Debts, External ; Swaps (Finance) ; Developing countries ; Mexico

Ramon Moreno

English

Research Papers in Economics

FRBSF WEEKLY LETTER
September4,1987
LDe Debt Swaps
In recent years, a market has developed that
enables investors to purchase the external debt
ofless developed couhtries (LDCs) to acquire
equity or domestic currency in those same coun-
tries. The market for LDC debt swaps, as the
transactions are called, has grown rapidly over
the past few years. The volume of debt swaps
amounted to about $4.5 billion between 1982
and 1986. Although the rate at which debt
swaps are occurring is still small in relation to
the $300 billion owed to banks by the 15 LDCs
listed in the Baker Plan, there are indications
that the debt swaps market is poised for even
faster growth. Five major debtor countries -
Chile, Mexico, Venezuela, Argentina, and the
Philippines - have initiated debt swaps pro-
grams, and there is reason to believe that more
will follow.
The loan loss reserves accumulated by major
bank lenders in 1987, which totaled over $15
billion dollars for the top twelve banks in June,
may permit large increases in the supply of debt
for the swaps market. At the same time, the
development of new instruments for debt swaps,
the recent change in Federal Reserve Regulation·
K authorizing bank holding companies to hold
100 percent equity holdings in nonfinancial
firms that are being privatized in LDCs, as well
as incentives by participating debtor countries,
may stimulate demand.
Because debt swaps may reduce the repayment
burden of debtor countries, they show promise
as a potential solution to the LDC debt problem.
However, a 1987 study of the Federal Reserve
Bank of New York highlights the disadvantages
of debt swaps and raises questions about their
ultimate usefulness. This Letter describes the
characteristics of the debt swaps market and the
potential implications of its development.
Types of debt swaps and their rationale
This Letter will focus on two types of swaps:
debt-equity and debt-"peso" swaps. Debt-equity
swaps enable foreign residents to purchase LDC
debt at a discount to acquire equity in the debtor
country. Purchasers include creditor banks,
multinational corporations, and more recently,
closed-end funds that pool the resources of pri-
vate investors.
Debt-peso swaps enable residents of a debtor
country to purchase their country's foreign debt
at a discount and to convert this debt into
domestic currency. Residents use funds held
abroad or hard currency acquired from interna-
tional trade or in the exchange market to finance
these purchases.
By arrangement with the debtor country, domes-
tic currency assets obtained via debt swaps are
acquired at closer to the original face value of
the debt. For example, in 1986, a purchaser who
acquired Mexican debt for 57 cents on the dol-
lar could obtain equity worth 82 cents. Even
after accounting for fees and redemption dis-
counts applied by debtor countries to convert
the debt into domestic currency, debt-swaps
permit investors to acquire the domestic cur-
rency of debtor countries much more cheaply
than do official exchange markets. In effect,
investors resorting to the debt-swaps market
enjoy a preferential exchange rate.
Because debt-equity swaps permit foreign resi-
dents to acquire equity in the debtor country at a
substantial discount, equity holders may be sat-
isfied with smaller hard currency dividends than
the interest on the debt that was retired, as long
as the risk-adjusted yield on the equity invest-
ment exceeds the return on alternative assets. In
this way, debt equity swaps may potentially
reduce the (discounted present) value of the
external liabilities of the debtor by the amount
by which the nominal value of the debt has
been discounted in the open market. Debt-peso
swaps, in contrast, reduce the foreign currency
liability of debtor countries to the full amount of
the debt swapped, as claims acquired by domes-
tic residents may be settled in domestic currency
and require no hard currency outflow.
Advantages of swaps
Debt swaps may enhance the repayment capac-
ity of LDCs by shifting the composition of theirFRBSF
external liabilities away from debt, toward
equity. From the standpoint of a debtor, the
advantage of equity liabilities is that smaller div-
idends may be paid if the revenue produced by
an equity investment declines (concommitantly,
larger dividends must be paid if revenue
increases). Thus, shifting toward equity liabilities
can have a large favorable effect on a country's
repayment burden when economicconditions
are adverse.
For example, consider the sharp decline in oil
prices late in 1985, which reduced the revenue
from oil exports earned by Mexico's state"owned
petroleum company PEMEX by $7.7 billion in
1986. If a company like PEMEX, which
accounted for over $15 billion of Mexico's
external debt of $97.5 billion in 1985, had
resorted to equity rather than debt in obtaining
external financing, the hard currency outflow
associated with dividend payments could have
declined to reflect the multibillion dollar tempo-
rary decline in the export revenues of Mexico's
petroleum sector, and significantly eased Mex-
ico's repayment burden.
At present, foreign investment in important eco-
nomic sectors in LDCs, such as the petroleum
sector, is often not permitted. A desireto retain
control over investmentshas prompted many
LDCs to prefer external debt over equity financ-
ing since the 1970s and to adopt policies that
have effectively discouraged foreign equity
investment. However, the experience of most
major debtor countries in recent years indicates
that an excessive reliance on debt financing can
be very costly.
A country with a large external debt that suffers
a temporary loss in export revenues will face no
corresponding reduction in its external obliga-
tions. It would be forced to compress its imports
substantially, a move that tends to discourage
investment and growth, or to borrow more,
which prevents default but increases a country's
vulnerability to future economic disturbances.
When too large a share of external liabilities
takes the form of debt, temporary economic dis-
turbances will have a more severe effect on a
country's future growth and repayment capacity.
Effects on capital flows
The effect of debt swaps on the flow of capital to
LDCs is uncertain. Consider the effect on bank
lending. On the one hand, because debt swaps
enhance the repayment capacity of debtor coun-
tries, creditors may be more willing to maintain
or even increase their exposure to LDCs. On the
other hand, debt swaps also may reduce the
pool of bank loans from which new money for
LDC debtors is potentially available. Since the
1982 debt crisis, lender consortia have arranged
for individual banks to supply new money to
debtor countries in proportion to their exposure.
If a large number of banks were to reduce their
exposure by selling their debt, the amount of
new money available from bank creditors would
fall. The net effect of debt swaps on bank lend-
ing is therefore unclear.
Consider also the effect on non-bank capital
flows. The preferential exchange rate provided
by debt-equity swaps has two offsetting effects.
On the one hand, because of the effective pref-
erential exchange rate for acquiring domestic
currency assets, foreign investors may invest
funds they otherwise would not have placed in
the debtor country, and residents of debtor
countries may repatriate foreign assets they hold
abroad. On the other hand, the preferential
exchange rate associated with swaps means that
a smaller amount of foreign assets will be
required to acquire any given amount of domes-
tic assets. If there were great uncertainty about
the economic outlook in the debtor country or if
the investment climate were unattractive, the
hoped-for increase in capital inflow likely would
not be large, and the net result may even be a
capital outflow.
Effects on money supply and exchange rates
A number of commentators have noted that debt
swaps may tend to increase the money supply of
debtor countries if they were to stimulate a large
volume of capital inflows and the countries were
unable or unwilling to sterilize the monetary
effects of such inflows. However, even in the
absence of increased capital inflows, debt swaps
may tend to increase the money supply of
debtor countries.
Because the debtswaps market offers a more
favorable exchange rate than do official
exchange markets, it creates an incentive for
arbitrage. For example, a resident of a debtor
country may exchange 100 pesos in domestic
currency in official exchange markets to acquire
a dollar in foreign assets. It may then use these
foreign currency assets to acquire, via the debt
swaps market, 125 pesos in domestic currency,
thus gaining a 25 peso profit. The effect is a
"round trip" of the assets of domestic residents,and the domestic currency profit from the
arbitrage tends to increase the domestic money
supply. This process may continue as long as the
differential between the debt swaps and official
exchange markets exists.
The arbitrage operation also means that the dif-
ferential between the exchange rate in the open
and debt swaps market will tend to narrow. As
domestic residents increase their demand for for-
eign assets in the open market, the exchange
rate of the debtor country will tend to depreci-
ate. Debt swaps thus may introduce unintended,
and perhaps undesirable, disturbances to asset
markets by affecting the money supply and
exchange rates.
Exchange controls will not necessarily be effec-
tive in preventing this "round trip" process as
domestic residents may eludeexchange controls
in a number of ways, e.g., by overstating
imports. In this manner, the debt swaps market
may make it more difficult for debtor countries.
to lift exchange controls when lifting those con-
trols may be desirable from the standpoint of
economic efficiency.
Implications for banks
The main advantage of the debt swaps market
for banks is that it permits them to unload non-
performing assets from their portfolios.
However, continued rapid growth in the debt
swaps market would increase the risk that deep
discounts on the debt will affect bank balance
sheets and market value far more adversely.
The discount on LDC debt and its impact on
banks will be influenced by the rate at which
debt is supplied to the swaps market. We may
conservatively estimate this supply as the sum of
(a) loans to the private sector of LDCs by large
money center banks, which can arguably be val-
ued on a case by case basis without having to
write down the value of the rest ofthe debt held,
and (b) the loans of regional banks. Regional
banks are prepared to mark down their entire
LDC debt as their exposure to LDCs is generally
quite limited.
At the end of December 1986, such loans by
u.s. banks to Latin America, the Philippines,
and Africa amounted to approximately $43 bil-
lion, or 46 percent of the total debt owed to u.s.
banks by those areas. Of this amount, $29.4 bil-
lion were loans by the top 23 banks to the LqC
private sector and $13.5 billion were loans by
banks other than the top 23 banks. If such large
amounts of debt were placed too rapidly in the
swaps markets, the market value of LDC debt
would fall sharply unless ways were found to
increase the demand for such debt rapidly. In
fact, significant declines in market rates have
already occurred in 1987.
Debtors can raise the demand for LDC debt by
adopting economic policies that create an
attractive investment climate. Unfortunately,
LDC debtors may instead have an incentive to
adopt inappropriate economic policies (or to
adopt scare tactics, such as suspending debt ser-
vice) to drive down the value of their debt, and
then purchase the debt in the open market as a
means of retiring it.
Conclusions
While the conversion of large amounts of debt
into equity liabilities can significantly alleviate
the repayment burden of debtor countries, debt
swaps are no panacea. Capital inflows and the
arbitrage opportunities provided by the debt
swaps market may affect monetary control and
exchange rates in debtor countries. Furthermore,
only a strong demand for LDC debt can ensure
that debt swaps result in capital inflows to LDCs,
and prevent steep discounts in the swaps market
that could adversely affect international banking.
The demand for the debt of LDCs will ultimately
depend on whether investment in the economies
of LDCs is attractive. Thus, the development of
the debt swaps market does not eliminate the
need for appropriate economic policies on the
part of debtor countries.
Ramon Moreno
Opinionsexpressed in this newsletterdo notnecessarily reflect theviews ofthe managementofthe Federal Reserve Bank ofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmay beaddressedtotheeditor(GregoryTong) ortotheauthor....FreecopiesofFederal Reserve publications
can beobtainedfrom the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.uo~6u!ljsom ljo~n U060JO 0POI\0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
8/12/87
Chang.e
from
8/5/87
Change from 8/13/86
Dollar Percent!
Loans, Leases and Investments1 2 204,706 27 2,810 1.3
Loans and Leases1 6 181,339 - 73 - 2,227 - 1.2
Commercial and Industrial 50,975 - 46 225 0.5
Real estate 69,843 150 2,629 3.9
Loans to Individuals 36,899 - 85 - 4,037 - 9.8
Leases 5,448 32 - 59 - 1.0
U.S. Treasury and Agency Securities2 16,417 81 5,844 55.2
Other Securities2 6,951 20 - 807 - lOA
Total Deposits 206,430 - 1,530 - 202 0.0
Demand Deposits 51,788 - 1,402 39 0.0
Demand Deposits Adjusted3 36,514 283 - 11,476 - 23.9
OtherTransaction Balances4 19,924 - 312 3,022 17.8
Total Non-Transaction Balances6 134,718 184 - 3,263 - 2.3
MoneyMarket Deposit
Accounts-Total 44,427 - 50 - 2,427 - 5.1
Time Deposits in Amounts of
$100,000 or more 31,464 76 - 4,389 - 12.2
Other Liabilities for Borrowed MoneyS 23,824 636 - 1,473 - 5.8
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+l/Deficiency(-)
Borrowings
Netfree reserves (+l/Netborrowed(-)
Penod ended
8/10/87
32
12
19
Penod ended
7/27/87
61
21
40
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading account securities
3 Excludes U.S. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percentchange

LDC debt swaps

http://www.frbsf.org/publications/economics/letter/1987/el87-36.pdf

LDC debt swaps

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