Journal Issue

Approaches to Debt Reduction

International Monetary Fund. External Relations Dept.
Published Date:
January 1989
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Debt reduction techniques

Debt-equity swaps. In this approach, the original lender or someone who has bought the debt at a discount on the secondary market takes a loan to the country and obtains in exchange local currency for its full face value at the official exchange rate. This local currency is used for purchase of local equity, relending, and so on. The advantage for lenders is that they find a use for their loans at face value while the advantage for the borrower is that its debt is reduced. But if the assets acquired by the creditor are private and the debt is held by the government, which is typically the case in most highly indebted countries, this type of conversion increases any existing fiscal deficit. In that case, to redeem the foreign debt, the government increases its internal borrowing or prints money. Informal conversions also fall in the same class but the terms of swaps are established in the private markets rather than set by the national authorities. Most of these transactions have involved financial restructuring of private companies through debt buybacks, conversions of debt to equity, and portfolio investment.

Exchange of claims. The exchange of debt at a discount for other debt instruments, such as bonds and exit bonds, requires that the new instrument be a more secure asset and the probability of the borrower fully servicing this asset is stronger than servicing the old debt. This usually means that the new asset is backed by collateral for the principal or a guarantee for interest, or both. To purchase the collateral, the country has to have excess reserves, which it can use, or it can obtain the resources from other sources.

Buybacks. In this type of operation, a country buys back its debt at a discount for cash. Bolivia and Chile are two such examples. Bolivia bought back 40 percent of its commercial debt ($335 million) in January 1988 at an average discount of 89 percent (i.e., at 11 percent of its face value). A similar arrangement was set up in early 1989. Chile repurchased $299 million of its commercial debt in November 1988 at a discount close to 44 percent. Countries in debt difficulties rarely have much ready cash: the 1988 Bolivian operation, for example, had to be financed by aid agencies.

Reduced debt servicing. This type of debt reduction has not so far been put into practice on a significant scale. Exit bonds issued by Argentina and Brazil could fall in this category. Banks unwilling to provide new money were invited to trade in their claims at reduced interest rates against bonds that were exempt from future debt relief operations. The reduced interest rate option is attractive from the viewpoint of debtors as they receive a substantial relief in cash flow. A case-by-case approach to interest rate reduction negotiated in the framework of an agreed structural adjustment program could make a significant reduction in the debt service burden, if the accounting and tax rules were modified to strengthen the incentives for the commercial banks.

Source: World Bank, Debt and International Finance Division.

Major debt reduction plans

The Brady initiative

Debtor countries. Debtor countries should maintain growth-oriented adjustment programs and take measures to encourage repatriation of flight capital.

International financial institutions. The IMF and World Bank should provide funding to countries for debt and debt-service reduction through:

• debt buybacks;

• exchange of old debt at a discount for new collateralized (secured by assets) bonds;

• exchange of old debt for new bonds at par value, with reduced interest rates.

The funding for these operations could be provided as follows:

• 25 percent of normal Fund and Bank policy-based lending could be reallocated to help reduce the principal of debt outstanding, through debt buybacks and collateralized reductions of principal;

• special resources could be used to support interest payments on discounted and par value reduced-interest bonds traded for commercial bank debt.

Over a three-year period, the IMF and World Bank would be expected to provide up to $20–25 billion, divided roughly equally between special pools and reallocations.

International financial institutions may lend to debtor countries for debt reduction operations before a financing package is complete but after these countries commit, in principle, to approaches that would facilitate new flows of commercial finance and related debt-reduction methods.

Commercial banks. Commercial banks would provide debt reduction and new money, and support the accelerated reduction of debt and debt service through a temporary and conditional relaxation of some conditions on current debt.

Creditor governments. Creditor governments would continue to reschedule or restructure their own loans through the Paris Club and maintain export credit cover for countries with sound reform programs.

Tax, accounting, and regulatory impediments to debt reduction would be eliminated.

Japan is envisaged as providing about $4.5 billion over the next several years as additional financing.

The Miyazawa plan

The plan put forward by Japan’s Finance Minister has three main elements and combines menu options and interest reduction. First, debtor countries would “securitize” part of their debt, with guarantees on the principal through liens on their exchange reserves and on the proceeds of the disposal of state-owned assets. Second, the remaining unsecuritized debt would be rescheduled with grace periods of up to five years, during which interest payments could be lowered, suspended or forgiven. Finally, multilateral and bilateral agencies would increase their lending to countries that had taken the first two steps.

The Mitterand proposal

The French President has proposed that a fund should be created in the IMF for the middle-income indebted countries. This fund would guarantee the payment of interest charged on certain commercial loans converted into bonds. The fund would help significantly lower the finance charges payable by debtor countries. In order to finance it, the developed countries would set aside their share of a new issue of Special Drawing Rights (SDRs) for use by the developing countries.

Source: Compiled by Bank staff from public statements of US Treasury Secretary Nicholas Brady and Under Secretary David Mulford, Finance Minister Miyazawa, and President Mitterand.

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