The expansion of the market has contributed to debt reduction and has facilitated commercial bank debt restructuring
The secondary loan market has rapidly become a key component in the economic and political efforts to relieve the debt problem of the developing countries. As in any other financial market, financial instruments—in this case, loans to developing countries—are traded among the original creditors and various other investors at a market-determined price. By providing a market-based valuation of developing country loans, the market has strengthened the Brady initiative, which emphasizes the role of debt and debt-service reduction. Several countries, including Brazil, Chile (see box), and Mexico have substantially reduced their commercial bank debt by using the secondary market as a vehicle for various debt conversion schemes. This article describes the evolution and function of the growing secondary market for bank claims on developing countries.
Since its inception in 1982, the secondary market for developing country loans has blossomed. The total volume of loans traded grew explosively from around $6 billion in 1985 to over $60 billion in 1989. Initially, the original holders of debt—commercial banks—were the principal participants in the market. The bulk of secondary market transactions was accounted for by debt swaps aimed at rearranging bank portfolios to reduce risk or enhance tax benefits. After 1984, the introduction of formal debt conversion programs in several major debtor countries (Chile, Argentina, Brazil, Mexico, and the Philippines) stimulated the growth in cash transactions, which were triggered by conversions of debt into equity and included purchases by countries of their own debt at a discount. Secondary market transactions have been facilitated by the emergence of specialized market makers (e.g., Citibank, Libra bank, J. P. Morgan, and Nederlandsche Middenstandsbank) in developing country debt. Over the last two years, debt restructuring arrangements involving debt repurchases and debt exchanges have boosted activity in the interbank segment of the market and generated an additional source of demand for developing country loans.
Secondary loan market transactions and related debt exchanges fall into five categories.
• Loan-to-loan swaps are simple trades of one loan for another undertaken by banks. During the first years of the market, loans were valued at par, while in recent years loans have traded at market-determined discounts. In many cases these swaps are a part of the chain of transactions set in motion by a debt exchange or debt conversion.
• Cash sales involve the payment of cash by either banks or investors in exchange for a loan. They also enable banks to exit, albeit at a loss, from involvement in a particular country.
• Debt buybacks allow debtor countries to retire debt at a discount by paying cash to creditors.
For further discussion, see “The Sensitivity of Secondary Sovereign Loan Market Returns to Macroeconomic Fundamentals,” and “Are Sovereign Debt Secondary Market Returns Sensitive to Macroeconomic Fundamentals? Evidence from the Contemporary and Interwar Markets,” by Mark Stone, IMF Working Papers (WP190155) and (WPI90I69), respectively, available from the author.
• Debt conversions transform loans into equity or domestic debt, and take the form of “debt-equity” and “debt-peso” swaps. Debt-equity swaps involve a purchase of a debt instrument in the secondary market (usually at a discount) in exchange for an equity investment in the borrowing country (see table). In “debt-peso” conversions, foreign currency debt is exchanged for obligations denominated in the debtor’s domestic currency. The debt conversions rights are either granted directly under the debt restructuring agreement, or are sold at special auctions. In the last two years a significant share of debt conversions was conducted under informal arrangements outside official debt conversion programs. Informal conversions are legal operations in public or private unmatured debt, transacted at secondary market prices, and leading to the cancellation of the original liability.
• Debt exchanges involve the transformation of bank loans into other types of external debt obligations, usually bonds. This type of conversion is generating a considerable amount of secondary market trading.
Although the growing number of participants has added to market liquidity and strengthened its cohesiveness, most transactions have still been heavily concentrated in the debts of a few countries. For example, in 1988 and 1989, transactions in the liabilities of Argentina, Brazil, Chile, and Mexico accounted for roughly 85 percent of debt conversions. In some smaller countries, debt conversion schemes are just taking off.
Overall developments in the secondary loan market are affected both by the participants and by nontraders in a position to influence market behavior. The incentives and strategies of the major market participants are presented below.
• Commercial banks. As the original source of supply of developing country loans to the market, commercial banks’ strategies strongly influence market conditions. Their participation in the secondary market rests, in large part, on their ability to absorb losses and by their assessment of developing country creditworthiness. The former, already reflected in bank share prices, depends on such factors as banks’ overall profitability, the share of developing country loans in bank portfolios, regulatory and tax treatment, the level of loan-loss reserves, and capital adequacy considerations. Elements influencing the perception of risk include bank appraisal of debtor country prospects (which in turn affect the probability of debt repayment), banks’ long-term strategies, and the interests of their major corporate clients. In general, banks are reducing exposure in countries where they lack expertise, strategic interest, or the ability to manage risks efficiently. However, they also acquire developing country loans when profitable opportunities emerge.
The expected return on banks’ developing country assets is significantly affected by creditor country governments through regulatory and tax decisions. Regulatory policies, which vary across countries, determine the extent of bank capital losses stemming from the creation of loan-loss provisions, loan write-offs or participation in loan exchanges, and outright loan sales. Tax decisions, which grant tax deductibility of loan-loss provisions, may discourage asset sales and participation in loan exchanges because banks can obtain tax benefits without disposing of the assets.
Debtor country authorities. The national authorities participate directly or indirectly in the majority of debt conversions. Debtor governments can represent public institutions whose debt is traded, and thus are directly involved in the negotiation of the deal. They can also act as regulators and administrators of the debt conversion programs. For example, they determine the required amount of new capital, the minimum discount for the converted debt, and any medium-term restrictions on capital repatriation and profit remittances.
Debt conversions are viewed mainly as a means of retiring external debt at a discount, or transforming it into local currency instruments. However, they can also encourage foreign direct and portfolio investment and the return of flight capital, enhance privatization programs, and offer additional revenue to the government in the form of transaction fees. Although debt-equity conversions only partly reduce the external liabilities of a given country (as the discounted debt-type liability is converted into foreign investment liability), they can also shift the risk of not meeting future foreign exchange obligations from borrower to foreign investors. Finally, to the extent that they reduce expected taxes and the general level of uncertainty, debt conversion programs may dampen the adverse impact of the debt “overhang” on domestic investment.
Debt conversion programs, however, have some disadvantages. First, unless they are accompanied by privatization programs, such operations can generate inflationary pressures if the redemption of external debt is financed by monetary expansion. When debt conversions are financed with domestic debt, the macroeconomic benefits may be limited because total government debt obligations may not be substantially reduced due to high borrowing costs of debtor country governments (see Michael Blackwell and Simon Nocera, “Debt-Equity Swaps” in Jacob Frenkel, Michael Dooley, and Peter Wickham (editors), Analytical Issues in Debt, International Monetary Fund, 1989). Finally, debt conversion schemes that offer a subsidy in the form of a favorable exchange rate may create opportunities for arbitrage and speculation, resulting in distortions in capital allocation.
Investors. The sharp spurt in secondary market transactions and the emergence of various debt conversion opportunities has generated considerable interest among investors. Foreign-based corporations and banks have participated in debt-equity conversion programs and in informal debt conversions either to start new projects, or to fund existing investment at a favorable exchange rate. The benefit an investor receives from conversions is determined by several factors, including the price of the debt and its redemption value in local currency.
|Debt equity conversion||Total conversions1|
Environmental groups. International environmental groups have had a long-standing interest in debt conversion programs and have sought to combine debt relief—through debt-for-nature swaps—with the protection of the natural environment in developing countries. Debt for nature swaps can be divided into two major categories: 1) conversion of debt into local currency or local debt instruments to be donated to local environmental organizations to fund specific projects, and 2) official debt relief tied to environmental policies and investments. The impact of debt for nature swaps has been very limited: only a small fraction of debt was converted under these schemes.
Secondary market prices
The market typically expresses the value of a given developing country loan as a percentage of face value. Several influences, including those mentioned below, help determine prices on the secondary market.
Macroeconomic conditions. Evidence (see box) suggests that the prices in the secondary market for countries with strong growth and lower overall levels of external debt are generally higher than countries with severe economic and debt problems. This is because investors associate these indicators with enhanced creditworthiness. But surprisingly, unexpected changes in debtor country exports, imports, exchange rates, and reserves have virtually no impact on short-term price movements. Moreover, there is little correlation between secondary market price movements and variations in measures of global economic aggregates such as industrial countries growth—factors that have an important impact on developing country economic performance, and therefore their ability to service external debt.
Actions of the debtor country. The introduction or termination of debt conversion programs appear to be important determinants of short-term price changes, although the impact is difficult to quantify. In addition to liquidity considerations, the positive impact of conversions on loan prices may reflect subsidies (i.e., in the form of a favorable exchange rate) provided by debtor countries through these transactions. Similarly, debtor country decisions to interrupt or resume debt repayments appear to have some impact on secondary market prices, although, as with the influence of debt-equity programs, the effect on prices is difficult to measure since, in many cases, announcements are anticipated by investors.
Actions of creditors. Given the high concentration of developing country claims in a relatively small number of banks, creditors’ decisions may significantly alter secondary market prices. In fact, the sharpest change in market prices occurred after Citicorp announced a $3 billion increase in its developing country loan-loss provisions in May 1987. Loan prices dropped owing to the perception that the augmented loan-loss provisions signalled a hardening of banks’ negotiating stance, as shown by the subsequent reduction in lending to developing countries. The reason prices stabilized only about five months after the increase in loan-loss reserves can be explained, in part, by the slow decision making of other market participants in response to the drastic change in the creditors’ strategy. In addition, because of considerable price uncertainty, potential sellers suspended or reduced their trading activity out of fear that, in a still illiquid market, additional loan sales would further reduce prices.
Actions of third parties. Creditor country governments can affect loan market prices by altering the regulations and tax structure faced by commercial banks lending to developing countries, and influencing the policies of the international financial institutions. The announcement of the Brady plan in March 1989, for example, which called for debt and debt-service reduction to be supported by additional lending, was quickly incorporated into higher market prices. In most cases, price increases in April 1989 were for the debt of those countries that were subsequently involved in debt restructurings.
Are these prices reliable?
Secondary loan market prices have occasionally been characterized as unreliable because of abrupt price movements that have occurred without any changes in underlying macroeconomic conditions. There are also allegations of differences between publicly reported and actual transaction prices. However, sharp price movements can be explained by a key difference between developing country loans and other securities. For example, the value of claims on corporations depends almost exclusively on the capacity of firms to meet contractual obligations. In the case of developing country debt, the market price depends not only on the debt payment capacity, but also on the willingness of the country to meet its debt payments obligations—a fundamentally immeasurable factor. Therefore movements in loan market prices that cannot be linked to macro-economic aggregates can be viewed as an inherent characteristic of developing country loans (soverign risk), rather than as evidence of the alleged discrepancy between market prices and investor’s valuation of these assets.
How Chile has used the secondary market
Chile has made an extensive use of secondary markets and various market-based operations in its external debt management. Since the inception of official debt conversion programs in 1985 until January 1990, the cumulative value of conversions of Chile’s commercial bank debt exceeded $9.1 billion. During 1985-89, Chile’s commercial bank debt declined by $6.7 billion to $9.2 billion at the end of 1989. Debt conversions in Chile are governed by two chapters of the foreign exchange regulations. One regulates debt conversions by residents into domestic currency instruments. The other regulates debt-equity conversions by foreign investors in Chile. The terms of conversion are agreed upon by the investor and creditor and must be approved by the Central Bank. During 1985-1989, debt conversions by residents totaled $2.6 billion, while debt-equity conversions by foreign investors reached $3.5 billion.
Other major transactions have included Central Bank buybacks arranged with creditor banks: In November 1988, the Central Bank, under the provisions of debt restructuring agreements, bought $299 million of its external debt to banks using $168 million of its reserves (a discount of 44 percent). A second buyback operation, carried out in November 1989, enabled the Central Bank to retire $140 million of debt at a total cost of $80 million (or a discount of 43 percent). Informal debt conversions by the private sector have also become increasingly important.
Secondary loan market prices are reported for each debtor country, rather than for individual loan transactions. Because of the heterogeneous nature of bank claims on a given debtor country, the publicly quoted prices may differ from the actual value at which certain types of loans are traded, due to differences in their eligibility for conversion, maturity, and degree of collateralization. Differences between the indicative prices and actual transaction prices have raised questions as to the validity of reported prices. However a comparison of the loan market of today with the international bond market of the 1920s and 1930s, when actual transaction prices were reported, suggests that the prices quoted in the market are reliable measures of loan values.
Secondary market for developing country debt, 1985-90
Source: Salomon Brothers.
1 In percent of face value.
2 Face value of converted debt including debt forgiveness and domestic debt swaps, Informal conversions, debt repurchases and other transactions excluding interbank trading. Data are in millions of US dollars Source same as In table. Data for 1990 not available.
The recent debt restructuring operations now being implemented under the Brady initiative involve complicated portfolio reallocations by the various participants. For example, loans are being traded for exit bonds, discount and par bonds, and equity claims. The secondary market has provided participants with incentives to develop expertise in these complex transactions and thereby has eased the implementation of the new strategy.
The market is particularly valuable in expediting debt restructurings by providing reasonably objective information on the value of debt. Without the guidepost of these secondary market prices, it would be quite difficult for the various participants in debt restructurings to agree on the valuation of debts.
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