The Debt-Equity Swap

The Third World's tough-talking creditors can be surprisingly flexible at times - particularly when they are in need. With debt-strapped developing nations stiffening their resistance to repayment, commercial banks have introduced new ways to eliminate unprofitable loans from their portfolios.

In an increasingly popular maneuver, banks are teaming up with multinational corporations to swap unwanted Third World loans for investment in the developing world.

The technique grew out of the burgeoning "secondary market" in loans to debt-ridden Third World nations, particularly in Latin America. In this market, Mexican debt has been selling at about 60 percent of its face value, Peruvian debt at about 20 percent.

The debt-equity swap brings together debtor, creditor and capital investor. For example: A U.S. bank wants to rid its portfolio of a $10 million loan it made to Mexico. A major multinational wants to expand its Mexican subsidiary. The bank sells the $10 million loan to the multinational in the secondary loan market for $6 million - its value in the secondary loan market. The company, in turn, sells the loan back to Mexico for $8 million worth of investment in its subsidiary.

In practice, debt-equity swaps are complicated transactions that can involve several brokers and are subject to both domestic and international currency regulations. Although the most common kind of swap has involved multinational investment in exchange for external public debt, some countries permit private debt to be exchanged and some banks have invested directly in debtor economies.

To date, banks are estimated to have eliminated more than $2 billion in unwanted loans using this technique. And companies like Nissan, General Motors, Fiat, Chrysler, American Express and Dow Chemical have used the mechanism to invest or retire the domestic debt of foreign subsidiaries. Over a dozen debtor nations, led by Mexico, Chile, and the Philippines, have already established or are actively considering debt-equity swaps.

"It's a win-win situation," says Paul Feldman, a spokesperson for the American Express Bank, which recently swapped a $100 million loan for an investment in 3,000 rooms in luxury hotels in Mexico.

Debt-equity swaps also fit nicely into the growing drive by Western governments and the multilateral lending agencies to promote privatization in the Third World.

Advocates say debt-equity swaps provide debtor nations with much-needed foreign investment and reduce, if only slightly, often staggering debt burdens without harming what's left of the countries' creditworthiness.

But critics of debt-equity swaps contend that in most cases, investors are simply being offered bargain basement prices on investments they would have made anyway - and all at the debtor nation's expense.

Moreover, since the debtor nation has to generate the local currency to buy back its loan - albeit at a discount, it runs the risk of fueling inflation. It also loses the foreign exchange that would have come with direct investment.

"Bankers look at who's investing [in a given country] and find people who had intended to invest anyway," says Rudiger Dornbusch, a Massachusetts Institute of Technology economist.

"There's a lot of enthusiasm for [debt-equity swaps] because they're madly profitable" for the bankers and investors involved, Dornbusch added. Bankers' brokerage fees alone can run as high as 15 percent of the value of the swap. ,

Most debtor governments also take a commission on debtequity deals. And so far at least, countries like Chile and the Philippines have been able to avoid potential monetary pitfalls by keeping a tight rein on the pace of swaps and setting down strict rules to govern investors' activity.

More significantly, however, Dornbusch and other critics also discount the theory that debt conversion will stimulate significant new flows of investment to the Third World.

"Conversion reduces the [investor's] cost of net foreign investment," says one development banker, but swap discounts alone won't be enough to entice investors into unsound economies. Instead, he says, the technique may end up shortchanging developing nations by cheapening valuable investment opportunities.

Wary of such problems Reginald Velasco, an economist with the Philippine embassy, said Manila intends to limit debt conversion deals so that investors don't take discounts for granted.

Out of S200 million worth of offers, only about $60 million in Philippine debt has been swapped for investment in the country. According to Velasco, American Express cut the largest deal to date when it purchased a 40 percent stake in Interbank, a commercial bank.

"There is an ambivalent attitude" toward debt swaps, Velasco said. "We want investors to come in because of market conditions, not because of the favorable conditions offered under this program."

Jorge Castaneda at the Carnegie Endowment for International Peace, says another problem with debt-equity swaps is that they do not allow the debtor nation much say over where investments should be made.

"What kind of a swap is set up depends essentially on chance," Castaneda said. "There's no development strategy behind it" since investments depend upon match-making between banks and investors in the marketplace.

And with the Third World's total debt burden now estimated to exceed $1 trillion, no one argues that debt-equity swaps are a solution to the debt crisis.

Enrique Larrogau, a Dow Chemical executive, calls the technique "a small valve" to reduce the growing pressures associated with the debt crisis.

"Bankers are not in a winning position. They are cutting their losses," Larrogau says.

As for the debtor nations, Larrogau says, "they're not losing anything. The discount is coming from the bank. Countries haven't taken any loss."

Under current conditions, the mechanism may simply offset new obligations. In 1985, for example, Chile used swaps to eliminate about $1 million worth of its $20 billion external debt. Against that reduction, however, Santiago borrowed about $1.5 million in new loans in 1985.

The growing enthusiasm for debt-equity swaps creates difficult questions for U.S. bank regulators and accountants, who must decide whether banks that engage in such deals should be forced to write down the book value of their Third World loans to match the secondary market rate.

According to Robert Bench, deputy comptroller of currency, "The regulatory environment is neutral, flexible, and not necessarily an impediment to swap transactions."

Bench, addressing a January conference sponsored by the Washington-based Heritage Foundation, added that "the accounting treatment for swaps, while not uniform, appears accommodating."

But Anthony Quale, a New York partner in the law firm Sidley and Austin, says regulators who have discretion over the question of write-downs need to ease regulations where possible, in order to allow banks to participate in swaps without being penalized for the loans they retain.

To date, the banks most active in selling discounted loans to investors have been the European and regional U.S. banks, that generally have already written down their Third World loans and can afford to absorb these losses.

The big money center banks, whose capital is far outweighed by the volume of outstanding Third World loans, have avoided outright confrontation with regulators by brokering deals for each other, rather than swapping their own loans directly with investors.

Acting as brokers, these banks have successfully argued that in brokering sales on someone else's loan, they are responding only to the demands of the marketplace, not altering the inherent value of the loan.

"If someone wants to sell a loan at 60 percent, that doesn't mean it's not worth 100 percent," says one banker. "It just means that person would rather take 60 percent now than gamble on 100 percent. That's just market psychology."

Sizing up the Debt Swap

Chile has turned more than $1 billion of public and private debt into investment, making Santiago the leading player in debt-equity conversion schemes.

The Chilean government distinguishes between debt-equity swaps that bring foreign investment into the country and conversions that typically involve local residents, and imposes slightly different rules for each.

Other governments currently prohibit local investors from participating in debt-equity conversion schemes. Mexico, which now prohibits local participation, is planning to change its rules.

With its debt selling at a discount of about 30 percent, the Chilean Central Bank authorized over 60 debt-equity , conversions that largely involved foreign investors in the I period from June, 1985 through December, 1986. These transactions were worth $346 million, and the Chilean Central Bank is now studying similar proposals worth an additional ' $400 million, according to Dr. Claudio Pardo, alternative executive director of the World Bank.

The government has imposed strict regulations to govern investment flows under the scheme. Restrictions adopted in May 1985 prohibit foreign investors from repatriating capital until 10 years after completion of the investment operation. ' Remittance of dividends is allowed four years after completion, and dividends accumulated during the first four years can be remitted in annual installments of 25 percent, according to a World Bank source. Dividends from foreign investment that result from such swaps are taxed at a higher rate than those generated by local enterprises.

Critics caution that if the Chilean economy does well, repatriation of profits may take more foreign exchange out of Chile than the amount of interest and principal payments due on the original loan. But advocates argue that Santiago would still come out ahead, since the economy has become more productive as a result of the investment.

Among the companies that have entered into debt-equity swaps in Chile are Nissan, Dow Chemical, and Bankers Trust.

Mexico, with a long tradition of wariness toward foreign investment, imposes more stringent rules for debt-equity swaps than Chile. Only about $500 million in debt has been swapped.

A key feature of the Mexican plan is that the Central Bank gives discounts according to how valuable Mexico City considers the investment. Some investors receive no discount, while others receive discounts of up to 25 percent.

For example, investments that boost exports, involve technology or small- to medium-sized firms are given a high priority. Acquisition of equity in parastatals, state-owned companies, that the government has decided to sell are not discounted at all, according to a World Bank source.

Only foreign investors are allowed to convert debt into equity in the country, and only the debt of state-owned entities may be converted under the scheme.

Under the government's regulations, such swaps are only approved if the investor is judged to be the only source for the investment funds, and the investment is deemed necessary to the survival of the operation.

Companies that have used debt-equity swaps to invest in Mexico include Nissan, Volkswagen, and a Philadelphia chemical company, Rohm & Haass, which traded foreign debt for a $3 million investment in its Mexican subsidiary, according to the U.S. State Department.