Michael Blackwell and Simon Nocera
A number of innovative ways to reduce the debt burden of heavily indebted countries have emerged in recent years. Schemes have been evolved in which these countries have offered to buy their debt back at a discount or to convert it into other assets such as bonds or even commodities. The most widely practiced of these schemes are those that provide for the swap of debt for equities.
The growth in the volume of debt-equity swaps has been fueled by an increasing recognition in debtor countries that foreign investment can make an important contribution to economic growth, by a flourishing secondary market in country debt obligations among the international banks, and by the current global trend toward the conversion of debt into negotiable securities.
The regulations governing the ways in which countries permit the swap of their commercial bank debt for equity in particular sectors of their economies differ importantly from country to country; even within individual countries, conditions applied to such transactions can vary according to the purpose for which the swap is undertaken, monetary policy considerations, and other factors.
Whatever the differences in the often arcane regulations and the actual forms of such transactions, most debt-equity swaps conform to a basic pattern. First, a bank sells at a discount (of, say, 35 percent) an outstanding loan made to a public sector agency—or sometimes to a private sector enterprise—in an indebted country. Second, an investor, often a multinational manufacturing company, buys the loan paper at the discounted price and presents it to the central bank of the indebted country, which redeems the loan at face value or at a modest discount (of, say, 10 percent) in domestic currency at the prevailing market exchange rate. Third, the investor acquires equity in the indebted country using this domestic currency, which it has in effect purchased on terms that are more favorable than could have been obtained through regular foreign exchange market transactions. Recently, the first and second steps of this process have often been telescoped together as some banks, encouraged by changes in US banking regulations, have swapped their own credits for equities in the debtor countries.
The main participants
The banks. Banks sell their debt paper or engage in debt-equity swaps for a variety of reasons, which reflect their assets management objectives and business strategies. A bank’s management will sell its loan paper, if it feels that by doing so it can strengthen its financial position and, ultimately, achieve a better credit standing. One specific advantage of selling debt paper is the opportunity it provides of clearing the bank’s books of problematic loans and of adjusting its assets position. A second advantage is that such loan sales allow a bank to reduce its credit exposure and possibly avoid or diminish the need to increase it later during a concerted financing package for the debtor country concerned. In many such packages, a creditor bank is expected not only to accept postponement of overdue principal repayments but also to join other creditor banks in committing new loans in order to cover the debtor country’s financing needs during an agreed adjustment period. If a bank fails to comply with these requirements and if its scheduled repayments are not met by the debtor country, then the bank’s original loan could be placed in a non-accrual or non-performing status, with the consequent need to recognize and show losses on the bank’s earning statement. Finally, a bank’s management may find it more profitable to sell debt paper at a discount and reinvest the proceeds than to hold on to the debt with uncertain prospects for repayment of interest and capital.
Most sales of debt paper have come from the continental European banks and smaller US regional banks with relatively small exposure to the heavily indebted countries. Banks with larger exposure have been reluctant to sell their loan paper at a discount because of uncertainty about the extent to which accounting standards would require that other loans to the relevant countries be similarly marked down. The major US banks have been particularly hesitant to release even small portions of their own loan paper in the light of statements by accounting and regulatory authorities to the effect that sales or swaps of assets at a discount, and therefore at a loss, may ultimately trigger the need to adjust the value of similar assets remaining in the bank’s portfolio. Consequently, any potential future requirement to write down assets with similar credit characteristics to the loan sold could have a major adverse impact on the bank’s balance sheet.
In mid-1987, a number of the major US banks set aside additional, relatively substantial reserves against their problematic international loans. This action was generally seen as signaling a recognition on the part of the banks that the actual value of their international loans was considerably lower than their nominal value. Furthermore, it seemed to suggest that these banks might be prepared to become net sellers in the secondary debt market, thus making more debt available for conversion into equity.
The investors. For companies wishing to invest in an indebted country, the most obvious advantage of a debt-equity swap is the possibility it affords of obtaining local currency on very favorable terms for investment. The larger the discount on the debt offered by the banks and the more attractive the price at which the debtor country will redeem the debt, the greater the incentive to engage in the transaction. However, the difference in costs between a debt-equity swap transaction and a regular foreign direct investment transaction, that is, the effective subsidy, may have to be quite high to compensate the investor for the potential disadvantages of such transactions. More specifically, authorities may impose greater restrictions on the repatriation of capital and profits in debt-equity swap transactions than on regular foreign direct investment transactions. In addition, companies might be restricted as to how and where they may use the local currency resources received in a debt swap.
The indebted countries. The countries that convert their debt into equity are prepared to do so not only because they want to reduce their level of external debt and, presumably, help to re-establish their creditworthiness, but also because they believe that the resulting new investment will stimulate economic growth. By channeling this investment into import-substituting or export-oriented industries, the authorities generally hope to improve the country’s trade performance. They also hope that successful investment of this nature will create employment either directly or indirectly through increasing demand for domestically produced inputs and will, in consequence, expand the country’s tax revenue base. In addition, they hope that the new technology and management expertise often associated with foreign investment will bring significant increases in productivity.
The balance of payments
From an accounting standpoint, a swap of equity for debt has little or no effect on a country’s net liability position. In most cases, the claims of the rest of the world on the country are merely reclassified, that is, there is no net capital inflow if the debt is redeemed at face value. There would be some capital inflow if the debt was redeemed at less than face value or if the country imposed a condition that a debt swap be accompanied by new direct investment. Through a debt-equity swap a country simply exchanges one form of external liability for another—-a debt with fixed service and continuing repayment obligations for direct investment. However, one way the balance of payments could be affected is if the payments abroad of dividends or capital associated with the equity investment exceed the interest and principal payments that would have been due on the redeemed external debt.
This situation would not always be detrimental to a country, however, since outgoing payments would be linked to the profitability of investments, rather than to a rate of interest that may be determined largely by factors beyond the debtor country’s control. Thus the risk of not meeting an international repayment obligation is shifted from the borrower to the foreign investor. To the extent that this shift reduces net repayments abroad and to the extent that foreign exchange earnings from the resulting new export or import-substituting industries increase, a debt-equity swap can help alleviate the debt-service burden of an indebted country.
Monetary and fiscal policies
Debt-equity swaps can have a significant impact on the monetary and fiscal policies of the country redeeming the debt, particularly if a substantial volume of swaps takes place. The monetary effect will depend on how the domestic side of the transaction is financed. If the government finances the conversion through the consolidated banking system, there will be an equivalent monetary expansion and possible inflationary pressures. Table 1 shows that in four of the major indebted countries, the conversion of as little as 5 percent of outstanding debt to commercial banks could lead to an increase of 33-59 percent in the domestic money supply.
|outstanding to||Money||effect on M|
|commercial banks||supply (M)||of 5 percent|
|(In billions of||(In billions of||conversion|
|US dollars)||US dollars)||(In percent)|
(In billions of US dollars)
|Total debt outstanding||Debt conversion|
|to Industrial country||1987|
Even if the authorities of the debtor country take a different approach and decide to finance the swaps directly by selling government bonds to the private sector, they may not avoid difficult policy choices. Financing debt-equity conversion by drawing on domestic capital markets could well result in substantial crowding-out by placing upward pressure on interest rates, thereby squeezing out domestic economic agents. Furthermore, the limited size of the domestic capital markets in most major debtor countries would appear to offer little scope for absorbing the amount of public debt that would be required for substantial debt-equity swaps. Domestic monetary authorities would, therefore, face limitations with regard to the volume of debt-equity swaps that they can reasonably accommodate.
On the fiscal side, the replacement of foreign liabilities with domestic obligations —whether to the consolidated banking system or the private sector—may result in an increase in the domestic-currency debt-service obligation of the government to the extent that the domestic real interest rate is higher than the rate applied to the external debt. This cost, as well as the financial implications of the early repayment of external debts, must be taken into account in the government’s financial program.
In most cases, the debt-equity swap is not settled in or through the foreign exchange market, and so there is unlikely to be any direct linkage with the foreign exchange rate of the debtor country involved. However, if the net flow of external payments decreases even marginally as a result of the conversion, possible demands on official reserves could be reduced. This beneficial effect on reserves could, however, be offset to some extent by the fact that when investment is made through debt-equity conversion instead of through direct purchases of domestic currency in the foreign exchange market, potential additions to foreign currency reserves will have to be forgone.
Growth and investment
All debt-equity swaps, whether they involve the conversion of public or private debt, are significantly influenced by the policies of the government of the indebted country concerned. The government can screen potential investors and decide which ones it will allow to engage in debt-equity swaps. It can decide to redeem the debt paper at less than face value, thereby reducing the incentive to the foreign investor to engage in particular transactions. More importantly, when a government specifies the sector into which the local currency proceeds of a debt conversion can be channeled, it is in effect pursuing an investment program that is not guided by purely market signals. The investment activities associated with such a program may not reflect an efficient allocation of resources and could, therefore, lead to distortions.
In assessing the benefits of debt-equity swap programs, the debtor countries have focused much attention on the question of whether such swaps cut the flow of new foreign exchange that they would otherwise have received. Concern that debt-equity swaps merely substitute for the flow of “new” money for direct investment has led some countries, such as Argentina, to formulate their programs in such a way that debt swapped for equity would have to be accompanied by “new” money.
Another reason why the authorities of some countries are hesitant to promote debt-equity swap programs comes from their anxiety not to cede any sovereignty in the control of their domestic economies. It was partly this concern that made foreign bank lending more attractive than equity investment during the 1970s. Those countries that believe that the domestic resources must remain in national hands are less likely to encourage debt-equity swaps.
While offering many advantages to creditors and indebted countries, debt-equity swaps cannot be seen as a panacea for the debt crisis. Since the conversion of debt into equity does not necessarily provide any additional foreign capital (indeed, the swap may substitute for additional foreign funds), some portion of the resources for any increase in gross investment will need to come from the domestic economy. To the extent that these are unemployed resources, the additional expenditure generated by the swaps can perhaps be accommodated with little increase in the rate of inflation or domestic interest rates or with little pressure on the balance of payments. However, if the economy is operating close to capacity, any increase in investment spending must either displace other domestic expenditure as a result of higher prices and/or higher interest rates, or result in a worsening of the trade balance.
Overall, debt-equity swaps may alleviate the debt burden by making more manageable the servicing of obligations to foreigners and can contribute to economic growth by attracting new investment into efficient sectors of an economy. It has to be acknowledged, however, that the limitations imposed by monetary, fiscal, and other economic considerations mean that the amount of debt-equity swaps that can be financed has to remain somewhat limited.
The classic debt-equity swap
A transaction organized by Nissan Motor Company in 1986 in order to expand the operation of its subsidiary in Mexico has been described in many press articles and become a classic case study of debt-equity conversion. According to several of these articles, the transaction took place as follows:
With the help of the Citicorp Latin America Investment Division, Nissan bought $60 million of Mexican government debt in the financial market at a price of $40 million.
Nissan redeemed the debt certificates at the Mexican Central Bank, receiving an equivalent of $54 million in Mexican pesos at the official exchange rate.
Nissan used the Mexican pesos acquired in this transaction to increase the capital of its subsidiary in Mexico.
All parties to the transaction benefited. The commercial bank that sold the debt to Nissan via Citicorp reduced its credit exposure in Mexico by $60 million, albeit at a loss of $20 million. This represented an effective discount of 34 percent. Nissan was able to acquire Mexican pesos at an effective discount of 26 percent (exclusive of the transaction fee). The Mexican Gov-ernment was able to convert some of its liabilities in foreign currency and, in so doing, captured a part of the discount equivalent to the difference between the face value of the loan and the amount paid for its redemption, that is, $6 million or 10 percent of the original loan.