42 – The Impact of “Petro-Dollars”

When the price of oil went up in the 1970s, OPEC nations acquired large revenues. They deposited much of these so-called “petro-dollars” in Western commercial banks. Those banks then found themselves with unexpectedly large cash reserves. Banks prefer not to have large cash reserves, because they have to pay interest on them. The way banks make a profit is by loaning out the money they have on deposit and charging the borrowers a higher rate of interest than they pay their depositors. If they were to avoid going broke, the banks had to seek new loan customers.

Their usual customers, the private business sector in the North, were experiencing a recession–because of the hike in oil prices–and were reluctant to increase their debt. So the banks turned their attention to the Third World.

Under other circumstances, many of these nations wouldn’t have been considered credit worthy, but at this point the banks were desperate for customers. They couldn’t afford to continue paying interest to their depositors unless they found customers to whom they could loan that deposited money.

And the interest rates they offered were very attractive. In certain cases, the rate of interest was fixed so that the real, or actual, rate paid would be adjusted by the current level of inflation. That meant that if the interest rate was, for example, 10% and the inflation rate was 8%, then the actual rate of interest charged would be 10 minus 8, or 2%. This arrangement even resulted, at times, in negative rates of interest. For the purposes of example, assume that the interest rate is still 10%, but now the inflation rate has jumped to 12%. In that case, the actual interest would be 10 minus 12, or a negative 2%. In order words, the borrowing country would receive a 2% credit from the bank for having the loan.

Banks provided other incentives for developing countries to take out loans as well, including paying bribes to public officials. But then in 1981, it all came to an end.

In an effort to control domestic inflation, the United States raised interest rates. When a country with as much economic influence as the US raises interest rates, other countries have to follow, because investors are going to put their money where they will received the highest return. If you can earn more money in the United States, because of high interest rates, than you can in Canada, you’ll take your money out of Canada and invest it in the US. The only way to prevent this is for Canada to raise its own interest rates.

That’s what occurred. A chain reaction was set off around the world, and interest rates began climbing. Developing countries found their debt service, the payment due on interest and principle, skyrocketing. In 1975, the debt service of the Third World was collectively around $26 billion. By 1982, after the rise in interest rates, the debt service jumped to more than $133 billion. Many developing nations found themselves with such enormous debt burdens they weren’t able to pay the interest due on those loans.

Mexico was the first nation to default. In 1982, the Mexican government declared a moratorium; they temporarily stopped their debt service payments. This made banking institutions nervous, but the Mexican situation was considered an anomaly–until Brazil also defaulted on their debt payments.