S. legislation was not modified and, if anything, it became stricter after the Basel agreement. Worse yet: even though successive Brazilian ministers and Central Bank teams have discussed our foreign debt, at no time was the point made for a change in the U.S. banking limits discussed. Which is a shame, because it’s the US Banking ability to lend as whole that is at stake. The US Banking system has lost its lending ability for ever.
The one way for Brazil to regain access to external savings will be by means of foreign pension funds, since these organizations are not controlled by the U.S. Controller of the Currency. The funds can loan amounts proportional to their equity, which is hedged against inflation, since it is usually invested in short-term operations such as Stock Exchange shares. Nearly 80% of the money that came into the country in the last years originated from pension funds.
Economists at the International Monetary Fund only made things worse — a series of completely mistaken measures were taken. The country implemented several stabilization plans, all of which failed. It altered its foreign exchange rate and reduced salaries drastically in order to make Brazilian exports more competitive.
Brazil became a huge exporting machine to face the deterioration of the banks' equity, steadily eroded by the U.S. inflation during the eighties.
World commodity prices therefore plummeted, compounding the problem. Exchange rates where artificially undervalued, in order to foster the export oriented companies, and imports of all kind where curbed by various means.
On the other hand, banks started insistently to demand repayment of the debt in order to comply with the inflation eroded lending limits. It is interesting to note that the international banks were not able to perceive that this process resulted in destruction of the U.S. banking system. During the ten years of the Brazilian foreign debt crisis — the lost decade — the financial institutions suffered as much as Brazil in terms of setbacks and losses.
Japanese banks became the largest ones, because their equity is adjusted to inflation.
The Japanese financial system eventually moved on ahead of the U.S. banking system. With a more effective set of laws, the Japanese banks ended up being the largest on earth. Japanese legislation allows real estate gains to be incorporated into their net worth, whether such gains were in their branch office buildings or in other properties. This is fairly similar to — or even better than — what happens in Brazil with inflation adjustment.
The Japanese shrewdly found out that they could create wealth and more lending ability by simply increasing the value of the real estate market. The more their facilities grew in value, the more they could lend; in other words, it was like being able to print your own money. They started lending massively to the real estate business. Bankers were the ones responsible for the real estate boom in Japan , because it generated even more lending ability.
The Japanese real estate boom exploded in 1989 and left banks in a situation similar to that of the U.S. financial institutions in 1981. The drop in real estate value in their net worth forced them to backpedal and ask Japanese companies to pay back their loans. This situation will stabilize only when the inflation curve in Japan meets the descending curve of real estate values. At the moment when the two curves meet, Japanese economy will be balanced once more. That may take another decade.
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