An important breakthrough in debt reduction and financing operations in support of Mexico’s growth-oriented adjustment program
An important breakthrough in debt reduction and financing operations in support of Mexico’s growth-oriented adjustment program
After a year of intensive negotiations, Mexico reached an agreement with its international commercial bank creditors on the most complex financing package to date. The agreement, signed on February 4, 1990, is the first comprehensive debt relief package under the strengthened debt strategy, with Bank and Fund resources being made available to finance debt and debt-service reduction operations with commercial banks.
The commercial bank package is a particularly important element of the country’s multiyear financing plan for its medium-term growth-oriented economic program supported by an arrangement under the Fund’s extended Fund facility and by World Bank project and sector loans (see box). The economic program involves important structural reform measures in the areas of production, trade, and financial services, accompanied by the sustained implementation of prudent fiscal, monetary, and pricing policies. The financing package covers eligible debt of some $48 billion of Mexico’s estimated total external indebtedness of $95 billion at end-1989. In addition to rescheduling principal obligations falling due and securing new loan commitments for the period ending 1992, the package extinguishes a portion of Mexico’s outstanding debt and reduces the contractual interest rate on a second portion. Accordingly, Mexico has been able to lower its debt-servicing obligations while, at the same time, improving in a sustainable manner, the structure of its external indebtedness. If Mexico manages to sustain the implementation of sound economic policies, the financing package will play an important role in fostering private sector investment activities, encouraging greater inflows of nondebt-creating foreign financing, and promoting higher economic growth.
Structure of the financing package
Mexico formally initiated negotiations on its multiyear financing package in April 1989. Preliminary agreement on the broad elements of the financing package was reached on July 23 with the advisory committee of commercial banks (consisting of representatives of 13 creditor banks). The key terms of the financing agreement were finalized on September 13; the agreement was subsequently “marketed” to Mexico’s bank creditors (around 500 banks), and signed on February 4, 1990, once almost all eligible claim holders had agreed to participate. The exchange of financial instruments between Mexico and its commercial creditors then took place on March 29, 1990.
Under the terms of the package, banks holding eligible claims on Mexico were to choose from one of three financing options:
• an exchange of claims for 30-year discount bonds (at 65 percent of face value) carrying a market interest rate (at a spread of 13/16 percent over LIBOR), full guarantee of principal to be paid back in one installment after 30 years, with 18 months guarantee on interest;
• conversion of claims into 30-year par bonds with below-market fixed interest rates (6.25 percent) and the same maturity and guarantee structure as for the discount bonds; and
• provision of net “new money” (i.e., new loan facilities) for 1989-92 amounting to 25 percent of eligible claims, repayable over 15 years, including 7 years’ grace.
The financing package incorporates a new debt-equity program, which replaces that suspended in 1988. Under the program, holders of restructured claims can convert their assets into equity participation in privatized enterprises and infrastructural investments. The program allows for conversions of $3.5 billion of eligible debt (original face value). The financing package also includes a “value recovery clause” that enables banks to receive higher payments from Mexico if, starting in 1996, oil prices exceed the threshold level of $14 a barrel after adjusting for inflation. Such payments would amount to 30 percent of “windfall” oil revenue, subject to an annual limit equal to 3 percent of the banks’ eligible claims at the time the agreement was signed. Finally, by incorporating waivers to certain key payment clauses, the package allows Mexico to conduct additional market-based debt and debt-service reduction operations in the future.
Collaterals for the package
Consistent with the terms of the financing package, Mexico took steps to provide commercial bank creditors with “enhancements” in the form of payments guarantees for all principal obligations on the converted bonds, as well as a rolling guarantee for part of the interest stream. Mexico purchased 30-year US Treasury zero coupon bonds (i.e., discounted bonds that pay no interest) to cover the principal to be paid on the bonds, and established an interest collateralization account at the Federal Reserve Bank of New York for an amount equivalent to the present value of 18 months of interest obligations. These enhancements would accrue back to Mexico should it meet all contractual payments on the bonds, or retire them prior to the contractual maturity date.
In total, some $7 billion was required for enhancing the debt exchanges. This was met through resources committed by the IMF (SDR 1.3 billion, equivalent to some $1.7 billion), the World Bank ($2 billion), and financing in connection with import facilities from the Export-Import Bank of Japan ($2.0 billion). The residual was funded from Mexico’s own reserves. As a portion of the resources from the Fund and Japan are to be released in installments over 1990-92, a commercial bank facility of $1.2 billion was put in place to bridge to the later disbursements of official assistance.
Direct impact of package
The financing package provides cash flow relief to Mexico in the form of new money disbursements, a rescheduling of principal obligations, and interest relief resulting from the reduction in contractual interest rates and the elimination of principal.
Banks holding $20.4 billion of eligible claims selected to exchange their claims for discount bonds, while those holding $22.7 billion chose the par bond option. Consequently, debt with face value of $7 billion was extinguished. In addition, the contractual interest rate on $23 billion of debt was reduced to a below-market fixed rate; this implies, at prevailing interest rates, the equivalent of an additional elimination of $8 billion of debt. New money commitments amounted to over $1 billion, with the first disbursements totaling $0.5 billion made in March-April 1990.
The debt and debt-service reduction operations result in an effective reduction of indebtedness to commercial banks of $15 billion—equivalent to some 16 percent of Mexico’s total external liabilities. This is partially offset by obligations to official creditors of $5.7 billion incurred to finance the debt exchanges. Consequently, the immediate effect of the package is to effectively reduce Mexico’s total external indebtedness by some 10 percent. The principal obligations on a substantial portion of the remaining debt may be regarded as effectively prepaid by the recent purchases of the zero coupon bonds.
Mexico will improve its cash flow immediately by reducing its contractual interest obligations for the period ending 1992 by some $4 billion, after taking account of net interest payments on the resources borrowed to purchase the guarantees. In addition, principal obligations of $8 billion would be effectively rescheduled. The beneficial cash flow effect of the package will increase over time as a result of lower interest payments that Mexico would have to make and consequently the lower financing requirement to be covered by new loans.
Other effects of the package
In addition to reducing debt-servicing obligations, the agreement contributes to Mexico’s balance of payments through its positive impact on perceptions of country risk. As Mexico’s indebtedness rose, concerns had mounted among domestic and foreign investors regarding the authorities’ ability to meet scheduled payments without, inter alia, substantial increases in effective taxation. This was reflected in relatively high real rates of interest internally as borrowers needed to compensate savers for the increased risk premia. At the same time, the discount on Mexican external claims traded on the secondary market for developing country debt increased to over 60 percent. These factors, and the associated erosion of investor confidence in the outlook for the Mexican economy due to the debt “overhang,” adversely affected productive activities and the country’s progress toward sustained medium-term growth.
Fund and Bank support for debt and debt-service reduction
In May 1989, the Executive Boards of the Fund and Bank approved the provision of financial assistance to member countries to finance debt and debt-service reduction operations with commercial banks. The guidelines for access to such assistance specify, inter alia, that: operations be in support of strong economic policies; that they be voluntary, market-based, and help the member country regain access to credit markets and attain external viability; and that they represent an efficient use of resources. In the case of the Fund, the guidelines allow for “set-asides” to finance principal reduction and “augmentation” to be used for interest support in connection with debt and debt-service reduction operations. The exact size of the set-asides is determined on a case-by-case basis, and involves around 25 percent of access under the underlying arrangement. Augmentation resources are subject to a limit of 40 percent of the member’s quota. As of end-June 1990, assistance had been approved for Argentina, Costa Rica, Ecuador, Mexico, the Philippines, and Venezuela; disbursements had been made for Mexico and the Philippines.
The recent debt and debt-service reduction operations, implemented in the context of strong economic and financial adjustment policies, are expected to reduce the debt overhang, thereby helping to achieve higher investment and growth. In effect, the lower contractual obligations resulting from the elimination of part of the external debt and below-market fixed interest rates reduce the risk premia on real investment. Consistent with this view, the announcement of a preliminary agreement on Mexico’s financing package in July 1989 was followed by a substantial reduction in domestic interest rates (by over 20 percent to an annualized nominal rate of 33 percent). Balance of payments developments were characterized by large inflows of private capital, including foreign direct investment and the repatriation of capital flight. While subsequent monetary developments led to a partial reversal of the decline in interest rates, domestic rates have responded favorably to the finalization of the bank package and the intensification of structural reform and demand containment measures. As a result, rates are substantially lower than at the time of the initial agreement on the package, private capital inflows have intensified, and there are indications of a gradual restoration of Mexico’s access to spontaneous credits from international bond markets.
The beneficial impact of the financing package has been accentuated by policy actions to attract nondebt-creating flows. Thus, Mexico has modified its investment regulations so as to increase foreign direct investment. It has also taken steps to facilitate foreign portfolio investment in domestic securities markets, including investment related to privatization efforts. At the same time, repatriation of foreign capital has been encouraged by the adoption of tight monetary policies and financial system reforms that have led to the emergence of competitive yields on domestic assets and increased confidence in the economy’s prospects.
Mexico’s agreement with commercial banks is important not only for the country, but also has implications for the orderly resolution of the debt problems facing a number of other developing countries. By encompassing large-scale debt and debt-service reduction operations, Mexico’s commercial bank financing package constitutes an important step in the implementation of the strengthened debt strategy, which seeks to facilitate debtor countries’ return to sustained economic growth and external payments viability.
The agreement—which supports a comprehensive economic adjustment package with a strong structural reform component—provides direct benefits for Mexico’s external position in the form of lower payment obligations to commercial creditors and reduced vulnerability to fluctuations in international interest rates. These effects are compounded by indirect benefits that include improved private sector confidence and therefore better prospects for higher investment financed by the return of flight capital and inflows of other forms of nondebt-creating capital. Accordingly, if accompanied by the sustained implementation of sound economic and financial policies, and in the absence of major adverse exogenous shocks, the financing agreement facilitates substantially Mexico’s return to sustained economic growth and financial stability.