Are we on the verge of a new Debt Crisis in the developing world (particularly Latin America)?

After a presentation at PERI, UMass (last summer)

The capitalist system has been plagued by international monetary and financial instability from its inception. Inflation, deflation, banking and currency crisis, and sovereign defaults have a long and somewhat sensational history. Latin America is in many ways the poster child for global debt crisis, and in the aftermath of the Pandemic and the hikes in interest rate in the United States as a result of the inflationary crisis, the fear of financial collapse has surged.

Latin America’s very existence is intertwined with the volatility of international financial markets, with the first debt crisis dating from the 1820s, right after the wars of independence. The long cycles of boom and bust, of debt and default explain the limits to the process of development in the region, and these, in turn, are directly tied to the monetary policies of the hegemonic center. The very idea that Latin America was peripheral to the crises generated in the center was fundamental for the elaboration of the early theories of economic development.

In fact, it was in the transition from British to American hegemony, during the inter-war crisis of the last century, when the inability of the United Kingdom (UK) to manage the economy, and the unwillingness of the United States (US) to do so, led to the development of the notion of center and periphery by Raúl Prebisch, who had helped create the central bank of Argentina in 1935, and had to manage it for almost a decade [1]. He became deeply aware of the problems of commodity exporting countries indebted in a foreign currency. The idea of the Global South, of the periphery, was developed in the context the crisis of the Gold Standard in the center, when the pound lost its hegemonic position, and when capital flight led a new wave of sovereign defaults in developing countries. Prebisch imposed capital controls to avoid the crisis, and used counter-cyclical monetary policy to promote the recovery at home. Both were quite innovative solutions in the 1930s. But the economies of the region needed a long-term solution, a new strategy of development [2].

The crisis of neoliberalism, which can be clearly dated, at least in advanced economies, to the Global Financial Crisis of 2008-9, the rise of China, and the more recent pandemic and inflationary surge, have led to fears of a collapsing global order, a crisis of American hegemony, and the possibility of another debt crisis in the Global South. In fact, many countries, about five as of 2023, have declared defaults [3], and the prospects for persistently higher interest rates in the center, and a slowing down of world trade, make the fears of a global debt crisis reasonable in the eyes of many analysts. Further, many see the inaction of the US, and the inability or unwillingness to provide the means for a global recovery, as the signs of the end of American hegemony. The rise of the BRICS (for Brazil, Russia, India, China and South Africa, that has now been amplified), the group of countries in the Global South that challenge the neoliberal model, that was globally exported by the US under the aegis of the so-called Washington Consensus, suggests that we are on the verge of a new world order. Even the US has abandoned the core policy propositions of the neoliberal era. But there are good reasons to be skeptical about both the significance of the changes in the global power structure, and about the eminent financial collapse of the periphery.

The Dollar Crisis and the New World Order

Fears of a dollar crisis are not new. The inconvertibility of the dollar to gold, announced by Richard Nixon in August 15 1971, was seen by many as the beginning of the end of dollar dominance. However, by practically any measure, the position of the dollar did not change significantly with the end of Bretton Woods. As Thomas Palley has noted recently, the dollar hegemony can be divided in two periods, a dollar hegemony 1.0 that corresponds to the Bretton Woods Era, from 1944 to 1971 broadly speaking, and a 2.0 version thereafter, associated to the Neoliberal Era (Palley, 2024). In the first era, according to him, the hegemony was associated to the manufacturing and trade dominance of the US, in a relatively closed financial world, while in the latter era it rests fundamentally on the already established financial dominance.

The key difference was the change from a fixed exchange rate regime in which capital controls were extensive to a flexible dollar standard with an increasingly integrated international financial system. However, the international role of the dollar as reserve currency remains essentially unchanged, with central banks holding about sixty percent of their reserves in dollars. The Federal Reserve (Fed) does not carry foreign reserves in any significant amount, while the People’s Bank of China (PBoC) holds about US$ 3.2 trillion, just as an example [4]. Even the New Development Bank, often referred to as the BRICS bank, still lends mostly in dollars.

Even though the data about trade invoicing is hard to obtain, it is well-known that the dollar is the main global vehicle currency. Maranoti (2022) suggests that about fifty percent of trade invoicing globally is done in dollars. In other words, most countries invoice their imports and exports in dollars even when the trade is not with the United States. Further, the dollar is involved in about ninety percent of all the daily transactions in foreign exchange markets, which had reached US$ 7.5 trillion on a daily basis (Ibid.).

Even more importantly, the dollar is the currency in which the key commodities, in particular energy commodities, are priced. Note, for example, that if the currency of a country in the Global South depreciates with respect to the dollar, not only this would have an inflationary effect because the price of imported goods would go up, but in particular because the price of oil is set in international markets in dollars, it will also increase the price of oil in domestic currency. This is of course highly inflationary, since energy affects the production of all goods and services. In contrast, the depreciation of the dollar has limited effect on US domestic prices. The price of oil does not change automatically when the dollar depreciates, and the worst effect of a depreciation is avoided in the country with the key or dominant currency [5].

This does not mean that the dollar will always be the dominant or hegemonic currency. In fact, many analysts suggest that there have been a few recent developments that put some strain on the international role of the dollar. For example, Luis Inácio Lula da Silva, the president of Brazil, has talked about de-dollarization in meetings of the BRICS. An important element of dollar dominance is tied to its role in financial markets and to the global payment system. The main system for interbank transfers globally is the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which is dominated by essentially by Western banking institutions. A SWIFT ban on Russian banks was one of the main sanctions against that country, and that might promote the use of alternative systems. China has been promoting, its own Cross-Border Interbank Payment System (CIPS) [6]. Janet Yellen, the current US Treasury Secretary has, in fact, noted that the SWIFT ban may impact negatively the international role of the dollar.

Further, one of the key roles of the country with the dominant currency is to act as a provider of global liquidity in times of distress. The US has done that through two mechanisms. First, the Fed provides swap-credit lines to a selected group of central banks. But this is a relatively limited program. In addition, as it is well-known the International Monetary Fund (IMF) acts as an arm of the US Treasury, and it has a responsibility to provide liquidity to countries with structural balance of payments problems. The money comes, as it would be expected, with many strings attached. Very rarely the IMF provides blanket increases of country quotas. However, in 2021, in the context of the pandemic, the IMF allocated US$ 650 billion worth of Special Drawing Rights (SDRs) to the member countries. SDRs were basically converted to dollars by member countries, and this allowed many to avoid a crisis.

The US under president Trump had refused to increase the SDR quota, and arguably under the pressures of the pandemic crisis, the more flexible Biden administration, assented to the demands of countries in the Global South. Many analysts saw in this a victory of peripheral countries (Cashman et al., 2022), and that can be seen as a defeat of the more orthodox views of the US Treasury, implying a loss of power at the IMF. However, if anything the increase in the SDR quotas strengthened the role of the dollar as an international currency, since it extended the use of the dollar both as a reserve and a vehicle currency.

The picture of a dollar crisis is much less clear than often broadcasted. Certainly, the dollar hegemony is contested, but if the renminbi is the alternative one must note that it is far away from being a serious challenger, and after the European debt crisis, nobody thinks the euro is a serious contender. The Fed policy rate remains the key rate affecting the monetary and exchange rate policies of all countries, in particular those in the Global South. Those that failed to maintain a relatively stable exchange rate with the dollar are in or on the verge of a debt crisis.

The Debt Crisis in the Global South

Benn Steil, of the Council of Foreign Relations, has recently said that “a new specter haunts the world: the specter of sovereign defaults” (Steil and Harding, 2024). The reasons for the heightened fears of a debt crisis in the periphery are, to some extent, associated to the higher levels of public debt in many developing countries, in a global context in which interest rates are higher in the center, as a result of inflationary pressures. Memories of Paul Volcker interest rate shock in the late 1970s, who was trying to control inflation in the US, after a decade of debt accumulation in developing countries, loom large. However, this is not the debt crisis of the 1980s.

It is important to understand what causes sovereign debt problems, leading to currency crises and then to debt crises. The conventional story, developed in the 1970s as the debt crisis was brewing, suggested that governments have a tendency to spend too much, and over-borrow, and central banks, often too close to the government, end up printing money [7]. The effects would be too much money, higher prices as a result, and a depreciation of the exchange rate, as domestic agents search for safer assets. The fiscal crisis causes inflation and the run on the currency, and eventually the country reaches its limit and is unable to pay, leading to default. The limit is given by the dollar reserves held at the central bank. A debt crisis requires a renegotiation of the public sector obligations. A fiscal adjustment, reduction in spending and increase in taxes, is needed to obtain fiscal consolidation, the reduction of deficits and debt.

However, the conventional story fails to distinguish between debt in domestic and foreign currency. In general, the problems for governments that need to borrow in foreign currency are associated to their inability to obtain funds in the dominant currency, dollars, and only indirectly related to the fiscal position. For example, if a country runs a large current account deficit, say importing way more than it exports, and borrows in foreign currency as a result, it will eventually need to generate more exports, that bring extra revenue in dollars, or it would have to get further indebted, making things worse. If exports fall, be that because the country experiences a bad year in terms of weather, for example in a country that exports an agricultural commodity, or because the price of its exports fall, then a crisis might follow. Further, if the interest rate on the debt in foreign currency goes up, something often tied to the rate of interest set by the Fed, then the external obligations of the country go up, and a crisis might also follow. That is essentially what happened in the 1980s. The price of commodities fell, and combined with the higher interest rates in the US, made several countries unable to pay. Financial markets, being panicky and prone to contagion, stopped lending to all developing countries, and some countries that could have avoided a crisis ended up defaulting too.

Fiscal issues are only relevant to the extent that government spending leads to higher private spending, and that, in turn, leads to higher levels of imports, making the external problem bigger. However, normally those are secondary, if at all relevant, in sovereign debt crises. In fact, it is the external crisis that often causes a fiscal problem, since the depreciation of the currency, and an external default, force a drastic adjustment of external accounts and a domestic recession that, not only brings down revenue in local currency, but also require fiscal transfers to the unemployed and those in need, increasing deficits and debt, in this case in domestic currency.

More importantly, crises are exacerbated by capital flight, which is much easier in the post-Bretton Woods era in which international financial markets have been deregulated. If a country maintains a domestic interest rate that is lower than the expected depreciation of the exchange rate, adjusted by the risk of default, then it is clear that there will be a run on the domestic currency, and the depreciation of the currency would lead to higher prices of domestic goods, and if the central bank runs out of reserves, a default on debt in foreign currency. In other words, not only the fiscal problems are caused by the volatility in foreign exchange markets, but inflation too results from foreign exchange speculation.

In general, in the period from the last series of external crisis in the Global South, roughly from the Mexican Tequila crisis in 1995 to the Argentine default of 2002 [8], until the pandemic, price stability had been maintained in the periphery because the inflation targeting regime, with high interest rates, had managed to maintain the stability of the exchange rate, even inducing phases of nominal appreciation, in a context of low wage resistance, as a result of the neoliberal labor market reforms of the preceding decades. Almost all the economies of in the Global South were able, not only to accumulate dollar reserves, but also to borrow in dollars with low interest differentials, and in domestic currency, considerably reducing indebtedness in foreign currency, and dollarization. Many authors speculated on the reasons for the overcoming of the so-called original sin, the notion that developing countries are unable to borrow in international markets in their own currency (Onen et al., 2023). In fact, with few exceptions, levels of debt in foreign currency in Asia and Latin America have been relatively low (Restrepo-Echavarría and Grittayaphong, 2021).

Also, ever since the debt crisis of the 1980s, the US interest rate has been falling and that combined with a significant expansion of international trade, suggesting that for the most part, countries could use the proceeds of their exports in dollars to at least service their debts and avoid default (Figure 1). That has changed with the higher interest rates in the US, which are the highest in a long time, but considerably lower than in the 1980s, and because international trade seems to have plateaued after the 2008-9 crisis. Still, the problem has been countries that, for a variety of reasons, maintained higher levels of debt in foreign currency, had negative interests rate differentials, causing capital flight, and, as a result, were more vulnerable when the pandemic and the subsequent inflationary crises, combining a slowdown in their export revenues, and higher interest rates in the US. In the case of Latin America, the main exceptions have been Argentina, Ecuador and Venezuela, that has also suffered with significant US sanctions.

The possibility of a more generalized debt crisis hinges on whether interest rates in the US will fall or persist at higher levels for a longer period, and on the ability of developing countries to avoid significant exchange rate instability. The latter has been directly associated to the accumulation of dollar reserves. In other words, the countries facing problems have been the ones that, at their own peril, ignored the mighty dollar, and did not accumulate reserves.

Concluding remarks

Although some elements of the current international situation are as problematic as that of debt crises of the past, the number of countries that remains vulnerable to a significant collapse and default is limited, and considerably smaller than during the 1980s debt crisis. The reasons for expecting a poor performance in some Latin American countries, which is to be expected even in some places that do not face an external problem, are related to the macroeconomic policies, which, again in some cases, tilt towards austerity for political reasons. The patterns of specialization in the region, associated to the production of commodities, or maquiladora exports, lead to significant problems, but in the current circumstances have not led to a generalized external problem. The fears of a default in the region are exaggerated.

If higher rates persist in advanced economies for a longer period, particularly in the US, which seems unlikely, and if the global economy slows down significantly, particularly a combination of a recession in the US and a lower rate of growth in China, then the possibility of a deeper debt crisis in the region cannot be ruled out. But that is an unlikely scenario. If that occurs, it would be the exaggerated fears about inflation in advanced economies, and the persistence of orthodox views about the nature of the macroeconomy in some peripheral countries in the region that would cause the problems.

References

Cashman, K., Arauz, A. & Merling, L. 2022. “Special Drawing Rights: The Right Tool to Use to Respond to the Pandemic and Other Challenges,” CEPR, Washington, DC, available at https://cepr.net/report/special-drawing-rights-the-right-tool-to-use/

Cline, N. & Vernengo, M. 2016. “Interest rates, terms of trade and currency crises: Are we on the verge of a new crisis in the periphery?” In O. Canuto & A. Gevorkyan (eds.), Financial Deepening and Post-Crisis Development in Emerging Markets. London: Palgrave-Macmillan.

Eichengreen, B. 2022. “Sanctions, SWIFT, and China’s Cross-Border Interbank Payments System,” CSIS Briefs, May.

Gopinath, G., Plagborg-Moller, M. & Boz, E. 2018. “Global trade and the dollar,” available at https://cepr.org/voxeu/columns/global-trade-and-dollar

Kindleberger, C. P. 1973. The World in Depression, 1929–1939. London: Allen Lane.

Kregel, J. 1998. “East Asia Is Not Mexico: The Difference between Balance of Payments Crises and Debt Deflations.” In Jomo K.S. (ed.), Tigers in Trouble: Financial Governance, Liberalization and the Crises in East Asia. London: Zed Books.

Maranoti, B. 2022. “Revisiting the international role of the US dollar,” BIS Quarterly Review, December.

Onen, M; Shin, H.S. and von Peter, G. 2023. “Overcoming original sin: insights from a new dataset,” BIS Working Paper No. 1075.

Palley, T. 2024. “Theorizing dollar hegemony: the political foundations of exorbitant privilege,” in T. Palley, E. Pérez Caldentey, & M. Vernengo (eds.), Dollar Hegemony: Past, Present, and Future. Cheltenham: Edward Elgar.

Pérez Caldentey, E. & Vernengo, M. 2016. “Reading Keynes in Buenos Aires: Prebisch and the Dynamics of Capitalism,” Cambridge Journal of Economics, 40(6): 1725-1741.

Restrepo-Echavarría, P. & Grittayaphong, P. 2021. “Dollar-Denominated Public Debt in Asia and Latin America,” in On the Economy Blog, available at https://www.stlouisfed.org/on-the-economy/2021/august/dollar-exposure-public-debt-asia-latin-america#:~:text=Compared%20with%20Asian%20countries%2C%20countries,3%25%20in%20select%20Asian%20economies.

Vernengo, M. 2021. “The consolidation of dollar hegemony after the collapse of Bretton Woods: Bringing power back in,” Review of Political Economy, 33(4): 529-551.

World Bank 2023. International Debt Report 2023. World Bank: Washington, DC.

Notes

[1] This is, of course the classic notion defended by Charles Poor Kindleberger to explain the deep causes of the Great Depression, and the crisis of capitalism in the 1930s (Kindleberger, 1973). See Vernengo (2021) for a discussion of hegemonic currency transitions.

[2] Prebisch understood that Argentina, that was very well adapted and integrated with the world economy when the UK was the dominant trading partner, was doomed with the rise of the US, since the latter was a competitor in many commodity markets. A few years later he developed the notion of center and periphery, not only to show the necessity of industrialization to overcome the low levels of income per capita in the periphery, but more specifically to note that the patterns of productive specialization caused by the integration of the periphery with the center were at the root of the problems of underdevelopment. On Prebisch and the invention of the Global South see Pérez Caldentey and Vernengo (2016).

[3] The five countries according to Fitch are Belarus, Lebanon, Ghana, Sri Lanka and Zambia. Note that there are more episodes of default, as defined by Fitch, in at least ten countries, namely, Argentina, Belarus, Ecuador, El Salvador, Ghana, Lebanon, Sri Lanka, Suriname, Ukraine, and Zambia (World Bank, 2023). Venezuela should be added to the list of countries in default.

[4] Note that the fluctuations of the value of the dollar reserves held by central banks is, to some extent, driven by the fluctuation of the value of the dollar itself, being considerably smaller than people think (Fields and Vernengo, 2013). For example, when the dollar depreciates, the dollar reserves lose value, and their share seems to fall more than they actually do, and in reverse when the dollar appreciates. When one adjusts for variations of the value of the dollar, it is visible that the dollar position has not changed significantly.

[5] As noted by Gopinath et al. (2018) pass-through effects of invoicing in vehicle currencies, i.e. the dollar, tends to be much larger than in the case of invoicing in producer or local currencies. In other words, changes in the value of the domestic currency with respect to the dollar affect domestic prices more than changes in the prices of the trading partners.

[6] It should be noted that Barry Eichengreen (2022) was very skeptical about the possibility of CIPS disrupting dollar hegemony in the short run, and there is little evidence of a significant decline in SWIFT, in part because the Russian economy is relatively small, even as the role of CIPS is growing.

[7] The classic currency crisis model was developed by Paul Krugman. Later models incorporated additional elements, in particular the possibility that self-fulfilling expectations played a role, and the relationship between banking and currency crises. In this view, the overspending and overborrowing is often associated to the excesses of the progressive or populist governments, or in some cases to the bias of politicians in general. For a critical summary that suggests that the orthodox view is incorrect see Cline and Vernengo (2016).

[8] The major external crises include the Asian Crisis in 1997, the Russian one in 1998, the Brazilian and Turkish ones in 1999. The Asian Crisis is very illustrative of the external nature of this crises, since there were no significant fiscal problems in those countries. For a discussion of the Asian crisis along these lines see Kregel (1998).