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DEBT-EQUITY SWAPS IN THE CONTEXT OF PRIVATIZATION: THE CASE OF BULGARIA

Sophia Kassidova

III. DEBT-EQUITY IMPLICATIONS FOR BULGARIA AS AN INDEBTED
COUNTRY


 

The previous two parts argued that by combining schemes for privatizing state-owned enterprises with programmes for swapping external debt into equity in these entities, the debtor country can foster greater economic efficiency, stimulate new capital inflows and capital formation parallel to external debt burden relief. The micro level effects of debt-equity conversions are enhanced by the macro implications for the indebted country, recipient of the equity investment. International experience evidence heterogeneity in the national welfare implications of DESs schemes.

3.1 Debt-Equity Swap Mechanism

DESs schemes are said to be a new market approach to debt adjustment initially originated as a plausible debt crisis solution in the Latin American countries. Types of swaps differ according to the guiding motives of the parties involved. Banks swap debt for portfolio reasons; sell debt at a discount for cash to MNCs who then swap it for the indebted countryвs currency at an implicitly preferential exchange rate and thereafter invest the cash in direct or portfolio assets in the debtor country; banks may sell the debt to local residents of the debtor country who may then swap it at an implicitly preferential exchange rate for local equity investment or sometimes for their own unrestricted use (see G. McKenzie and S. Thomas). This way debt may be swapped several times as banks and final investors structure their portfolios to reach a particular desired allocation. DESs entail diverse number of participants each of them pursuing own objectives - foreign creditors (commercial banks), foreign and domestic investors, the government of the indebted country and number of complex operations.

DES schemes cover the privatization program framework, legal and regulatory framework, debt instruments that can be converted, eligible investors and criteria for local asset eligibility, discount involved in the conversion (and the fee if charged), dividend remittances and capital repatriation, requirements with regard to additional investment, accounting and tax issues involved in converting debt into equity. These diverse transaction steps impose certain advantages for all participants. An implicit subsidy is captured by the foreign investor who buys the debt notes at discount in the international secondary markets. The extent to which this market discount is gained by the debtor depends on the value at which this note is recognized by the debtor's central bank. As accessible data from countries that have implemented DESs suggest that most of this discount is captured by the foreign investor or creditors.

As a debt-capitalization transaction DESs can take a variety of forms. These many variations depend on the countryвs regulations governing the operations of the schemes.

The essential advantages and disadvantages of debt conversion schemes may be understood by making an important distinction - the present analysis is made on the basis of the conventional debt-equity-swap scheme. An investor buys in the international financial markets at discount country's current obligations to commercial banks which obligations are in the form of $-denominated bonds issued by the indebted country. These bonds are either directly converted into equity (direct or portfolio investment) or exchanged for local currency (the central bank of the debtor country exchange these bonds at face value, multiplied by the exchange rate). The local currency cash is invested in the proposed investment in the country that has been approved by the country's government. At the end of the transaction, everybody seems to be better off: the bank has sold a risky asset, even though at a discount, the final investor has acquired a local asset at a discounted price, and the debtor country government has retired some of its external debt outstanding. The case when there is no requirement for the debt-local currency to be invested in the debtor county will not be considered. For Bulgaria as an indebted country the mechanism is beneficial since it provides for the cancellation of the debt swapped at its full $-denominated face value. If an auction-base system is used for swapping debt holdings the debtor country may capture revenues from fees.

3.2 The Determinants of The Size of The Market

The volume of DESs transactions for the debtor country is determined by supply and demand in the secondary market. It is often said that the secondary market is very thin in term of its trading volume. Other features of the market are: high concentration of buyers and sellers; relatively long lag for deal completion (typically 2 month); high degree of heterogeneity and the absence of firm quotas (see K. Dezseri and J. Marcelle).

The theory of pricing behaviour in the secondary market for the loans of the indebted country suggests that the determinants of the portfolio value include: economic performance measured by the standard indicators ( real economic growth, inflation, trade and account balances) and debt servicing capacity measures (ratios of outstanding debt to GNP, exports, international reserves, imports). Econometric testing of the determinants of the pricing of the LDCs debt was made by Laney , including both economic, political and sociostructural explanatory variables. His main result proved that secondary market prices are mainly determined by economic forces (see Laney).

On this basis the economic forces-driven behaviour of the secondary market nevertheless rather unpredictable reflects the interplay of supply and demand changes. It was pointed out above in this paper that the demand for debt trading in the secondary market is driven by the motives of the banks for changing their portfolios priorities, foreign investorsв expectations for the profitability of an equity investment in the debtor country and the supply of viable projects.

There is empirical evidence that in the secondary market demand mostly determines the volume of DES transactions. Final demand can increase as more equity investment projects become attractive to external investors. This connection requires a supply of a set of attractive long-term investment opportunities offered to investors who are interested in purchasing countryвs debt.

The supply of outstanding debt in the secondary market by the creditor banks depends crucially on the regulatory environment in the countries where the swapping banks are domicile and banksв capital structure strategy. Tax and accounting issues in the creditor banksв countries shape banks decision for managing their exposure to debtor countries with servicing difficulties. Creditor banks face several alternatives: they can continue to restructure credits; sell debt instruments at a discount in the secondary market; convert the credit into equity investment in the debtor country.

The attractiveness of market-based debt stock reduction operations through debt-equity swaps is affected by the discount that is captured by the buyer. As Basile argues this market-based discount reflects the market valuation of the debt assets of the indebted country and governs the supply and demand of debt obligations (see An. Basile, 1992). This way, raising secondary-market prices as a result of a deal settlement reduces the percent discount. This discount over the face value of the obligations vary from country to country depending primarily on the creditworthiness of the country (this discount is very high for countries with high credit risk).

The securitization of debtor country's external obligations helps financial institutions to realign their foreign portfolio holdings to their risk preferences. Some of Bulgaria's risk-averse creditors prefer to receive their obligations in cash (mainly by buy-back) while others (Austrian and German banks) have shown considerable interest in debt-equity-swaps and rather insignificant in debt buy-backs. These creditors are traditional Bulgaria's business partners and they are optimistic about country's economic recovery. Austrian banks and firms are particularly interested in the Bulgarian economy since many enterprises in Bulgaria were established with Austrian capital and credits.

Finally, the selected response from the banks will depend on the profitability that each of the policy instruments (sales of assets, debt-debt swap to focus to change the ownership of the debt holdings, further bargaining with the debtor country).

By exchanging the foreign debt obligations, acquired at a market discount over the face value at the official exchange rate, the purchaser of the external debt can obtain local assets at a much lower cost and advantageous position. Basile views the inefficient nature of capital markets that allows foreign investors and an indebted country to gain from these transactions at the expense of the creditor banks. The secondary markets of debt obligations generate these negative externalities imposed on creditors which price the $-loans of the indebted country bellow the present value of the expected payments of principal and interest.

3.3. Impact Assessment

In managing countryвs debt problem there are short-term and long-term considerations. The long term measures include all these that induce growth, investment, promote export-oriented development and restructuring of the economy. Measures that are concerning balance of payments equilibrium are of a more short-term character. Multi-year restructuring, reduction of interest rates and spreads which help to maintain levels of import and debt service are example of these (see K. Dezseri and J. Marcelle). A comprehensive impact assessment needs also to include medium term time horizon.

Evaluation of DESs implications on the debtor country economy should weight the gains these transactions will raise as opposed to the costs which countryвs external indebtedness imposes on the economy. The countryвs debt overhang has deteriorated the terms of trade and investment financing. K. Dezseri and J. Marcelle give an indication of the economic costs of indebtedness for the troubled country: debt service payments in absolute and relative terms remains high; decline in GDP per capita growth levels; high inflation because of low growth; declining levels of investment; rising levels of unemployment. The situation can be greatly improved upon debt and debt service reduction agreement, including debt-equity schemes.

It is not only the economic theory that is not to enthusiastic about the "all-solving" effect of DESs but also the empirical data on the volume of swap transactions relative to the size of outstanding debt. There are advantages and disadvantages that are effected by debt-equity financing.

Domestic aspects

The macroeconomic implications of DESs can be understand in terms of the nature of such swap. The exchange of external debt in the debtor country creates new equity. The problem is that the Bulgarian government has to finance the repurchase of its debt in some way, either by issuing domestic debt or printing money. DESs lead to some difficulties related to the adverse impact of the increase of local money supply. Therefore providing in cash local currency in exchange for the external loans owed now by the investor, inflation will rise. To avoid this effect the local money supply has to be held constant which finally implies "loan currency substitution" through the DESs (G. Franke, 1992). The solution can be found in borrowing the money for debt conversion from local agents and give the investor a long-term local-currency loan. A monitoring of the amount converted can be achieved by introducing by the central bank a monthly auction quota of conversion rights as was the case of Chile. In the case of Bulgaria this inflationary impact can be neutralized if debt-equity transactions employ use of government bad-loan obligations, particularly those denominated in US dollars, when converting the external debt obligations into internal equity. Foreign investors may trade their external debt bonds with the local commercial banks which at present hold the bad-loans bonds. Since these long-term bonds are recognized as instrument of payment in privatization, the Privatization Agency is authorized to accept these bonds in exchange for parts of or the entire enterprise. This process can be further facilitated when the Government provides clear framework which will regulate the operation of swapping external debt for portfolio investment in the commercial banks which are to be privatized. Undoubtedly, there is no threat for inflation or interest rate impact from the conversion if these transactions directly lead to an exchange of debt for equity, i.e. direct privatization.

In the case of issuing domestic bonds for financing the transactions, very likely, with a high yield, there will be a jump in interest rates, thus making the intertemporal government budget constraint more stringent (see Dornbusch, 1987). The increased cost of the public debt would involve decrease in the governmentвs potential to finance its operations. As a debtor country implementing IMF binding arrangements Bulgaria must carefully monitor these impacts since they may result in noncompliance with IMF liquidity criteria.

Furthermore, interest rates which are high enough in times of restrictive monetary policy during transition will limit foreign investors when the latter aim to expand their business. They are looking for the cheapest way to finance investment and thus borrow at lower rate in the international financial markets. This will inevitably deter the development of liquid and large domestic capital markets.

Some arguments may be put foreword for a fiscal burden that may result from some preferential tax treatment of foreign investors' business. Notwithstanding, that international experience suggest that concessions do not necessarily stimulate foreign investment the Government serious about attracting investment should be cautious in giving fiscal incentives. Foreign investors' main concern is with political and macroeconomic stability and long-term profitability rather than preferences. Above all providing preferences to foreign investment is possible only in terms of clear privatization strategy.

External aspects

Debt-equity swaps have implications both for the flow and stock of Bulgariaвs foreign assets and liabilities: they are closely associated with the repatriation of flight capital and the creation of new investment through the inflow of capital. DESs effectively cancel external debt and relief interest payments on the converted debt.

There are some arguments raised that exchanging debt for capital brings to a debtor a counter-cyclical effect. DESs involves a change in the composition of the debtor country's external obligations since the transaction replaces interest payments by profit remittances from return on investment. Profits are more sensitive to the economic cycle and fluctuate according to the type of the economic phase. In times of recession as is the transition to market-based economy economic profits tend to fall. This way after-tax profits of foreign companies are lower so the amount of capital outflow is less than what would have been if interests ware paid. This process contributes to the improvement of the net capital position of the debtor country. The availability of net FDI which is to be effected by a debt conversion programme will provide for the short-run macroeconomic stability of the economy. On the contrary, in a paper R. Davis claims that empirical data from heavily indebted Latin American countries do not evidence such an effect. Data which refer to FDI originating in US companies, show that, after the 1981-2 shocks, FDI profits dropped considerably, but remittances were stable even increasing in current dollars (see R. Ffrench-Davis).

Franke argues the favourable evaluation of DES is not well-founded and DESs can be expected to improve the situation if they improve the situation as compared to the conventional method of financing investment (Gunter Franke, 1992). In the present analysis it is claimed that for Bulgaria as a troubled country DESs will improve this investment process since the conversion schemes change the quality of the debt and raise the country's creditworthiness. DESs imply a change of the creditor - multinational firms substitute international banks, and in this way the quality of the debt is changed - project financing substitutes of balance of payments deficit financing. This novel way of post-deal methods of financing Bulgariaвs economy restructuring will contribute to the overall management of the economy. From the foreign investorвs point of view this improved quality of the debtor country external obligations means a substitution of the risk of nationalization for the default risk on debt servicing. A control by the foreign investor is effected over the local asset after the swap transaction. This new ownership guarantees efficient management as opposed to the lack of monitoring over the use of money borrowed from abroad.

Through the reduction of foreign indebtedness of the country foreign investors reduce their exposure to risk and inward foreign investments are streamed into the country. It is particularly important for the present situation of Bulgariaвs economy , when levels of domestic and foreign direct investment are insignificant. All advantages that are subsequent from FDI - increased capital formation, private sector development, utilization of country's production and exporting capacity will improve foreign exchange constrains and pick up employment as well as increase social product. These effects amount to increases in liberalization and privatization of state sector, as was the example with Mexico where DESs were used in the privatization of around 520 SOEs.

The termination of the financial isolation which Bulgaria has faced for a certain period of time will open an access of the country to the international financial markets where foreign financing can be obtained at some profitable terms. External resources and foreign influence exerted by outstanding international financial institutions help catalyzing policy measures.

 
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