COUNTRY RISK ASSESSMENT External Debt Crisis Investment

1
COUNTRY RISK ASSESSMENTExternal Debt
CrisisInvestment Opportunities-II-

• April 2008

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Various approaches to country risk assessment

• Qualitative analysis
• Quantitative approach rating and scoring
• Econometric approach and modelization
• Analytical approach crisis typology (Indosuez)
• Principal Component Analysis (CDC)
• Logit Analysis
• Non-linear conditional analysis (threshold levels
  breaking points)
  
• External debt analysis

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US banks cut lending to EMCs... while improving
capital ratios!
US billion
Tier 1 capital
US Banks loans to EMCs
BAKER PLAN
BRADY PLAN
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US Banks cross-border claims on EMCs end-2007

• Total US banks claims US189 billion
• O/w on India US28319 million
• O/w US foreign office claims on India US25162
• O/w claims on Indias banking sector US10097
• OW claims on Indias public sector US6785
• O/w Citibanks claims on India US17470 million
• O/w
• (1 of total assets or 20 of capital)

Source USFFIEC
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The Brady Plan Menu-based debt restructuring
workouts
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The 1989-2000 Brady Debt Reduction Plan

• Debtor countries
• Tough macroeconomic adjustment programs under the
  monitoring of the IMF/WB (SALs)
  
• Cofinance LT debt repayment guarantees with
  purchase of zero-coupon bonds
  
• London Club banks
• Provide deep discounts through interest or debt
  stock reduction
  
• Get accounting and regulatory incentives
• Shift to specific purpose financing and voluntary
  lending (2003-2007)

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The Brady Plan

• Objective defaulted sovereign London Club bank
  loans would be exchanged for collateralized,
  easily tradeable 30-year bonds, with bullet
  repayment
• London Club banks would grant some amount of debt
  relief to debtor nations, in some proportion of
  secondary market discounts.
  
• The new Brady bonds would be guaranteed by
  zero-coupon US Treasury bonds which the
  defaulting nation would purchase with financing
  support from the IMF/World Bank.

8
Brady Bonds

• Brady Bonds are named after former U.S. Treasury
  Secretary Nicholas Brady.
  
• Brady bonds have their principal guaranteed as
  well as x semi-annual interest payments, whose
  guarantee is rolled over.
  
• Bullet repayment is collateralized by 30-year
  zero coupon bonds, with a specific-purpose issue
  of the US Treasury, the Banque de France or the
  BIS.
• Cross-default clause

9
The Brady plan in action
Debt cancellation backed up by commercial banks
reserves for loan-losses with regulatory
incentives
35
65
SENIOR DEBT
New debt with long-term maturity,
principal collateralization, rolling interest
guarantee, and cross-default clause
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Brady Bonds
Default on interest payments would trigger
exercise of interest guarantee
and of principal collateral guarantee
Bullet Payment at maturity
Prime rate or LIBOR Spread of 13/16
ZCB
t20
t30
t10
t0
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How to assess and calculate the market value of a
collateralized Brady Bond?

• Brady bonds comprise defaulted London Club debt,
  repackaged and backed by 30-year US Treasury
  bonds as collateral, often including a rolling
  18-month interest guarantee.
• 1. Strip the bond by separating the risk from the
  no-risk elements (interest and principal)
  risk-free discount rate
  
• 2. Calculate the risk-adjusted NPV of the
  guaranteed and non-guaranteed streams of interest
  payments and the principal payment at maturity

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Brady Bonds

• In February 1990, Mexico became the first country
  to issue Bradys, converting 48.1 billion of its
  eligible foreign debt to commercial banks.
  
• US200 bn of Bradys from 18 countries in Asia,
  Africa, Eastern Europe and Latin America
  
• Mexico, Brazil, Venezuela Argentina accounteed
  for more than 2/3 of Brady Bonds issued.

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• Market-driven menu of options
• new money loans discounted buybacks exit
  bonds debt conversion debt restructuring
  bonds
  
• Official Support up to US 25 billion to
  support the Brady initiative from the IMF World
  Bank RDB OECD creditors

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Financial components of a Menu

• I. Buying back debt at a discount, either
  formally or informally, enables developing
  countries to reduce debt by exploiting the
  discount on commercial bank loans in the
  secondary market.
• The effectiveness of a buyback depends on how it
  is financed whether it be by a loan or donation
  and on its impact on the future debt servicing
  profile. For highly indebted countries, one aim
  of buying back debt is to enable small banks to
  exit before a restructuring plan.
• For low income countries with little debt, the
  purchase can be used to eliminate commercial bank
  debt in its entirety. However, the purchase of
  debt raises legal and legislative issues.
  Restructuring agreements require the legal waiver
  of restrictive clauses prohibiting buybacks or
  conversions.

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Financial components of a Menu

• II. Debt Exchange consists of converting old
  claims for more favorable instruments both for
  the creditor and the debtor country
  
• Brady bonds (discount bonds, par bonds, and
  FLIRBs)
  
• Debt/Equity conversion
• Debt restructuring with new coupon and longer
  term maturity
  
• (Pakistan, Russia, Ukraine in mid-1999)

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• Types of Brady Bond Instruments
• Par Bonds Maturity Registered 30 year bullet
  issued at par Coupon Fixed rate semi-annual
  below market coupon Guarantee Rolling interest
  guarantees from 12 to 18 months Principal is
  collaterallized by U.S. Treasury zero-coupon
  bonds
• Discount Bonds (DB) Maturity Registered 30 year
  bullet amortization issued at discount Coupon
  Floating rate semi-annual LIBOR Guarantee
  Rolling interest guarantees from 12 to 18 months.
  
• Front Loaded Interest Reduction Bonds (FLIRB)
  Maturity Bearer 15 to 20 year semi-annual bond.
  Bond has amortization feature in which a set
  proportion of bonds are redeemed semi-annually.
  Coupon LIBOR market rate until maturity.
  Guarantee Rolling interest guarantees generally
  of 12 months available only the first 5 or 6
  years.

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Brady Bonds

• Debt Conversion Bonds (DCB) Maturity Bearer
  bonds maturing between 15-20 years. Bonds issued
  at par. Coupon Amortizing semi-annual LIBOR
  market rate. Guarantee No collateral is provided
  
• New Money Bonds (NMB) Maturity Bearer bonds
  maturing 15-20 years. Coupon Amortizing
  semi-annual LIBOR. No collateral
  
• Past Due Interest (PDI) Maturity Bearer bonds
  maturing 10-20 years. Coupon Amortizing
  semi-annual LIBOR. No collateral
  
• Capitalization Bonds (C-Bonds) Issued in 1994 by
  Brazil in the Brady plan. Maturity Registered 20
  year amortizing bonds initially offered at par.
  Coupon Fixed below market coupon rate stepping
  up to 8 during the first 6 years and holding
  until maturity. Both capitalized interest and
  principal payments are made after a 10 year grace
  period.

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• Par, Discount and FLIRB bonds
• may have principal collateralization, usually 30
  year U.S. Treasury zero-coupon bonds, and/or
  rolling interest collateralization (usually 12-18
  months)
• may be excluded from further new money requests
  of the bond issuer in order to maintain the
  implicit seniority of the new debt
  
• may be eligible for debt-equity conversions in
  the developing country.
  
• bonds with recapture clause (Argentina, Nigeria,
  RCI) In some cases, the bonds carry rights to
  receive additional payments that are triggered by
  an increase in the price of the country's major
  exportable goods. The value recovery clause can
  be linked to the evolution of GDP, an index of
  terms of trade, or export receipts.

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The market-based menu of debt restructuring
instruments
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Brady Bonds

• Arg Par 48.000  50.000
• Arg FRB 41.000  42.000
• Arg '27 31.000  33.000
• Brz C 75.250  75.437
• Brz '27 72.750  73.000
• Bul IAB 85.000  85.500
• Mex Par 93.000  93.250
• Pol Par 75.250  76.250
• Rus '28 107.750  108.000
• Ven DCB 78.250  78.750
• Vie Par 44.000  45.000

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Market-based menu approach the importance of the
tax, accounting and regulatory framework

• In June of 1999, the BIS launched a revision of
  the capital adequacy guidelines, known as the
  1988 Cooke ratio. The BIS 12 banking
  comptrollers were to edict new regulations to be
  applied by 2002, in consultation with the EUs
  commission.
• The Cooke solvency ratio imposes an 8 proportion
  between risk-weighted assets and capital.
  
• There are four risk categories, between 0 (OECD
  countries, IFIs) and 100 (EMCs risk).
  
• In 1995, the BIS adopted a reformed Capital
  Adequacy ratio to account for investment and
  transaction financial instruments. The ratio also
  distinguishes between market risk and counterpart
  risks.

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Market-based menu approach the importance of the
tax, accounting and regulatory framework

• The Capital Adequacy ratio stipulates that
  various exposures to risk must be considered,
  including interest, counterpart, volatility,
  currency risks) and that capital requirements
  must be assessed by Value at Risk methods.
• Capital comprises two categories
• 1. Tier 1 capital, reserves, benefits, and
  FRBG
  
• 2. Tier 2 reevaluation reserves, guarantees,
  public subsidies, subordinated debts under
  specific conditions.
  
• The 2000 BIS reform aimed at adjusting the risk
  weighted assets to take into account (i) not the
  legal nature of risk but rather the underlying
  risk quality, (ii) risk mitigating tools
  (guarantees, collaterals) and (iii) risk ratings.

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International banks reserves against LDCs claims
in the mid-1990s
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Basles II regulatory guidelines

• Came in operation in 2007 the new guidelines
  force banks to allocate more capital against
  loans to countries (and companies) that are lower
  rated or not rated at all.
• In addition to credit and market risk, the
  operational risk capital charge rests on a basic
  indicator approach, a standardised approach and
  an advanced risk-sensitive measurement approach.
  This risk stems from inadequate or failed
  internal processes.

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Basles 2 Tax, accounting and regulatory framework

• Impact of new capital adequacy guidelines on EMCs
  capital market access?
  
• Negative impact on OECD countries with ratings AA- higher capital requirements (Mexico,
  Turkey, Korea) 100
  
• Non OECD countries with ratings capital backing
  
• Non OECD countries with ratings BB lower
  capital backing from 100 to 50 or even 20
  and 0 (Taiwan and Singapore)
  
• Growing risk of procyclicality of banks internal
  risk rating systems

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Tax, accounting and regulatory framework
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• Commercial banks which include general reserves
  in capital (France and the United States) might
  be reluctant to enter debt reduction schemes
  owing to the related upfront capital loss.
  Buybacks and discount bonds will probably meet
  strong opposition from the creditor banks. These
  banks will tend to prefer par bonds with
  temporary reduced interest rates in order to
  stretch the accounting loss in the income
  statement over the life of the loan.
• Commercial banks which must reserve against new
  money credits (e.g., France) face an additional
  cost compared to banks which have the discretion
  of increasing or maintaining reserves at existing
  levels. Finally, banks which benefit from very
  limited tax deduction on loan-loss reserves
  (e.g., in Japan) prefer selling discounted LDC
  claims in order to shrink their new money base
  and improve asset/capital ratios.

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The Secondary Market of Emerging Markets Debt
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The Secondary Market of Emerging Markets Debt

• The secondary market for commercial bank claims
  is the market where buyers and sellers trade
  sovereign debt. Since the late 1980s, the debt of
  many developing countries sells at below its face
  value on the secondary market, the discount
  reflecting the risk associated with holding such
  debt.
• An active secondary market in LDC debt began to
  emerge in 1983-84 in which banks traded their
  portfolios on an inter-bank loan swap basis in
  order to consolidate or diversify their claims or
  to take advantage of accounting and tax benefits.
  The market expanded significantly in 1987-88
  owing to the rise in reserves and a growing
  number of debt-equity conversion programs and
  portfolio rebalancing strategies.

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• Secondary market trading has been dominated by
  Latin American country debt, in particular debt
  from Brazil, Mexico, Argentina and Venezuela,
  accounting for close to 70 of volume. Many
  investors consider the Mexican par bond as a
  benchmark as it is one of the most liquid markets
  in the world after the US Treasury market,
  reportedly.
• Outside Latin America, the debt of Nigeria,
  Russia, Morocco, the Philippines, Bulgaria and
  Poland is traded in a market which is considered
  reasonably liquid. Privatization programs and
  conversion schemes which are active in several
  countries such as Argentina, Venezuela, and
  Brazil have stimulated trading of sovereign
  country debt.

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• Asset Trading Definition and purposes
• Asset trading is the exchange of claims on
  emerging market countries between creditors and
  investors, for book rebalancing purposes. The
  claims are mostly in the form of syndicated
  loans, promissory notes, bonds, restructured
  debt, etc., which are traded at a discount from
  their nominal value.
• The discount (i.e, 1 minus market price) is the
  key characteristic of the asset trading market.
  
• Holders of claims sell their assets for enhancing
  their liquidity, for restructuring their
  portfolio, for benefiting from upward pressure on
  prices.

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• How Does Asset Trading Work?
• Trading is typically conducted by specialists in
  commercial and investment banks, and in
  specialized institutions. Trades might be priced
  outside the available quoted price range.
  Occasionally, the market anticipates the
  possibility of debt restructuring negotiations or
  of government buybacks.
• Trading has often a speculative element.
  Moreover, buybacks can occur on a formal or an
  informal basis, i.e. outside the framework of
  officially sponsored debt reduction workouts.
• Often, they are also concluded by third parties
  working on behalf of the government, which are
  typically investment banks. The most active
  market makers in developing country debt are
• ING Bank, FH International, JP Morgan, Santander,
  Bankers Trust-Deutsche Bank, BNP/Paribas,
  SocGen., Citibank and Salomon Brothers.

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EMC debt traders

• Phase 1 (1980s) short-term speculation
• Phase 2 (1990s) highly active, short-term
  traders, and investors for debt swap
  transactions
  
• Phase 3 (2005-08) More stable buy-and-hold
  investors, life insurance companies, central
  banks, pension funds, retail investors, private
  investors

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The EMTA
EMTA was formed in 1990 by the financial
community in response to the many new trading
opportunities created by the Mexico and Venezuela
debt reschedulings under the Brady Plan
In an effort to develop market mechanisms to tra
de nearly U.S. 50 billion face amount of newly
issued debt securities, a small group of debt
traders from major international financial
institutions formed the LDC Debt Traders
Association (changed to the Emerging Markets
Traders Association in May 1992).
EMTA is the principal trade group for the Emerg
ing Markets trading and investment community and
is dedicated to promoting the orderly development
of fair, efficient and transparent trading
markets for Emerging Markets instruments and to
helping integrate the Emerging Markets into the
global capital markets. EMTA also provides a for
um that enables market participants to identify
issues of importance to the trading and
investment community. . .
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• Volume Increase and change in product structure
• Following an initial phase of bank portfolio
  re-balancing transactions, secondary market
  activities have diversified toward discounted
  debt repurchases, new money bond issues, and
  large-scale securitization. The overall size of
  the market rose to about US 225 billion at
  end-1991 --more than 25 times the trading volume
  in 1986. Volumes increased to US500 billion in
  1992 about US3000 billion in 1997, and to
  US6500 billion in 2007.
• Market growth has been concentrated in Brady
  bonds, i.e., LDC bank loans repackaged as loans
  with IFIs-financed enhancements and guarantees,
  until the late 1990s.
• Trading in Brady bonds rose sharply in 1993-94,
  representing about 61 of overall turnover. In
  1997, Brady bonds shared dropped to about 40 of
  total trading volume and to a mere 2 in 2007.

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Emerging Market Debt Trading 1989-2007 (US
billion)
Source EMTA-London
38
The evolving structure in the secondary debt
market
Source EMTA 2006
39
Trading Volume by instrument in 2007 turnover
Bradys transactions which accounted for 50 of
debt trading in the mid-1990s have shrunk due to
early redemption, exchange offers and debt
buybacks
2
10
21
66
40
Share of Securities in Total External Debt
41
Trading Volume by Region
12
69
42
Trading Volume by Country (EMTA)
21
17
6
7
9
4
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• Weak Liquidity
• Angola, Nicaragua, Cameroon, Albania, Congo,
  Tanzania, Zaire (Rep. Democr.), Zambia, Iraq,
  North Korea
  
• Limited Liquidity
• Algeria, Cuba, Egypt, Madagascar, Panama,
  Jamaica, Ivory Coast, Sénégal
  
• Moderate Liquidity
• Nigeria, Morocco, Costa Rica, Bulgaria, Peru,
  Jordan, Vietnam
  
• Good Liquidity
• Brady Bonds Argentina, Brazil, Russia, Ecuador,
  Mexico, Philippines, Poland, Venezuela. South
  Africa, Turkey
  

44
EMBI spread evolution 1997-2007
Average spread weighted by debt volume
Source CBONDS
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Argentinas and Russias shrinking spreads
1997-2007
ARGENTINA
Bond crisis
RUSSIA
Oil price surge
46
Secondary Market Price of RCI s London Club Debt
1986-2008
of face value
Debt servicing suspension
Weighted average LDC debt price
Soro-Gbagbo alliance
CFA devaluation
47
Secondary Market Prices of Cubas London Club Debt
(1990-2008- in percent of face value)
48
Hyper-exotic Debt prices end-2007

• Myanmar 20
• Cambodia 20
• Mongolia 28
• North Korea 28
• Cuba 14
• Albania 38
• Bosnia 50

• Irak Bonds 60
• Libya 65
• Syria 10
• Yemen 30
• Angola 60
• Ethiopia 10
• Senegal 15
• Sudan 13
• Uganda 15
• Zimbabwe 5

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Instrument Diversification

• The market has become more diverse in the variety
  of instruments available as well as the type of
  investors. For instance, the Venezuela Brady Plan
  included a complex menu of options, such as Debt
  Conversion Bonds (DCB) and Front-Loaded Interest
  Reduction Bonds (FLIRBs). The debt conversion
  bonds are bearer in form and as such they are
  more easily tradable and likely to be held by
  non-bank investors.
• The investor base has widened over the past
  years. One estimates that more than US10 billion
  face value of sovereign debt is held by
  institutional investors. In addition, the
  fast-growing market in developing country debt
  has expanded in terms of region and in terms of
  instruments. Thus, Salomon Brothers issued two
  tranches of warrants on Poland's debt for about
  US100 million in August of 1992. Chase,
  likewise, issued a US15 million two-year CD for
  a Venezuelan bank guaranteed by Brady bonds (par
  bonds and FLIRBs). The face value of the
  collateral is more than 200 of the value of the
  CDs.

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• Various debt funds have emerged.
• In December 1989, Banque de l'Union Européenne
  set up a Financial Investment Portfolio Company.
  The objective of the fund was to offer investors
  the opportunity to take advantage of the
  potential yields available on LDC debt.
• In October 1991, SG Warburg set up a Latin
  America Extra Yield Fund, which has been
  described as the first fund targeted exclusively
  at Latin American debt securities.
• In November of 1991, Citicorp Investment Bank
  launched an Argentine Debt Fund that invests at
  least 60 and up to 80 of its assets in
  Argentine debt.

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• ING Bank has also set up a similar LDC debt fund,
  the LFM Emerging Markets Capital Fund. It is an
  open-ended investment fund incorporated in
  Luxembourg.
• The fund initially focused on the major Latin
  America economies of Mexico, Argentina, Chile,
  Brazil and Venezuela. Some investments are being
  made in Hungary, the Philippines and in other
  regions when appropriate.
• The investor has a choice between capital growth
  and dividend distribution shares.
  
• FH International launched in July 1992 the First
  African Asset Fund Limited under the laws of
  Jersey. The fund is managed by FH Carlson
  Investment Management. It had a life of two
  years, with the possibility of one further
  one-year investment program.

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Institutional Developments

• The combination of Brady debt restructuring
  agreements and officially supported privatization
  programs has strengthened the secondary markets
  in the mid-1990s.
• New instruments have emerged such as new money
  bonds, exit bonds and interest reduction bonds.
  With the securitization of the LDC debt market,
  liquidity has improved. For example, Mexican and
  Venezuelan Brady bond transactions are processed
  through the Eurobond clearing institutions, and
  CEDEL.
• In addition the major credit rating agencies have
  formalized ratings of LDC debt such as giving
  ratings to Brady bonds, both the floating rate
  (discount bond) and the fixed-rate (par bond).

53
Price Trends

• Secondary market prices have kept fluctuating
  strongly over the last 20 years. The weighted
  average of prices dropped from 71 cents per US
  at end-1985 to about 35 cents per US in the
  beginning of 1991, reflecting deepening doubts
  regarding normalization of debtor-creditor
  relationships and further desire to reduce or
  eliminate country risk exposure.
• An accentuation in declining trend can be
  observed following the announcement of the March
  1989 Brady initiative. Secondary market prices,
  however, showed an upward trend since the year
  1991. The market price index averaged 55 during
  the the year 1997 despite the impact of the
  Mexican peso crisis. Average prices dropped
  sharply since mid-1998 and the overall emerging
  markets crisis.
• Gradual price increase over the period 2003-2007
  due to large global liquidity, IMF programs,
  large current account surpluses, FDI flows, and
  strong reserve assets.

54
Factor Affecting Prices

• 1. Interest rate volatility
• In 1993, the continuing decrease in US Treasury
  30-year bond rate has been a driving force behind
  the increase in fixed rate Brady par bonds. In
  late 1994, however, the upward trend in US
  Treasury bonds led to a decrease in Brady bond
  prices. In late 1998, the spill-over effect of
  the Asian and Russian crisis has severely hit the
  market with sharp drops in prices for all LDCs
  debts. In 2002-2004, the decline in US rates
  enhanced the value of fixed-rate discount bonds.
  
• 2. Macro-economic situation
• Factors such as reserves, balance of payments,
  privatization programs tend to affect price
  volatility. In addition, signing of an economic
  adjustment program with the IMF is also a
  positive factor behind price changes (Argentina
  in 2003). Likewise, a Paris Club rescheduling
  agreement is considered as a positive element
  towards a normalization of relationships with
  foreign creditors.

55

• 3. Rating by SP and Moody's
• A credit rating by credible international rating
  agencies is likely to lead investors to consider
  LDC debt as a meaningful investment opportunity
  SPs increase Argentine rating to B in 2006 and
  Moodys upgrading of Peru to investment grade in
  04/2008
• 4. Securitization
• The exchange of bank loans into long-term bonds
  with guarantees funded by international
  institutions enhances the quality of claims. In
  addition, Brady bonds can be traded on a fairly
  liquid market, thereby leading to the emergence
  of arbitrage opportunities as well as derivatives
  instruments.
• 5. Deal-driven transactions
• A debt-equity program will open the way for swap
  transactions adding liquidity to the market as
  well as investment opportunities in the domestic
  economy.

56
September-October 1999 The debt default of
Ecuador occupies the limelight

• Ecuador Brady bonds account for US6.1 billion
  in Ecuadors overall external indebtedness of
  US13 billion. The Brady bonds have been subject
  to a lot of financial engineering, including the
  stripping of the collateral out of the bonds.
• IMFs position Ecuador needs to find out some
  US500 million to cover its balance of payments
  shortfall until the end of next year, and about
  US1 billion to cover its budget shortfall, and
  probably more since Ecuador has foreign currency
  denominated domestic debt.... For the first time
  in 55 years, the IMF is acquiescing in a
  countrys decision to default on its debts to the
  international bond markets.

57
Mexico whittles down its Bradys

• September 2002 Mexico issues US1.75 billion
  with a 20-year global bond exchange with Brady
  par bons (JP Morgan Lead manager with CSFB)
  
• Mexico exchanged US1.3 billion for Bradys and
  raised US450 million in new money bonds. The
  exchange released US651 million in collateral
  and produced NPV savings of US59 million.
• January 2003 Mexico buys back US500 million of
  Bradys

58
COTE d IVOIRE-Debt Restructuring
59
COTE d IVOIRE-Debt Restructuring (end)
60
Market-Based debt exchange offers2000-2006

• Argentina (2001 2005)
• Mexico
• Brazil
• Venezuela
• Peru

61
Argentinas Bonds

• Total amount US94 billion 3/4 - denominated
• Dollar bonds are traded at default discounts
• All rating agencies have downgraded Argentinas
  bonds
  
• Fitch downgraded Argentinean government bonds to
  a high risk CC rating, in effect making them
  junk bonds
  
• Global Committee of Argentina Bondholders (55
  billion claims)
  
• 2005 Request 75 write off of bonds nominal
  value
  

62
Argentinas Bonds
63
Voluntary Debt Restructuring - Swaps

• May 2001 Argentina offered ? 30 bn debt swap
• in exchange for old securities it issues four NEW
  GLOBAL BONDS and a NEW PAGARE

64
Voluntary Debt Restructuring - Swaps

• Argentinas local banks, insurance companies and
  pension funds (that hold at least a third of
  Argentinas 95bn bonds) have already swapped
  more than 55bn in federal government debt for
  new obligations that carry lower interest rate
  over a longer period
• The operation has reduced Argentinas debt
  service cost by 3.5bn per year

65
Voluntary Debt Restructuring - Swaps

• Dec. 3 Argentina offered to swap another 60bn in
  locally owned bonds the new bonds are backed by
  futures tax revenues and will pay a maximum of
  7
• Argentina hoped that voluntary exchange of local
  debt will be followed by similar foreign debt
  exchange reduced pressure on its budget
  

66
Trading of Official Bilateral Debt

• During 1990, the Paris Club agreed on the
  principle of reducing debt through clauses
  stipulating the conversion of part of the
  obligations into local currency.
• The Paris Club does not set a limit for
  conversions applied to development aid. However,
  a limit of 10 is applied to officially
  guaranteed commercial loans (for example those
  covered by COFACE, ECGD and Hermes).
• Conversion is a voluntary option and should be
  ratified by each creditor government in Paris
  Club bilateral agreements.
  

67

• The French Treasury started auctioning
  developing countries' debts with US20 millions
  of claims on the Philippines in September of
  1992.
• The sales' objective is to fund viable and
  productive local projects in the tourism,
  infrastructure and industry sectors, with either
  French, foreign or local private investors.
• A few large debtor countries are excluded from
  the list Russia, Mexico, Brazil, Argentina and
  Venezuela. The Treasury followed with Tanzania
  in November of 1992, and with Honduras during the
  first quarter of 1993.

68

• The debt conversion operation for Tanzania was to
  be implemented by November 30, 1992. It involved
  FF 120 million of French government's claims.
  
• The offer has reportedly not met with much
  investor interest. Accordingly, the Treasury
  contemplates offering claims in a less formal
  framework thereby negotiating discrete sales on a
  case-by-case basis.
• In the case of Honduras, conversion involved
  about FF 55 million of claims by way of bids to
  COFACE with minimum offers of FF 5 million.

69

• In March of 1993, COFACE started auctioning
  about FF 550 million of claims on Egypt through
  the Treasury. Successful bidders were Egyptian
  investors reportedly.
• In November of 1993, the French Treasury and
  COFACE announced a further offer of FF1 billion
  of claims on Egypt.
  
• In April of 1994, COFACE auctioned off FF1.5
  billion of export credits. In September of 1994,
  Frances Credit National auctioned FF1.5 billion
  of official development debt.
• Such claims were consolidated in the agreement
  dated September 12, 1991. The banks acted on
  behalf of local investors for pre-authorized
  projects Potential investors were to be
  represented by a banking intermediary and must
  have obtained an investment permit from Egypt's
  authorities. Successful bidders paid about 47.2
  of face value with the Paris-based bank UBAF
  purchasing nearly FF700 millions of Egyptian
  claims reportedly. CCF and BNP purchased the
  remaining claims.

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• In September 1992, the United Kingdom export
  credit agency (ECGD) announced a fairly ambitious
  program of selling Paris Club debt.
  
• In a period of around six months, the ECGD was
  very successful with such sales, selling around
  100 million (face value) of debt. The debts
  concerned are those which have been rescheduled
  under certain Paris Club and related bilateral
  agreements.
• Although quoted in US dollars, both sterling and
  US dollar denominated debts are available in
  almost all cases. The ECGD will only sell debt
  if the price it will receive implies a higher
  level of income than the net present value of the
  expected recovery of the debt, within the
  framework of the Paris Club agreement and given
  the projections of the country studies department
  of the ECGD.

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• The demand for ECGD paper has come from banks
  (who wish to act as an intermediary), and
  increasingly from end-users. The latter option
  reportedly allows for greater speed and a
  somewhat higher prices for the ECGD.
• In January of 1993, ECGD auctioned off 48
  million of Egyptian Paris Club debt. The proposal
  did not include capitalized moratorium interest,
  which remains as debt within the bilateral
  arrangements.
• In March of 2000, the French government and
  Morocco signed an agreement of debt conversion.
  
• In July of 2000, Algeria and the Algerian
  government signed a debt swap scheme for the
  equivalent of some FF400 million. Algeria will
  have to set up a regulatory framework to
  implement the transactions within an adequate
  macroeconomic and legal framework.

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Part IIIDebt Conversion Transactions

• Debt conversion constitutes the transformation of
  the legal and financial nature of a country's
  liability from a hard currency debt into some
  form of a domestic currency obligation. In other
  words, a debt conversion is a prepayment of debt
  at a discount in local currency.
• The vehicle for such debt conversions is often
  the secondary market of commercial bank claims
  where bank and nonbank creditors can sell or swap
  their LDC assets, investors can obtain bank loans
  at a discount for subsequent conversion into
  domestic currency assets, and debtor countries
  can repurchase their own discounted debt.
• Altogether, cumulative debt conversion volumes
  have reached about US45 billion, with an annual
  peak of US10 billion in 1990, owing to
  large-scale debt-equity conversion programs in
  Argentina and Chile.

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Debt Conversion a positive sum game?
Face value 1000
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Positive Sum Game!

• Debtor debt cancellation with local currency
  payments while stimulating foreign direct
  investment and enhancing the role of private
  sector activity in the local economy
  (privatization)
• Creditor cleaning up of portfolio with upfront
  cash payment while accounting losses get absorbed
  by loan-loss reserves
  
• Investor access to local currency at a
  discounted exchange rate that boils down to an
  investment subsidy, thereby mitigating the
  overall country risk and the specific project risk

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Corporate debt swap transactions

• 04/2001 South Koreas largest builder HEC
  (Hyundai Engineering Constr.) makes a debt swap
  with its creditors to reduce debt ratios from
  1240 to 250, by issuing new shares and bonds
  to creditors as a part of the rescue package
  after Hyundai reported losses US2.2 billion
  that wiped out its equity capital!

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Source OSF
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EXCHANGE OF DEBT CANCELLATION

• There are various forms of local currency payouts
  in debt conversion transactions
  
• i) local currency for local cost component of
  investment or operating costs (salaries)
  
• ii) transfer of ownership of equity in a public
  company (privatization programs)
  
• iii) local currency and/or financial instruments
  to fund humanitarian or environmental projects
  
• iv) non-traditional exports or other domestic
  assets
  
• v) tax vouchers, customs duties, oil exploration
  bonuses...
  
• vi) monetary stabilization bonds

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• Enabling legislation What are the various
  parameters of a conversion regulatory program ?
  
• A key prerequisite in debt conversion and buyback
  transactions is the formulation of enabling
  legislation so as to waive various legal clauses
  which prohibit a debtor country from inequitable
  treatment of its debt obligations. In addition,
  restrictions on permissible assignees must be
  waived if creditor banks are to be able to sell
  debt to private investors. In particular,
  mandatory prepayment and "sharing" clauses in
  loan and refinancing agreements must be waived in
  order to open the door to debt conversion
  transactions.
• A second prerequisite is the formulation of a
  regulatory framework in the debtor country. One
  can distinguish a number of critical variables of
  a debt conversion program

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• 1. Amount and Pace of Conversion the Central
  Bank must monitor debt conversion owing to its
  potential impact on monetary and budget policy.
  The domestic monetary implications result from
  the release of local currency at the time
  external debt is redeemed. This may create
  inflationary pressure, hence an impact on the
  IMF's performance criteria. When the monetary
  effect is mitigated by the issue of
  local-currency bonds, the creation of additional
  domestic debt affects credit and budget policy.
  Sound macro-economic policy is thus a
  prerequisite for any lasting debt conversion
  program.
• 2. Exchange rate (official or market rate)
  applicable for debt conversion. The exchange rate
  determined for the conversion has a direct impact
  on the actual discount that is obtained by the
  investor. The gap between the official and
  parallel market rates could be so large that it
  wipes out the discount the investor obtained in
  the secondary market transaction, thereby
  eliminating the implicit "subsidy" inherent in
  the conversion.

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• 3. The eligibility criteria applicable to the
  type of debt The Central Bank has the following
  range of choices regarding the origin of the
  debtor's or guarantor's liabilities to be used
  for conversion
• i) public sector external debt
• ii) external debt of national government
• iii) external debt guaranteed by a public sector
  entity
  
• iv) private sector external debt with or without
  a public sector guarantee
  
• v) original claims or secondary market debt
• 4. Legal nature of debt Short term/Long-term,
  promissory notes, trade and suppliers credits,
  bank loans, official bilateral debt...

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• 5. Quotas or ceiling on the annual (or quarterly)
  amount of debt to be swapped. The quota is to be
  determined in close relation the macro-economic
  policy objectives. Annual ceilings have been
  implemented in Tanzania, Argentina, Chile,
  Ecuador, the Philippines, and Mexico.
• 6. Redemption rate Debt conversion boils down to
  discounted repurchase. The redemption fee
  represents a "second" internal discount. It helps
  the central bank "capturing" a portion of the
  discount, thereby sharing with the investor the
  benefit of the transaction. Indeed, by purchasing
  the debt directly in the market, the country
  could take the full market discount for itself
  instead of the redemption fee only, and in the
  process avoid problems of creating a preferential
  exchange rate. In an auction based situation, the
  redemption rate is determined by a market-based
  system potential investors bid by offering
  competitive discounts from the face value of the
  debt. The relationship between the discount rate
  and the redemption rate gives rise to the
  investor's pay-out ratio.

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• 7. Fees taken by the local authorities and/or by
  the local intermediaries for the right to
  participate in a conversion.
  
• 8. Degree of transparency in the program The
  issue of transparency (the disclosure of
  complete information) is important from the
  investor's standpoint, since the regulatory
  framework is officially defined and applicable to
  all investors.
• 9. Specified parties eligible for use of the debt
  conversion mechanisms for instance, allowing the
  local nationals/residents to take part in the
  program (allowing residents to bid for local
  currency can be a way of encouraging capital
  flight repatriation).
• 10. Procedure to be employed in assigning the
  right to convert debt the procedure can be
  quarterly ceilings of local currency, regular
  auctions of local-currency assets, case-by-case
  allocation with regard to sectoral priorities...

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• 11. The form of the conversion proceeds Very
  few programs provide for an upfront cash, due to
  monetary implications. In most cases LDC
  governments create some sort of deposit account
  or alternative local currency denominated term
  debt. The Central Bank might also provide
  protection to the investors against inflation
  and/or currency depreciation. If conversion leads
  to the issue of local-currency assets, two ways
  are possible the investor can gradually redeem
  the "stabilization bonds" in local currency for
  investing the proceeds, or the investor has only
  access to the interest payment flow on the bond.
  This latter case is often use for NGOs involved
  in debt-for-nature swap.

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• 12. Eligibility of local currency investment (or
  Additionality) Debt equity conversion could be
  used as a vehicle for mobilizing new foreign
  investment in priority sectors of the economy and
  for stimulating privatization. The program could
  also be designed (with appropriate restrictions
  on the sector eligibility) to promote export
  generation and import substitution. One of the
  objectives of the government is to prevent "round
  tripping", that is, access to local currency
  through the use of discounted bank claims without
  investing at home the local currency proceeds.
• 13. Requirement of "matching funds" Most LDC
  governments prefer not to allow debt conversion
  proceeds to be used for any imported inputs.
  Hence, there is an implicit requirement of new
  money to cover imports. In the case of Argentina,
  debt conversion coupled with privatization
  required a combination of debt and new money.

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• 14. The schedule of capital and dividend
  remittance Restrictions on capital repatriation
  and profit remittance vary widely across
  different programs. The repatriation guidelines
  are generally not on terms more flexible than
  those of the underlying debt.
• 15. Restriction (if any) on the percentage of
  shares held in a company through debt equity
  conversion In general, investors must agree
  with the broader framework of the foreign
  investment legislation of the host country.