I Overview and Current Issues
- International Monetary Fund
- Published Date:
- September 1995
Over the course of 1994 and the first half of 1995, several countries concluded debt deals with their commercial bank creditors, and a few others announced agreements in principle.1 Among those making progress in normalizing relations with commercial bank creditors are a number of low-income developing countries. Although the progress achieved by these countries is commendable, further substantial efforts are needed to deal with their debt problems, especially for those countries with relatively large debt obligations to commercial banks. Conditions in world financial markets tightened in early 1994 with the shift in U.S. monetary policy and the rise in long-term interest rates, reducing the flow of portfolio capital to developing countries. Moreover, demand for all developing country securities was profoundly affected in early 1995 by the eruption of the Mexican financial crisis in December 1994. Subsequently, conditions improved significantly, reflecting the steps taken to deal with that crisis, the adjustment efforts of other countries encountering difficulties (supported in some cases by financing from the IMF), and the continued strong economic performance of many developing countries. The impact of the Mexican crisis across a broad range of developing country securities raises a number of issues regarding how the composition of the investor base may have contributed to the spillover effects that were observed. In the wake of the crisis, some questions have also been raised about external debt-management practices and the implications for macroeconomic policies of growing foreign borrowing by entities outside the government sector.
Progress with Commercial Bank Debt Restructuring
Over the past year and a half, Bulgaria, the Dominican Republic, Ecuador, and Poland concluded debt- and debt-service-reduction operations with their commercial bank creditors, and Albania, São Tomé and Príncipe, Sierra Leone, and Zambia conducted debt buybacks with assistance from the Debt Reduction Facility for IDA (International Development Association)-Only Countries (see the Statistical Appendix, Table A1). As of end-June 1995, a total of 21 countries had completed debt- and debt-service-reduction operations, restructuring a total of $170 billion in commercial bank debt. Original claims payable to the banks have been reduced by about $76 billion, at a cost of $25 billion.
Several other developing countries have made substantial progress toward resolving their commercial bank debt problems. In May 1995, Panama announced an agreement in principle with its bank creditors. Sierra Leone completed a debt buyback in July 1995, and Albania concluded a debt buyback in August 1995. Financing in both of these cases was provided by the Debt Reduction Facility for IDA-Only Countries. In addition, Peru has renewed discussions with its commercial banks, and Vietnam has made substantial progress, with the expectation that negotiations on a comprehensive package will be concluded by late 1995.
Côte d’lvoire met with its commercial banks to reconcile debt stocks; however, given the large debt stock and a relatively high secondary market price, the cost of a comprehensive buyback appears to be prohibitive. As an alternative, a Brady-type operation consistent with the country’s limited debt-servicing capacity and the availability of financing for enhancements is under consideration. Similarly, progress on a debt-buyback operation for Nicaragua is dependent on the availability of sufficient financing; it appears that the financing package for the deal is nearing completion.
Algeria reached agreement in May 1995 with its commercial banks on a rescheduling of bank claims falling due through 1997, including amounts that were previously rescheduled. Russia and its commercial bank creditors agreed that the country would pay $500 million into an escrow account at the Bank of England by end-June 1995 with respect to 1992/93 interest arrears, following the resolution in October 1994 of the legal framework for negotiations (most notably, the banks’ requirement that Russia waive sovereign immunity). In March 1995, it was agreed that a further $500 million would be paid in settlement of 1994 arrears. An initial round of negotiations between Russia and the commercial banks on a debt-stock rescheduling was held in early July 1995, and a working group was formed to make proposals with a view to reaching a final agreement by the end of 1995. Slovenia reached an agreement in principle in June 1995 with the coordinating committee of commercial bank creditors of the former Socialist Federal Republic of Yugoslavia.
The sharp run-up in secondary market prices of bank claims during the second half of 1993 and into early 1994 raised concerns that future bank debt negotiations might be complicated by market speculation that a country would conclude a debt- and debt-service-reduction operation. As a result of such “pre-Brady” speculation, secondary market prices in several instances were not seen to be reflective of the countries’ medium-term capacity to service their debts. In addition, the upfront costs of debt operations (especially straight debt buybacks) were bid up substantially. Subsequent developments (most notably, the rise in world interest rates during 1994 and the Mexican crisis at end-1994) have contributed to large declines in the secondary market prices of developing country bank claims from their early 1994 peaks.
With the adjustment in prices, there is less concern in some cases that high levels of secondary market prices will make it more difficult for countries to reach agreements with their creditors. Nonetheless, despite the general fall in secondary market prices, prices for the debt of many low-income developing countries have remained significantly above their levels in mid-1993 and potentially out of line with the ability of these countries to service debt over the medium term. Pre-Brady speculation also remains a potential concern, as evidenced by the run-up in the price of Côte d’Ivoire’s debt in advance of discussions between the country and its bank advisory committee in May 1995. Creditors will need to show considerable flexibility in reaching agreements to resolve the debts of these low-income countries, possibly entailing even steeper discounts on debt buybacks than those that creditors have accepted at times in the past.
Even at very steep discounts, the total amount of assistance that a few low-income countries would require to buy back their commercial bank debt far exceeds available resources. In these cases, Brady-type debt- and debt-service-reduction operations may have to be considered. Key considerations in structuring such operations will be assessments of the country’s medium-term debt-servicing capacity and the resources available to fund the upfront costs of the operation. The menu of options in such deals may entail, in addition to steep discounts on debt buybacks, sizable discounts on discount bonds, par bonds with interest rates substantially below market levels, the write-off of past-due interest, and the provision of less than full collateralization of principal on bonds issued as part of the package.2 To meet the financing requirements for such operations, there will be a continuing need for substantial concessional resources from multilateral institutions and bilateral donors.
Private Financial Flows
Recent Developments and Prospects
Over the course of 1994, private market financing to developing countries declined from the level reached in 1993, reflecting in part a less favorable external environment. The tightening of monetary policy in the United States early in 1994 set off considerable turbulence in world financial markets. As a consequence, there was a significant decline in placements of bonds and equities by developing countries in international markets from late February to April 1994. With the subsequent return to more stable conditions in the markets, new bond and equity issues by developing countries picked up sharply in the second half of 1994. Terms on new bond issues (interest rates and maturities), however, were generally less favorable than previously, and market access tended to be restricted to more creditworthy borrowers.
The Mexican financial crisis in December 1994 prompted a relatively broad sell-off of developing country securities in late December and early January 1995. Selling pressures were concentrated in Latin American countries, and they continued with only brief respites until mid-March 1995. Some Asian developing countries also experienced pressures in domestic financial markets in early January 1995, but these pressures were short lived, dissipated rather rapidly, and were generally followed by renewed inflows of portfolio capital. Recovery of prices in Latin American securities markets after April 1995 reflected market perceptions of improved prospects for Mexico (following the strengthening of its adjustment program) and for the other major countries in the region, and the reported return to these markets of some investors who had exited earlier in the year. In early 1995, issuing activity by developing countries in international bond markets was very weak and was dominated by Asian entities, led by Korea; equity issuance came to a virtual halt. Beginning in April and continuing through June, international placements of bonds picked up. Although Asian issuers continued to dominate, non-Asian entities returned to the international markets.
The external environment improved somewhat with the declines in U.S. long-term interest rates in the second quarter of 1995, enhancing prospects for capital flows to developing countries. Moreover, the Mexican financial crisis appears to have produced only a temporary disruption in the general trend toward globalization of financial markets and diversification of investors’ portfolios. Nonetheless, some questions remain about the level of flows to developing countries in the near term. In general, during the first half of 1995, only the most creditworthy developing country borrowers had substantial access to the dominant dollar segment of the international bond market; for the most part, other borrowers were able to place issues only in the other currency segments of the market, which lend to be less liquid. Although portfolio capital flows to developing countries in 1995 are likely to be significantly below their levels in 1993-94, sizable flows are likely to continue over the medium term as portfolio diversification continues, and provided that developing countries sustain strong economic policy performances and adjustment efforts.
Pricing of Developing Country Securities and Managing External Debt
The tumult in the markets for developing country securities precipitated by the Mexican crisis (sometimes called the “tequila effect”) demonstrates once again how returns on these securities become increasingly correlated in periods of stress in the financial markets. Following the Mexican devaluation in December 1994, the correlations in total returns on Brady bonds among developing countries rose sharply, particularly among Latin American countries. Similar behavior was observed in early 1994, as correlations in returns on Brady bonds rose sharply in the wake of the initial increases in U.S. interest rates beginning in February and remained high through April 1994, when more stable conditions were re-established in world financial markets.
Correlations in the returns on these bonds (especially among the Latin American countries) may be explained in part by the reported use by market participants of Mexican securities as benchmarks for the pricing of other developing countries’ securities. The rise in the correlations in times of stress may also reflect the composition of the investor base. A significant number of investors with similar characteristics (for example, information sets and liquidity needs) and risk/return preferences have entered the markets for developing country securities in recent years; most notable among these were institutional investors (mutual funds, pension funds, and insurance companies). This development may have contributed to establishing conditions conducive to producing higher volatility in developing country securities markets. These investors would tend to react simultaneously in a similar manner to a shock affecting expected returns and the perceived riskiness of developing country securities. Such concerted movements, given the lack of substantial liquidity in most of these securities markets, would add to market volatility. Moreover, limited liquidity in developing country markets is likely to have led to a bunching of investments in a few markets and in only a limited number of security issues.
The rules-based approaches to portfolio allocation generally followed by institutional investors may be another contributing factor. These investors appear to follow a two-step process in allocating their portfolios among various assets. Investable funds first tend to be allocated to different classes of assets—in part on the basis of fundamental economic factors determining expected asset returns—but asset allocation decisions are also influenced by other considerations, such as liquidity in the asset markets and diversification of the overall portfolio. Reflecting this behavior, institutional investors in recent years have come to identify developing country securities as a distinct asset class. Once investable funds have been allocated to a particular asset class, they are then invested in individual securities in the asset class primarily on the basis of economic fundamentals affecting expected returns.3
Thus, there is the potential for a shift in investor sentiment away from developing country securities as an asset class to lead to the selling off of securities across a broad range of countries without a change in, or without fully reflecting, the basic economic fundamentals in individual countries.4 Such a shift in sentiment could be inspired by developments in one key country in the group, such as Mexico, with the impact of the shift spilling over to asset markets in all other countries. To some extent, such spillover effects might reflect investors’ reappraisal of countries with similar characteristics after the difficulties encountered by the key country; in the aftermath of the Mexican crisis, for instance, countries with relatively large current account deficits and fixed (or heavily managed) exchange rate regimes were tested. In general, however, selling pressures across the full range of country asset markets would not be expected to persist for a prolonged period because, to the extent that the selling behavior of institutional investors in individual country markets pushed prices significantly out of line with expectations based on economic fundamentals in those countries, profit opportunities would be created and would likely be exploited by other investors. Moreover, an improved flow of information about economic conditions in developing country markets would be expected over time to moderate inconsistencies between the prices of developing country securities and the countries’ underlying economic fundamentals.
The short-lived selling pressures experienced in Asian markets after the Mexican devaluation support the view that such pressures will not persist in the absence of changes in fundamentals. The ability of Asian countries to weather these pressures largely reflected their basically strong economic positions, underscoring the importance for countries to consistently implement sound macroeconomic and structural policy programs. Implementation of such policy programs also will serve to ensure that access to foreign capital will be maintained on reasonable terms. Maintaining access to international markets is particularly important, since a number of developing countries are now entering a period of significantly rising debt amortizations as bullet repayments on bonds issued in the late 1980s and early 1990s are beginning to come due.
Developments over the past year and a half point to the general resilience of the market for developing country securities and provide reassurance that market access can be maintained. The resilience in part reflects the continuing strong economic performance of many developing countries. It also reflects the economic adjustment efforts of authorities in countries experiencing difficulties. Latin American securities generally have posted strong gains in the past few months, and Brazil was able to return to the international financial markets in May 1995 with a new bond issue. Mexico itself made a dramatic return to the international bond market in July 1995 with two issues that met very strong demand. Argentina followed an April bond issue to foreign banks with operations in the country with two new issues in the international bond markets in July. This contrasts with the scenario that could have developed if, short of decisive action, Mexico and others had had to resort to payments moratoriums.
In the aftermath of the Mexican financial crisis and renewed concerns about the volatility of capital inflows, questions have been raised regarding external debt-management practices. In managing the government debt, the Mexican authorities prior to the crisis took actions that entailed the shortening of maturities and the indexing of part of Mexico’s debt to the U.S. dollar. These actions appear to have complicated the situation by creating conditions conducive to short-term liquidity problems. The currency composition of government external debt also created some difficulties for developing countries that borrowed in yen, owing to the sharp appreciation of that currency against the U.S. dollar in early 1995. This situation illustrates the need for a country to carefully assess the cost, including the foreign exchange risks, when borrowing in foreign currency. Such risks should be adequately hedged—either indirectly, by keeping the currency composition of foreign borrowing in line with the composition of foreign exchange earnings, or explicitly, through the use of financial market instruments such as foreign currency swaps. Otherwise, what might appear to a country’s authorities lo be a cheap source of funds owing to low interest rates may turn out to be rather expensive as a consequence of the foreign currency exposure acquired.
In many countries, the more active role of the private sector and public sector corporations in tapping international capital markets raises a number of additional issues for external debt management. Although these entities should be held accountable for their own debts, difficulties encountered by the government can negatively affect the ability of nongovernment entities to service debts, adding to the severity of a financial crisis. The situation in Mexico following the devaluation provides a good illustration of this point, as some commercial banks encountered difficulties in rolling over short-term foreign currency debts falling due, and the Government stepped in to provide the necessary foreign exchange to avert a further crisis in the banking system. At the same time, problems in the private sector and the public sector corporations can quickly pose significant challenges for macroeconomic policies. This may be the case especially if the banking sector has borrowed heavily abroad to fund its domestic lending and if important segments of the sector encounter difficulties in meeting their obligations. Weakness in a country’s financial sector seriously inhibits the ability of the authorities to conduct monetary policy and may entail significant fiscal costs. Debt-servicing problems of nonfinancial corporations may also have spillover effects on the government’s conduct of economic policy if major corporations are the source of the difficulties, owing to the impact that failure of a major corporation could have on the domestic economy and the negative consequences of such a failure on the ability of the government and other borrowers to maintain access to international financial markets.
In dealing with the external debt of the private sector and the public sector corporations, it is crucial for the government to carefully monitor debt flows in order to maintain timely information on the economy’s overall foreign exposure. Such information is critical to the authorities’ ability to accurately assess the appropriateness of macroeconomic policies, and it fits with the authorities’ responsibilities to collect and publish accurate statistical information on the state of the domestic economy and the country’s external position on a timely basis. As the capital account transactions are liberalized, it is important that the ability of nongovernment entities to access foreign markets does not outstrip the ability of the government to monitor these activities, particularly in countries that are in the process of stabilizing their economies.
Beyond simply monitoring flows, it is especially important in the case of intermediation of capital inflows through the domestic banking system that the government provide for adequate supervision and regulation of the banks. As the principal shareholder in the public sector corporations, the government has the responsibility to oversee the corporations’ activities, to ensure that the government achieves an adequate return on its equity interest with an acceptable degree of risk, and to see that the national interest is served. In the case of private sector nonfinancial corporations, the most appropriate role for the government would be to put in place adequate standards and requirements for public financial reporting of the activities of these corporations.
Measures to restrain foreign borrowing by the private sector may be found useful in a few cases. For example, measures to limit the intermediation of capital flows by the banking system might be an appropriate response in instances where supervision and regulation of the banks may be weak. These types of measures, however, may be effective only in the short run, especially in relatively open economies. Furthermore, such measures impose costs on the economy, particularly in the sense that some significant opportunities may be forgone by restricting capital inflows. In the end, successful management of external debt by the private sector rests on the sector’s ability to develop and employ appropriate business practices. Capital controls would tend to impede this development.