**2.1 The 1980s Latin American debt crisis1**

The 1973 and 1979 oil shocks created current account deficits in many Latin American (LA) countries. In parallel, these shocks created substantial current account surpluses in the oil-exporting countries. With the encouragement of the US government, large banks became intermediaries between the two groups, providing the oil-exporting countries with a safe dollar-denominated, liquid asset and lending those funds mostly in dollars to Latin America (FDIC).

World economic expansion and low real rates on short-term loans made this situation tenable during the seventies. But this changed when Federal Reserve (Fed) chairman Volcker and other Western CBs raised interest rates to contain the inflation of the seventies, creating a worldwide recession in the early eighties. Commercial banks

<sup>1</sup> This subsection draws partially on Ref. [1, 2].

*Current Challenges to World Financial Stability: To What Extent is the Past a Guide for the… DOI: http://dx.doi.org/10.5772/intechopen.107432*

raised rates and shortened repayment periods. As a result, LA countries discovered that their debt burdens were unsustainable.

The crisis erupted in August 1982, when the Mexican finance minister informed US authorities and the International Monetary Fund (IMF) that Mexico would no longer be able to service its debt. Other countries quickly followed this path. Ultimately 16 LA countries and 11 less-developed countries (LDCs) in other parts of the world rescheduled their debts. In response, many banks stopped new overseas lending and tried to collect and restructure existing debt portfolios. Funds scarcity in the debtor countries plunged them into recessions and triggered devaluations of domestic currencies and inflation.

Initially, US banking regulators allowed lenders to delay recognition of the full extent of overseas lending in their loan loss provisions. By 1989, US Secretary of the Treasury Brady proposed a plan that would permanently reduce loan principal and debt service obligations conditional on the undertaking of domestic structural reforms in debtor countries. The plan was backed and partially financed by the IMF and the US Treasury. Ultimately about one-third of the total debt of the 18 countries that signed on to the plan was forgiven.
