The 1982-86 Banking Crisis in Chile: Lessons For the Paulson Plan

In the past 150 years, several times Chile suffered large income losses because of declines in its terms of trade and often it had to change expansionary domestic policies. The 1982-83 recession was the fourth largest one after the Great Depression, the oil crisis of the mid-1970s, and the one at the beginning of the First World War. Aggregate output fell in real terms over 20 percent between the peak level of the third quarter of 1981 and the bottom level of the same quarter of 1983. By late 1983, unemployment had climbed to over 30 percent of the labor force, and the share of population in absolute poverty had increased to around 55 percent from about 30 percent in 1981. Also, CPI measured inflation had more than double in relation to the low level of 9.5 percent in the twelve months to December 1981.

The magnitude of the 1982-83 recession was determined by the circumstances of the economy at that time. First, in the two years up to mid-1981, the domestic private demand for consumption and fixed capital investment had increased rapidly to a record level. Later most of this investment would be the basis for a large increase in output and exports, but in late 1981 it had yet to mature. Independent of its driving forces, the expansion of domestic private demand was possible by the sudden access to both domestic and foreign loanable funds intermediated mostly by private national banks(foreign banks still accounted for a small share of domestic loan markets).

Second, to some extent, the bank’s loan portfolios reflected excessive risk taking by banks in the sense that their depositors (and perhaps other creditors) had not been explicitly fully compensated by the credit risks they were taking. The magnitude of this problem was not known at the time of the crisis, and has never been possible to assess its importance. Although two large banks were intervened in November 1981 because of the allegation of excessive risk taking, when the crisis deepened in 1982 the deterioration of the loan portfolios was due mostly to the new macroeconomic conditions.

Third, the 1980-81 boom had led to changes in relative prices, in particular, an increase in real wages. The latter resulted from the economic boom, the indexation of nominal wages to past inflation and from substantial reductions in the cost of labor to companies (due to cuts in wage taxes). These changes were difficult to reverse in the recession mainly because of Chile’s traditional inflationary bias—changes in relative prices were possible only by increasing some nominal prices. The reforms of labor laws notwithstanding, nominal wages were still rigid downwards and political pressures quickly mounted for devaluing the Chilean peso.

Fourth, last but not least, notwithstanding the new legal and government institutions of the 1980 Constitution, they were yet to bound effectively government’s powers. Thus, given the income losses anticipated by the main constituencies of the military government, pressures for its intervention quickly mounted. It took some time for the government to abandon its commitments to a fixed exchange rate policy and to a policy of no bailing out any party affected by the crisis.

By mid-1981, the record level of the aggregate demand for consumption and investment was no longer sustainable. The increase in real interest rates in the first semester of 1981 and the decline in terms of trade in the previous twelve months forced a contraction in private demand for both consumption and investment. The magnitude of the subsequent recession was determined by some combination of all four factors mentioned above. Independent of their relative importance in determining the magnitude of the recession, it is important to note that these factors were not the cause of the large expansion in private demand in previous years. The latter was a direct consequence of new and raising expectations about the country’s potential income level, in turn the result mainly of the economic reforms of 1974-81 and the new institutions of the 1980 Constitution.

The resolution of the financial crisis triggered a complex process. It took some time to complete it, and it consisted mainly of many ad-hoc measures. To achieve their objectives, most had to be revised and fine tuned often. More important, it was an expensive process with a cumulative fiscal cost of over 40 percent of GDP. Nevertheless, its success was a prerequisite for aggregate demand and output to recover their pre-crisis levels.

The recovery that started by 1985 led to high GDP growth rates (per capita GDP reached the 1981 record level in 1988) and facilitated the development of a strong financial sector that since then has fared well the turmoil of international capital markets. In fact, Chile’s recovery probed to be more sustainable than that of other Latin American economies affected at that time by a serious external debt crisis.

Four elements were decisive to that strong and sustainable recovery. First, key macroeconomic variables—i.e., fiscal deficit, inflation, etc.—were kept under control or stabilized around reasonably low levels in the years following the crisis (and additional progress was made on reducing or stabilizing them through the 1990s). Second, Chile’s terms of trade recovered after 1987, greatly facilitating the restoration of fiscal discipline and external equilibrium. Third, the incentives to substitute equity capital for debt capital—in particular, the reform of the income tax system to encourage the reinvestment of profits—were effective. Finally, the prudential and regulatory frameworks for banks and other financial companies were completely overhauled in the aftermath of the 1982- 84 crisis.

Chile in turn faced a similar situation to the one that the United States is experiencing today. In Chile, the government adopted two types of program: one for bank debtors and another for banks. Bank debtors were offered the possibility of rescheduling their obligations and receiving a preferential exchange rate for the repayment of foreign-currency liabilities. Banks were assessed for their long-term viability. Viable banks were offered the possibility of selling bad loans to the Central Bank, with a repurchase agreement based on future profits. Indeed, the majority of domestic banks used this facility and the total amount involved reached US$5 billion. Non-viable banks were intervened and liquidated.

Debt Restructuring Programs
By late 1981, some interest groups started to press the government for relief assistance to service their debts. They consisted of companies (including farmers) that had suffered or claimed to have suffered a large income loss due to changes in relative prices and the slowdown of economic activity. The rapid deterioration of the economy made evident, however, that the problem was not limited to some areas or activities, and that a concession to any particular group would lead quickly to similar demands by many other groups. The pressures continued growing, however, and not surprisingly the devaluation of June 1982 with its large impact on relative prices reinforced the idea that some sectors of the economy had already been hit hard.

The first government program for restructuring commercial debts was announced in August 1982. It provided debtors with loans to repay up to 30 percent of their outstanding debts with the banking system. With a total amount of US$250 million (equivalent to 0.96 percent of 1982 GDP), the main objective of the program was just to transform short-term debts into debts with maturities between three and five years. The interest rates of the new loans were not low but implied a large subsidy for the debtors because their cost of capital at that time was much higher. Soon, in October 1982, another similar program was implemented with a total amount of US$320 million but only for peso-denominated debts

The two programs set three conditions that were repeated in subsequent programs. First, they were intended not to benefit the main debtors of the banking system because it was in the self-interest of each bank to restructure the debts of its main debtors. Thus, the ceiling on the amount of restructured loans was equivalent to US$500,000. Second, only viable companies could benefit. This condition was expected to force the banks first to separate their business debtors into viable and nonviable, and then to initiate legal action against the latter to recover the funds or to take over the collateral. Finally, only debts of productive companies, that is, those producing goods and services could be restructured, explicitly excluding the debts of investment companies holding shares in the productive companies.

Final Remarks
In turn, one alternative to the Paulson plan in the United States would be the Chilean plan where the government provided secured loans to troubled institutions as a way to allow them to recapitalize. The collateral against the loans would be bank assets. The transaction would be similar to a "repo" where the borrower is required to repurchase the securities, with interest in the future in order to retire the loan. This was an important tool to solve the 1983 Chilean banking crisis. It is true that the government intervened directly in two banks, wiping out shareholders, removing management and nationalizing the firms. Those banks were later re-privatized in a sale that gave tax incentives to encourage Chileans to participate in the offering.

The many other banks that were in trouble were handled differently. For those, the government provided loans that were secured by bank assets, with an agreement that the banks would later repurchase those assets. These "repos" had conditions attached, including a provision that the shareholders could not take profits out of the company until the loan was repaid. This meant that shareholders were asked to give something in return for getting rescued by taxpayers; and it gave the bank a strong incentive to get back on its feet and return the money.
It is true that it took several years for Chile to recover from its banking crisis and it may take long for the US to recover too. It is also true that federal assistance is needed to solve systemic banking crisis. The open question is ‘how to solve’ the crisis. In Chile, federal assistance came in the form of subsidize loans to some banks. Afterwards the loans were paid and insolvent banks were liquidated.

Enter your email address:

Delivered by FeedBurner