POTENTIAL AND NATURE OF A GLOBAL FINANCIAL PANIC

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP84B00049R001102640015-0
• Release Decision: RIFPUB
• Original Classification: K
• Document Page Count: 11
• Document Creation Date: December 20, 2016
• Document Release Date: May 8, 2009
• Sequence Number: 15
• Content Type: REPORT

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Panic Scenarios
Potential and Nature of a Global Financial Panic
1. The base-line recovery scenario could be derailed by a
financial panic. The international financial system now seems
more prone to panic than at any time in the past 30 years. The
cumulative adverse strains of the prolonged economic slowdown
have reached the point where an inordinate number of companies,
countries and banks must deal with precarious financial
situations. This situation has been made worse by high interest
rates and the unsettling burden of the increased short-term
debt. On top of the Polish and Argentine debt problems, there
has been a spate of sudden failures among financial institutions-
-Dreyfus Government Securities, Penn Square Bank, Banco
Ambrosiano, and Lombard Wall. Finally, the recent Mexican
foreign exchange run added a significant new sense of uneasiness
since that country owes more than $80 billion.
2. Although the odds of such a panic are now higher than
usual, they remain low. The international financial system that
evolved since World War II has a proven record of resiliency.
That strength arises from the system's flexibility, and the
growing common interest of both lenders and borrowers in a smooth
functioning system. In addition, bankers and other western
financial leaders have worked together effectively, even during
emergencies.
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3. If there is a panic its impact would likely fall far
short of the devastating consequences suffered in the 1930s.
Much will depend on the nature of the crisis and the ability of
central banks to respond quickly. A situation is certainly
conceivable whereby central banks find that they are unable to
prevent a panic from starting, but are successful in halting the
panic soon thereafter. For example, the sudden impact of some
massive triggering event(s) may not give central banks adequate
time to sort out the problems of national responsibility for
overseas banks thereby making a rescue operation much more
difficult if not impossible. Within farily short period of time,
however, the central banks could devise a stop gap formula to
meet the emergency. Thus the economic consequences of a panic
could range widely from a temporary disruption of trade and
investment transactions to causing a depression.
4. If there is a panic, it would have the following
characteristics:
It would spread quickly as a growing number of financial
institutions are suspect of having either or both
liquidity or solvency problems. Doubts as to the ability
of the bank or banks hurt by the initial triggering event
to meet its obligations to other banks would greatly
increase questions as to the soundness of these other
banks.
-- Depositors, banks firms or individuals would seek what
they believe to be the soundest placement of their
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funds: i.e., the most creditworthy banks and government
securities. In today's market, that probably would mean
a mass flow of funds to the United States. Large
quantities of US government securities would probably be
bought and many foreign individuals and companies would
deposit funds here because this country has the most
comprehensive formal deposit insurance scheme and is
considered the ultimate safe haven.
Banks would retire old loans as soon as they mature and
not extend new loans to those companies or countries
which do not possess the strongest credit ratings.
The international interbank market (i.e., Eurodollar
market) would shrink drastically as loan and deposit
activity slows.
The Major Dangers
5. Three type of circumstances would most likely cause a
panic.
Central banks are unable or unwillin to act suicki and
in unison to meet an emergency. Among the three
possibilities, this one is most important because lender-
of-last-resort actions by central banks are the key to
arresting a panic caused by the other two.
An undercutting of the informal codes of conduct that
sustain confidence in the international financial
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system. For example, the leader of some major debt-laden
country could decide to repudiate its loans fey? whatever
reason (political or economic), and this type of action
could become commonly accepted.
A confluence of a number of major events. Most likely
such a situation would involve the near simultaneous
inability of several major countries to meet its foreign
exchange obligations and some large scale bankruptcies of
companies within the industrial world. According to a
"Group of Thirty" survey, more than 60 percent of the
banks responding believe that under present arrangements,
the international banking system would be vulnerable to a
chain collapse in a crisis that caused the failure of a
major bank or a groups of banks. That percentage is more
than 70 percent for European banks and 45 percent for US
banks.
The Panic Scenarios
6. Shown below are some currently plausible (although low
probability) scenarios that match each of the three above
categories.
Central Bank Action
7. A break in the Group of Ten unison in face of a major
threat to the international financial system is the least
plausible of our three types of dangers, although the most
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serious. Such a division would almost certianly require a
profound divergence of policies among the governments of the
Group of Ten countries, especially the United States, West
Germany, France and the UK. Moreover, such deep political
splits, in all but the most extreme cases, would sooner or give
way to a common desire to avoid a global economic calamity.
Until that happens, each country would pursue individual or
partially coordinated emergency steps. If these were ineffective
in halting a panic, the global economy could be seriously hurt.
8. The scenario presented here involves a deteriorating
French economy combined with major political differences between
the US and France on East-West issues. During the next few
months, the French could face a stagnating economy and rising
unemployment as a result of Paris recent tilt toward restrictive
fiscal and monetary policies. Meanwhile, these actions may not
have had sufficient time to bring down France's high inflation
rate. The Communist party members of the cabinet might resign,
not wanting to be stigmatized by the worsening economic
conditions. Under those circumstances, the party might call for
strikes by the labor unions it controls and other disaffected
groups might participate.
9. The Mitterrand Government, under such pressure, might
return to its previous emphasis on stimulating economic activity
by increasing budgetary outlays and by allowing workers to
achieve real increases in wages. Hyper-inflation might result,
leading to a capital outflow that drains foreign exchange
reserves to the point at which Paris must close its foreign
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exchange window. Without any assistance from otter central
banks, Paris would be unable to restore the franc to full
convertibility. French banks and other businesses would thus be
unable to repay all their foreign debts as they come due or
obtain new loans.
10. Meanwhile, the United States and French Governments
could be at odds over East-West issues. The United States could
try to hold up emergency loans to France in the hope of gaining
political concessions. Out of nationalist pride, Paris might be
unwilling to make even minor modifications in its East-West
policy, and this hardening of attitudes might make it more
difficult than usual to accept the significant austerity measures
that accompany any such loans. Until a way could be found, at
least temporarily, to paper over the political differences the
international financial system could be significantly damaged.
Codes of Conduct
11. Argentina provides a plausible example of a major debt-
laden country that might repudiate its debt within the next year
or so. The effectiveness of the current military regime to rule
has been undermined by the Falkland Island debacle. There is
considerable dissension among its leaders and the regime has
little popular support. If the military leaderhsip lacks the
ability to take the tough political measures needed to overcome
current economic and financial troubles, the economy could
deteriorate further leading to unemployment and inflation that is
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high even by Argentine standards. As a result of this political-
economic chaos, the chances would increase that a strongman could
seize power with the support of factions within the military and
the Peronist labor groups. The general populace probably would
accept the new leaderhsip in the hope of a return to more normal
conditions.
12. Based on Argentina's political structure, the new
regime's policies could conceivably be based on populists'
beliefs including the reoudiation of the foreign debt (or more
likely a moratorium on debt and interest payments). It would
support this move domestically by arguing that the industrial
countries are responsible for many of Argentina's economic
problems and, anyhow, that group supported the UK during the
Falkland Island crisis. In economic terms, the new regime could
argue that Argentina normally has a surplus on its trade account
and, therefore, would be in good shape if it was not for the
enormous debt burden. Further, the leaders might think the
country could easily handle foreign transactions on a cash-and-
carry basis. They might believe that attempts by foreign
creditors to attach their goods could be overcome since many
countries want to maintain exports to Argentina. They might also
believe, with historical evidence to back them up, that as soon
as their economy regained its strength, foreign lenders would
provide large amounts of new credits.
13. A number of other countries, especially in Africa,
might follow the Argentine lead. Although the additional amount
of loans might be relatively small, the post-war precedent
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whereby countries promise eventually to meet their debt
obligations would no longer stand and confidence in the efficacy
of the international financial system could be shattered. The
solvency of so many banks might be suspect that the central banks
may not be able to step in quickly enough to prevent a panic.
A Confluence of Events
14. Although many combinations of triggering events are
possible, a most plausible scenario in the next few months would
include the inability of the Mexican government to regain the
confidence of foreign bankers. The Mexican situation may not
itself cause a panic but might lead to a sharp reduction in
commercial bank exposure to other major borrowers, such as
Brazil, creating severe foreign exchange problems for that
country. The Mexican trigger might also occur at the same time
some major US company or bank suddenly declares bankruptcy. The
deep involvement of US banks in all these cases would raise
questions as to the solvency of many major US banks and again the
central banks might find that they were unable to provide
assistance fast enough to calm fears and thereby rip the panic in
the bud.
15. A crisis atmosphere would most certainly emerge in the
international financial markets if the Mexican government seemed
unwilling or unable to institute the severe austerity measures
needed to restore the confidence of foreign bankers. Mexico is
the largest LOC borrower, accounting for 20 percent of the
groups' outstanding loans from commercial banks.
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16. Such an unfavorable development is certainly
conceivable since the most crucial period for restoring banker
confidence occurs when a lame duck president is on office.
Between now and when he leaves office on December 1, President
Lopez-Portillo might not take strong austerity measures because
he does not want to be remembered as a leader whose policies
created considerable and widespread hardships. Mexico's powerful
labor unions could take advantage of the outgoing President's
weak position and press vigorously for maintaining the real wages
of workers. Widespread demonstrations by workers could take
place with radical students joining in. These and other interest
groups could play upon the country's fierce nationalism while
some others could attack the government for mishandling Mexico's
oil wealth. To contain the discontent, Lopez-Portillo might not
accept an agreement with the IMF on needed corrective steps, a
key requirement in retaining banker confidence and acquiring new
financial help.
17. Under these conditions, the peso would likely slide
further, sustaining the vicious circle between large currency
devaluations and hyper-inflation. Many Mexican companies which
borrowed trade and other short-term credits from US banks would
find they were unable to make their repayments in dollars at the
devalued rate. Banks meanwhile would not roll over short-term
credits. The point might be reached where the United States and
other industrial countries would find that they were unable to
provide sufficient foreign exchange to halt the dollar exodus
from Mexico. Mexico would then be forced to reimpose full
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foreign exchange controls, creating further uncertainties for its
creditors and depositors. In some cases, the financial plight of
non-Mexican concerns would become unbearable.
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Table 1
Select LDCs: Foreign Debt Service Burden
(as a percent of exports of goods and services)
Interest
1975 1979 1981 1982*
Argentina
14
12
29
36
Brazil
19
19
38
45
Chile
17
17
31
31
S. Korea
7
7
13
14
Mexico
17
22
26
30
Peru
12
15
19
26
Philippines
6
10
16
1g
Principal Repayment
(Med/long)
1975
1979
1981
1982*
Argentina
25
20
32
30
Brazil
21
38
29
33
Chile
27
28
31
28
S. Korea
8
9
7
7
Mexico
17
52
28
21
Peru
35
17
38
34
Philippines
10
9
9
12
Short-term debt
1975
1979
1981
1982*
Argentina
78
53
89
96
Brazil
20
28
32
38
Chile
56
43
49
57
S. Korea
41
36
40
40
Mexico
44
30
48
75
Peru
59
29
36
35
Philippines
26
27
54
62
*Estimated
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