Debt Equity Swaps

CONVERSION OF DEBT into equity has figured prominently in “menus” of financial options for dealing with debt problems and is the subject of a growing body of literature. This paper provides a general overview of the development of debt-equity swaps and the manner in which such swaps affect commercial banks, investing companies, and debtor countries.

The regulations governing how countries permit the swap of their commercial bank debt for equity in particular economic sectors differ from country to country; even within individual countries, conditions applied to such transactions can vary according to why the swap is undertaken, monetary policy considerations, and other factors. Most debt-equity swaps conform, however, to the following basic pattern. First, a bank sells at a discount an outstanding loan made to a public sector agency—or sometimes to a private sector enterprise—in an indebted country that is experiencing difficulty in adhering to an agreed repayment schedule. Second, an investor, most often a multinational manufacturing company, buys the loan paper at a discount and presents it to the central bank of the indebted country, which redeems all or most of the face value of the loan in domestic currency at the prevailing market exchange rate. Third, the investor acquires equity using this domestic currency, which it has in effect purchased on terms more favorable than can be obtained through regular foreign exchange market transactions. This paper focuses primarily on this type of debt-equity swap.

The growth in the volume of debt-equity swaps in recent years derives not only from increasing recognition in debtor countries that foreign investment can contribute to economic growth, but also from the development of a flourishing secondary market in country debt obligations among the international banks and from the current global trend toward the securitization of debt. Moreover, the growth in debt-equity swaps can also be attributed to benefits that such transactions offer the participating parties. The international bank that sells an outstanding loan at a loss, reflecting the difference between its face value and its value in the secondary debt market, can realize the cash value of a problematic asset, liquidate any reserves set aside to cover possible losses on the loan, and employ these resources more profitably in other investments. The indebted country is able to reduce its interest payments and shift the risk of servicing the claim to the foreign investor; moreover, depending on the buyer of the debt, the conversion of debt to equity may provide a mechanism for the repatriation of flight capital and encourage domestic investment. Finally, the investing company is able to acquire investment capital on more favorable terms than those available through direct exchange market purchases of domestic currency.

Although advantages may be realized by participants in the debt-equity swap, potential difficulties and costs may obtain. For example, for banks the sale of outstanding loans at a discount may require provisioning and ultimately the writing down in value of other assets, which in turn may give rise to a number of regulatory and accounting problems. For investing companies, debt-equity swaps can be subject to more onerous conditions governing capital repatriation and profit remittances than is regular direct investment. For the debtor countries, debt-equity swaps can have adverse budgetary and monetary consequences and may be regarded as infringements on national economic sovereignty.

These advantages and disadvantages of debt-equity swaps are addressed in more detail in the body of the paper. The first section identifies the countries that have participated in debt-equity swaps and describes the main features of their policies; it then gives some indication of the present volume of such swaps and discusses possible trends. Section II identifies the types of banks that are most involved in debt-equity swaps and describes the workings of the secondary market in debt. Section III analyzes the possible advantages and disadvantages for international companies using debt-equity swaps. Section IV analyzes how debt-equity swaps are treated in the balance of payments accounts of indebted countries and discusses possible effects in these countries on the money supply, the foreign exchange rate, and economic growth. Section V provides some concluding remarks.

I. Overview

The present debt-equity swaps market emerged with the onset of the debt crisis in the summer of 1982, although several isolated instances of such swaps had been recorded earlier. For example, in Brazil since 1962, certain nonresidents had been allowed to convert external debt into equity investments at face value and at the official exchange rate. In Turkey, in 1980 the authorities enacted legislation dealing with the settlement of some $1.4 billion of foreign arrears claims and providing for creditors to be paid either in foreign exchange over ten years or in local currency on demand. The local currency could be used for a wide variety of purposes, including the purchase of equity. Soon after the enactment of this legislation a certain amount of trading in Turkish debt began, with debt paper being sold at a discount from its face value.¹

The first debt-equity swaps after the emergence of the debt crisis took place in Brazil in 1983. As part of a major rescheduling package agreed that year, private sector borrowers were required to deposit with the Central Bank of Brazil the cruzeiro equivalent of their foreign currency borrowings when those borrowings became due for repayment. Some creditors decided to relend this money in Brazil and some decided to use it for the purchase of equity. Several creditors, however, decided to sell their loans, and thus the right to use the corresponding cruzeiro deposits, to a multinational corporation or similar institution planning to invest in Brazil. In this manner the first of the post-debt crisis debt-equity swaps was introduced.

The Central Bank of Brazil imposed conditions on debt-equity transactions designed to prevent repatriation of capital before the scheduled date for the repayment of the loan and to ensure, in the interim, there would be no repatriation of profits from the venture that would exceed interest payments on the original loan.² In the summer of 1984, the Brazilian authorities became concerned that the scheme might discourage the inflow of new money from direct investors and so restricted authorizations for debt-equity swaps to the original creditors. From 1983 to mid-1987, almost $2 billion worth of Brazil’s external debt was converted into equity. In February 1988, the authorities introduced a new debt-equity swap scheme intended to increase the volume of transactions. During the first three months of its operation, external debt was reduced by over $500 million.

Toward the end of 1984, Argentina also began debt-equity swaps. The Argentine scheme was related to a rescheduling package, but took a different form. The Argentine authorities issued promissory notes (BONODS) for debt covered by the package and then permitted the conversion of these notes to equity on a case-by-case basis. This scheme provided the only mechanism by which creditors provided with an exchange rate guarantee could realize immediately the capital gain that was associated with this guarantee. This particular debt-equity swap arrangement was discontinued before the end of 1985 after about $500 million worth of debt had been converted. According to banking sources, the scheme was terminated because of concern, as in Brazil, that the investment associated with debt-equity swaps would substitute for inflows that would have taken place in any event, and that such swaps would lead to increased credit expansion. In June 1987, the Argentine authorities introduced a new scheme that allowed debt-equity swaps as long as the face value of the swapped debt was matched by the investment of an identical amount of “new” money. The limited demand for debt-equity swaps in Argentina during the ensuing months seemed to provide evidence that this provision was reducing the scheme’s attractiveness. Several changes in the debt-equity scheme were made in the series of economic reforms announced in October 1987, including an increase in the 50/50 ratio of debt to new money to a 70/30 ratio, and a modification to permit the new money requirement to be met by local as well as foreign currency. Following these reforms some debt-equity swaps were agreed and by October 1988 some $325 million of debt had been converted at an average discount of 50.6 percent.

In May 1985, Chile introduced a more comprehensive scheme than those then operated by Brazil and Argentina.³ The scheme provided for debt-equity conversion through the use of mechanisms designed to avoid any expansion of the monetary base. The provisions were set out in Chapters 18 and 19 of the Compendium of Rules on International Exchange issued by the Chilean Central Bank. Under the provisions of Chapter 18, the Central Bank holds a monthly auction at which local banks bid for the right to engage in transactions to convert a specific limited amount of foreign debt into domestic currency. The banks act as agents by assisting the holders of the foreign debt to convert it, with the consent of the local debtor, into cash or a peso-denominated asset, which can be resold. These provisions were the first to permit a country’s own residents to exchange foreign debt obligations purchased at a discount for domestic currency or instruments denominated in domestic currency. The proceeds of the conversion may be used to repay debts to local financial institutions, acquire assets of those institutions, or be held as an investment. Under certain conditions, the proceeds may be used to acquire equity in local firms without going through the auction process. Thus, these regulations effectively permit the repatriation of capital sent out of the country as part of the capital flight of earlier years. On the one hand, Chapter 18 does not require that the domestic currency obtained be used for specific types of investment; on the other, it does not provide for transfer abroad of capital or dividends.

The provisions of Chapter 19 allow nonresidents to convert into equity certain external debt claims, which can be purchased on the secondary market without going through the auction mechanism. The domestic currency obtained must be used for approved investments, however, and repatriation of capital or dividends is subject to a number of conditions. The Central Bank considers each application on a case-by-case basis and during 1988 began to insist that each conversion be accompanied by at least a small amount of new money.

In September 1987, Chile’s Central Bank announced an extension of the country’s debt-for-equity scheme to allow the formation of foreign investment societies, whose funds—obtained through the purchase of discounted debt—could be invested in a range of Chilean shares and financial instruments. The investment societies will be required to maintain 60 percent of their portfolios in shares, while the remainder can be invested in local bonds and other financial instruments. No society will be allowed to take a majority holding in any company.

In 1986, Mexico, the Philippines, and Ecuador introduced arrangements for making debt-equity swaps. Under the Mexican arrangement, until its suspension in November 1987, the Bank of Mexico was empowered to redeem foreign currency public-sector debt at a discount related to the perceived utility to the economy of the proposed investment of the proceeds of the swap. The Bank of Mexico would offer to purchase Mexican debt paper at face value when the domestic currency was to be used to acquire state-owned firms; at 95 percent of face value when it was to be used for investment that would create new employment and introduce new technology in a firm that exported 80 percent or more of its production; and at other fractions of the face value down to 75 percent. The scheme was suspended in November 1987, as the authorities became concerned at the possible inflationary consequences of debt-equity swaps and at the possibility that such swaps were effectively subsidizing investments that would have been made without this added incentive.

In the Philippines, the authorities introduced in August 1986 a program for debt-equity swaps intended to provide incentives for investment in designated priority sectors, to reverse capital flight, and to reduce the burden of external debt. As amended in October 1987, the program provides for the exchange of specified types of debt paper for domestic currency at face value with a conversion fee amounting to 0.0 percent to 20.0 percent for investment in certain preferred sectors and to 0.0 percent to 24.0 percent for investment in less preferred sectors. The amount of the fee is determined by the amount of “fresh money” accompanying the investment. For example, in the preferred sectors an investment financed entirely by debt-equity conversion would incur a conversion fee equivalent to 20 percent of the face value of the debt, whereas no conversion fee would be charged where the amount of debt to be converted is matched by the same amount of “fresh money.” (There are four intermediate points between these two extremes.) Investors are free to choose their own combination of conversion fee and fresh money, with their choice influenced by the magnitude of the discount in the secondary market. Since fees cannot be funded from the peso proceeds of the converted debt, every conversion will involve some fresh money unless the investor can borrow from the Philippine banking system or has access to other peso funds. The conversion fee and fresh money requirement ensure that the Philippine authorities obtain some benefit from the secondary market discount on the country’s external bank debt. Gradual capital repatriation is allowed after three years for investments in the most preferred sectors and after five years for those in the less preferred sectors. Dividend payments abroad can be made out of profits realized from the outset in the most preferred sectors and after four years in the less preferred.

In determining whether to approve proposals, the authorities wish to ensure that the swap will increase foreign resources available to the economy rather than merely providing a means for converting at a more beneficial rate to the investor those funds already intended for investment in the Philippines. In general, therefore, approval is not given for the purchase of claims of current stockholders on existing assets, or for increasing working capital or paying off the obligations of existing firms. However, an exception to this rule is made for the purchase of non-performing assets of government financial institutions, which are being disposed of by the Asset Privatization Trust. Attention is also paid to the monetary impact of the debt-equity swap, particularly with regard to the conversion of Central Bank debt instruments.

In February 1988, the authorities introduced a number of further changes to the debt-equity conversion program. An indicative limit for the conversion of Central Bank paper was set to contain the expansionary monetary impact of debt-equity swaps. No limitation was placed on the conversion of private corporate debt since the redemption of this debt does not involve additional credit creation. Fees for the conversion of private debt were also waived since, in practice, the purpose of the fees—capturing part of the discount on the debt—could be achieved by the debtor in negotiations over the terms of the swap agreement. The authorities also announced that they would be guided, in their decision to approve debt-equity swaps, by the extent to which the investments that would be financed met the following criteria: (i) at least 80 percent of production is for exports; (ii) a new export product is involved; (iii) the export product is not subject to foreign quotas; (iv) employment is generated; (v) the productive process involved is labor intensive; and (vi) location is in the regions that are not heavily industrialized.

In Ecuador, the authorities announced their intention to introduce debt-equity swaps in November 1986 and issued regulations in February 1987, which essentially specified that all applications under the scheme would be handled on a case-by-case basis. By August 1987, however, the scheme had been suspended because a significant proportion of the operations originated from domestic residents which, in the authorities’ view, tended to put excessive pressure on the exchange rate. In practice, debt-equity swaps continued to be made at the discretion of the authorities until August 1988.

In April 1987, the Venezuelan authorities issued a number of rules covering the conversion of public external debt into foreign direct investment. Essentially, conversion can be authorized if the proceeds are invested in import-substituting or export-oriented industries or in industries in one of 11 designated priority sectors. The proceeds can also be used to invest in enterprises in danger of being closed down. The rules limit profit remittances to a maximum of 10 percent of the converted debt during the first three years and to 20 percent plus LIBOR thereafter. No capital repatriation from converted equity is allowed during the first five years; afterwards, repatriation can be made in eight equal yearly installments.

Colombia, Costa Rica, Dominican Republic, Jamaica, Morocco, Nigeria, Peru, and Uruguay are also introducing or are contemplating the introduction of debt-equity swap schemes.⁴

Although details differ from country to country, the arrangements for debt-equity swaps in these countries have a number of common features. Most arrangements provide some opportunity for the debtor country to share part of the discount on the debt, either through auction proceeds or through redemption charges; most give some direction with regard to the sectors of the economy from which equity can be purchased; and most place some restrictions on the volume and frequency of payments that can be made abroad in the form of dividends or repatriated capital.

Can a country’s propensity to engage in debt-equity swaps be correlated with its market capitalization, its volume of direct and portfolio investments, and its outstanding debt? Excluding Chile from Table 1 and looking at absolute values, it would appear that there might be a positive correlation between the amount of debt converted and each of these indicators. In normalizing these figures in terms of GNP these correlations disappear, however. This would tend to confirm the view of the banking community in the industrial countries that a commitment to debt-equity swaps depends not so much on economic and financial considerations as on the political climate in the country concerned.

Table 1.

Selected Indicators for Countries Engaged in Debt-Equity Swaps

(In billions of U.S. dollars and in percent¹)

¹Percentage value in relation to 1985 GNP in U.S. dollars.

²Estimates from various sources.

³Source: International Finance Corporation.

⁴Source: International Monetary Fund, Balance of Payments Statistics, Volume 37, Yearbook, Part 1, 1986.

⁵Estimates from U.S. Federal Financial Institution Council and Bank for International Settlements, quoted by Cline (1987).