Academic journal article Review of Business

The Effect of the Brazil Suspension Announcement on Returns to Large U.S. Bank Stocks

Academic journal article Review of Business

The Effect of the Brazil Suspension Announcement on Returns to Large U.S. Bank Stocks

Article excerpt

The Effect of the Brazil Suspension Announcement on Returns to Large U.S. Bank Stocks

Introduction

"In February 1987, Brazil stunned the world by unilaterally suspending interest payments on its commercial-bank debt for an indefinite period" [5, p.617]. This quote from a respected international economics text accurately reflects the general reaction, as seen in the popular and financial press, to the Brazilian announcement of February 20, 1987. However, an interesting question arises as to the degree to which financial markets were "stunned" as a result of Brazil's action. An analysis of the performance of stocks of large United States banks during the period just prior to and following Brazil's action sheds some light on the effect which such disturbances have on securities markets.

Because large U.S. banks are major holders of Brazilian debt, as well as debt of other Latin American countries which could be influenced by Brazil's actions, it would be reasonable to assume that bank stocks would be adversely affected by the announcement. If markets are operating efficiently, such effects should occur only in bank stocks exposed to Latin American debt and should be quickly discounted into stock values. If, on the other hand, markets were "stunned" the effects might spread to non-exposed banks, and stock prices may take longer to adjust fully as market participants try to evaluate the new information.

The following study is an empirical analysis of the returns on large U.S. bank stocks during the thirty-six day period surrounding Brazil's announcement of unilateral suspension of interest payments. The results may be useful as an example of how the stock market reacts to an international disturbance.

Study Results

A sample of 52 banks stocks was analyzed, including nine that were identified as being heavily exposed to Latin American debt. All returns were adjusted for movements in the Standard and Poor's 500 index. The returns for the entire sample did not fall just prior to, on, or just after February 20, 1987. In fact, there were slight gains immediately following the announcement. By contrast, when only the nine most heavily exposed banks were analyzed returns fell immediately following the announcement and continued to fall for 17 of the next 22 days.

There are two conclusions of the analysis. First, market participants discriminated in their reaction. Losses in value of the most exposed stocks were offset by gains in the less exposed stocks, perhaps reflecting a flight to safety. There was no general panic affecting bank stocks as a group.

Second, the most exposed banks adjusted as expected, but not quickly. Twenty-one days is an exceptionally long adjustment period in the stock market where most new information such as earnings and dividend announcements is fully discounted within hours. The Brazilian announcement may have been only the first piece of an information flow which actually occurred over a period of several weeks as negotiations and further developments regarding the crisis unfolded.

Debt Crisis Background

A detailed discussion of the Latin American debt crisis is beyond the scope of this study; however, a brief background of the context of the Brazilian suspension is relevant [1,9]. The first overt manifestation of the debt crisis is generally perceived to be the announcement on August 19, 1982 by the government of Mexico, that a moratorium was being placed on repayment of debt principal to foreign creditors. That announcement was followed by a series of debt restructuring agreements between Mexico and its international creditors.

Problems with other South American countries followed at a rapid pace. By early 1984, all except Colombia and Paraguay had undergone debt rescheduling. Brazil underwent a rescheduling every year from 1982 through 1985. After a remarkable economic resurgence in 1985, the Brazilian economy suffered a severe reversal in 1986 with the failure of the "Cruzada Plan" to halt inflation while maintaining a trade surplus. …

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