Chapter

Appendix I. Specific Financial Instruments and Transactions: Classifications

Author(s):
International Monetary Fund
Published Date:
June 2003
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The purpose of this appendix is to provide detailed information on specific instruments and transactions and to set out their classification treatment in the gross external debt position. There are two sections. The first provides a description of specific financial instruments and how they should be classified in the gross external debt position; the second sets out the classification treatment of some specific transactions that, experience suggests, require particular clarification.

Part 1. Financial Instruments: Description and Classification in the Gross External Debt Position1

A

American Depository Receipt (ADR)

An ADR is a negotiable certificate that represents ownership of the securities of a non-U.S. resident company. Although the securities underlying ADRs can be debt or money market instruments, the large majority are equities. An ADR allows a non-U.S. resident company to introduce its equity into the U.S. market in a form more readily acceptable to U.S. investors, such as in U.S. dollars, without needing to disclose all the information normally required by the U.S. Securities and Exchange Commission. A U.S. depository bank will purchase the underlying foreign security and then issue receipts in dollars for those securities to the U.S. investor. The receipts are registered. The investor can exchange the ADRs for the underlying security at any time. See also Bearer Depository Receipts and Depository Receipts.

Classification

These instruments are classified by the nature of the underlying instrument backing the ADR. This is because the “issuing” intermediary does not take the underlying security onto its balance sheet but simply acts as a facilitator. So, the debtor is the issuer of the underlying security—that is, an ADR is regarded as a non-U.S. resident issue. If owned by nonresidents, these instruments are to be included in the gross external debt position if the underlying security is a debt security. The security is classified as long-term, bonds and notes (debt securities, portfolio investment in the IIP) or, depending on the relationship between debtor and creditor, as direct investment, intercompany lending (see the description of direct investment in Chapter 3). If the underlying item is an equity investment it should be classified in the memorandum item, equity liabilities.

Arrears

Amounts that are past due-for-payment and unpaid. These include amounts of scheduled debt-service payments that have fallen due but have not been paid to the creditor(s).

In the context of the Paris Club, arrears are the unpaid amounts that fall due before the consolidation period. See Paris Club, Creditor, and Consolidation Period in Appendix III.

Classification

Arrears of principal and/or interest are reported as new short-term liabilities. If owned by nonresidents, these new instruments are to be included in the gross external debt position as arrears. Regarding the original borrowing, the debt outstanding is to be reported as though the principal and interest were paid on schedule.

Asset-Backed Securities

Asset-backed securities are bonds whose income payments and principal repayments are dependent on a pool of assets. Securities may be backed by various assets—for example, mortgages, credit card loans, automobile loans—in effect, converting illiquid assets into tradable securities. An asset-backed security enables the original lending institution to devolve credit risks to investors. There are several key features of asset-backed securities: the original lender will usually sell the assets to a trust or other form of intermediary (special purchase vehicle) and so, in the case of a bank, this frees “capital” that regulatory guidelines require a bank to hold against the assets. The intermediary will finance the purchase of the assets by issuing securities. Because income and the repayment of principal are dependent on the underlying assets, if the underlying assets are prepaid so is the security. Issuers often provide different tranches of the security so that if there are prepayments, the first tier will be repaid first, the second tier next, etc. The pricing of the various tranches will reflect the probability of early repayment. Asset-backed securities have also been developed that securitize future income streams—such as the earnings of musicians.

Classification

Asset-backed securities owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). These securities present a special problem regardless of the amount outstanding because there can be partial repayments of principal at any time. So, simply revaluing the original face value to end-period market prices will cause overvaluation of the position data if there has been a partial repayment.

B

Balances on Nostro and Vostro Accounts

A vostro (your) account is another bank’s account with a reporting bank, while a nostro (our) account is a reporting bank’s account with another bank.

Classification

Liability positions in nostro and vostro accounts are to be included in the gross external debt position. They are classified as banks, short-term, currency and deposits, or loans (other investment in the IIP ) depending on the nature of the account.

Bank Deposits

Bank deposits are claims on banks that are either transferable or are “other deposits.” Transferable deposits consist of deposits that are exchangeable on demand at par without restriction, or penalty, and directly usable for making payments by check, giro order, direct debit/credit, or other payment facility. “Other deposits” comprise all claims represented by evidence of deposit—for example, savings and fixed-term deposits; sight deposits that permit immediate cash withdrawals but not direct third-party transfers; and shares that are legally (or practically) redeemable on demand or on short notice in savings and loan associations, credit unions, building societies, etc.

Classification

Bank deposits are liabilities of banks and other depository institutions, and if owned by a nonresident are to be included in the gross external debt position. They should be classified as banks, short-term, currency and deposits (other investment in the IIP) unless detailed information is available to make the short-term/long-term attribution.

Banker’s Acceptances

A negotiable order to pay a specified amount of money on a future date, drawn on and guaranteed by a bank. These drafts are usually drawn for international trade finance purposes as an order to pay an exporter a stated sum on a specific future date for goods received. The act of a bank stamping the word “accepted” on the draft creates a banker’s acceptance. The acceptance represents an unconditional claim on the part of the owner and an unconditional liability on behalf of the accepting bank; the bank has a claim on the drawer, who is obliged to pay the bank the face value on or before the maturity date. By writing the word “accepted” on the face of the draft the bank carries primary obligation, guaranteeing payment to the owner of the acceptance. Banker’s acceptances can be discounted in the secondary market, the discount reflecting the time to maturity and credit quality of the guaranteeing bank. Since the banker’s acceptance carries a banker’s obligation to pay (in effect “two-name paper”) and is negotiable, it becomes an attractive asset. Banker’s acceptances are always sold at a discount and have maturities of up to 270 days.

Classification

Banker’s acceptances are money market instruments that are claims on the accepting bank, with the bank owning a claim on the issuer of the bill. As recommended in the 1993 SNA, flexibility in the application of this recommendation is required to take national practices and variations in the nature of these instruments into account.

If owned by nonresidents, banker’s acceptances should be included in the gross external debt position. They should be classified as short-term, money market instruments (portfolio investment, debt securities in the IIP) unless they have an original maturity of over one year, in which instance they are to be classified as bonds and notes. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Bearer Depository Receipt (BDR)

A form of depository receipt issued in bearer rather than registered form. See Depository Receipts.

Classification

A BDR is classified according to the nature of the underlying instrument backing it. This is because the “issuing” intermediary does not take the underlying security onto its balance sheet but simply acts as a facilitator. So, the debtor is the issuer of the underlying security. If owned by nonresidents, these instruments are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Bonds and Notes

Bonds and notes are debt securities with an original maturity of over one year. They are usually traded (or tradable) in organized and other financial markets. Bonds and notes usually give the holder the unconditional right to fixed money income or contractually determined variable money income. With the exception of perpetual bonds, bonds and notes also provide the holder with an unconditional right to a fixed sum as repayment of principal on a specified date or dates.

Classification

Bonds and notes owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP). Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Bonds with an Embedded Call Option

A bond that gives the issuer a right to buy back the bonds on or by a particular date. The value of this right is usually reflected in the interest rate on the bond.

Classification

Bonds with embedded call options owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Bonds with an Embedded Put Option

A bond whereby the creditor has the right to sell back the bonds to the issuer on or by a particular date, or under certain circumstance, such as a credit downrating of the issuer. This right is usually reflected in the interest rate on the bond.

Classification

Bonds with embedded put options owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). The option is regarded as an integral part of the bond and is not separately valued and classified.

Brady Bonds

Brady bonds, named after U.S. Treasury Secretary Nicholas Brady, arose from the Brady Plan. This plan was a voluntary market-based approach, developed in the late 1980s, to reduce debt and debt service owed to commercial banks by a number of emerging market countries. Brady bonds were issued by the debtor country in exchange for commercial bank loans (and in some cases unpaid interest). In essence they provided a mechanism by which debtor countries could repackage existing debt. They are dollar denominated, “issued” in the international markets. The principal amount is usually (but not always) collateralized by specially issued U.S. Treasury 30-year zero-coupon bonds purchased by the debtor country using a combination of IMF, World Bank, and the country’s own foreign currency reserves. Interest payments on Brady bonds, in some cases, are guaranteed by securities of at least double-A-rated credit quality held with the New York Federal Reserve Bank. Brady bonds are more tradable than the original bank loans but come in different forms. The main types are as follows.

  • Par bonds: Bonds issued to the same value as the original loan, but the coupon on the bonds is below market rate. Principal and interest payments are usually guaranteed.

  • Discount bonds: Bonds issued at a discount to the original value of the loan, but the coupon is at market rate. Principal and interest payments are usually guaranteed.

  • Debt-conversion bonds: Bonds issued to the same value as the original loan but on condition that “new” money is provided in the form of new-money bonds.

  • Front-loaded interest reduction bonds: Bonds issued with low-rate fixed coupons that step up after the first few years.

There are also other, less common types.

Classification

Brady bonds owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP). When a Brady bond is issued, the original loan is assumed to have been redeemed unless the terms of the issue of the Brady bond state otherwise. Any debt reduction in nominal value terms should be recorded—see Chapter 8. The initial purchase of the principal collateral (U.S. Treasury bonds) is a separate transaction and is classified as debt of the United States.

C

Certificate of Deposit (CD)

A certificate issued by a bank acknowledging a deposit in that bank for a specified period of time at a specified rate of interest; CDs are essentially a form of negotiable time deposit (evidenced by the certificate). CDs are widely issued in the domestic and international markets, and are typically bearer instruments, issued at face value with original maturities of one to six months, although there have been maturities of up to seven years. Typically, interest costs are payable at maturity for issues of one year or less, and semiannually on longer issues. The rate of interest on a given CD depends on several factors: current market conditions, the denomination of the certificate, and the market standing of the bank offering it. Typically, CDs are highly liquid instruments, which allows banks access to a cheaper source of funds than borrowing on the interbank market.

Classification

CDs owned by nonresidents are to be included in the gross external debt position. Those with an original maturity of one year or less should be classified as short-term, money market instruments (portfolio investment, debt securities in the IIP), while those with an original maturity of over one year should be classified as bonds and notes. A small minority of CDs are known to be nonnegotiable—not tradable—and if owned by nonresidents are to be classified as banks, short-term, currency and deposits (other investment in the IIP). Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Collateralized Debt Obligations (CDOs)

CDOs are bonds whose income payments and principal repayments are dependent on a pool of instruments. Typically, a CDO is backed by a diversified pool of loan and bond instruments either purchased in the secondary market or from the balance sheet of a commercial bank. The diversified nature of the instruments differentiates a CDO from an asset-backed security, which is backed by a homogeneous pool of instruments, such as mortgages and credit card loans. Because income and the repayment of principal are dependent on the performance of the underlying instruments, there is a probability of early repayment. Issuers are often provided with different tranches of the security, so that if there are prepayments the first tier will be repaid first, the second tier next, etc. The pricing of each tranche reflects the probability of repayment.

Classification

CDOs owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). These securities present a special problem regardless of the amount outstanding because there can be partial repayments of principal at any time. So, simply revaluing the original face value to end-period market prices will cause overvaluation of the position data if there has been a partial repayment.

Commercial Paper (CP)

Commercial paper is an unsecured promise to pay a certain amount on a stated maturity date, issued in bearer form. CP enables corporations to raise short-term funds directly from end investors through their own in-house CP sales team or via arranged placing through bank dealers. Short-term in nature, with maturities ranging from overnight to one year, CP is usually sold at a discount. A coupon is paid in a few markets. Typically, issue size ranges from $100,000 up to about $1 billion. In bypassing financial intermediaries in the short-term money markets, CP can offer a cheaper form of financing to corporations. But because of its unsecured nature, the credit quality of the issuer is important for the investor. Companies with a poor credit rating can obtain a higher rating for the issue by approaching their bank or insurance company for a third-party guarantee, or perhaps issue CP under a MOF (Multiple Option Facility), which provides a backup line of credit should the issue be unsuccessful.

Classification

Commercial paper owned by nonresidents is to be included in the gross external debt position. Such paper should be classified as short-term, money market instruments (portfolio investment, debt securities in the IIP). Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). When CP is issued at a discount, this discount represents interest income.

Commodity-Linked Bonds

A bond whose redemption value is linked to the price of a commodity. Typically, issuers whose income stream is closely tied to commodity earnings issue these bonds.

Classification

Bonds with payoffs linked to movements in commodity prices and owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Commodity-Linked Derivatives

Derivatives whose value derives from the price of a commodity. These include:

  • Commodity future—traded on an organized exchange, in which counterparties commit to buy or sell a specified amount of a commodity at an agreed contract price on a specified date;

  • Commodity option—gives the purchaser the right but not the obligation to purchase (call) or sell (put) a specified amount of a commodity at an agreed contract price on or before a specified date; and

  • Commodity swap—a swap of two payment streams, where one represents a currently prevailing spot price and the other an agreed contract price for a specified quantity and quality of a specified commodity.

Net cash settlements are usually made.

Classification

Commodity-linked derivatives in which the counterparty is a nonresident are included indistinguishably in the memorandum item, financial derivatives.

Convertible Bonds

A convertible bond is a fixed-rate bond that may, at the option of the investor, be converted into the equity of the borrower or its parent. The price at which the bond is convertible into equity is set at the time of issue and typically will be at a premium to the market value of the equity at the time of issue. The conversion option on the bond may be exercised at one specified future date or within a range of dates—“the window period.” The conversion right cannot be separated from the debt. The instrument allows the investor to participate in the appreciation of the underlying asset of the company while limiting risk. A convertible bond will generally pay a coupon rate higher than the dividend rate of the underlying equity at the time of issue but lower than the rate of a comparable bond without a conversion option. For the investor, the value of the convertible bond lies in the excess return of the bond yield over the dividend yield of the underlying shares.

Classification

Convertible bonds owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). As bonds are converted into equity, so the debt is extinguished. The equity issued is recorded in the memorandum item, equity liabilities. If the nonresident is in a direct investment relationship with the issuer, then the equity is classified as Direct investment in reporting economy: equity capital and reinvested earnings in the memorandum item.

Credit Derivatives

Derivatives that provide a market in credit risk. Investors will use credit derivatives to gain or reduce exposure to credit risk. With a credit derivative the investor is taking a view on the creditworthiness of the issuer(s) of the underlying instrument(s) without necessarily risking principal (although credit derivatives may be embedded in a security). For instance, a creditor may lend to a debtor but wants to protect against the risk of default by that debtor. The creditor “buys” protection in the form of a credit default swap—the risk premium inherent in the interest rate is swapped by the creditor for a cash payment in event of default. Also, these instruments are used to circumvent local investment rules; for example, if a foreign investor cannot invest in equity securities and so enters into a total return swap where the foreign investor pays a reference rate, say LIBOR, against the total return—dividends and capital gain/loss—on an equity security. The other most common structure is a spread option whose payoff structure depends on the interest rate spread between emerging country debt and, say, U.S. Treasury bonds.

Classification

Credit derivatives in which the counterparty is a non-resident are included indistinguishably in the memorandum item, financial derivatives.

Credit-Linked Note

A so-called structured security that combines a credit derivative and a regular bond.

Classification

Credit-linked notes owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP). Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). The credit derivative is regarded as an integral part of the bond and is not separately valued and classified.

Currency

Currency consists of notes and coin that are in circulation and commonly used to make payments.

Classification

Domestic currency owned by nonresidents is included within the gross external debt position as monetary authorities (or perhaps banks), short-term, currency and deposits (other investment in the IIP).

Currency-Linked Bonds

A bond in which the coupon and/or redemption value are linked to the movement in an exchange rate. Examples of these types of bonds were the tesobonos issued by Mexican banks in 1994. These bonds, issued and payable in pesos, had a redemption value linked to the movement in the U.S. dollar/Mexican peso exchange rate. When the Mexican peso depreciated, the redemption value increased.

Classification

Bonds with payoffs linked to movements in exchange rates and owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Currency Pool Loans

Currency pool loans, provided by the World Bank and regional development banks, are multicurrency obligations committed in U.S. dollar-equivalent terms whose currency composition is the same (pooled) for all borrowers. The World Bank guarantees that at least 90 percent of the U.S. dollar-equivalent value of the currency pool is maintained in fixed currency ratios of 1 U.S. dollar: 125 Japanese yen: 1 euro. These ratios have been maintained since 1991, and prior to the introduction of the euro, the currency ratios were maintained in a fixed ratio of 1 U.S. dollar: 125 Japanese yen: 2 deutsche mark equivalent (consisting of deutsche mark, Netherlands guilders, and Swiss francs). The currency amount disbursed is converted into a U.S. dollar equivalent amount, using the applicable exchange rate on the day of disbursements. The U.S. dollar equivalent amount is then divided by the pool unit value on the day of disbursement to determine the pool units disbursed. The pool units are what the borrower will have to repay. When pool units are to be repaid, they are converted back into the dollar equivalent amount using the prevailing pool unit value. Thus, the pool unit value may be thought of as an exchange rate used to convert the units into their equivalent value in U.S. dollars, and it changes daily in accordance with movements of the exchange rates of the currencies in the pool. The pool unit value is calculated by dividing the U.S. dollar equivalent of the currencies in the pool by the total number of pool units outstanding. As the U.S. dollar appreciates relative to other currencies in the pool, the pool unit value decreases.

Classification

Currency pool loans of the borrowing economy are to be included in the gross external debt position. They should be classified as loans (other investment in the IIP).

D

Deep-Discount Bond

A bond that has small interest payments and is issued at a considerable discount to its par value. See also Zero-Coupon Bonds.

Classification

Deep-discount bonds owned by nonresidents are to be included within the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Depository Receipts

A depository receipt allows a nonresident entity to introduce its equity or debt into another market in a form more readily acceptable to the investors in that market. A depository bank will purchase the underlying foreign security and then issue receipts in a currency more acceptable to the investor. The investor can exchange the depository receipts for the underlying security at any time. See also American Depository Receipts and Bearer Depository Receipts.

Classification

A depository receipt is classified according to the nature of the underlying instrument backing it. This is because the “issuing” intermediary does not take the underlying security onto its balance sheet but simply acts as a facilitator. So, the debtor is the issuer of the underlying security. If owned by non-residents, these instruments, if a debt security is the underlying instrument, are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). If the underlying item is an equity investment, it should be classified in the memorandum item, equity liabilities. If the nonresident is in a direct investment relationship with the issuer, then the equity is classified as Direct investment in reporting economy: equity capital and reinvested earnings in the memorandum item.

Deposits in Mutual Associations

Deposits in the form of shares or similar evidence of deposit issued by mutual associations such as savings and loans, building societies, credit unions, and the like are classified as bank deposits. See Bank Deposits.

Classification

Deposits in mutual associations owned by nonresidents are to be included in the gross external debt position. They should be classified as banks, short-term, currency and deposits (other investment in the IIP).

Dual-Currency Bonds

Dual-currency bonds are a group of debt securities where the interest and/or principal payments differ from the currency in which the bond is issued. The issue of currency-linked bonds followed the development of the currency swap market that broadened the range of currencies in which international bonds were issued.

Classification

Dual-currency bonds owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

E

Equity

Equity securities cover all instruments and records acknowledging, after the claims of all creditors have been met, claims to the residual values of incorporated enterprises.

Classification

Equity securities are included in the memorandum item, equity liabilities. If the nonresident is in a direct investment relationship with the issuer, then the equity is classified as Direct investment in reporting economy: equity capital and reinvested earnings in the memorandum item.

Equity-Linked Bond

An equity-linked bond comprises features of both debt and equity. Equity-linked bonds are debt instruments that contain an option to purchase (either by conversion of existing debt or by exercising the right to purchase) an equity stake in the issuer, its parent, or another company at a fixed price. These instruments are usually issued when stock market prices are rising because companies can raise funds at lower than market interest rates while investors receive interest payments, and potentially lock into capital gains.

Classification

Equity-linked bonds, if owned by nonresidents, are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). If the bonds are converted into equity, the debt is extinguished. The equity issued is recorded in the memorandum item, equity liabilities. If the nonresident is in a direct investment relationship with the issuer, then the equity is classified as Direct investment in reporting economy: equity capital and reinvested earnings in the memorandum item. See also Equity Warrant Bond and Warrants.

Equity-Linked Derivatives

Derivatives whose value derives from equity prices. These include:

  • Equity future—traded on an organized exchange, in which counterparties commit to buy or sell a specified amount of an individual equity or a basket of equities or an equity index at an agreed contract price on a specified date;

  • Equity option—gives the purchaser the right but not the obligation to purchase (call) or sell (put) a specified amount of an individual equity or a basket of equities or an equity index at an agreed contract price on or before a specified date; and

  • Equity swap—in which one party exchanges a rate of return linked to an equity investment for the rate of return on another equity investment.

Net cash settlements are usually made.

Classification

Equity-linked derivatives in which the counterparty is a nonresident are included indistinguishably in the memorandum item, financial derivatives.

Equity Warrant Bond (Debt-with-Equity Warrants)

Equity warrant bonds are debt securities that incorporate warrants, which give the holder the option to purchase equity in the issuer, its parent company, or another company during a predetermined period or on one particular date at a fixed contract price. The warrants are detachable and may be traded separately from the debt security. The exercise of the equity warrant will normally increase the total capital funds of the issuer because the debt is not replaced by equity but remains outstanding until the date of its redemption. The issue of equity warrant bonds reduces the funding costs for borrowers because the investor will generally accept a lower yield in anticipation of the future profit to be gained from exercising the warrant.

Classification

Because the warrant is detachable and may be traded separately from the debt security, the two instruments should be separately recorded. Bonds owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). Warrants owned by nonresidents are to be included indistinguishably in the memorandum item, financial derivatives.

F

Fixed-Rate Bond

A bond whose coupon payments remain unchanged for the life of the bond or for a certain number of years. See also Variable-Rate Bond.

Classification

Fixed-rate bonds owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Foreign Bonds

A foreign bond is a security issued by a nonresident borrower in a domestic capital market, other than its own, usually denominated in the currency of that market. Issues are placed publicly or privately. These bonds generally adopt the characteristics of the domestic market of the country in which they are issued, such as in terms of registration—bearer or registered form—settlement, and coupon payment arrangements. Common foreign bonds are Yankee bonds (U.S. market), Samurai bonds (Japan), and Bulldog bonds (U.K.).

Classification

If the owner of the foreign bond is a nonresident, and this is most likely given that the bonds are issued in foreign markets, the bonds are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Foreign-Currency-Linked Derivatives

Derivatives whose value is linked to foreign currency exchange rates. The most common foreign-currency-linked derivatives are:

  • Forward-type foreign exchange rate contracts, under which currencies are sold or purchased for an agreed exchange rate on a specified day;

  • Foreign exchange swaps, whereby there is an initial exchange of foreign currencies and a simultaneous forward purchase/sale of the same currencies;

  • Cross-currency interest rate swaps, whereby—following an initial exchange of a specified amount of foreign currencies—cash flows related to interest and principal payments are exchanged according to a predetermined schedule; and

  • Options that give the purchaser the right but not the obligation to purchase or sell a specified amount of a foreign currency at an agreed contract price on or before a specified date.

Classification

Foreign-currency-linked derivatives in which the counterparty is a nonresident are included indistinguishably in the memorandum item, financial derivatives.

Forward-Type Derivatives

A contract in which two counterparties commit to exchange an underlying item—real or financial—in a specified quantity, on a specified date, at an agreed contract price or, in the specific example of a swaps contract, agree to exchange cash flows, determined by reference to the price(s) of, say, currencies or interest rates according to predetermined rules. In essence, two counterparties are trading risk exposures of equal market value.

Classification

Forward-type derivatives in which the counterparty is a nonresident are included in the memorandum item, financial derivatives.

G

Gold Swaps

A gold swap involves an exchange of gold for foreign exchange deposits with an agreement that the transaction be reversed at an agreed future date at an agreed gold price. The gold taker (cash provider) will not usually record the gold on its balance sheet, while the gold provider (cash taker) will not usually remove the gold from its balance sheet. In this manner, the transaction is analogous to a repurchase agreement and should be recorded as a collateralized loan. See Appendix II; see also Repurchase Agreements in Part 2 of this appendix.

Classification

For the cash taker, a gold swap is classified as a loan; so borrowing under a gold swap from a nonresident is included within the gross external debt position. The debt should be classified as a loan (other investment in the IIP).

I

Index-Linked Securities

Index-linked securities are debt instruments with coupon and/or principal payments linked to commodity prices, interest rates, stock exchange, or other price indices. The benefits to the issuer of indexing include a reduction in interest costs if the deal is targeted at a particular group of investors’ requirements, and/or an ability to hedge an exposed position in a particular market. The benefit to investors is in the ability to gain exposure to a wide range of markets (for example, foreign exchange or property markets) without the same degree of risk that may be involved in investing in the markets directly. Issues linked to a consumer price index also provide investors with protection against inflation.

Classification

Index-linked securities owned by nonresidents are to be included within the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as short-term, money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). When interest payments are index linked, the payments are treated as interest. If the value of the principal is index linked, the issue price should be recorded as principal, and any subsequent change in value due to indexation should be treated as an interest cost, and added to the value of the underlying instrument.

Interest-Rate-Linked Derivatives

Derivatives whose value is linked to interest rates. The most common are:

  • Interest rate swaps, which involve an exchange of cash flows related to interest payments, or receipts, on a notional amount of principal in one currency over a period of time;

  • Forward rate agreements, in which a cash settlement is made by one party to another calculated by the difference between a market interest rate of a specified maturity in one currency on a specific date and an agreed interest rate, times a notional amount of principal that is never exchanged (if the market rate is above the agreed rate, one party will agree to make a cash settlement to the other, and vice versa); and

  • Interest rate options that give the purchaser the right to buy or sell a specified notional value at a specified interest rate—the price traded is 100 less the agreed interest rate, with settlement based on the difference between the market rate and the specified rate times the notional value.

Classification

Interest-rate-linked derivatives in which the counter-party is a nonresident are included indistinguishably in the memorandum item, financial derivatives.

L

Land Ownership

By convention, land can only be owned by residents. So if a nonresident purchases land, then a notional resident entity is created on which the nonresident has a financial claim.

Classification

The financial claim the nonresident has on the notional resident entity is assumed to be a direct investment equity investment, so the equity investment is classified in the memorandum item, Direct investment in reporting economy: equity capital and reinvested earnings.

Letters of Credit

Letters of credit provide a guarantee that funds will be made available, but no financial liability exists until funds are actually advanced.

Classification

Because letters of credit are not debt instruments, they are not included within the gross external debt position.

Loans

Loans comprise those financial assets created through the direct lending of funds by a creditor to a debtor through an arrangement in which the lender either receives no security evidencing the transaction or receives a nonnegotiable document or instrument. Included are loans to finance trade, other loans and advances (including mortgages), use of IMF credit, and loans from the IMF. In addition, finance leases and repurchase agreements are covered under loans. Loans may be payable in the domestic or foreign currency(s).

Classification

Loans extended by nonresidents to residents are to be included in the gross external debt position as loans (other investment in the IIP). Alternatively, depending on the relationship between debtor and creditor, the debt could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

M

Medium-Term Notes (MTNs)

These are debt instruments of usually one- to five-year maturity issued in bearer form under a program agreement through one or more dealers. Once a program is set up, issues can be made quickly to take advantage of market conditions, with issues structured more closely to investors’ needs than in the public bond markets. Typically, the MTN market is not as liquid as the international bond market, so issuers may have to pay a higher interest rate.

Classification

Medium-term notes owned by nonresidents are to be included within the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Military Debt

Loans and other credits extended for military purposes.

Classification

Military debt owed to nonresidents is to be included in the gross external debt position, allocated by the nature of the debt instrument.

Miscellaneous Accounts Payable and Receivable

See Other Accounts Payable and Receivable.

Money Market Instruments

Money market instruments are debt securities that generally give the owner the unconditional right to receive a stated, fixed sum of money on a specified date. These instruments usually are traded, at a discount, in organized markets; the discount is dependent upon the interest rate and the time remaining to maturity. Included are such instruments as treasury bills, commercial and financial paper, banker’s acceptances, negotiable certificates of deposit (with original maturities of one year or less), and short-term notes issued under note issuance facilities.

Classification

Money market instruments owned by nonresidents are to be included in the gross external debt position. They should be classified as short-term, money market instruments (portfolio investment, debt securities in the IIP). Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Mortgage-Backed Securities

A mortgage-backed security is a form of asset-backed security. See Asset-Backed Securities.

Classification

Mortgage-backed securities owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP).

Mutual Fund Shares

Mutual funds are financial institutions through which investors pool their funds to invest in a diversified portfolio of securities. The shares in the fund purchased by individual investors represent an ownership interest in the pool of underlying assets—that is, the investors have an equity stake. Because professional fund managers make the selection of assets, mutual funds provide individual investors with an opportunity to invest in a diversified and professionally managed portfolio of securities without the need of detailed knowledge of the individual companies issuing the stocks and bonds. Usually, fund managers must adequately inform investors about the risks and expenses associated with investment in specific funds.

Classification

Because nonresidents own mutual fund shares, the shares are equity investments to be included in the memorandum item, equity liabilities.

N

Nondeliverable Forward Contracts (NDFs)

A nondeliverable forward contract is a foreign currency financial derivative instrument. An NDF differs from a normal foreign currency forward contract in that there is no physical settlement of two currencies at maturity. Rather, based on the movement of two currencies, a net cash settlement will be made by one party to the other. NDFs are commonly used to hedge local currency risks in emerging markets where local currencies are not freely convertible, where capital markets are small and undeveloped, and where there are restrictions on capital movements. Under these conditions, an NDF market might develop in an offshore financial center, with contracts settled in major foreign currencies, such as the U.S. dollar.

Classification

NDF contracts in which the counterparty is a nonresident are included indistinguishably in the memorandum item, financial derivatives.

Nonparticipating Preferred Shares

These are a type of preferred shares in which the payment of a “dividend” (usually at a fixed rate) is calculated according to a predetermined formula and not determined by the earnings of the issuer. In other words, the investor does not participate in the distribution of profits to equity investors (if any), nor share in any surplus on dissolution of the issuer. See also Preferred Shares and Participating Preferred Shares.

Classification

Nonparticipating preferred shares are debt instruments, and so if owned by a nonresident are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Nontraded Debt

Debt instruments that are not usually traded or tradable in organized and other financial markets.

Classification

Depends on the nature of the instrument.

Note Issuance Facilities (NIFs) / Revolving Underwriting Facilities (RUFs)

A note issued under an NIF/RUF is a short-term instrument issued under a legally binding medium-term facility—a form of revolving credit. A bank, or banks, underwrite, for a fee, the issuance of this three- or six-month paper and may be called upon to purchase any unsold paper at each rollover date, or to provide standby credit facilities. The basic difference between an NIF and an RUF is in the underwriting guarantee: under an RUF the underwriting banks agree to provide loans should the issue fail, but under an NIF they could either lend or purchase the outstanding notes. First developed in the early 1980s, the market for NIFs grew substantially for a short period in the mid-1980s. It was a potentially profitable market for international banks at a time when the syndicated credits market was depressed, following the debt crisis of the early 1980s. By the early 1990s, euro commercial paper (ECP), and euro medium-term notes (EMTNs) had become more popular forms of finance.

Classification

Notes issued under an NIF/RUF that are owned by a nonresident are to be included in the gross external debt position. They should be classified as short-term, money market instruments (portfolio investment, debt securities in the IIP). This is because the contractual maturity is less than one year’s maturity. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

O

Operational Leases

Operational leases are arrangements in which machinery or equipment is rented out for specified periods of time that are shorter than the total expected service lives of the machinery or equipment. Typically under an operational lease, the lessor normally maintains the stock of equipment in good working order, and the equipment can be hired on demand or at short notice; the equipment may be rented out for varying periods of time; and the lessor is frequently responsible for the maintenance and repair of the equipment as part of the service which he provides to the lessee. Under an operational lease, ownership of the equipment does not change hands; rather, the lessor is regarded as providing a service to the lessee, on a continuous basis.

Classification

Operational leases are not financial instruments, but rather the provision of a service, the cost of which accrues continuously. Any payments under an operational lease are either classified as prepayments for services—creating a trade credit claim on the lessor—or postpayments for services rendered—extinguishing a trade credit liability to the lessor.

Options

An option is a contract that gives the purchaser the right but not the obligation to buy (call) or sell (put) a specified underlying item—real or financial—at an agreed contract (strike) price on or before a specified date from the writer of the option.

Classification

Options owned by nonresidents are to be included in the memorandum item, financial derivatives.

Other Accounts Payable and Receivable

Other accounts payable and receivable—see also Trade Credit—include amounts due in respect of taxes, dividends, purchases and sales of securities, rent, wages and salaries, and social contributions.

Classification

Other accounts payable owed to nonresidents are to be included in the gross external debt position. They should be classified as other debt liabilities (other investment in the IIP). Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

P

Participating Preferred Shares

Also known as a participating preference share. These are a type of preferred share where the investor has some entitlement to a share in the profits or a share of any surplus on dissolution of the issuer (in addition to the fixed dividend payment received). See also Preferred Shares and Nonparticipating Preferred Shares.

Classification

Because of the claim on the residual value of the issuer, participating preference shares are classified as equity instruments, and so are included in the memorandum item, equity liabilities. If the nonresident is in a direct investment relationship with the issuer, then the equity is classified as Direct investment in reporting economy: equity capital and reinvested earnings in the memorandum item.

Permanent Interest-Bearing Shares (PIBS)

These are deferred shares issued by mutual societies, which rank beneath ordinary shares (which are more akin to deposits than equity in mutual societies) and all other liabilities (including subordinated debt) in the event of a dissolution of the society. They provide “permanent” capital. In the United Kingdom these instruments are non-profit-participating by regulatory requirement; rather, predetermined (but not necessarily fixed) interest costs are payable, with the amounts to be paid not linked to the issuer’s profits; interest costs are not to be paid if this would result in the society breaching capital adequacy guidelines and are noncumulative; but more PIBS can be issued in lieu of a cash dividend.

Classification

PIBS are debt instruments because they are a form of nonparticipating preferred share (defined as such because the holders of the instruments do not participate in the profits of the society). PIBS owned by nonresidents are to be included within the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Perpetual Floating-Rate Notes

A debt security whose coupon is refixed periodically on a refix date by reference to an independent interest rate index such as three-month LIBOR. Generally, these instruments are issued by financial institutions, particularly banks, and are perpetual so as to replicate equity and qualify as tier-two capital under the Basel capital adequacy requirements. Investor demand for perpetual floating-rate notes has been weak in recent years.

Classification

Despite the perpetual nature of these instruments, they are debt securities because the instruments give the holder a contractually determined money income. Perpetual floating-rate notes owned by nonresidents are to be included within the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Preferred Shares

Also known as a preference share. Preferred shares are a class of equity capital that rank ahead of common equity in respect of dividends and distribution of assets upon dissolution of the incorporated enterprise. Investors have little control over the decisions of the company: voting rights are normally restricted to situations where the rights attached to preferred shares are being considered for amendment. Preferred shares are registered securities. Preferred share issues typically pay a fixed-rate dividend payment that is calculated according to a predetermined formula, but some preferred shares participate in the profits of the issuer.

Classification

Preferred shares are classified as equity securities if the shares are participating and debt securities if the shares are nonparticipating. See Nonparticipating and Participating Preferred Shares for specific classification requirements.

Promissory Note

An unconditional promise to pay a certain sum on demand on a specified due date. Promissory notes are widely used in international trade as a secure means of payment. They are drawn up (issued) by an importer in favor of the exporter. When the latter endorses the note, provided the importer is credit-worthy, a promissory note is traded.

Classification

Promissory notes are money market instruments that are claims on the issuer. If owned by nonresidents, promissory notes should be included in the gross external debt position. They should be classified as short-term, money market instruments (portfolio investment, debt securities in the IIP) unless they have an original maturity over one year, in which instance they are to be classified as bonds and notes. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

R

Reverse Security Transactions

See Appendix II.

S

Stripped Securities

Stripped securities are securities that have been transformed from a principal amount with periodic interest coupons into a series of zero-coupon bonds, with the range of maturities matching the coupon payment dates and the redemption date of the principal amount. Strips can be created in two ways. Either the owner of the original security can ask the settlement or clearing house in which the security is registered to “create” strips from the original security, in which case the strips replace the original security and remain the direct obligation of the issuer of the security; or the owner of the original security can issue strips in its own name, “backed” by the original security, in which case the strips represent new liabilities and are not the direct obligation of the issuer of the original security. Usually, short-term strips are bought by money managers as government bill or note substitutes; intermediate maturity strips will be purchased by investors who believe that the yield curve might become more positive. Whereas demand is strongest for the longer maturities because these instruments have longer duration than the original bonds and are leveraged investments, a relatively small up-front payment gives the investor exposure to a larger nominal amount.

Classification

Stripped securities owned by a nonresident are to be included in the gross external debt position. Depending on their maturity, a stripped security is to be classified as either short-term, money market instruments (original maturity of one year or less) or long-term, bonds and notes (original maturity of over one year) (portfolio investment, debt securities in the IIP). Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). The residence of the issuer depends on who has issued the strips. If the owner of the original security issues the stripped bonds, then the residence of the issuer is that of the entity issuing the strips; the underlying securities remain extant. If the strips remain the direct obligation of the original issuer, then the issuer is the original issuer, and the strips “replace” the original securities that have been stripped.

Structured Bonds

Structured bonds have characteristics that are designed to attract a certain type of investor and/or take advantage of particular market circumstances. However, structuring securities to appeal to a particular type of investor risks the possibility of a loss of liquidity if the market moves in such a way as to make the structured features of the issue no longer attractive. Typically the structured features are achieved through the use of derivatives—for instance, a credit-linked note is a bond with an embedded credit derivative.

Classification

Structured bonds are debt instruments, and if owned by a nonresident are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). Any embedded derivative is regarded as an integral part of the bond and not separately valued and identified.

Structured Floating-Rate Notes

The structured floating-rate note is a variation of a standard variable-rate bond (that is, a long-dated debt security whose coupon payment is reset periodically by reference to an independent interest rate index such as six-month LIBOR). The structured issue includes a derivative that allows the coupon calculation to be tailored to meet investors’ interest rate expectations. For instance, there may be an interest rate collar or band—the interest rate cannot increase above an upper specified rate or fall below a lower specified rate. The issue of structured floating-rate notes has grown as borrowers have used financial derivatives to tailor financing products to investor demands while meeting their own funding needs.

Classification

Structured floating-rate notes are debt instruments, and if owned by a nonresident are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). Any embedded derivative is regarded as an integral part of the note and not separately valued and identified.

Swaps

A forward-type financial derivative contract in which two counterparties agree to exchange cash flows determined with reference to prices of, say, currencies or interest rates, according to predetermined rules. At inception, this instrument typically has zero market value, but as market prices change the swap acquires value.

Classification

Swaps in which the counterparty is a nonresident are included in the memorandum item, financial derivatives.

T

Total Return Swap

A credit derivative that swaps the total return on a financial instrument, cash flows and capital gains and losses, for a guaranteed interest rate, such as an interbank rate, plus a margin.

Classification

Total return swaps in which the counterparty is a nonresident are included in the memorandum item, financial derivatives.

Trade Credit

Trade credits consist of claims and liabilities arising from the direct extension of credit by suppliers for transactions in goods and services, and advance payments by buyers for goods and services and for work in progress (or to be undertaken). The direct extension of trade credit by buyers arises when they prepay for goods and services; the debt is extinguished when the supplier provides the goods and/or services.

Classification

Trade credit owed to nonresidents is to be included in the gross external debt position. Such credit should be classified as trade credit (other investment in the IIP). Alternatively, depending on the relationship between debtor and creditor, the credit could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). 1993 SNA regards trade credit as a form of accounts payable/receivable (1993 SNA, paragraph 11.100).

Treasury Bills

A common form of sovereign short-term debt; many governments of the world issue treasury bills. Typically issued through the central bank with maturities ranging from four weeks to two years, they are typically issued at a discount to face value and are redeemed at par.

Classification

Treasury bills are debt instruments, and so if owned by a nonresident are to be included in the gross external debt position. These bills should be classified as short-term, money market instruments (portfolio investment, debt securities in the IIP) unless they have an original maturity of more than one year, in which instance they are to be classified as long term, bonds and notes.

U

Use of IMF Credit and Loans

These comprise members’ drawings on the IMF other than those drawn against the country’s reserve tranche position. Use of IMF credit and loans includes purchases and drawings under Stand-By, Extended, Structural Adjustment, Enhanced Structural Adjustment, and Systemic Transformation Facility Arrangements, together with Trust Fund loans.

Classification

Use of IMF credit and loans is to be included in the gross external debt position as monetary authorities, loans (other investment in the IIP). Because of the particular accounting procedures of the IMF, the use of IMF credit might be considered to have some of the characteristics of a swap of currencies. However, since the IMF has lent in SDR terms, with payments in SDR terms, at an interest rate that is SDR-related, the recommended classification reflects the economic nature of the transaction—a loan.

V

Variable-Rate Bond

A bond whose interest payments are linked to a reference index (for example, LIBOR), or the price of a specific commodity, or the price of a specific financial instrument that normally changes over time in a continuous manner in response to market pressures.

Classification

Variable-rate bonds owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Variable-Rate Notes (VRNs)

These securities adopted the standard characteristics of a variable-rate bond. However, whereas a standard characteristic of a variable-rate bond is that it carries a fixed spread over a referral index, the spread over LIBOR on a VRN varies over time depending on the change in the perceived credit risk of the issuer. The spread is reset at each rollover date—normally every three months—by means of negotiation between the issuer and arranging house. VRNs are usually issued with no maturity date (perpetual VRNs) but fixed five-year and longer-dated issues are in existence. VRNs generally have a put option for the existing holders of notes to sell the issue back to the lead manager of the issuing syndicate, at par, at any interest payment date.

Classification

VRNs owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3). The put option, embedded in the instrument, is not valued and classified separately.

W

Warrants

Warrants are a form of financial derivative giving the owner the right but not the obligation to purchase or sell from the issuer of the warrant a fixed amount of an underlying asset, such as equities and bonds, at an agreed contract price for a specified period of time or on a specified date. Although similar to traded options, a distinguishing factor is that the exercise of the warrants can create new securities, thus diluting the capital of existing bond or shareholders, whereas traded options typically grant rights over assets that are already available. Warrants can be issued in their own right or with equity or bonds to make the underlying issue more attractive. They can be quoted and traded separately in the secondary market.

Classification

Warrants owned by nonresidents are to be included in the memorandum item, financial derivatives.

Z

Zero-Coupon Bonds

A single-payment security that does not involve interest payments during the life of the bond. The bond is sold at a discount from par value, and the full return is paid at maturity. The difference between the discounted issue price and the face or redemption value reflects the market rate of interest at the time of issue and time to maturity. The longer the maturity of the bond and the higher the interest rate, the greater the discount against the face or redemption value. Zero-coupon, and deep-discount bonds, have four particular advantages for investors:

  • There may be some tax advantage in receiving a capital gain rather than an income payment;

  • There is no or little (deep-discount bond) reinvestment risk (the possibility that when coupon payments fall due, and need to be reinvested, interest rates will be lower);

  • The bond has a longer “duration” than a bond of comparable maturity that pays fixed- or variable-rate interest, so making the zero-coupon bond’s price more sensitive to interest rate changes; and

  • A zero-coupon bond is a leveraged investment in that a relatively small initial outlay gives exposure to a larger nominal amount.

See also Deep-Discount Bond.

Classification

Zero-coupon bonds owned by nonresidents are to be included in the gross external debt position. They should be classified as long-term, bonds and notes (portfolio investment, debt securities in the IIP) unless they have an original maturity of one year or less, in which instance they are to be classified as money market instruments. Alternatively, depending on the relationship between debtor and creditor, these securities could be classified as direct investment, intercompany lending (see the description of direct investment in Chapter 3).

Part 2. Classification of Specific Transactions

This section discusses the classification treatment within the gross external debt position of specific transactions.

Arrears: When Should They Be Recorded?

Arrears should be recorded from the day after a required payment has not been made. It is recognized that, in some instances, arrears arise for operational reasons rather than a reluctance or inability to pay. Nonetheless, in principle such arrears when outstanding at the reference date should be recorded as arrears.

Collateralization of External Debt

To provide additional assurance to the creditor, the debtor may set aside either financial assets or future streams of income as collateral for the debt incurred. In other words, payments on the debt might be “backed” by future export earnings, such as receipts from petroleum sales, or the creditor may have a claim on certain financial assets held with third parties if the debtor defaults. Alternatively, the debtor might invest funds in a zero-coupon instrument that at maturity will equal the value of the principal debt incurred, which is then due for repayment. In all cases, external debt should be recorded gross—that is, separately from the collateral. For instance, where the debtor has invested funds in a zero-coupon bond, both the external debt and the zero-coupon bond are recorded on a gross basis, the zero-coupon bond being an asset of the debtor. Also, when debt is contractually to be serviced by an income source of the debtor (for example, future export earnings), the debtor continues to record the receipt of income and the payment of principal and/or interest even if the income is passed directly from “source” (for example, the purchaser of the exports) to the account of the creditor, without directly involving the debtor. There may well be analytical interest in information on the value of external debt that has been collateralized, and in the type of financial asset or income stream used to back the external debt.

Consignment Trade

No debt is created for goods on consignment—that is, goods intended for sale but not actually sold at the time of crossing a frontier—because ownership of the goods has not changed hands.

Defeasement

Defeasance is a technique by which a debtor unit removes liabilities from its balance sheet by pairing them with financial assets, the income and value of which are sufficient to ensure that all debt service payments are met. Defeasance may be carried out by placing the paired assets and liabilities in a separate account within the institutional unit concerned or by transferring them to another unit. The Guide does not recognize defeasance as affecting the outstanding debt of the debtor as long as there has been no change in the legal obligations of the debtor. In other words, provided the payment obligations remain de jure with the original debtor, ownership of the liabilities remains unchanged, and should be reported as external debt of the original debtor.

Financial Leases: Treatment of Residual Values

As explained in Chapter 3, under a financial lease, ownership of the underlying item is considered to have changed hands because the risks and rewards of ownership have, de facto, been transferred from the legal owner to the user; this de facto change of ownership is financed by a financial claim, which is the asset of the lessor and a liability of the lessee. However, even though the rentals may enable the lessor over the period of the contract to recover most of the costs of goods and the carrying charges, there may be a residual amount. The lessee may have an option to pay the residual value to gain legal ownership of the underlying item. How should the residual amount be recorded?

The residual amount is part of the debt obligation that arises when the goods are assumed to have changed ownership. In other words, under statistical convention, the debt at the inception of the lease is defined as the full value of the good, inclusive of the residual amount. This debt obligation is recorded as a loan. The loan liability arising from the residual value is extinguished either when the goods are returned or when a payment is made and legal ownership changes hands. The IMF’s Balance of Payments Textbook (IMF, 1996, page 126) provides an example of the circumstance in which there is a final residual payment.

This issue also raises the question of whether there is a point at which the residual value is such a large percentage of the total value of the goods that the lease should be regarded as operational and not financial. There is no firm percentage; rather, these arrangements are determined more by their nature. When a lease is a financial arrangement, it is usually evident from the roles and obligations of the transactors—for example, the lessee is responsible for repairs and maintenance, and the lessor is a financial institution, etc.

Fundamental to the assumption of a change of ownership is the idea that, de facto, the lessee assumes the risks and rewards of ownership from the legal owner. But if there is option rather than agreement to purchase the residual value, or if it is agreed that the lessee will pay a market price for the residual amount, the greater the percentage size of the residual amount at inception, the more diminished the extent to which the de facto risks and rewards of ownership can be said to have changed hands.

Guaranteed External Debt

The provision by one institutional unit of a guarantee to make future debt-service payments to a non-resident creditor if certain conditions are met, such as a default by the debtor, does not negate the claim the creditor has on the debtor. Thus, the debtor on whom the nonresident creditor has a claim, and not the guarantor, should record an external debt liability, unless and until the guarantor assumes the external debt. Chapter 8 provides guidance on the classification of debt assumption.

Islamic Banking2

Activities of Islamic financial institutions differ from those of standard commercial depository corporations in that predetermined interest on financial transactions is prohibited. As is evident from the definition of external debt in Chapter 2, the nonpayment of interest on liabilities does not in itself preclude instruments from being classified as external debt. The classification of Islamic banking instruments as external debt, or not, can be determined by the following general guidance.

Islamic instruments—deposits include conventional and transferable deposits, such as Amanah and Qardhasan deposits—as well as various investment participation certificates that are not investments in the permanent capital of a financial institution and do not have the characteristics of tradable securities.

Islamic instruments—debt securities consist of various investment participation certificates that have the characteristics of tradable securities and are not permanent capital of an institutional unit. Included in this category are the most tradable investment certificates recorded as liabilities of a financial corporation.

Islamic instruments—loans cover arrangements in which a financial institution makes prepayments for clients, finances ventures or trade, or supplies working capital to clients. The arrangements may include short-term or other partnerships in which a financial institution is not making permanent, equity-type investments.

Nonlife Insurance

For nonlife insurance the following transactions result in external debt:

  • Any prepayments of premiums by nonresidents are classified as external debt of the insurance company, under other debt liabilities.

  • Reserves that are held against outstanding claims of nonresidents—that is, claims that have arisen because an event has occurred that results in a valid claim—are also external debt of the insurance company. Again, these reserves are included in other debt liabilities.

Nonresident Deposits

Because of exchange control or other restrictions, nonresident deposits in domestic banks may not be transferable out of the economy. Such restrictions may be introduced after the deposits have been made or may have been established when the accounts were opened. All such nonresident deposit claims on resident banks should be classified as external debt. Nonetheless, if the amounts are significant and are of analytical interest in their own right, it is recommended that additional information be provided.

On-Lending of Borrowed Funds

An institutional unit within an economy might borrow funds from a nonresident(s) and then on-lend the funds to a second institutional unit within the economy. In such instances, the first institutional unit—that is, the institutional unit that borrowed from the nonresident(s)—should record an external debt liability, with any subsequent on-lending classified as a domestic claim/liability. As set out in Chapter 2, the decisive consideration is whether the creditor has a claim on the debtor, and in this example the nonresident creditor has a claim on the first institutional unit.

If an institutional unit within an economy borrowed from a nonresident(s) and on-lent the funds to a non-resident, the unit should record both external debt and an external claim. The nonresident borrower would also record an external debt liability in that economy’s measure of external debt.

Part-Payments for Capital Goods

For capital goods with long delivery periods, such as ships, the purchaser may make part-payments to the builder or exporter while the good is being produced. These part-payments should be recorded as trade credit debt of the exporter. The debt is extinguished when the purchaser takes delivery of the good.

Penalties Arising from Commercial Contracts

Under the terms of a commercial contract, one party (resident) may be required to compensate another party (nonresident) (that is, pay a penalty) in the event of the first party failing to meet its obligations, or some of its obligations, under the contract. Once the penalty is owed and until it is paid to the nonresident, it is external debt, and recorded under other debt liabilities. The debt should be recorded from the time when the resident becomes liable under the contract for the penalty.

Prepayments of Goods and Services

When an importer makes a prepayment to an exporter for goods and services, the exporter has a liability to the importer that remains outstanding until ownership of the goods changes hands or the service is provided. Similarly, when an importer makes a postpayment some time after he acquires goods or services, the importer has a liability to the exporter that remains outstanding until the postpayment is made. These liabilities should be recorded as debt liabilities because future payments are required; in the case of the prepayment, the principal amount outstanding is repaid in goods or in a service provided, whereas in the case of the postpayment, it is likely that a financial payment will be made, although in the instance of barter, goods or services may be provided to extinguish the debt. Unless the prepayment is for more than one year hence, these debt liabilities should be recorded as short term, trade credit. Also, unless the agreed date for payment is past, neither the prepayment nor postpayment of goods and services should be recorded as arrears.

Processing of Goods

In BPM5, when goods are exported across a border for processing with the intention that the processed goods are returned to the exporting economy, a goods transaction should be recorded in the balance of payments—an import of the processing economy from the original economy. In such circumstances, a corresponding financial liability is established and recorded as external debt under trade credit. When the processed good is returned, the financial liability is extinguished. If the amounts are significant, it is recommended that such trade credit be separately identified (as is recommended in the trade account of the balance of payments).

Project Loans: Disbursements

Disbursements of project loans can take the form of

  • Advances to the borrowing entity—disbursements are to be recorded when the lender advances funds to the borrower;

  • Direct payment by the lender to suppliers of goods and services—disbursements are to be recorded when the lender pays the supplier; and

  • On a reimbursement basis after the borrower has already paid the suppliers—disbursements are to be recorded when the lender makes reimbursements to the borrower.

Public Investment Projects

Public investment projects involve the construction and operation by private corporations of assets of a kind that are usually the responsibility of the general government sector, or public corporations. These commonly include, for example, roads, bridges, water supply and sewerage treatment works, hospitals, prison facilities, electricity generation and distribution facilities, and pipelines. In many such instances, such transactions are likely to be classified as resident to resident, particularly if the private corporation creates a separate unit to construct and/or operate the asset (although in such instances that unit may incur external debt liabilities to its nonresident parent, which need to be recorded). But if the private sector corporation is a nonresident, the classification of the transactions as external debt depends on the nature of the arrangement:

  • Where an asset is constructed by a corporation and transferred to government on completion, any pre-payments by the government are claims on a non-resident enterprise—that is, external debt of the private nonresident corporation. If the government only pays on completion and needs to borrow abroad to finance this purchase, then the government will incur external debt when it borrows.

  • Where there are lease arrangements between the government and corporation, these are classified in the normal way as operating or finance leases, and hence external debt or not, depending on whether the government or corporation gains most of the risks and benefits of ownership as a result of the contracts entered into. For instance, if the private corporation continues to own the asset but will transfer ownership to the government at a later date, and in the meantime the government makes payments both to cover the costs of operating the asset and to meet the financing costs, then a finance lease, and hence external debt, arises for the government and should be recorded as such.

As with all finance leases, at the time of effective change of ownership, the market value of the good is recorded and represents the external debt of the government. The payments to be made need to be separated into operating and financing costs. If a market value is available, the total amount paid in financing costs over the life of the lease in relation to that price will determine the implicit rate of interest on the loan. Otherwise, the financing costs discounted by a representative interest rate of the government—the present value of the finance payments—could represent the market value of the asset in the absence of other information, and generate data on the future interest and principal payments—Appendix to Chapter 2, examples 1 and 2, provides calculations that illustrate the principles involved.

Reinsurance

Positions arising from reinsurance are treated in the same way as those arising from insurance.

For reinsurance relating to life insurance, any technical reserves held by insurance companies that are assets of nonresident policyholders are external debt of the insurance company. As with claims of households in life insurance companies, any such external debt should be included under other debt liabilities in the gross external debt position.

For nonlife insurance, prepayment of premiums by nonresidents, and reserves held against claims of nonresidents that have arisen, are also external debt. In both instances, any such external debt is included under other debt liabilities (see also Nonlife Insurance, above).

Repurchase Agreements: Delay in Returning the Security

If the security taker fails to return the security to the security provider, then the recording treatment depends on whether the failure is simply a delay or whether there is a default. If the failure is due to a delay (for example, the result of another party in the chain of repo securities being unable to access the specific security at that particular date), it has no impact on the gross external debt position, although in line with common market practice the security provider may retain the funds without paying any interest. If there is a default, usually under the terms of the reverse agreement the security provider’s loan liability to the security taker is extinguished—the security taker no longer has a claim on the security provider. If the security provider defaults on returning the cash, then the security provider’s security holdings fall, and those of the security taker increase, and the loan is extinguished. In either event, because the security provided is likely to be of greater value than the cash provided, residual claims may still continue to exist.

The Value of Debt After Consolidation Is Greater Than the Value of the Consolidated Debts Combined

If the terms of a loan are changed, a new contract is created. Thus, if two or more old debts are consolidated into one debt, the new debt replaces the two or more old debts and is classified by type of instrument (loan, security, etc.). If the total value of the new debt is greater than the old debts combined—for example, because of extra charges arising from rescheduling—the gross external debt position increases.

This appendix has drawn significantly upon the Bank of England (1998), Financial Terminology Database.

Islamic banking is described in detail in Appendix 2 of the IMF’s Monetary and Financial Statistics Manual (IMF, 2000d).

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