New Financing Approaches in the Debt Strategy: A wider array of choices to address debt problems

Contributor Notes

A guide to the growing and evolving array of new financing techniques for developing countries with debt-servicing problems; the “menu approach” explained

This paper examines the policy implications of structural changes in financial markets. Domestic financial markets have become less segmented, and the major financial centers more integrated. At the same time, the structural changes in financial markets have improved efficiency by lowering intermediation costs, increasing the ability to hedge financial risks associated with currency, interest rate, and price volatility and opening up access to new sources of savings. The widespread application of computer and telecommunications technology to financial markets has permitted markets to process a significantly larger volume of transactions.

Abstract

This paper examines the policy implications of structural changes in financial markets. Domestic financial markets have become less segmented, and the major financial centers more integrated. At the same time, the structural changes in financial markets have improved efficiency by lowering intermediation costs, increasing the ability to hedge financial risks associated with currency, interest rate, and price volatility and opening up access to new sources of savings. The widespread application of computer and telecommunications technology to financial markets has permitted markets to process a significantly larger volume of transactions.

Klaus P. Regling

Commercial bank financing packages for indebted countries have evolved considerably since the beginning of the debt crisis in 1982 (see chart). The adoption during 1987 of the “menu approach,” offering a range of options for creditors and debtors, was supported by the international financial community, including the International Monetary Fund. The first tentative steps by commercial banks were welcomed by the Fund’s Interim Committee in the Spring of 1987. Additional support was evident during the 1987 Bank/ Fund Annual Meetings when the Interim Committee in its communique stated that “a further broadening of the range of initially agreed market-oriented options can be of benefit in securing timely agreement on financing packages and rebuilding debtor-creditor relations.” The Fund’s Managing Director, Michel Camdessus, in his speech at the Annual Meetings emphasized that “the spirit of innovation that has pervaded the international capital markets needs also to permeate the area of bank debt restructurings.”

The initial 1982–83 round of bank financing packages typically involved “new money” or “concerted lending,” (i.e., equiproportional increases in bank exposure coordinated by a bank advisory committee) in the form of general purpose financing to the central government, and restructuring agreements that transformed private sector debt, often publicly guaranteed, into direct public sector debt. The terms of these loans reflected the perception that the debtor country’s debt-servicing difficulties were temporary: consolidation periods over which the rescheduling took place covered only one or two years, maturities for the rescheduled debt ranged up to ten years, and spreads were typically increased to 2-2¼ percent above the London inter bank offered rate (LIBOR).

The next financing round in 1984–85 saw the use of certain new options—currency denomination and redenomination, interest retiming, onlending or relending, trade facilities, cofinancing, debt conversions—and modifications of terms. There was also a further decline in total bank lending to developing countries, from $45 billion a year in 1982–83 to only $11 billion in 1984–85. Adaptations in financing packages in those years reflected a desire to tune these arrangements more closely to the needs of both the creditors and debtors. Creditors saw these new approaches as helping to facilitate participation in financing packages by marrying them with the business interests of banks, and their regulatory, tax, and accounting environments. Debtors saw an improvement of terms—lower spreads, reduction or elimination of fees, multiyear consolidation periods, and extension of maturities—that provided additional debt relief. In early 1987, in the light of long delays in assembling financing packages and because of net repayments from developing countries to banks, the range of bank financing modalities was increased by further innovative approaches.

This article traces the changes in bank financing packages since 1982, distinguishing between the “traditional” approaches and the more recent developments and innovations under the so-called menu approach.

“Traditional” modalities since 1982

Currency denomination. Under most “new money” packages and restructuring agreements, banks have the option to denominate new loans and to redenominate existing loans in certain domestic currencies of the participating banks or the European Currency Unit (ECU). This option provides banks with an asset management technique that can reduce funding risks and exchange rate-induced movements in capital/asset ratios, and perhaps lower funding costs. For debtor countries, currency diversification through redenomination to currencies of countries with lower interest rates may reduce debt-service payments, although actual savings depend to a large extent on the timing of such a transaction relative to exchange rate movements.

Currency denomination options exist in new financing packages and restructuring agreements concluded in 1986 and early 1987 with nine countries (Argentina, Brazil, Chile, Mexico, Mozambique, Nigeria, the Philippines, Uruguay, and Venezuela). In general, bank creditors whose domestic currency is internationally convertible are eligible to denominate their claims in that currency, within certain limits. Banks of European Community member countries also have the option to denominate in ECUs. Creditors whose domestic currency is ineligible often may denominate in US dollars, ECUs or a specified convertible currency. Election of the denomination option for all or part of any bank’s claims generally is a one-time choice which must be exercised either on or before the date the debt becomes subject to the refinancing agreement.

Interest rate options. As a counterpart to currency denomination options, many recent financing agreements provide banks with alternative interest rate bases to which a spread is added for some eligible currencies.

Such provisions allow banks to choose LIBOR, a domestic rate (typically a market-determined cost-of-funds rate, adjusted for reserve requirements and deposit insurance premiums), the prime rate, or a fixed rate. Not all interest rate options are necessarily available for each currency. Most recent agreements, for example, excluded the prime rate option from US dollar loans because this rate has typically been higher than LIBOR. Borrowers may benefit from lower intermediation costs, and from lower financing costs when interest charges are market-related. Debtor countries’ vulnerability to future increases in interest rates may be reduced to the extent that their external debt is converted to a fixed interest rate. Interest base options were included in restructuring agreements concluded over 1986 to mid-1987 with Argentina, Chile, Mexico, Mozambique, Nigeria, the Philippines, Uruguay, and Venezuela.

Financing Instruments and options in “New Money Packages” (NM) and restructurings of bank debt (R) of selected developing countries, 1983-871

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Sources: New financing and restructuring agreements.

Classified by year of agreement in principle.

Libor and domestic floating rate options or fixed rate options.

Parallel financing.

Philippine investment notes.

Guarantees.

Revolving short-term trade facility.

Overall, in the countries where this option together with the currency redenomination option existed, most of the bank debt was switched from a variable to a fixed-rate basis and was converted into low-interest currencies such as the Japanese yen, the deutsche mark, and the Swiss franc. In the medium term, if the present trend continues, more than one-quarter of bank debt could be denominated in low-interest currencies at fixed rates.

Interest retiming essentially extends the interval between interest payments, permitting a country to defer one or more interest payments. Retiming thus enables banks to extend finance without committing new money and without incurring any income loss. The interest base is usually adjusted to reflect the extended interest periods. For example, a switch from quarterly to semiannual interest payments would bring about a change in the interest base from a three- to a six-month LIBOR. Experience with retiming is confined to three bank agreements (Chile in 1985 and 1987, and Argentina in 1987).

Onlending and relending allows banks to reallocate credit to different debtors in the same country without increasing their overall exposure. Onlending occurs when the lenders and original borrower, usually a public sector entity, agree that the proceeds of a loan will be transferred to a new debtor who assumes the repayment responsibility of the original borrower. The lender usually assumes the credit risk that stems from this transfer to a new borrower. Relending involves the repayment of an outstanding debt by the original borrower; the lender then relends those proceeds to other borrowers in the country. Both relending and onlending enable banks to develop business relationships with clients in developing countries, to support the export activities of their customers in industrial countries, and, more generally, to reallocate credit risks among different borrowers within a particular country. Provisions for onlending and relending exist in the 1986-87 restructuring and new money agreements with Argentina, Brazil, Chile, Mexico, Morocco, the Philippines, and Venezuela.

Two aspects of onlending and relending merit particular emphasis. First, to the extent onlending induces a more rapid and unpredictable expansion of domestic credit to the private sector, these provisions affect monetary developments and the design of Fund programs. Second, onlending and relending expand the role of international banks in the domestic capital markets of developing countries. To mitigate these effects, many agreements include restrictions on the scale of such operations.

New trade credit facilities. To reduce the size of general purpose bank finance and to facilitate the assembly of financing packages, new trade credit facilities have been incorporated in these packages. Such facilities enable banks to foster relations with the private sector in the debtor countries and with their own customers (e. g., exporters in industrial countries) while providing additional finance for a country’s imports. Moreover, some banks view debtor countries as assigning a higher priority to servicing of trade-related debt; thus, such lending could involve a smaller risk for banks. New money in the form of trade credit facilities has been extended to Argentina, Costa Rica, the Philippines, and Poland.

Cofinancing. Commercial banks have been very interested in linking their loans to developing countries to lending from multilateral development institutions. Banks participating in cofinancing arrangements with multilateral institutions benefit from these institutions’ analysis of projects, supervision of their implementation, in some cases the administration of loans until their full repayment, and varying degrees of financial protection.

The World Bank began cofinancing operations with commercial lenders in 1983, and currently uses three techniques for this purpose: (1) direct participation by the Bank in the longer-maturity portion of a commercial loan, so as to encourage banks to extend their own maturities; (2) a guarantee by the World Bank of the later maturities of a loan made by commercial banks, which provides an incentive for the co-lender banks to finance longer maturities than would otherwise be the case; and (3) the assumption by the World Bank of a contingent obligation to increase its participation in the loan in the event of interest rate increases for commercial loans with fixed repayment installments, on loans with a combination of floating interest rate and variable principal repayments.

Although cofinancing normally involves direct World Bank lending as well, the Bank also has been willing to consider the selective use of guarantees and other cofinancing instruments in heavily indebted countries on a case-by-case basis. The first such case was Chile, when $150 million of the later maturities of $300 million in concerted lending committed in 1985 carried a guarantee from the World Bank. Recently the Bank has made use of such guarantees in the cases of Mexico and Uruguay.

The Inter-American Development Bank and the Asian Development Bank have also entered into cofinancing arrangements (and complementary financing programs) with commercial banks, but the number of arrangements and the amounts are relatively small.

Debt conversion schemes have been established by several debtor countries (including Argentina, Brazil, Chile, Costa Rica, Ecuador, Mexico, the Philippines, and Venezuela), to benefit from the prevailing discounts on sovereign debt in secondary markets. Such schemes are also under active consideration in a number of other developing countries (e.g., Guatemala, Honduras, Jamaica, Morocco, and Nigeria). During the period 1984-September 1987, an estimated $6 billion in bank debt was converted under officially recognized schemes. This amount represented about 3 percent of outstanding bank debt of those debtor countries with active conversion schemes, although in some cases a substantially larger share of bank debt was retired (e.g., in Chile 13 percent of the bank debt was converted).

These debt conversion schemes can be open to foreigners, and to residents of debtor countries. Foreign banks may swap their own loan claims for an equity investment, usually in a financial institution, while foreign nonbanks may purchase loan claims at a discount in the secondary market to finance direct investment or purchases of domestic financial assets, benefiting from the redemption of those claims at near par by the authorities. Resident nationals of the country may also purchase bank loan claims at a discount, employing their own external assets (e.g., flight capital) in order to convert them into domestic financial assets.

While conversion schemes have a variety of features, reflecting the need to tailor such schemes to the circumstances of each country, certain similarities exist among them. Both public and private sector external debt may be converted. Frequently, there is a mechanism by which the debtor country may benefit immediately from these transactions. Conversion fees are imposed in some cases, or debt is exchanged at a price below face value. Some countries require matching foreign exchange inflows to offset the economic impact of early debt retirement. Typically, conversion schemes impose restrictions on profit remittances and capital repatriation beyond those restrictions that would apply on other types of foreign investment.

Some general issues have arisen concerning the economic impact of debt conversion. There are concerns related to the availability of foreign savings to the economy; the impact on domestic spending and the associated implications for financial policies. On the other hand, the longer-term signals provided by such schemes to creditors and foreign invesstors may well be positive and could affect a debtor country’s future access to spontaneous finance.

Secondary market transactions. The emergence of a secondary market for bank loans since 1982 has been a major factor in the proliferation of conversion schemes and the increase in debt conversion in recent years. Discounts on this market have ranged from 20 to 90 percent for the 15 heavily indebted developing countries, and in late September 1987 averaged about 55 percent. Estimates of the total volume in the secondary market (counting both sides of the transactions) range from $13 billion to $18 billion, a small fraction of the approximately $300 billion of bank debt of countries that have restructured their debts since 1982. A number of banks and investment houses—notably in New York and London—have emerged as intermediaries in transactions of loan claims.

Two types of transactions appear to dominate this market. The first is debt swaps among banks which are often designed not to diversify portfolios, but to concentrate holdings of claims on countries where banks have a strategic business interest and to eliminate minor holdings. The second is outright sales. Thus far, supply has been limited to smaller banks—particularly those in continental Europe and US regional banks—that have sought to reduce their exposure.

The “menu approach”

Explicit development of the menu approach was initiated with the 1987 package for Argentina; however, it represents the culmination of many developments both within and outside the restructuring process. The menu includes traditional financing modalities, described above, plus recent innovations described below.

Fees. Performance incentives for either the banks or a debtor country have been included in three recent restructuring agreements. The 1987 Argentine financing package included an early participation fee for banks. Those banks which committed themselves to the agreement within eight weeks of the agreement in principle received a ⅜ of 1 percent flat fee on the amount of the commitment; those banks which committed within another month received a flat fee of ⅛ of 1 percent. Bankers believed that such fees played an important role in accelerating commitments. The recently concluded restructuring agreement with Ecuador envisages a similar early participation fee.

The 1987 agreement with the Philippines provided the borrower with an incentive to make scheduled amortization and optional prepayments to gain a better interest rate. The spread on the restructured debt would be reduced from 1 percent to ⅞ of 1 percent during 1987–89 if the Philippines were to make an annual prepayment of at least 4 percent of the outstanding debt, as of January 1, 1987, under the 1984/85 New Money Agreement. Thereafter, the spread would remain at ⅞ of 1 percent if during these years amortization prepayments were made as scheduled.

Alternative participation instruments. Obtaining agreement from hundreds of banks on a new money package became increasingly difficult during 1986. Bank advisory committees (responsible for negotiating financing packages and restructuring arrangements) sought to make the process more orderly and less expensive by developing techniques to permit banks with small exposures to contribute and then to exit from the process. Two approaches have been tried or suggested. One approach is the de minimis rule applied by official creditors in the context of Paris Club reschedulings. Banks with exposure below a specified amount would be exempted from requests to participate in new money packages. The principal drawback of this approach, in the view of some major banks, is that it permits smaller banks to exit without contributing, thus increasing the contribution required of remaining banks.

The second approach permits all banks to reduce their base exposure (i.e., the exposure of each bank at a certain date that is shown for calculating new money contributions) by up to the same specified limit. This approach was adopted in the 1987 financing agreement with Argentina. Banks had the option to exchange up to $5 million of their claims on public sector borrowers, or $30 million if it completely extinguished their exposure, for alternative participation instruments (APIs). These instruments—often called “exit bonds”—had a fixed interest rate in the case of Argentina of 4 percent and a maturity of 25 years with 12 years’ grace. (The new medium-term loan for Argentina in 1987 had an interest rate of ⅞ above LIBOR and a maturity of 12 years with five years’ grace). APIs were to be excluded from the base for calculating new money contributions for the 1987 or future concerted lending programs for Argentina. But because these instruments carry a relatively low interest rate, the contribution to new money packages from banks that opt for these instruments would stem from the banks’ receipt of a lower stream of interest payments.

Commercial bank requests for APIs have been very limited, mainly because banks did not consider them attractively priced. A debt exchange that could also be seen as an exit instrument was proposed by Mexico in late December 1987. Under this scheme a portion of Mexico’s medium-term debt would be exchanged for about $10 billion of new 20-year Mexican bonds; the principal of these bonds would be secured by zero-coupon US Treasury securities purchased with a part of Mexico’s international reserves. The new Mexican bonds would also carry a more attractive interest rate than existing bank claims.

Securitization, which refers to the substitution of more tradable financial instruments for bank claims, allows banks to reorganize their portfolios. In some cases, it enhances the perceived priority of the debt vis-a-vis other obligations. Securitization also may provide debtor countries greater access to nonbank sources of finance.

In general, there are two ways to “securitize” existing bank loans: a country can refinance existing loans by issuing securities; and banks, or other intermediaries, can issue securities backed by existing bank loans. For example, interbank credit lines frozen by maintenance-of-exposure or other agreements have been converted to securities: in 1986, three Mexican banks and one Brazilian bank refinanced $0.5 billion of such debt, using note issuance facilities (NIFs) and floating rate notes. Certain types of Nigerian debt were exchanged into promissory notes under the 1983 restructuring agreement, albeit of qualified transferability. The 1987 financing agreement with Argentina provided any bank that committed its full share of the new money the option of receiving bonds rather than loan claims for up to $1 million of its commitment.

Prioritization of debt. With a view to lessening the adverse impact of rescheduling on access to spontaneous financing, commercial banks have standardized to some degree their procedures for debt restructuring. Bank agreements, where possible, have excluded short-term trade finance, interbank debt, and bonds from formal rescheduling. The setting of a cutoff date and exclusion of short-term debt each offer analogies with Paris Club procedures that are designed with a similar intention. While short-term trade and interbank debt have been better serviced than longer-term obligations, they nevertheless have been covered by agreements to maintain exposure and occasionally have been formally restructured. New money claims often carry higher spreads and shorter maturities than restructured debt; however, these terms are not always protected by the cutoff date for restructuring agreements; in a few cases, banks have adjusted the terms of loans contracted after the cutoff date; and new money contributions have sometimes been included in the base for subsequent new money packages.

In addition to the above procedures, securitization has been viewed as a means of establishing the priority of claims. Market participants have pointed out that marketable debt has typically been excluded from rescheduling agreements, reflecting the time and costs involved in rescheduling the relatively small amounts of securitized debt as compared with bank loans.

Interest capitalization. Voluntary limited interest capitalization is a financing technique under which some of the interest payments due are added to the total amount of the loan outstanding. Some banks, especially continental European and US regional banks, have expressed a preference for such a scheme, partly for tax and accounting reasons. Interest capitalization also facilitates participation in financing packages by reluctant banks since it often avoids approvals by bank boards (usually required for new money contributions). On the other hand, it raises difficult questions about the equitable distribution of contributions from banks in different countries, since interest levels vary greatly. Experience with capitalization of interest is limited so far to two low-income countries experiencing extreme difficulties in servicing their debt: the 1980–82 restructuring agreements with Nicaragua, and the 1985 restructuring agreement with Sudan.

Debt buy-backs permit countries to repurchase their debt at a discount. In July 1987, Bolivia’s creditor banks agreed to amend the 1981 rescheduling agreement with Bolivia to permit a two-step approach to resolving Bolivia’s bank debt problem. A portion of the outstanding principal and associated unpaid interest will be reduced by a debt buy-back at a discount and the remaining debt will be restructured. The buy-back operation will take place directly between Bolivia and banks rather than in the secondary market and will use foreign exchange obtained from donor governments.

The bank advisory committee for Bolivia insisted that donated foreign resources be employed for the buy-back so as not to divert domestic official resources from debt-servicing. IMF involvement was requested by Bolivia in implementing this scheme to assure bank creditors that the funds received for the buy-back are indeed grants from other countries, to maintain the anonymity of the donors if so requested, and to keep the amount of contributions received confidential.

Caveat

The menu approach has become an important element in the evolving debt strategy. It encourages the continued participation by banks, which have differing business interests and operate under different regulatory systems, in the cooperative effort to solve the debt crisis. However, the benefits that can be derived from financing techniques should not be exaggerated. There are natural limits to the scope of a number of items on this menu, reflecting the continuing need of developing countries for general purpose financing, and constraints of fiscal and monetary management.

Finance & Development, March 1988
Author: International Monetary Fund. External Relations Dept.