Chapter

Chapter 6 Debt-Equity Swaps and Conversion Funds

Author(s):
Robert Effros
Published Date:
June 1994
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The debt-equity swap is a mechanism by which a bank exchanges foreign sovereign external debt of a debtor country for an equity stake in a company in that country through privatization, stock market investment, or direct investment. That is, a bank holding debt has three choices. It can (1) continue to hold the debt, (2) try to sell it in the secondary market, or (3) swap it, either for debt of another country or for an equity stake. By using the debt-equity swap, a bank can sell its debt to Coca-Cola or another multinational that—rather than make a direct investment in, say, Brazil—buys the debt at a discount. The size of the discount varies. Following a moratorium, Brazilian debt traded at about 25 cents on the dollar.

To make an equity swap the bank turns its debt over to the central bank, which then issues local currency, usually taking a discount for itself. The central bank might give 50 cents’ worth of local currency. Now the asset that was worth 25 cents on the secondary market can be swapped for 50 cents of local currency. The problem, of course, is that the 50 cents of the local currency has to remain in the country, usually for as long as the longest maturity of the debt that has been swapped. Given a long-term horizon, however, an investor can start off with twice the original value of the debt.

Multinationals make use of debt swaps, especially multinationals with existing investments in countries where they want to add to their registered capital base rather than put in fresh cash. For example, if debt is selling for 25 cents on the dollar, a multinational can go to a bank and buy $400 worth of debt for $100. The central bank would take half, but the multinational would retain $200 worth of investment in local currency. So the multinational would actually get twice as much as if it had made a direct investment.

A number of countries—including Brazil, Argentina, Chile, and the Philippines—have set up debt conversion mechanisms and usually the banks made the debt conversion on behalf of companies that wish to make an investment. To the extent that countries have established a debt-equity conversion mechanism this provides a certain amount of liquidity on the secondary market for banks as an exit mechanism. With no debt-equity conversion, the only chance a bank would have to get out would be to sell its debt to another bank or exchange its Brazil debt for a Peru debt with another bank. Clearly, if all the commercial banks tried to sell their debt on the secondary market, the price would soon plummet and liquidity would vanish. So in the context of the debt crisis, what the debt-equity swap has achieved is some liquidity for banks to sell the debt in the secondary market.

In fact the ability to swap creates a value for this debt. Chilean debt traded for 62 cents on the dollar when Chile had a total debt of only $20 billion. Five or six large debts have been converted over the last five years. Brazilian debt traded at about 26 cents on the dollar, Argentine debt at about 14. The amount of debt-equity conversion in the last five years around the world totals about $20 billion, compared with the total external debt of the most indebted developing countries of roughly $600 billion. Although the conversions represent only 3 or 4 percent, with 500 banks in the restructuring agreement for Brazil (some with $10 million or $20 million exposed), the fact that there is a secondary market providing some liquidity means that a small bank is unlikely to want to make a direct investment in Brazil.

In the debt-equity swap, a bank has sovereign debt (sometimes the proceeds of the sovereign debt have been deposited in the central bank), and the central bank does not have dollars to make available to the bank, so the local currency is sitting at the central bank. The bank or the multinational that buys the debt takes it to the central bank with an assignment agreement, and presents it to the central bank for cancellation, and the central bank then remits local currency less some discount that it keeps for itself. Discounts vary from country to country. Sometimes the discounts are set by the central banks, as in Chile and the Philippines, and sometimes they are arrived at through an auction, a process described below.

Debt-equity swaps are only one of many kinds of swaps. There are interest rate swaps and currency rate swaps. Banks also trade debt for debt. If Brazilian debt is trading at 25 cents and Argentine debt at 12½ cents, one could swap $1 of Brazilian debt for $2 worth of Argentine debt, and then take the Argentine debt to the Argentine Central Bank.

Basically a debt-equity swap is no different from the normal reorganization that occurs when a company cannot meet its debt-service payments. In that case the consortia banks get together to restructure the debt, perhaps converting part of it into equity to reduce the total debt-service burden. Similarly, Brazil would allow the purchasers to buy a piece of a Brazilian company either through a privatization or through a new issue of shares of an existing company.

Another form of swap is debt-for-nature. That has been a growing trend. Some charitable organizations around the world and some companies have been buying up debt, and rather than exchanging the debt for an equity investment in a productive company, they will buy, for example, a forest reserve in Paraguay and maintain it. The International Wildlife Fund has done this in parts of Africa. If the African debt is trading for 20 cents on the dollar, rather than make a contribution of a dollar, they buy the debt on the market and for that dollar buy five times as much debt. Even if the central bank takes a 40 percent discount, the investors still have three times as much local currency to buy the reserve and pay for its upkeep. Moreover, if a U.S. company buys $5 worth of debt for $1, there are ways it can take a tax deduction for the full $5.

Debt-for-commodities swaps—where banks exchange debt directly for a shipment of gold or copper, for example—have happened in Peru and in other countries. These are a little harder because of restrictive covenants in the different bank loan agreements. It is difficult for one bank to cash itself out by exchanging debt for a commodity because all the other banks would be entitled to a pro rata share. Accordingly, debt for commodities is not very active.

Moving now to debt-for-athletes, we find the same mechanism. If an Italian club wished to buy an athlete from Brazil for a few million dollars, the club would buy debt at a discount and swap the debt for the athlete.

Different kinds of investments can be made with a debt-equity swap. One type is a direct investment. Here one takes a piece of a local company, registers shares with the central bank, and then has remittance rights with the relevant restrictions. Argentina opened up its debt-equity conversion program for privatization to allow the banks to use the sovereign debt to buy into state-owned companies that are being privatized.

One program on the Brazil slate would have allowed foreign banks in Brazil to exchange their debt for privatized companies. The legislature specifically excluded that provision and indicated it would consider regulation in the future. From a policy point of view, the question was should Brazil, with $120 billion worth of foreign debt trading 25 cents on the dollar, allow a bank to come in and buy its privatized assets? Even with a discount of 50 percent, the bank would still gain. But if the long-term plan is not to pay the debt back at all, it would be illogical to allow unlimited conversions at 50 cents on the dollar. How much conversion should be allowed? How does that fit into the overall strategy? If a central banker owes $100 billion and is looking at combining some form of a Brady Plan, exit bonds, debt forgiveness, and interest rate reduction, how much should be converted into equity and under what conditions?

Debt-equity swaps have been greatly facilitated, at least in the United States and in Europe. The Federal Reserve Board modified its Regulation K, which now allows banks and bank holding companies to acquire shares of companies in developing countries. Previously, there were extremely severe restrictions on the right of banks, commercial banks especially, to hold shares of companies, limiting participation to 10 percent.

The other relevant aspects are the banking and investment laws in the host country. In the 1980s some countries embraced the idea of debt-equity swaps. Brazil issued regulations very early. Chile has one of the most developed and successful conversion programs. Argentina issued some regulations but total conversions were initially disappointing. Brazil has done probably between $3 billion and $5 billion of conversions. Chile is the best example, with between $5 billion and $6 billion. The country has been able to maintain foreign debt at slightly under $20 billion over the last five or six years and has continued to service that debt. That is one reason that Chilean paper traded for 65 cents while Brazilian paper traded for 25 cents. The Philippines passed a central bank resolution to permit debt-equity conversions, but few took place. All the schemes generally provide for case-by-case analysis of the sectoral consequences by the central bank.

Another significant aspect of the conversion framework, especially for U.S. banks, is the accounting framework. U.S. accounting principles maintain that if debt is held, even though the secondary market says it is worth only 25 cents on the dollar, no loss has been realized. The book value remains as stated even though provision for loss has to be taken. However, once the debt is sold in the secondary market or converted into an equity investment, the holder is deemed to have exchanged the asset and at that point a recognition of loss takes place for accounting purposes. If debt has a face value of a dollar and assuming a 50 percent discount, the debt must be written down by at least 50 cents on the dollar. Sometimes the accountants will insist on a steeper write down because this 50 cents is in Brazil in local currency and it cannot come out for 12 years because the repatriation restrictions generally rule that the converted equity has to stay in as long as the longest maturity of the original debt.

We have seen how the secondary market works to provide liquidity as an exit mechanism for the commercial banks. Debt-equity swaps allow banks to make swaps directly or allow them to sell their debt to a multinational that can make the swap. The swaps provide an exit mechanism and for that reason have been embraced by the banks in many restructuring agreements. There are two principal routes to conversion for the debt. One is the auction process found in Brazil and Argentina. In Brazil the program had to be suspended because of monetary policy and local, political, and economic considerations. In the past, monthly auctions were held at the stock exchange, and banks would indicate how much discount they were willing to take. Each month they converted about $150 million of debt. At the auction opening, perhaps $400 million would be put up, seeking a swap of 100 cents on the dollar. It would go down by pennies. At 98 cents on the dollar in local currency perhaps two banks would drop out and there would be $390 billion. At 90 cents on the dollar, $300 million, and so on, until at 50 cents on the dollar perhaps $150 million would want to convert. Thus, the price for that auction would be 50 cents on the dollar. If in the next auction there were $700 million that wanted to convert, the price might be 40 cents. It was a free market mechanism based on a set amount of debt to be converted each month.

The other way is through government regulation. Chile might say, in effect, “We take 20 percent. If you want to make a conversion, today’s secondary market price is 65 cents on the dollar; we will give you 80 cents.” The bank is still better off than if it had sold. It takes part of the premium between the secondary market price and the face amount. The Philippines had a similar system, which was even more confusing because it also provided that the discount would vary depending on how much new money was put in. One topical discussion now is the question of a country saying, “We will allow debt conversion but we want to see new investment as well.” That is a much more complicated transaction because of the need for a partner with new money and a partner with bank debt.

Turning to the potential economic effects and the costs and the benefits, one large concern is with denationalization. Selling off the equities and privatizations to banks and foreign investors has to be seen within a program of foreign ownership. Many countries have restrictions on the amount of foreign ownership in a particular sector, and of course those have to be obeyed. Others do not allow foreign ownership in any given sector. Then there is the concern about inflation. Essentially, when a debt-equity conversion is completed, no new money is coming in. In some countries where inflation has been a real problem, like Brazil and Argentina, inflationary effects of debt-equity conversions have been one reason for not implementing them more regularly.

Another issue is the absorptive capacity of the country. How many good investment opportunities are there? The Philippines had $30 billion worth of debt, and set up a program, but very few conversions were made. Perhaps there were not many good opportunities or perhaps the local entrepreneurs were asking too much for the shares. This just puts swaps and conversions in perspective among the other items on the menu of the international debt crisis.

Other costs include overpayment in redeeming the debt. There has to be a sharing of the burden between the face value and the secondary market value. The government takes some for itself, the bank gets some for itself; somewhere in the middle the price has to be set.

Then there is the problem of additionality. Does the total level of investment increase by the full amount of the swap? In some cases, yes. The bank would not have made an investment except through a swap. If, however, the bank has sold its loan to Coca-Cola, and Coca-Cola has made an additional investment in the country and received twice as much local currency, then there is no additionality through the debt-equity swap.

So much for the adverse monetary and fiscal consequences of an increase in foreign ownership. A related concern is “round tripping” or the “bicycle”—an arbitrage technique that looks at the price of debt in the secondary market, looks at the exchange rate, and looks at the parallel market exchange rate. If the pricing is not right, people come in, buy the debt in the secondary market for 25 cents on the dollar, exchange it for 50 cents’ worth of local currency, take it out through the parallel market, and convert it back into dollars. The investment is supposed to stay in place for 12 years if the investor wants to take it out through the central bank at the official rate. Nevertheless, there are parallel market rates and traders use those routes.

The outflow problem arises if someone is making an additional investment in a company in which they have previously invested. If, like Coca-Cola, a company has a registered investment of a billion dollars in its subsidiary and it wishes to increase the investment, swap or conversion makes a lot of sense. The company already has a billion-dollar investment on which it can remit dividends or capital. It may choose to make an additional $100 million investment with a debt-equity swap because even though that $100 million must stay in the country, the investor can create that $100 million with only $50 million. If the subsidiary has other kinds of transactions where it is using the parallel market, for example, for imports or anything else, it is very hard to control the money flow because the local currency is fungible—it does not show that it is from a debt-equity swap and thus must remain in the country.

What are the benefits of swaps and conversions for the debtor country? Obviously, a country can reduce part of its external debt and at a discount from its face value. Countries are not generally allowed to buy their debt back in the secondary market because of restrictive covenants in the restructuring agreements. Rather than using foreign exchange, if it can be bought back with 40 cents of local currency, that is to be preferred. Conversion eliminates all the burden of interest payments on whatever debt is swapped—an ongoing type of benefit. The foreign investment in the country is increased. In terms of additionality, it is not clear whether that investment would have taken place anyway.

Another advantage is increased visibility of the debtor’s stock market. Chile allowed debt-equity conversions into the stock market in 1988 through a fund. The bank pooled debt into a fund, and the fund invested directly in the stock market instead of in privatizations. The fund was allowed to buy securities and has done very well. Its rate of return over two years was about 120 percent; since then Chile has launched other single-country funds (one on the New York Stock Exchange, two on the London Stock Exchange). By doing this Chile attracted new money into its stock market. Earlier Chile was not thought to be stable nor interesting enough for a direct cash investment, but the banks did very well, tripling their investment over the period. Of course, they had to leave the proceeds in for 12 years, but the price-earnings ratio in Chile was 5, new money funds came in, and on the whole, the program was successful.

The other thing about debt-equity conversion is that, once debt has been converted into shares, the foreign lender is paid back based on how profitable the enterprise is. A debt has to be paid back no matter what; an equity investment, only if things go right.

The final advantage is that the debt gets converted from a public liability to a private obligation. It is no longer an obligation of the government but is transferred onto a local company.

Let us turn to debt-equity conversion funds that are pooled investment vehicles like mutual funds, where a group of banks and other financial institutions pool their debt. Rather than taking one $10 million debt and making one equity investment in a local company in Brazil, 20 banks each contribute $10 million and create a $200 million fund as a limited partnership or an offshore corporation. The new fund hires professional managers, and the banks that contributed the debt form an advisory board to monitor the fund’s performance. The day-to-day investment decisions are recommended by the managers—highly qualified local people with investment banking and appraisal experience. Diversification is key: they take the $200 million and make 20 different investments of $10 million each. Each bank owns shares of the fund corresponding to the pro rata share of its contribution. At the end of the process (usually 10 to 12 years down the road, depending on what the holding period is for the converted debt), the fund liquidates, and the proceeds are distributed to the investors. The fund pays the management fee to cover overhead expenses of the operating company. Sometimes profits are built in, for example, on a venture capital formula whereby 20 percent of the profits generated by the entity over time go to the local management company as an incentive bonus, with the balance going to the banks.

The International Finance Corporation (IFC) has pioneered in the development of these instruments, which are similar to country funds like the Korea Fund or the Japan Fund. These are mostly new cash funds that sell shares to the public, raise $50 million or $100 million, and become listed on the New York Stock Exchange. They are mutual companies that invest only in the selected country of operation. The IFC has been instrumental in underwriting many of these funds. The pooled investment vehicle has the advantage of a professional firm like Morgan Stanley Asset Management combined with a local advisor in the country. They get paid a 1 percent fee per annum. In addition, there are venture capital companies that raise money for direct investment in a specific country in order to try to find the next high-growth industry or product. Investment is made not through the stock market but through purchase of a large share of a company and participation on the Board of Directors.

The mutual fund vehicle is especially useful to those banks that lack a substantial local presence. Thus, Citibank in Brazil, with its own operations and a huge staff, can make its own debt-equity conversions without having to go through a fund. This is because it has lots of debt on the one hand, lots of clients on the other, and so lots of opportunities to find interesting investments. Country funds have been established in Argentina, Brazil, Chile, and the Philippines. Let us focus on the first three to highlight some of the legal and regulatory considerations that go into structuring one of these funds.

These funds had a small beginning. In Chile the first stock market fund was $30 million, and the second tranche was $50 million, based on what the absorptive capacity of the market seemed to be. In Brazil a fund was established with $100 million. In Argentina a very small one was set up of $40 million or $50 million. However, they have become larger. Thus, the IFC closed on a fund in Argentina with Midland Bank, the Bank of Rio, the Bank of Tokyo, and the Bank of America with $1.2 billion of face-amount sovereign debt, to be invested in the privatization program. By far the largest fund to date, it required a complex structure with an advisory board and a local management company experienced in venture capital investments. There was talk about trying to establish a similar fund for Brazil with $2 billion to $3 billion. The idea was that with 50 or 60 companies going to be privatized, a professional team should look at all the possibilities and then place different parts of the fund for the benefit of the banks. The banks could then participate and diversify their portfolios without having a whole staff to monitor. The fund itself would place members on the boards of the various companies and sign agreements with other shareholders about dividend policies and operating policies. There is some potential for this to be a new initiative in the debt crisis.

As to legal form and structure, some of the Chile funds were incorporated there because local regulations stipulated that these funds should be established in Chile. The debt has been converted and with the proceeds the banks have purchased shares of a Chilean company. In Argentina the fund was set up as an offshore company with a local management company. One in the Philippines was set up as a limited partnership with the banks as limited partners and the general partner as the manager of the fund.

Funds may thus take different legal forms. The legal structure has some impact on the placement corporation. The duration of these funds is generally as long as the converted debt is supposed to stay in the country (there are often provisions for extensions for a few years). Unfortunately, one often cannot wind up the whole investment portfolio in a six-month period. Part of the fund might be wound up at the first opportunity of remitting the invested capital. Then it might be extended for a few years, and venture capital could be used to support the other investments.

The funds all have their own operating policies and repatriation policies; most pay out the maximum allowed as dividends. Others reinvest the proceeds in new opportunities following the articles in the shareholders’ agreement. Of course, fees are associated with all these projects, but the fees have been declining because of economies of scale as the funds become larger. The $1.2 billion Argentine Fund had a management fee of 20 basis points (.2 percent of the face amount of debt). Some earlier fees were as high as 1.5 or 2 percent. There are very small front-end fees. Banks have suffered enough and do not like to pay an organizer the 3 or 4 or even 5 percent usually charged to enter a limited partnership. Therefore the organizers often have to take a profit participation in the form of an override at the end. Organizers consider 15 to 25 projects sufficient for adequate diversification.

Looking at the advantages and the disadvantages of these pooled investment vehicles, but turning now to the investors’ side, one sees the economies of scale possible when several participating banks engage one management company to administer the entire portfolio. Regarding diversification of assets: when it is decided not to dispose of all debt at 25 cents on a dollar or hold it all for exit bonds, an equity investment not only diversifies the asset base but also offers participation in the growth of the country. As the funds get larger they can attract professional portfolio managers. They also tend to attract the larger creditor institutions as well as the smaller ones. Some countries have granted special fiscal or other benefits to funds to encourage their growth. In the Philippines, if the fund was making an investment, there was only a 5 percent discount in local currency as opposed to the 25 percent discount charged to a regular investor. Nevertheless, some funds have been very hard to structure and have taken up to a year to put together because of banks being from different jurisdictions, and because of host country investment and banking laws. Once in a fund the banks compete for power and influence. The larger banks want to have a member on the board and a say in the management along with the professional staff. Working out the governing relationships of these entities has been a complex matter.

There is always country policy and currency risk. Repatriation restrictions are another concern. Bankers may want to know how the country would guarantee that the assets being privatized and sold to them would not be renationalized.

The discounts imposed by host governments are part of the sharing of the cost. No holder will receive 100 cents on the dollar for converted debt. The accounting consideration is also a problem. If a bank makes one investment for $10 million, it may get 50 cents’ worth of local currency. Assume that this is invested in IBM and that the auditors can be convinced that even though this is Brazil, it is still worth 50 cents; now one has to write off 50 cents. But the asset has been exchanged. With an investment in a fund, although the entire debt is contributed on day one, the fund invests the debt over a period of, say, two years. The fund may take a while to find the best investment opportunities. In the meantime, the U.S. accountants say, “Well, that is an exchange: you have given up your debt and now you have shares. You must realize the loss on the entire amount contributed.” A bank may have to argue whether the loss is going to be 50 cents or 70 cents, and that has been a disincentive for the large bankers (several banks in the Argentine case contributed $100 million). If a bank makes debt-equity conversions on its own, one at a time, it can write them down individually. A bank that puts $100 million into a fund must write it down entirely. This is becoming less of a problem, because banks have reserves for losses, and they can write it off against the reserve, but it remains a consideration among bankers.

Turning to a country’s capacity to absorb investment, does a small country have $1.25 billion of assets to sell? It would not be $1.25 billion in fact because this sum will go through a discount process and perhaps it will allow a third in local currency. But that is still $400 million to $500 million. As noted previously, there may be concern about foreign ownership and the denationalization issue. There is always the risk that the best company in the world after 11 years and 10 months could be nationalized, extinguishing its value to the fund. The IFC has been discussing with member governments financial sector reform, including creation of single-country funds and debt-equity mutual funds. Amid these complicated concerns, the IFC has been the honest broker between the banks and the governments, to ensure that operating policies are in place and that the objectives of the fund match the objectives of the host country as to industries to be purchased, restrictions on ownership, and size of investments.

COMMENT

JOHN D. SHILLING

The Financial Advisory Services group at the World Bank has been an important part of the debt restructuring and debt-reduction negotiations between debtor countries and their creditor banks. Debt-equity swaps have been a major component of some of these deals. The Bank has provided advice to debtor governments about arrangements that might work best in the specific context of each country.

Mr. Wallenstein gave an overview of debt-equity swaps in general and raised some of the issues around them. This comment concentrates on two economic issues: the objectives of the swap program and the kinds of conversions. Each set of issues has implications for regulatory authorities.

The first thing in designing a debt-equity swap program is to define the real objective: how much debt reduction is intended, how important the debt-reduction component is, and how much investment is desired. Swap programs can be aimed at three things: debt reduction, investment incentives, and privatization programs. These objectives are not entirely complementary, and the relative priority among these three will determine the shape of specific program elements.

As a debt-reduction instrument, the advantage depends on the secondary market price. The lower the secondary market price for the debt, the more the outstanding amount of the debt can be reduced by giving up domestic resources (cash or assets) compared with the face value of the debt. How much an advantage this is depends on what the debtor evaluates as the likely repayment scheme stream on the existing debt. Here is an example. If a particular debtor country has no expectation of repaying a debt or much of the interest on it, the benefit of swapping it for $10 or $15 or $20 worth of domestic assets may not be very attractive, since that amount of assets is given up right away, and any actual repayment would be in the future. The real saving on a debt stream is doubtful. This is equivalent to the analysis of a buy-back, which is beneficial if there is serious intent to repay the debt. If, however, the debt is never going to be repaid, neither a swap nor a buy-back is necessarily the best thing to do with the available funds. If the country does intend to repay most or all of its debt eventually, then a swap at a discount may be beneficial.

The second reason for having a debt-for-equity swap is as an investment incentive. It can offer a premium to the investor who goes through the swap mechanism for part of his or her investment. It works very simply. Assume a 50 percent discount. The investor buys $100 worth of debt for $50 and exchanges it with the government for the equivalent of say $75. The investor has bought $75 worth of domestic investment for an expenditure of $50. It may offset unfavorable exchange rates or other problems in the domestic climate. In either case it is an incentive. And this can be done by foreigners or private domestic nationals who have assets abroad. In the Chilean program a large part of the debt-equity swap activity was undertaken by Chilean nationals who brought assets back from abroad and invested them.

Depending on the primary goal, specific characteristics of a debt-equity swap program will be put in place. If debt reduction is the primary objective, the government will want to capture as big a portion of the discount as possible. If investment incentive is the primary objective, the government may want a slightly larger portion of the discount left for the investor to increase the incentive. A key issue here is how much of the investment in the program is additional. If the person’s intent was to invest anyway, a 30 or 40 percent premium for investing is both redundant and wasteful. Bear in mind that the program has to be designed to encourage additional investment. Most of these programs require at least that the investment is not to acquire existing domestic assets but to increase domestic assets, through the extension of an existing plant or through a new installation. In some programs, the swap has been used for recapitalization of existing enterprises. This is particularly attractive to international commercial banks that have domestic branches and that can convert some of the debt into a domestic asset to recapitalize or increase the capital of their domestic subsidiary. This is allowed in some cases.

A third possible objective is a privatization program. If the government wants to privatize a number of public assets, it can do so by trading these assets for the debt instruments at a mutually agreeable exchange factor. One advantage of this is that the true price of the asset sold may not have to be made explicit. Obviously, governments can always sell their assets, but the debt swaps address a special audience with a particular interest in helping the government: banks that hold nonperforming debt and that are interested in converting it into potentially more valuable assets, for themselves, or more often with clients with cash in hand.

With any of the objectives, the debtor may reduce, but generally does not eliminate, its external liability. Merely converting a liability in the form of a debt instrument on which there are contractually fixed payments for a contingent liability that is an equity share in some asset does not eliminate the external liability. In most cases, the owner of the asset retains the right to repatriate dividends and eventually principal, and the terms for repatriation are an important element in the program.

Most Latin American countries allow capital repatriation and dividend remittances (even when debt is unpaid). They assume (rightly) that this is the only way to maintain the investment in a number of industries. However, they may limit repatriation in the initial years after the investment. With the repatriated capital belonging to nationals, this is less of a problem, depending on how porous the capital controls are and on the state of the capital market.

There are three kinds of debt-for-equity conversion, each with different characteristics: (1) conversion into domestic debt; (2) conversion into public assets; and (3) conversion into private assets.

A conversion into domestic debt takes the liability of the government denominated in dollars or other foreign currency and converts it into a liability denominated in local currency. Obviously, this does not eliminate the debt, but it does eliminate the foreign exchange requirement. There are various reasons an economic actor might do this: perhaps a national can obtain a favorable interest rate by bringing back assets, can repay some debts, or can help recapitalize an industry or a firm in the country. If handled correctly, these local currency debt-equity conversions tend not to have severe inflationary results because they simply exchange one debt instrument for another. A conversion does not relieve the government of the long-term payment obligation; it merely changes the currency. The country, however, may have given up foreign assets if a national used assets held abroad to acquire debt for conversion. Nonnationals are not generally interested in these conversions unless they can use the domestic debt to recapitalize enterprises they already own in the country (for example, financial institutions) on more favorable terms than bringing in fresh capital.

The second kind is the conversion into public assets. This is the debt-for-privatization type of program. For example, the government owns a railway or a cigarette factory, and it says to the foreign debt holder, “We cannot pay you, but we will trade this valuable asset that we have for the debt at some agreed price; you wipe out the debt and you get the asset.” This approach raises questions. Is the government willing to have foreign ownership? Are the creditors interested in buying these particular assets? Using the debt-for-privatization mechanism avoids increasing inflation. The indebted government has the asset and can transfer ownership, so there is no monetary impact. The Philippines debt-equity swap program has a debt-for-privatization component: a series of firms have been identified for privatization and those bidding for them can use external debt at an agreed discount as part of the payment. This allows the investor to get a certain benefit: a certain discount on price or a certain premium on the investment. Again, this does not have a negative impact on any of the monetary variables.

The third kind of swap, probably the most common or most commonly referred to, is conversion of the debt into private assets. In this case the debtor government says, “We cannot pay your debt, but we will give you some assets, except that we do not own the assets. Mr. Smith owns the assets, and you will have to negotiate with him.” The government gives a sum in local currency to the investor in exchange for the external debt. That money can only be used to invest locally. The investor has already reached an agreement with Mr. Smith to buy his equity for this sum, or to engage in an investment or extension of a plant depending on the local rules. This type of operation can lead to a severe inflationary problem. Why? Because the debtor government has to create or somewhere obtain the money it gave the investor to pay Mr. Smith to invest somewhere. Here the government is taking an obligation that requires payment in the future and is effectively prepaying it. This kind of debt-for-equity conversion may also place constraints upon the investor, who has to invest in the particular sector that the debtor government permits.

Where does the government find the money to give to the investor to give to Mr. Smith? There are three ways of raising this money. First, the government can cut expenditures elsewhere or raise taxes. Then the budget deficit stays the same and there is no inflationary impact. Second, the government can increase the deficit and use that money. It then has to face increased domestic demand and inflation potential. Third, the government can issue a bond to absorb that amount of money out of capital markets and then use those resources to pay for the investment. Raising money through government bonds implies either increasing interest rates or diverting capital that would have gone into some other investment. This is not without cost. While there are ways to mitigate these effects, there is no way to avoid them altogether. To a certain extent, expenditures can be adjusted, taxes can be raised, or other resources can be diverted; the government may be able to absorb a certain amount of monetary expansion.

A study in the Philippines looked at this question in great detail and devised ways of minimizing the impact and then building an overall debt-equity swap program that was eventually agreed with the International Monetary Fund. If there is going to be some monetary expansion in the normal growth of the economy, part of this can be allocated to the debt-equity exchange program. In the short run, the program displaced other uses of those resources, but over three or four years, the future reductions and service payments on the debt more than offset this. There was a large monetary expansion in the first year and then lower than normal expansions the following years. This took into account profit remittances, increased output, and other factors, including the 30 percent discount on the debt captured by the government.

Several other issues need to be examined. One is the terms for capital repatriation. The original debt instrument had a fixed payment stream, which has probably been replaced by a renegotiated (or twice or thrice renegotiated) payment stream. In converting that stream into equity, the country should not end up with a higher repayment stream in the near term. Thus, most of these programs have restrictions on the amount of capital that can be repatriated in the first several years. The country does not want to use this instrument to increase the short-run demand on the transfer of resources.

Mr. Wallenstein discussed the possibility of requiring that expenditures be directed for specific tranches of the investment to avoid roundtripping. Other programs have limited the use of the debt-equity exchange to domestic costs and not allowed them to finance imports.

Although debt-equity swap programs are viewed very cautiously by debtors, both because of inflation concerns and concerns about foreigners buying assets “on the cheap,” these plans are very popular among the creditor banks. They offer a market for the nonperforming debt the banks are holding. With a debt-equity program, there are third-party investors who want to buy the debt, so that keeps its price up, and banks who want out can sell. Early programs in Chile, Mexico, Brazil, Argentina, and the Philippines were so popular that they were oversubscribed, at which point concerns about inflation and monetary creation arose, slowing down these programs significantly.

With debt-reduction negotiations, there is usually pressure to include debt-equity swaps in most of the agreements. There will be more of these, probably on a smaller scale with limited amounts of conversion phased over time. The banks can sell their debt if they want to get out, or they can act as broker, earning a fee for putting the deal together. There are some regulatory problems and some accounting problems, some of which were discussed by Mr. Wallenstein. How do you count the change in assets even if it has been reserved against? The differential value has to be calculated and must appear according to the bank’s own accounting. This will affect its distribution of assets between other domestic offices and abroad. If the bank is involved in a recapitalization, that has to be addressed in the overall accounting relationship.

Initially, some jurisdictions effectively prohibited banks from participating in these activities with their own funds. In Japan, the Ministry of Finance refused to allow banks to engage in swaps. The ministry then allowed the creation of an offshore company for some very special purpose transactions and now increasingly they are allowing banks to use their own judgment with their own portfolios. Before this, the Japanese banks had merely traded and bought other debts and sold when they had clients who wanted to do a conversion.

How such programs are accounted for tax and regulatory capital purposes will also influence how active banks want to be in this market. The secondary market has grown large because there are these kinds of activities and other speculative activities with the LDC debt selling at a discount. All this will have regulatory implications for the authorities in the countries concerned.

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