LDC DEBT PROBLEM: POTENTIAL FOR NEW FINANCIAL MECHANISMS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP88T00706R000400280002-9
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 30
• Document Creation Date: December 22, 2016
• Document Release Date: December 5, 2011
• Sequence Number: 2
• Publication Date: August 1, 1987
• Content Type: REPORT

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Directorate of
Intelligence
LDC Debt Problem:
Potential for New
Financial Mechanisms
A Research Paper
Secret
Secret
GI 87-10061
August 1987
404
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Directorate of Secret
Intelligence
LDC Debt Problem:
Potential for New
Financial Mechanisms
A Research Paper
Division, OGI
and may be directed to the Chief, Economic
This paper was prepared by~ Office of
Global Issues. Comments and queries are welcome
Secret
GI 87-10061
August 1987
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LDC Debt Problem:
Potential for New
Financial Mechanisms
Scope Note As part of the ongoing OGI effort to monitor the broader political and eco-
nomic strains created by the LDC debt problem, this Research Paper
examines the potential impact of new financial mechanisms being suggest-
ed to ease those strains. In particular, it identifies and assess the various fi-
nancing options open to debtor countries and how these options might
affect them. Our evaluation of the potential role of the new mechanisms is
intended to help the reader assess the degree of flexibility available to
debtors and creditors in current and future debt negotiations
Secret
GI 87-10061
August 1987
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LDC Debt Problem:
Potential for New
Financial Mechanisms
Summary The growing variety of new financial mechanisms coming onto the LDC
Information available debt scene appear capable of making only marginal inroads against the
as of 31 May 1987 LDC debt problem. Although a number of mechanisms are capable of
was used in this report.
providing relief to debtors, they run up against important constraints on
their implementation or widespread use:
? Interest-delaying mechanisms-such as interest capitalization and caps
on debt service-probably would entail substantial losses for banks in
several countries, including the United States, without significant
changes in bank regulations or accounting standards. Such changes do
not appear to be immediately forthcoming.
? Secondary market mechanisms-such as debt-for-equity swaps-are
handling only small amounts of obligations compared with the overhang
of debt that stands between the LDCs and creditworthiness.
? Outright forgiveness of some debts would also entail substantial losses
for creditors, making them even more reluctant to extend new credit to
the debtors.
? Concessionary mechanisms, including interest capitalization, carry the
risk of spillover to other debtors. If relief is granted to one country, others
are certain to insist on similar treatment and, failing to receive it, might
act unilaterally to curtail payments.
? All the mechanisms share the characteristic of shifting some of the
burden of the debt, or at least its risk, from debtors to creditors.
At the same time, mechanisms to stimulate fresh lending to the LDCs
appear stalemated by creditors' continuing concerns about LDC repayment
prospects, on the one hand, and by developed country governments'
reluctance to protect private creditors on the other hand. Existing World
Bank programs to guarantee commercial bank loans, for example, are
judged by many private bankers as inadequate to motivate significant new
commercial lending to LDCs.
Within their limited role, we believe some new mechanisms will be more
important than others. The issue of interest-delaying mechanisms, in
particular, is likely to come to the fore over the next 12 months as debtors
continue to focus on interest relief. Use of marketable interest bonds, such
as those recently implemented by the Philippines, also may expand.
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Secondary market mechanisms probably also will be increasingly adopted
by both creditors and debtors in coming months, especially in view of
recent moves by key international banks to increase sharply loan-loss
reserves and position themselves to sell off bad loans or convert them to eq-
uity investments. Exit bonds-which allow banks unwilling to provide fresh
loans for a debtor to withdraw after paying a financial penalty-may
become a common feature of debt rescheduling deals for the LDCs,
streamlining future debt negotiations somewhat. Packaging of new or
existing LDC debts into marketable securities probably also will gain
increasing attention, but will remain confined to only a handful of the most
creditworthy debtors.
Nevertheless, we expect that new mechanisms this year will remove only
about $5 billion of the more than $800 billion LDC debts outstanding,
reduce LDCs' $115 billion debt service bill by roughly $2 billion, and
channel about $3 billion of new funds to the debtors. Debt-for-equity
swaps, for example-the biggest and potentially most promising mecha-
nism-probably will have canceled only about $10 billion of debts between
1982 and the end of this year. By comparison, we calculate that new
mechanisms would need to effect a debt reduction of roughly $100-200
billion to bring the 10 major Latin debtors alone within desired cre-
ditworthiness levels. Even as these results improve somewhat in 1988 and
1989, as appears likely, we can see only about $15 billion in debt relief be-
ing generated by new mechanisms over that time.
For the LDCs as a group, therefore, we see little prospect that new
mechanisms will significantly improve the LDC debt problem over the next
two years, and we believe the debt situation will continue to be marked by
a lurching from crisis to crisis. The relatively slow pace at which new
mechanisms are being applied indicates it will be years before they remove
the debt overhang. While a few countries will achieve modest debt relief
through new mechanisms, most will continue to have problems servicing
their debts. LDC debt negotiations will remain contentious, and talks
might even be further complicated by new mechanisms as debtors and
creditors haggle over their implementation.
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Options Under Consideration: A General Look
4
Debt Relief Options
New Financing Incentives
4
Interest Delaying Mechanisms
11
Interest Capitalization
11
Debt Service Contingencies
12
Debt-for-Equity Swaps
15
Interest-for-Equity Swaps
17
Debt Buyback
18
Securitization of Existing Debt
18
Forgiveness
21
New Financing Incentives
23
Cofinancing
24
Factoring Company
25
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LDC Debt Problem:
Potential for New
Financial Mechanisms
At the April 1987 meeting of the International Mone-
tary Fund Interim Committee, Treasury Secretary
Baker encouraged new and creative ways of providing
debt relief and new financing to Third World debtors.
Commercial creditors were called upon to develop a
menu of alternative financial options from which all
banks could choose in supporting the LDCs. This
Research Paper examines a number of new approach-
es that might appear on such a menu in coming
months and evaluates how they would affect both
debtors and creditors.
European creditors, for example, already have sug-
gested a preference for interest capitalization rather
than extend new loans to debtors, against which they
are required to set aside additional reserves.
Several key US bank creditors now also have greater
flexibility to implement new mechanisms because of
recent large additions to loan-loss reserves. In addi-
tion, Japanese creditor banks, if they follow through
on their plans to transfer some troubled LDC loans off
their own balance sheets and onto that of a new shell
company, will be better able to use new debt relief
With the LDC debt problem now well into its fifth
year, pressures are growing for greater modification
of the current debt management strategy. Even with
the widespread use of a variety of debt relief mea-
sures, such as lower interest rate spreads; longer
repayment periods; and multiyear debt reschedulings,
and increasing use of incentives for new financing,
such as marketable LDC debt instruments and some
limited multilateral guarantees, pressures continue to
build for even more relief. Debtors, tired of economic
adjustment but not appreciably closer, in their view,
to manageable debt service levels, are interested in
new approaches to reducing interest payments on
their debts, particularly since they have already de-
ferred most principal repayments to the future
through rescheduling.
Creditors, for their part, remain divided between
those who are able to use-and are pushing for-new
financial mechanisms, and those who essentially re-
main captives of the current debt management strate-
gy. Bank creditors with fewer LDC loans, stronger
loan-loss reserves, or more liberal regulatory require-
ments and accounting standards are in a position to be
the most flexible in considering new mechanisms, and
these creditors already are taking the lead in propos-
ing and implementing them. Some well-reserved West
approaches.
In this environment, an increasing number of players
are moving toward new, so far untried, debt relief
mechanisms:
? Mexico's latest financial package, agreed to in
1986, contains several innovative and important new
concessions, including IMF economic targets ad-
justable in case of oil price declines or sluggish
economic growth, and guarantees of extra new
lending if oil prices drop sharply.
? The Philippines and its bankers recently agreed that
some interest may be paid to banks in the form of
Philippine Investment Notes (PINS)-a form of
interest-for-equity swap in which banks would be
issued bonds redeemable in pesos for investment in
the Philippines. Brazil is also considering trying to
reduce its interest payments through such interest-
for-equity swaps.
? Argentina and its bankers have agreed on the use of
exit bonds, which allow small banks unwilling to
participate in new money packages to withdraw as
creditors after paying a financial penalty. Exit
bonds also appear likely for Costa Rica.
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Secret
Table 1
New Financial Mechanisms and the Debt Problem
Interest
capitalization
Philippines (via interest-
for-equity swaps)
Debt service
contingencies
Debt-for-equity
swaps
In effect for Peru, Zam-
bia; imposed then re-
scinded by Nigeria; con-
sidered by Zaire and
Ecuador
Argentina, Bolivia, Bra-
zil, Chile, Costa Rica,
Dominican Republic,
Ecuador, Honduras,
Mexico, Philippines, and
Venezuela
Interest-for-equity Philippines
swaps
Bolivia; under consider-
ation by Costa Rica
Estimated Volume of
Activity, 1983-87
(million US $)
Pros
60
? Reduces debtor's cur-
rent interest payments:
cash flow relief
? Stabilizes debt service
at known level
? Payment delay should
put debtor in better
position to make fu-
ture payments
? Preserves value of loan
to creditors
? For banks, deferred in-
terest unlikely to be
accruable unless guar-
anteed or specified in
original loan terms
? Potential significant
damage to banks if
broadly applied
? Moves closer to view
that interest may be
left unpaid entirely
? Spillover effects on
other debtors
NEGL
? Makes debt service
more commensurate
with ability to pay
? Cash flow relief for
debtor
? Attractive to debtors
receiving no new loans
in any case
? Same accounting
problems for creditors
as interest capitaliza-
tion because most
debtors paying only
interest
? Moves away from vol-
untary lending
10,000
? Reduces external debt
and related debt
service
? Accelerates foreign
investment
? Banks gain freedom
from reschedulings,
new money
? Investors discouraged
by LDC investment re-
strictions and tight
swap regulations
? Few good investment
opportunities
? Can fuel inflation in
debtor country
? Politically sensitive for
debtor
? Reduces external debt
and related debt
services
? Accelerates foreign
investment
? Few good investment
opportunities
? Could fuel inflation in
debtor country
? Uncertain if creditors
can accrue deferred
interest
As much as 670
? Reduces external debt
and related debt ser-
vice for fraction of full
value
? Organized recognition
that LDC debts not
worth full value could
spill over to other
debtors
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Table I (continued)
Securitization of
existing debt
Estimated Volume of Pros
Activity, 1983-87
(million US $)
? Spreads LDC loan risk
to nonbank creditors
? Low investor interest
? No reduction of debt
service unless debtors
buy their own debts
Argentina and Costa
Rica
? Direct reduction of
debtor debt service
obligations
? Streamlines debt talks
by facilitating removal
of reluctant creditors
? Further damages LDC
credit reputation
? Erodes lending base
for new-money loans
? Income loss for
creditors
? Cash flow relief; mod-
est increases in eco-
nomic growth
? Reduces bank earn-
ings; also capital loss
equal to amount of for-
giveness-grave dam-
age to banks if broadly
applied
? Moves away from vol-
untary lending
Principal
forgiveness
? Greater benefits for
debtor than interest
forgiveness
? Greater costs for cred-
itors than interest
forgiveness
Securitization of
new debt
Algeria, India, Indone-
sia, Malaysia, Panama,
Singapore, and South
Korea
5,000
? Credit risk channeled
to creditors willing to
accept it
? Lower cost, more flexi-
bility for debtors
? Creditworthinesss cri-
teria even higher than
for standard loans
? Low investor interest
Brazil, Chile, Colombia,
Hungary, Ivory Coast,
Thailand, and Turkey
2,200
? Dilutes banks' risk, at-
tracts more funds
? More lenient terms for
debtors
? Reluctant banks be-
lieve protection does
not go far enough
Guarantees and
insurance
? Dilutes banks' risk, at-
tracts more funds
? Requires substantial
startup funds or capi-
tal increases for multi-
lateral institutions
? Vulnerable to criticism
as taxpayer bailout of
private corporations
Factoring company
Japan; under consider-
ation by South Korea
580
? Improves creditor
banks' capital
adequacy
? Could free up funds
for new lending to
debtors
? Possible tax advan-
tages for creditor
banks
? Government involve-
ment and regulatory
changes probably re-
quired in most
countries
? No direct relief of obli-
gations for debtors
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? Chile received an innovative retiming of commercial
bank interest payments that postpones until 1989
$450 million of interest in 1988, allowing Chile to
close its 1987-88 financing gap.
? Bolivia reportedly is seeking to buy back its own
debt at a discount on the secondary market.
Options Under Consideration: A General Look
The debt relief and financing options being used and
proposed vary widely in mechanics, impact, and likli-
hood of implementation.' All, however, share the
characteristic of shifting some of the burden of the
debt, or at least its risk, from debtors to creditors.
Debt Relief Options
Because most debtors now pay only the interest on
their debts-having rescheduled principal repayments
to future years-the next step in debt relief for the
LDCs probably will entail some type of deferral or
reduction of interest obligations. This might be ac-
complished by interest capitalization, which would set
a ceiling on interest payments-either in dollar terms
or as a "maximum" interest rate-and defer any
unpaid interest until the end of the loan. Alternative-
ly, debtors might choose, as Peru and Zambia already
have, to establish unilateral debt service contingencies
that limit debt service to a specified percentage of
export earnings, leaving the unpaid interest for future
negotiation.
A second category of debt relief mechanisms stems
from the secondary market for LDC debts. This
market for troubled LDC loans, where creditors buy,
sell, and trade existing loans at less than their face
value, has grown much larger and more open over the
past two years, and has gained increasing attention
for the large discounts at which some countries' debts
are traded. Debt-for-equity swaps remain the most
significant secondary market mechanism. Eleven
LDCs-Argentina, Bolivia, Brazil, Chile, Costa Rica,
Dominican Republic, Ecuador, Honduras, Mexico,
the Philippines, and Venezuela-now have programs
in effect to convert foreign debts into equity invest-
ments, and the programs' cumulative debt reduction
could total as much as $10 billion by yearend.
Other secondary market mechanisms also are begin-
ning to gather steam. The Philippines new interest-
for-equity swap program, for example, combines some
features of interest capitalization with some from
debt-for-equity swaps. The secondary market has also
made exit bonds possible, and some debtors are
considering using the secondary market to buy back
large portions of their own debts at a discount and
retire them. In addition, entrepreneurs are trying to
repackage LDC debts bought on the secondary mar-
ket and resell them to speculative investors as securi-
ties
Finally, some observers even have suggested that a
portion of LDC debts be forgiven. Forgiveness might
encompass interest or principal obligations, or both,
and proposals range from further reducing or elimi-
nating the interest rate spreads debtors pay, to simply
canceling 30 percent or more of LDCs' debts. For-
giveness proposals also differ on the scope of relief.
Some suggest forgiveness only for the most acutely
troubled debtors, such as Sub-Saharan African na-
tions, while others call for across-the-board forgive-
ness, which would not discriminate between more-
deserving and less-deserving debtors.
New Financing Incentives
With creditor banks increasingly unwilling to cooper-
ate on new money loans and with prospects bleak for a
return soon to traditional voluntary bank lending to
LDCs, attention is also increasingly shifting to possi-
ble incentives for, and alternatives to, new money for
the LDCs. Over the next several months, in particu-
lar, international banks will be putting forward new
proposals in response to Treasury Secretary Baker's
encouragement of a menu of options for LDC financ-
ing instead of new money.
Several financial mechanisms have been suggested, or
already are being used, as incentives for new lending
to the LDCs. The World Bank, for example, has been
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successful in stimulating about $2 billion in new
commercial lending to LDCs through cofinancing,
whereby the Bank dilutes the commercial banks' risk
with its own guarantees of repayment, but some
commercial banks claim that a much more extensive
program of official guarantees or insurance is needed
to mobilize significant amounts of new private loans.
At the same time, the process of securitization-the
shift away from traditional bank loans toward mar-
ketable borrowing instruments-has raised hopes that
debtors might increasingly be able to obtain funds
directly from world capital markets rather than from
commercial banks. Colombia, for example, recently
raised $50 million from capital markets by issuing
floating-rate debt obligations in its own name
In addition, creation by Japanese commercial banks
of a.factoring company to buy troubled LDC loans
from the banks at a discount might yield new funds
for the debtors. Although the mechanism functions
primarily for the tax benefit of the creditor banks,
resulting improvements in the banks' capital
adequacy will free up funds that could be made
available to the LDCs.
Although a variety of mechanisms are capable of
providing financial relief to debtors, the mechanisms
encounter important constraints on their implementa-
tion or widespread use. For example:
? Interest-delaying mechanisms, if broadly applied,
are likely to entail substantial losses for banks in
several countries, including the United States, with-
out significant changes in bank regulations or
accounting standards to allow banks gradually to
phase in the losses from such delays. Such changes
do not appear to be immediately forthcoming.
? Secondary market mechanisms, although growing,
still handle only small amounts of debt, compared
with the overhang of debt that stands between the
LDCs and creditworthiness. Even with heavily
reserved banks now interested in increasing their
use of debt-for-equity swaps, for example, swap
experts say there are not enough profitable invest-
ments in the developing countries to absorb the
amount of debt banks want to shed.
? Outright forgiveness of some debts also would entail
substantial losses for bank creditors, making them
even more reluctant to extend new credit to the
debtor countries. Forgiveness probably would
worsen the problem of capital flight by fueling
domestic concerns in debtor countries about their
governments' economic policies, and it ultimately
would reduce the valuation of banks' remaining
LDC loans, including those to countries that were
not granted forgiveness.
? Concessional mechanisms, such as interest capital-
ization and forgiveness, carry the risk of spillover to
other debtors. If such relief is granted to one
country, others are certain to insist on similar
treatment and, failing to receive it, might act
unilaterally.
At the same time, mechanisms to catalyze fresh
lending to the LDCs appear stalemated by creditors' 25X1
continuing concerns about LDC repayment prospects,
on the one hand, and by developed country govern-
ments' reluctance to protect private creditors on the
other hand.
We believe some new mechanisms will be more
important than others. The issue of interest-delaying
mechanisms, in particular, is likely to come to the fore
over the next 12 months as debtors continue to focus
on interest relief. Use of marketable interest bonds,
such as the Philippines's PINs, may expand in this
regard.
Secondary market mechanisms also are now certain to
be increasingly adopted by both creditors and debtors
in coming months, in view of recent statements by
major bank creditors. Debt-for-equity swaps, in par-
ticular, will continue to be a focus of attention. In
addition, exit bonds may become a common feature of
debt rescheduling deals for the LDCs, streamlining
future debt negotiations somewhat. Securitization of
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Secret
The debt problem arises from LDCs having more
external debt than they are capable of fully servicing
while also sustaining domestic econmomic growth. In
short, the LDCs have too much debt. The external
debt of 10 major Latin American debtors a amounted
to $362 billion at the end of 1985, but reducing that
figure to zero would clearly be going further than
necessary to "solve" the problem. How much debt,
then, would have to be repaid or otherwise removed
before the remainder would no longer be "too
much? "
There is no precise way to measure how much debt is
sustainable. The amount depends on the volume of
foreign capital inflows, growth of imports and ex-
ports, and exogenous factors, such as commodity
prices and interest rates. Ultimately, the breaking
point comes when creditors perceive the load as too
heavy and begin to pull back their credit lines. In
weighing these factors, creditors use several arithme-
tic ratios:
? Total debt as a share of GDP. A number above
40 percent is worrisome; above 50 percent is danger-
ous.
? Total debt as a share of exports of goods and
services. Any number above 200 percent indicates
trouble.
LDC debts-either existing or new-probably will
gain increasing attention but will remain confined to
only a handful of debtors.
On balance, in our view, the new financial mecha-
nisms at this time appear capable of making only
marginal inroads against the LDC debt problem. This
year, for example, we expect that new mechanisms
will remove only about $5 billion of the more than
$800 billion LDC debts outstanding, reduce the
LDCs' $115 billion debt service bill by roughly
$2 billion, and channel about $3 billion of new funds
? Total interest as a share of exports of goods and
services. This ratio is considered critical at levels
above 20 percent.
By comparing desired levels for these ratios with the
actual levels for 10 major Latin American debtors,
we calculate a roughly 40 percent overhang of debt
beyond the desired level. This translates into a
hypothetical reduction of $144 billion from the cur-
rent $362 billion debts of these countries to place
them within desired levels. It is this debt overhang,
rather than the entire debt, against which new finan-
cial mechanisms are targeted and judged:
Actual Maximum Reduction
1985 Desired Implied To
Level Level Achieve
Desired Level
(billion US $)
Total debt/GDP 73 40 163
Total debt/exports of 364 200 163
goods and services
Interest/exports of 28 20 105
goods and services
Average reduction
implied to achieve
desired level
to the debtors. By comparison, we calculate that new
mechanisms would need to effect a debt reduction of
$100-200 billion to bring the 10 major Latin debtors
alone within desired levels of creditworthiness.
Even as these results improve somewhat next year and
in 1989, as appears likely, we can see only about
$15 billion in debt relief being generated by these new
mechanisms over that time. It will therefore take
years before the process removes the debt overhang.
Moreover, if the application of new mechanisms
shows no signs of restoring LDC debtors to
25X1
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creditworthiness, even the small amounts of funds
now directed to these programs may dry up as
creditors again become concerned about repayment.
For the LDCs as a group, therefore, we see little
prospect that new financial mechanisms will signifi-
cantly improve the LDC debt problem over the next
two years, and we believe the debt situation will
continue to be marked by a lurching from crisis to
crisis.' While a few countries-Chile, for example-
will achieve modest debt relief through new mecha-
nisms, most will continue to have problems servicing
their debts. LDC debt negotiations will remain con-
tentious, and talks might even be further complicated
by new mechanisms as debtors and creditors haggle
over their implementation.
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25X1
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Appendix
Debt Relief Mechanisms
Interest Delaying Mechanisms
Secondary Market Mechanisms
Forgiveness
New Financing Incentives
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Interest Delaying Mechanisms
Interest Capitalization
How It Works
Interest capitalization is the primary mechanism for
delaying interest payments. Under this mechanism, a
ceiling is set on interest payments and any interest
owed above the ceiling is added to the principal
outstanding on the loan, or capitalized. The ceiling
could be expressed as an annual dollar amount, or as a
"maximum" interest rate-either would have the
same effect of reducing current interest payments.
Capitalization temporarily delays "excess" interest
payments until the end of the life of the loan, when
they either become due in a balloon payment or are
spread over additional years. In this way, capitaliza-
tion supposedly preserves the value of the loan to
creditors.
Benefits to Debtors
For the debtor, interest capitalization offers cash flow
relief and stabilizes interest payments that, because
most LDC debt is contracted at floating interest rates,
otherwise would vary with market interest rates.
Stabilizing interest payments at a known level would
help protect against the risks that result from interest
rate increases: cuts in imports and drawing on foreign
exchange reserves on the debtor side, and, on the
creditor side, the need for new lending to enable the
debtor to meet higher interest payments. At the same
time, putting off some interest payments into the
future theoretically gives debtors the opportunity to
put themselves in a better position to pay when those
payments finally fall due.
Recent experience suggests, however, that debtors are
likely to be concerned about just how the capitalized
interest will eventually have to be paid. The current
US initiative to permit interest capitalization on debts
owed under the Foreign Military Sales (FMS) pro-
gram stipulates balloon payments of capitalized inter-
est, plus interest on the capitalized interest, at the end
of the loan. Even though the real value of the FMS
loans would remain unchanged under the capitaliza-
tion proposal, the large nominal value of the final
balloon payments startled debtors and was an impor-
tant reason behind some debtors' rejection of the plan.
Costs to Creditors
Deferral of interest payments under any circum-
stances is a particularly sensitive subject with credi-
tors, however, because of an important accounting
principle and bank regulatory concern. Under that
principle, commercial bank creditors generally may
not count, or accrue, delayed interest payments as
current income. That is, delayed interest generally
cannot be added into income as though it had been
received on schedule. Instead, delays in interest pay-
ments usually cause a loan to be shifted from an 25X1
accrual basis to a cash basis, where interest can be
counted as income only when it is actually received. If
deferral of interest payments is part of the original
loan agreement, the deferred interest probably would
be accruable as current income. If the deferral were
applied retroactively, however, as part of a debt
rescheduling agreement- and this is where the real
relief lies-allowance of accrual would be unlikely.
This inability to record delayed interest in income is a
major stumblingblock for bank creditors because it
would cut earnings, in turn eroding profits or even
causing an operating loss.
Interest capitalization also presents other problems.
Even if delayed interest payments could be counted as
current income, deferring some interest until the end 25X1
of the loan-and possibly until additional years after-
ward-would cause a loss of liquidity for creditors.
The liquidity loss only occurs, however, if the debtor
would be servicing its debts fully, even in the absence
of new money from banks. We see this prospect as
unlikely given the recent experience of Mexico and
Nigeria, which needed new money even in the absence
of a big rise in market interest rates. Finally, creditors
fear deferring interest also moves debtors a significant
step closer to leaving interest unpaid entirely
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Variations
One variation on interest capitalization is the interest-
averaging cap. Like capitalization, this mechanism
would specify a ceiling on the interest rate, and any
interest in excess of the ceiling would be added to the
principal outstanding on the loan. If interest rates
subsequently fell below the ceiling, however, the
debtor would continue to pay interest at the ceiling
rate until it paid off any interest that had previously
been capitalized. After this, if market interest rates
remained below the ceiling, the interest rate would
revert to the original terms of the loan-a market
reference rate plus a spread. Interest averaging, while
it shares the same pitfalls as interest capitalization,
has the extra benefit of helping to avoid huge balloon
payments of capitalized interest at the end of the loan.
Another device related to interest capitalization is the
variable maturity loan. This type of loan allows the
interest rate to vary in response to market conditions,
but adjusts the size of principal repayments to offset
fluctuations in the interest charges. Thus, an increase
in interest payments triggers a cut in principal repay-
ments to keep the total debt service payment stable.
The "missed" principal repayments are then added to
the end of the loan in the form of a longer loan life, or
maturity, not as a balloon repayment.
Most major debtors, however, currently are repaying
very little principal because of recent reschedulings,
and a variable maturity loan offers no relief if there is
no principal to vary. The value of this mechanism,
then, is limited to new loans in the future. In addition,
it is uncertain whether there would be accounting or
regulatory problems with this type of loan. Variable
maturity mortgages have been used in the United
Kingdom and in Australia for years, but mortgages
are secured with collateral while sovereign loans are
not.
How It Works
A second debt relief proposal is based on the premise
that debtors' servicing capability is to some extent out
of their control, being determined by shifts in global
economic conditions. As such, many LDCs have
argued that their debt service should be more com-
mensurate with what they perceive as their ability to
pay. LDCs have for some time considered limiting all
debt service payments to a specified fraction of export
earnings. A handful of countries have taken concrete
steps to adopt such a limitation, but only Peru and
Zambia have actually imposed limits, and only Peru
has sustained a limitation over a significant period.
Even for Peru, the limit achieved little more than to
formalize preexisting debt service levels, leaving this
mechanism essentially untested as a means of debt
relief. Debt service limitations are usually ambiguous
about whether payments owed in excess of the ceiling
should be capitalized or simply forgiven, but in prac-
tice creditors have done neither. Instead, they have
built reserves against the loans and allowed arrear-
ages to accumulate but have not abandoned their
claims on the countries.
As a close alternative to total export revenue, some
have proposed that debt service instead be made
contingent on the market price of a key export
commodity. Argentina's debt service, for example,
could be linked to world wheat prices, or Mexico's
payments could be adjusted with oil price fluctua-
tions. Debt service could also be linked to world
interest rates, or to a debtor's GDP. Before its
suspension of debt service in February, Brazil had
targeted 2.5 percent of its GDP as an informal goal,
although not a limit, for its debt payments.
Benefits to Debtors
For major debtors, reducing debt service by half, for
example-from an average of 40 percent of exports to
20 percent-would appear to free up substantial
foreign exchange for other uses. Against this benefit,
however, the limitation almost certainly would result
in a cutoff of new lending by commercial creditors,
which remains a critical component of the debt
management strategy. Nevertheless, debtors probably
would receive some modest cash-flow and economic
growth benefits; and, for a debtor receiving no new
lending in any case, this option becomes even more
attractive.
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Table 2
Examples of LDC Debt Service Contingencies
10 percent of export August 1985
revenues
30 percent of export December 1985
revenues
10 percent of export October 1986
revenues
10 percent of net export May 1987
earnings
Brazil 2.5 percent of GDP Goal for 1987 before
suspension of debt ser-
vice in February
30 percent of export Under consideration for
revenues 1987 before earthquakes
occurred in February
In effect Formalized existing debt
service levels
Repealed; IMF standby Formalized existing debt
in effect; reschedulings service levels
completed
Used as bargaining Would have been a
position with creditors; 50-percent cut in debt
never implemented service
In effect Estimated 50-percent
cut in debt service
Publicly stated policy Probably would have
target been achievable with
commercial and official
debt reschedulings and
new money
Overtaken by debt If implemented, would
service moratorium in have been a slight reduc-
response to earthquake tion from scheduled debt
service
Costs to Creditors
Because most major debtors' debt service currently
consists mainly of interest, debt service contingencies
create the same accounting difficulties for creditors as
interest capitalization. The more a contingency mech-
anism cuts debt service payments, the larger nonac-
crued interest would be and the more banks' earnings
would be reduced. For smaller debtors like Peru,
creditors' strong reserves against their relatively small
loan exposure have minimized the impact of the
country's debt service limit. If a debt service ceiling of
20 percent of exports were applied to larger debtors,
however, creditors would suffer huge cuts in earnings,
up to nearly two-thirds for the largest US banks,
according to one private study.
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Secondary Market Mechanisms
Debt-for-Equity Swaps
How It Works
In a typical debt-for-equity swap, a commercial bank
sells its debt at a discount to a multinational corpora-
tion or other private investor who transfers it to the
debtor country for redemption at near or full face
value in local currency or government notes. The
investor then uses the proceeds to buy equity shares in
a local business. Alternatively, a bank creditor can
swap its debt for an equity investment of its own,
buying additional debt on the secondary market if
necessary to afford the desired investment.
Debt-for-equity swaps have been one of the most
significant factors in the growth of the secondary
market. Eleven countries-Argentina, Bolivia, Brazil,
Chile, Costa Rica, Dominican Republic, Ecuador,
Honduras, Mexico, the Philippines, and Venezuela-
currently have debt-for-equity swap mechanisms in
effect, and the programs together have reduced Latin
America's $219 billion commercial bank debt by
about $5 billion. Chile's program has been the most
successful, eliminating about $1.5 billion, or roughly 7
percent, of the country's debt. Mexican debt-for-
equity swaps have been taking place at the rate of
about $100 million per month and total some $1.6
billion to date.
Benefits to Debtors
For the debtor countries, debt-for-equity swaps reduce
the external debt outstanding and the related interest
Table 3
Recent Secondary Market Prices
for Selected LDC Debts
In US cents per
dollar offace value
Argentina
59-60
62-66
Bolivia
20-25
8-9 a
Brazil
63-65
75-81
Chile
68-70
65-69
Colombia
86-89
86-89 a
Ecuador
54
68-71
Egypt
49-51
NA
Ivory Coast
79-80
NA
Mexico
58-61
69-73
Nicaragua
10-12
10-12 a
37-40
NA
14-16
25-30
Philippines
70-71
NA
Poland
45-46
50-53
Romania
88-89
80-82 a
South Africa
61-62
75-80 a
Venezuela
74-75
80-82
Yugoslavia
76-78
78-81
obligations. At the same time, foreign investment can LDCs are concerned about "round tripping," where
be stimulated as investors are attracted by the pros- the investor profits by reconverting the swap proceeds
pect of obtaining local currency more cheaply- into hard currency and then taking the money out of
through secondary debt market discounts-than the country, leaving the central bank with a loss and
through the foreign exchange markets. A key pitfall the country without the investment.
of debt-for-equity swaps for the debtor, however, is
the domestic monetary effects. An LDC government
must either create new local currency or borrow it on
domestic markets to buy back its debts through the
swap mechanism. Excessive money creation could
send already troublesome LDC inflation even higher,
and borrowing at higher domestic interest rates could
result in an increased overall debt burden. In addition,
Debtors also are politically sensitive to swaps, which
are vulnerable to criticism as a capitulation to foreign
interests under the pressure of the debt problem.
Political opposition and labor groups in Ecuador, for
example, have accused the government of "selling out
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Secret
Figure 1
Mexico: An Example of How a Debt/Equity Swap Works
n
$10 million
Mexican debt
Investment
Bank
Cash
$6 million
(secondary market
price of debt)
Multinational
Corporation
n
I
Cash or equivalent swap
$6 million
(secondary market price
of debt)
$10 million
Mexican debt
Mexican
Government
Mexican
Subsidary of
Multinational
Corporation
a The price at which the Mexican Government repays the debt in
local currency varies according to the type of investment, from
75 to 100 cents per dollar of face value of the debt.
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the country to foreigners," and Mexican businessmen
complain that swaps give foreigners an additional
steep discount in a currency that already is substan-
tially undervalued.
Costs to Creditors
Trading loans on the secondary market can help
individual creditors cut their risk, or consolidate their
risk within a preferred geographic region. For credi-
tors with small LDC loan exposures, selling off their
loans can be a way out of the liquidity loss they suffer
when loans become tied up in successive debt resche-
dulings. Banks that have already written off much of
their LDC loans may even be able to recoup more
than their book value. The marketability of loans does
not by itself eliminate the risk for the system as a
whole, however, when a debtor is not in a position to
repay them.
One important concern about the secondary market is
that the source of new money in rescheduling pack-
ages for the LDCs might be eroded if both the buying
and selling banks disclaim responsibility for participa-
tion. Under Mexico's $6 billion new money package
agreed to last year, for example, banks' participation
was determined according to their 1982 loan expo-
sure. Creditors that had sold or swapped their Mexi-
can loans since then resisted-and in some cases
refused-new money contributions.
Bank creditors converting debt into equity for them-
selves probably view the swap as a middle ground
between remaining caught in a cycle of successive
debt reschedulings and new money requirements and
simply writing off the debt, taking a straightforward
loss. Against these benefits, however, creditors and
investors also face important disadvantages. Investors
confront a variety of discouraging investment restric-
tions and regulations attached to the swap programs,
including cumbersome and expensive host country
approval procedures, sharp limits on profit repatria-
tion, and restriction of foreign investors to minority
participation in local firms. Commercial bank inves-
tors, in addition, are deterred by LDC restrictions on
foreign involvement in the financial sector-the in-
vestments banks are most willing to make-and by
limits in their home country on the activities they can
undertake abroad.
1/ts wnnucrrrw iK+w.. r ~ m.apa/wmnf arw
US$161,191,57740
Debt for Equity Conversion
niwu.r rnmrxa nwmae a m
o
~
rd~ah
c..waa.a. d
ry
Carter Halt Harvey
International Limited
Y
Compenia Y Desar olk
Los Andes SA
w,s apudy irae9rw9 i
Companla De Petmleoa
Do Chile SA (COPEC)
Managed by
Citicorp Investment eanl
Shearson Lehman aronwars ft ? Beal Steams a Ca l ix
Ciricc Of 0 subs d &y aced as rlnancW ad.;sw to
Caner HON Harveylntema, wLnnaed Iar ma line c g,
January 1987
CIT/CORPO/NVESTMENT BANI(1NG
Figure 2. Public announcement of a debt-for-
equity swap completed under Chile's swap
How It Works
Just as LDC debt principal now can be converted into
equity investments in some debtor countries, so too
could LDC interest payment obligations. Although
Brazil has hinted to creditors that it would favor such
a mechanism, only the Philippines has implemented a
program whereby bank creditors have the option of
converting interest obligations into Philippine Invest-
ment Notes (PINs). Banks that buy the six-year,
dollar-denominated PINs, which are sold at a dis-
count from their face value, have three options: they
can hold the PIN to maturity and receive the full face
value of the note in dollars; they can redeem the note
0
.
/~
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Secret
anytime before maturity for its full value in local
currency and invest the proceeds in government-
approved projects; or they can sell the PIN on the
secondary market to other investors wanting to cash
in the note for local investment.
Benefits to Debtors
Like debt-for-equity swaps, interest-for-equity swaps
offer the dual benefits of easing current debt service
obligations and stimulating foreign investment. In the
Philippines' case, even if creditors do not invest with
the PINs but instead hold them to maturity, the
country still has succeeded in delaying current inter-
est obligations until years into the future. At the same
time, however, interest-for-equity swaps suffer from
the same domestic inflationary drawback as debt-for-
equity conversions-the local currency for investment
conversion must be either borrowed or created anew.
Costs to Creditors
Creditors, too, face essentially the same difficulties
with interest-for-equity conversions as they do with
debt-for-equity swaps-limited LDC investment op-
portunities and restrictive financial regulation. In
addition, it is uncertain whether the interest payments
deferred by the conversion process can be counted as
current income by creditors. Some international ac-
counting firms have argued that banks may record
receipt of the notes as interest, but others contend the
notes are not interest.
How It Works
The secondary debt market has also given rise to
proposals for some LDC debtors to buy back their
own debts outright at the market's deeply discounted
prices. These proposals have centered on smaller
debtors, such as Bolivia and Costa Rica, where the
country's debt is small and creditors have accumulat-
ed large reserves against their loans or have already
written down the debts. Bolivia and its commercial
bank creditors, for example, recently agreed to a plan
allowing the country to buy back as much as $670
million of its debt at a discount. The discount has not
yet been determined, but at the going secondary
market price for its debts of about 15 cents per dollar
of face value, Bolivia could clear its debt to commer-
cial banks with only about $100 million
Benefits to Debtors
Debtors able to finance a buyback would receive
immediate and substantial debt relief. They would
reduce their outstanding debt directly by the face
value of the debt bought back, as well as eliminate the
corresponding interest payments. Debtors also would
save substantial principal repayments because the
debts would be bought back on the secondary market
for less than their full face value.
Costs to Creditors
Bank losses probably would be minimal for the most
troubled small debtors, for which most banks have
built strong reserves. As with debt-for-equity swaps,
banks that have already written down their loans
could even recoup more than their book value. At the
same time, however, such a visible and organized
recognition that LDC debts are not worth their face
value could lead other debtors to argue that their
obligations should be correspondingly adjusted down-
ward. For example, Mexico might argue that, with
the market price of its debt only 58 cents on the
dollar, its debts should be only $60 billion, rather than
the $104 billion the country actually owes.
How It Works
The secondary market could also help spread the risk
of LDC loans away from the banks if new nonbank
investors became active participants in the market,
but, in practice, banks have traded debts mainly
among themselves. One reason is that most bank loans
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are not standardized in such a way that individual
investors can know what they are getting. Recently,
however, entrepreneurs have begun using the second-
ary market to buy up LDC debt, repackage it into
tradable securities-sometimes referred to as sover-
eign junk-and resell the securities to speculative
nonbank investors at a deep discount from face value.
So far, this activity appears to be focused on Nigeria's
debts.
Benefits to Debtors
Debtors receive no direct benefit from this mechanism
because principal is not forgiven, and they must
continue to make full interest payments. Debtors
could benefit indirectly, however, by buying securities
made from their own debts and retiring the obliga-
tions at a discount.
Costs to Creditors
Although some of the world's largest banks are
involved in marketing these sovereign junk securities,
according to press reports, investors so far remain cool
to the innovation because of concerns about prospects
for repayment and less than $5 million of LDC debt
has been repackaged to date, according to industry
experts. Another obstacle is that many bank loan
agreements require the permission of the debtor coun-
try to turn them into marketable securities. In addi-
tion, like most secondary market mechanisms, securi-
tization of existing debt can erode the source of new
money in debt rescheduling packages if both the
buyer and seller of the securities disclaim responsibil-
ity for participation.
How It Works
Still another mechanism involving the secondary mar-
ket is exit bonds, which would allow individual credi-
tors to withdraw entirely from the business of lending
to a particular LDC by paying a financial penalty.
Creditors wishing to withdraw would accept payment
from the LDC in the form of bonds that would carry
an exemption from future debt reschedulings and
participation in new loans. In exchange for this
exemption, the bonds probably would carry a lower
interest rate and longer term than the loans they
replace. Creditors could then resell the exit bonds on
the secondary market, completing the withdrawal. In
the first-ever application of exit bonds, Argentina and
its commercial bank creditors agreed in April 1987 to
permit the bonds for small creditors who want to close 25X1
down their loans to the country. The 25-year,
4-per-cent government-backed bonds will be available
to creditors who are owed up to $30 million-perhaps
as many as half of Argentina's 360 creditor banks,
according to press reports.
Benefits to Debtors
Exit bonds would provide debtors with a direct reduc- 25X1
tion in debt service obligations because of the bonds'
lower interest rate. If used on a large scale, however,
the bonds almost certainly would work against return-
ing a debtor to market creditworthiness because the
use of exit bonds would indicate that the debtor's
financial prospects had become so poor that creditors
were prepared to accept, sizable losses to leave the
country.
Cost to Creditors
For creditors, exit bonds carrying a lower interest rate
would mean a loss of some income. Creditors willing
to accept the bonds, however, would view the freedom
from future loan problems as outweighing the income
loss. For remaining creditors, however, exit bonds
would erode the lending base for new-money loans 25X1
and thereby increase the amounts of new money that
remaining banks would be expected to provide.
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How It Works
Some observers have suggested that LDC debts
should simply be forgiven. Proposals for forgiveness
have involved canceling either interest obligations or
principal repayments, or both, and range from further
reducing or eliminating the interest rate spreads
debtors pay, to simply erasing 30 percent or more of
LDCs' debts off their creditors' books. Several observ-
ers have suggested that debts should be forgiven to an
extent commensurate with their secondary market
discount, which they claim indicates what the market
believes debtors can actually pay.
Forgiveness proposals also differ on the scope of relief
that would be offered. Some believe forgiveness
should be granted only to the most acutely troubled
debtors, such as Sub-Saharan African nations, while
others call for across-the-board forgiveness without
discrimination among more-deserving and less-deserv-
ing debtors. Still others believe forgiveness should be
reserved as an incentive and reward for LDC econom-
ic policy reform.
Benefits to Debtors
Like proposals to limit debt service payments, simply
forgiving a portion of interest payments due could
benefit debtors in the short run by freeing up the
foreign exchange that otherwise would have been used
to pay interest. This would allow increased imports
and capital investments that would translate into
modest increases in economic growth in the short run.
The almost certain loss of new lending, however,
would erode these gains over the longer run.
Forgiveness of principal presumably also would entail
cancellation of interest payments on that portion of
principal that is forgiven, which would benefit debt-
ors. Forgiveness of principal as such, however, would
yield little immediate benefit because most debtors
have delayed principal repayment until future years
through rescheduling agreements with creditors.
Costs to Creditors
For creditors, any cuts in interest payments would
reduce earnings and impair profits. Moreover, be-
cause interest would be forgiven rather than deferred,
creditors would suffer a capital loss on the value of the
affected loans equal to the forgiven interest. If a
substantial amount of interest were forgiven for the
major debtors, the resulting reductions in bank profits
and losses of bank capital would be huge and could
create serious risks for the global financial system.
Interest forgiveness could be limited to a select group
of extremely troubled smaller debtors, with less de-
structive bank losses, but larger debtors almost cer-
tainly would demand similar treatment and might
even be spurred to unilateral curtailment of interest
payments.
Forgiveness of debt principal would increase the
benefits to debtors over interest forgiveness, but would
be costlier as well. Creditors would suffer capital
losses equal to the forgiven principal, in addition to
losing both earnings and capital from the correspond-
ing interest. Because commercial creditors would be
unlikely to offer new loans to countries whose debts
they had forgiven, debt forgiveness in either form
almost certainly works against returning debtors to
market creditworthiness.
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Table 4
Cumulative Effects of LDC Debt Forgiveness, 1987-89
Effects on Debtors a
(billion US $)
Effects on US Banks
(Resulting reduction in average annual after-tax
earnings, 1987-89, as a percentage of 1985 after-
Scenario 1 b
Elimination of spreads 8.4 0.0
Scenario 2 c
30 Percent forgiveness 12.9 57.8
Scenario 3 d
Forgiveness referenced to secondary 14.7
market discount
Scenario 4 e
Three-year program of interest and 18.9
principal concessions
Memorandum: total 1985 interest 36.9
obligations of the 15 debtors
Memorandum: total debt owed by
banks and public-sector borrowers of
the 15 debtors
a All data are for the 15 Baker Initiative countries: Argentina,
Bolivia, Brazil, Chile, Colombia, Ecuador, Ivory Coast, Mexico,
Morocco, Nigeria, Peru, Philippines, Uruguay, Venezuela, and
Yugoslavia. Assumes that all banks, not just US banks, would
grant the same concessions.
b Scenario 1: Interest rate spreads on all bank debt are eliminated.
c Scenario 2: 30 percent of bank debt is forgiven and written off
over 10 years.
Nine Moneycenter
Banks
15 Other Large Banks
13.4
5.7
50.8
21.5
57.6
25.3
d Scenario 3: A proportion of each debtor country's bank equal to
the current secondary market discount on that debt is forgiven and
written off over 10 years.
c Scenario 4: During a three-year period, interest rates on bank debt
are reduced by 3 percentage points and each year 3 percent of bank
debt is forgiven and written off.
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New Financing Incentives
How It Works
A major trend in international financial markets in
recent years has been the shift of credit flows away
from traditional bank loans and toward debt obliga-
tions that can be easily traded among a variety of
creditors. In the late 1970s, for example, as much as
80 percent of global lending was in the form of
syndicated bank lending, and lending in the form of
tradable securities was small. By the end of 1985,
however, this relationship was reversed (figure 3). This
shift to marketable debt securities is referred to as
securitization.
Traditional fixed-rate bonds and floating rate notes
(FRNs) account for most securitized longer term
credit, while note issuance facilities (NIFs) are the
main form of securitized short-term credit. A NIF,
rather than lending money directly to a country,
instead provides only a mechanism for placing the
country's own short-term notes with other investors.
For a fee, banks manage the placement of the notes,
and they often underwrite them-that is, they agree
either to buy any notes that the issuing country is
unable to sell directly to investors or to make cash
advances against unsold notes.
Another tradable borrowing instrument that has at-
tracted attention concerning the LDCs is the zero-
coupon bond because it defers all interest payments
until it is redeemed at its face value at maturity-
typically some 10 to 20 years in the future. These
bonds are sold initially at a deep discount from their
face value and the return on the instruments depends
entirely on the relationship of the purchase price, the
face value, and the time remaining until maturity.
rate bonds was less than 2 percent, and less than 10
percent of both FRNs and NIFs. Even these small
shares were confined to several LDCs, such as South
Korea, Singapore, India, Indonesia, and Panama.
Moreover, they consisted mainly of commercial, non-
governmental, borrowers, and were mostly for small
amounts. Most recently, Colombia completed a $50
million FRN issue in April and plans another $60-70
million issue later this year. Even though the country
is one of only two in South America that have not
rescheduled external debts-the other is Paraguay-
Colombia is paying substantially higher interest than 25X1
other Latin debtors to attract voluntary funds.
Creditworthiness concerns make it unlikely, in our
view, that the range of borrowers that has relied on
syndicated loans will be able to arrange bonds, FRNs,
or NIFs in the near future. For the few LDCs that are
sufficiently creditworthy to do so, however, the instru-
ments allow much more flexibility than bank credits
and can be a cheaper source of funds because they tap
the market directly, reducing the role of commercial
banks as middlemen.
Costs To Creditors
With the risk of extending longer term credit to LDCs
no longer acceptable to many commercial creditors,
creditors find securitization attractive because it
channels the risk of lending to those willing to accept
it. The investment banks and commercial banks that
arrange the securities enjoy the certainty of an up-
front fee for their services rather than riskier interest
income spread out over many years. Moreover, an
underwriting commitment remains off the underwri-
ter's balance sheet and thereby often not subject to 25X1
the same capital adequacy regulations as traditional
Benefits to Debtors
Bank for International Settlements data indicate the
LDC's get little out of securitization because the
criteria of creditworthiness are even stricter for secu-
rities than for bank loans. While LDCs accounted for
roughly half the global volume of syndicated lending
annually between 1981 and 1986, their share of fixed-
loans
The credit risk of securitization-the risk that the
borrower will be unable to pay, which lending banks
traditionally have borne-is borne by the ultimate
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Figure 3
The Securitization Trend in International Capital Markets
Note issuance facilities
a OECD data.
b BIS data.
holders of the securities. Little is known about the
identity of these creditors, but they are thought by the
BIS to be primarily European, Middle Eastern, and
Asian banks. Securitized LDC debt could help spread
the risk of LDC lending away from banks if nonbank
participants became active buyers, but in practice
nonbank investors-mainly investment funds, corpo-
rations, insurance companies, and wealthy individ-
uals-remain unwilling to hold more than a small
fraction of the instruments.
How It Works
Since 1983 the World Bank has attempted to increase
the flow of commercial bank lending to LDCs by
offering banks a partnership arrangement, referred to
as cofinancing, with the World Bank. For its part, the
World Bank can help arrange a syndicated loan with
private banks and take on a share of the loan for itself,
guarantee part of a loan provided entirely by private
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banks, or provide contingency financing to help the
borrowing country meet its commercial loan pay-
ments if interest rates rise sharply. Although it was
hoped these options would speed the restoration of
voluntary commercial lending to LDCs, the program
has mobilized only about $2 billion of new commer-
cial lending in the four years since its inception. F_
from expansion of existing programs, such as cofin-
ancing, to the creation of new multilateral institu-
tions.
Benefits to Debtors
Because cofinancing helps dilute commercial banks'
risks, debtors receive more funds from the banks than
they would expect without World Bank involvement.
In addition, cofinancing arrangements often carry
somewhat more lenient terms for the debtor than
standard bank loans, including a longer repayment
period, smaller fees, and lower interest rate spreads.
Costs to Creditors
The World Bank's guarantee and contingency fund-
ing options help assure creditor banks that they will
be repaid. The syndication option also offers a degree
of repayment assurance because the World Bank's
participation effectively exempts these loans from
rescheduling and because the debtor risks having
other World Bank loans cut off if it does not repay.F-
The cofinancing program makes continued LDC lend-
ing more attractive for marginally reluctant commer-
cial banks, but some more recalcitrant banks believe it
does not go far enough. They want the World Bank to
forgo its preferred creditor status, which entitles it to
be paid before other lenders, for example; and they
want a firm commitment from the Bank that it will
declare its loans in default if an LDC defaults on
payments to another cofinancing creditor-something
How It Works
Clearly, an effective incentive for commercial lending
to LDCs would be to guarantee or insure the banks
that they will be repaid. Because private insurers
remain unwilling to share the risks of sovereign
lending to any significant degree, proposals have
centered on official guarantees or insurance and range
Benefits to Debtors
As with cofinancing, debtors would receive more
money than otherwise would be the case. At the same 25X1
time, however, the existence of a widespread safety
net for debtor nonpayment might possibly encourage
some debtors to avoid their obligations-unless they
expected a reprisal similar to the cutoff of funds,
which usually follows missed payments to commercial
Costs to Creditors
Under this mechanism, creditor banks benefit from
straightforward protection of their loans. This protec-
tion would, however, have to be funded almost entire-
ly by the developed country governments. Any new
institution would entail substantial startup funds to
provide credible backing for the guarantees or insur-
ance, and even existing institutions would need new
capital infusions. In the case of the World Bank, for
example, guarantees are treated as if they were new
loans and, unless its capital is not raised commensu-
rately, it must forgo new lending by the amount of the 25X1
guarantees. Official guarantees thus are primarily a
domestic political issue for the developed country
governments, which would effectively be underwriting
the activities of the large international banks. Govern-
ments certainly would draw criticism for a taxpayer
bailout of private corporations
Factoring Company
How It Works
Factoring companies, as they exist in the private
sector, for years have functioned typically by buying
accounts receivable at a discount from manufacturers
and then later collecting full or near-full payment on
the accounts. In what may be the most innovative
approach yet to handling troubled LDC loans, 28
Japanese commercial banks formed an offshore com-
pany-which will function essentially like a factoring
company-to buy bad LDC loans from the banks at a
discount
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The new company, called JBA Investments, Inc., will
Dbe managed by Fuji Bank, the world's third-
largest commercial bank. The 28 member banks each
contributed money to get the company started. Pay-
ments the company receives from LDCs on the trou-
bled loans will be passed along to its commercial bank
"shareholders" as dividends. Japan's Finance Minis-
try has publicly expressed support for the idea
only 1 percent of bad loans annually as a tax deduc-
tion. The discount at which a bank sells loans to the
new company, however, will be fully tax deductible.
In addition, some Finance Ministry officials had
hoped to allow a tax deduction of 5 percent of new
loans provided to LDC debtors, but this component of
the mechanism now appears uncertain at best.
The plan also will help Japanese banks improve their
capital adequacy-a step other developed country
financial authorities have been urging-by reducing
the amount of loans the banks hold. For other credi-
tors, the Japanese Government's support of the plan
brings greater prominence to the issue of new mecha-
nisms that could be employed as part of an approach
Benefits for Debtors
Although the Japanese debt plan functions primarily
for the benefit of the creditor banks, debtors may
benefit from additional loans that could be made
available by the banks once old loans are shifted to
the factoring company.
Benefits for Creditors
The major purpose of the plan for Japanese banks is
tax relief. Japanese banks are required to set aside
5 percent of bad loans as reserves, but they can claim
to the LDC debt problem.
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Secret
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