Debt Restructuring and Rescheduling

1. Debt Restructuring and Rescheduling National Workshop on Capacity-Building For External Debt Management in The Era of Rapid Globalization August 30 – 31, 2005 Francis Odubekun Government Debt Issuance & Management Advisor US Treasury Department – Office of Technical Assistance

2. Debt Rescheduling • Debt Rescheduling - a form of debt re-organization in which debtors and creditors negotiate to defer payments of principal and/or interest falling, due in a specified interval for repayment on a new schedule. • The term “Restructuring” is used to include the rescheduling of interest and principal payments as well as a write-down on the debt principal or interest rate. • Conventionally, Debt Restructuring is the process of rescheduling medium- to long-term debt maturities or refinancing short-term debts and/or interests.

3. Historical Perspective • Debt has been the largest source of capital flows to developing countries in the past 50 years. • Lending increased drastically starting in the 1970s, and today the total external indebtedness of developing countries is close to $3 trillion – representing about 42.5% of their GDP. • Long-term foreign debt owed or guaranteed by governments is $2.2 trillion or 75% of all long-term debt. • Given their weak economies, developing countries have found it difficult to service such debts.

4. International Debt Crises • Long history of sovereign debt problems and crises. Includes advanced economies. • During 1930s Great Depression, both the U.K. and France defaulted on their debts. • During latter 1900s, Latin America became more associated with debt payment problems, • 1914 - Mexico suspended its debt payments. • 1956 – Following Argentina’s debt problems, a group of wealthy industrialized nations met in Paris to develop a solution to problems in Argentina - led to what is now known as the “Paris Club”. • Since the first case involving Argentina in 1956, Paris Club has reached 347 agreements concerning 77 debtor nations

5. 80s & 90s • Following huge lending increases in lending in the mid-1970s, mainly in the form of syndicated bank loans, debt crises swept through developing world, starting with Mexico in August of 1982. • 1994 - “Tequila Crisis” started in Mexico - spread through Latin America and other parts of the developing world. • 1997/98 - debt crisis in East Asia • 1998 - Russian default • 2001 - Turkey • 2002 - Largest sovereign default in history occurred when Argentina defaulted on U$141 billion of public debt.

6. MOVE FROM BANK LENDING TO LARGE-SCALE BOND ISSUANCE • Throughout this debt crisis prone period, there were many efforts to restructure sovereign debts, • Each effort was a problem in itself. • This problem became greater with the introduction of bond lending. • Whereas the restructuring of official debt and syndicated bank loans involved sometimes dozens of lenders, the introduction of bonds expanded the base to involve hundreds if not thousands of creditors.

7. Short-Term Objectives Of Debt Restructuring Solve The Liquidity Crisis By: • Deferring or refinancing most current debt maturities • Spreading bunched maturities over several years Provide New Credits To • Ease the liquidity crisis • Finance imports essential for producing exports that will generate foreign currency

8. MEDIUM TO LONG-TERM OBJECTIVES OF DEBT RESTRUCTURING • Avoid a further liquidity crisis. • Mitigate and eventually eliminate the crisis atmosphere. • Restore a climate in which the sovereign may operate normally in the international credit markets.

9. What Factors Force States To Reschedule Debts ? Origins of the Crisis • Originated in the mid-1970s, following oil price shocks • High prices for commodities • Overly optimistic assumptions about economic growth • Declining terms of trade • Inappropriate domestic economic policies • Petro-dollar recycling • Excessive military expenditure contributed to the building crisis • Corruption

10. What Factors Force States To Reschedule Debts ? • Low interest rates led many countries to contract loan obligations which proved unsustainable when conditions took turn for worse • By early 1980s, commodities prices fell sharply • As real interest rates rose, many developing countries had difficulties in meeting their obligations • Global recession • Some countries were successful in responding to these problems, others could not adjust quickly enough • Debt crisis erupted in 1982, when Mexico announced that it was no longer able to service its foreign debt.

11. EARLY APPROACHES TO THE DEBT CRISIS • Large middle-income countries owed much of their debt to major commercial banks • At first, there was real concern that a default would undermine the international banking system • Debt often exceeded the capital base of many of these international banks • International financial community feared that the banking system would collapse

12. Liquidity vs. Solvency Problems • Initially, it was believed that the debt crisis was due to short-term liquidity problems. • Assumption was that short-term debt relief, such as extended repayment periods, combined with new money and macroeconomic adjustment would return countries to creditworthiness and enhance their ability to finance economic growth

13. EARLY APPROACHES TO THE DEBT CRISIS • Focus was on re-scheduling large, middle-income countries such as Brazil and Mexico, as they presumably posed the greatest threat to the world financial system • Later realization of the uniqueness of each debtor country's debt situation, economy, and debt service capacity, creditor governments agreed to manage the debt crisis on a case-by-case basis • Became evident that many debtors' economic problems were more structural than had been assumed and required a longer-term response from debtors and creditors alike • Meanwhile, private capital from within these countries fled abroad seeking greater and more secure rates of return. This Capital flight exacerbated debtors' difficulties.

14. Baker Plan • In 1985, the Baker Plan embraced a new strategy for managing the debt of middle-income countries. It analyzed a debtor country's adjustment program, then increased bank lending to support policy efforts while continuing to monitor the results through the IMF. • Baker Plan made new money available to sustain levels of investment necessary to restore growth and allow the major debtors to outgrow their debt

15. The Brady Plan • The Brady Plan acknowledged the need to combine the objectives of the debt strategy with those of development policies. • First among the Brady Plan's innovative elements was its explicit recognition of the need for commercial debt reduction and for reducing debt service. • Secondly, the Brady initiative made IMF and World Bank funds (as well as contributions by governments, particularly, that of the Japanese) available to support debt reduction operations.

16. Brady Plan • In May 1989, IMF Board agreed to guidelines defining its role in the new third world debt strategy. • Guidelines provided for separate funds to be devoted by the IMF to debt reduction • 25% of a country's extended fund facility or standby loan arrangement to be "set aside" and • Up to 40% of a debtor country's quota to be devoted to interest support

17. Brady Plan • The Plan recognized the need to loosen legal, regulatory, tax, and accounting constraints that limited the possibility of debt/debt service reduction. • required banks to waive provisions such as sharing and negative pledge clauses in existing agreements • mandated a review of creditor countries' regulatory, accounting, and tax provisions to eliminate disincentives (or create incentives) for debt reduction

18. Mexican Brady Plan • Mexico's debt deal was the first comprehensive deal within the Brady initiative. Banks involved in the negotiations had three options. • First, banks could exchange old loans for new bonds at a discount of 35% of their face value, keeping interest rates at market levels (equivalent to LIBOR + 13/16bps) • Alternately, the banks could exchange old debt for face-value new bonds (called par bonds) bearing fixed interest rates of 6.25%. • The third option was a provision of new money, equivalent to 25% of the banks' medium- and long-term loans. • (Both of the first two options reduced interest payments.)

19. Mexican Brady Deal • Both options also provided for 30 year bonds, whose principal was guaranteed (collateralized) with loans provided by the IMF, World Bank, Japan, and Mexican reserves used to purchase U.S. Treasury zero-coupons • The bonds had 30 year "bullet" maturities - no annual amortization payments, and principal was repaid only at the end of 30 years - which also reduced debt service • Official support also guaranteed interest payments for 18 months (rolling) • Mexico's bonds also included a novel value recovery clause linking debt service payments to oil prices, the country's main source of foreign exchange

20. Mexican Brady’s “Value Recovery Clause” • From July 1996 onwards, if the oil price surpassed the barrier of U.S. $14 dollars per barrel (adjusted for U.S. inflation), up to 30% of the additional revenues would accrue to creditors. • This additional payment, however, could not exceed 3% of the nominal value of the debt converted into new bonds.

21. Mexican Brady Deal • When Mexico signed the deal, its total debt stock was U$95.6 billion • Only the share of the long-term debt with the commercial banks was subject to restructuring. • The debt value involved in the agreement was about U$49 billion, roughly half of the total debt • Principal reduction = $19.7 billion (40%) • Interest reduction = $22.8 billion (47%) • New money = $6.4billion (13%) • Most banks opted for the par bond, implying interest rate reduction ($22.8 billion, or 46.7% of the total). • Other banks ($19.7 billion, or 40% of the total) chose to reduce the principal; • A few offered new loans ($6.4 billion, or 13.1% of the total).

22. Debt Conversion Programs The Brady Plan proposals recognized that the debtors had to adopt policies to attract both direct and indirect investment and that debt/equity swaps could be a useful component of such a strategy. • Several Latin American countries used other debt conversion mechanisms, such as debt buy-back and debt-for-nature swaps.

23. Debt Conversion Programs • A debt-equity swap converts a developing country's debt into equity via foreign investment (direct or portfolio) in a domestic firm. • Once the project is approved, the company purchases the developing country's foreign debt on the secondary market at less than its full face value. • Recently, several developing countries have used extensive conversions of private commercial debt to promote foreign investment, reduce debt, conduct privatization and further other development objectives

24. Debt /Equity Swap • The central bank of the host country redeems the debt in local currency, usually at an implied exchange rate somewhere between the face value and the secondary market value of the paper. • The foreign company uses this local currency to make the approved investment via purchase of shares or an injection of capital. • According to IMF research, an estimated U.S. $33.6 billion of commercial debt was extinguished through ongoing official commercial debt conversion programs between 1985 and 1990. • Chile demonstrates an impressive example, where the conversion of almost 70% of the commercial debt in 1985 overcame the debt overhang significantly and helped the country return to international capital markets. . • Several Latin American countries have successful debt-equity programs

25. DEBT CONVERSION PROGRAM RESULTS Positive Debt Conversion Results Include: • Major reduction in commercial debt • Investment promotion and return of flight capital • Export promotion and import substitution • Privatization • Strengthened private sector finance • Debt conversions can help catalyze FDI flows

26. OTHER DEBT RESTRUCTURING ISSUES • While some countries have survived the crisis, many others, despite their efforts, show clear signs that the debt burden is intolerable and its servicing requirements exorbitant. • Obviously, the poorest and most heavily indebted countries have different needs than lower-middle-income debtors. The debt problem of the poorer developing countries was qualitatively different from that of the large middle-income countries. • Many of the debt-distressed poor countries had a larger debt burden in relation to their economic size and potential. • Moreover, these countries relied heavily on the export earnings of one or two commodities. • A significant decline in the terms of trade for these commodities severely disrupted the countries' capacity to service debt or resume growth. • Recent developments combine the goals of debt relief and development • Because the commercial debt of the poorest countries is small in absolute terms, future measures to help these debt-distressed countries must emphasize grant or highly concessional external finance as well as greater debt reduction. • Consensus that creditors should afford the poorest debtors even more generous terms

27. OTHER DEBT BURDEN ALLEVIATION PROPOSALS Under The "Enhanced Toronto Terms” Creditors Can Opt To: • Cancel 50% of eligible maturities being consolidated • Have interest rates on non-concessional debt.Further stretch export credit and concessional debt repayments • Capitalize reduced interest rates to equalize net present value (NVP) terms with the other options.

28. OTHER DEBT BURDEN ALLEVIATION PROPOSALS TRINIDAD TERMS SUGGESTED: • Rescheduling the entire stock of debt for maturities falling due in 15 to 18 month intervals, instead of re-negotiation tranche by tranche. • Increasing the amount of relief provided by debt stock cancellation from 1/3 to 2/3. • Capitalizing for 5 years interest payments on the remaining 1/3 of the debt stock and requiring phased repayment with steadily increasing payment based on export and output growth in the debtor economy. • Stretching repayment of the remaining 1/3 stock over 25 years.

29. OTHER DEBT RESTRUCTURINGS • During the mid-1980s, larger middle-income countries received better terms than most sub-Saharan African countries. • As a result, many countries "left out" of the Baker initiative have had to seek other forms of debt rescheduling and relief. • E.g., the London Club is one alternative.

30. Role of Paris & London Clubs • The Paris Club and the London Club are the two principal frameworks for restructuring (or, more practically, for rescheduling) sovereign debt. • Each club has a set of rules and procedures used for rescheduling operations. • In general, the Paris Club reschedules debts owed to official creditors, whereas the London Club reschedules debts owed to commercial banks

31. Paris Club The Paris Club is an informal forum where countries experiencing difficulties in paying their debts to governments and private institutions meet with their creditors to restructure these debts. Paris Club is • not a club, • not a formal international organization. • has no offices or secretariat, • has no charter. • ad hoc institution with no legal status.

32. LONDON CLUB • A forum for rescheduling credits extended by commercial banks (without a creditor-government guarantee). • Negotiations often take place in London, • Informal body comprising commercial banks exposed to third World debt. • Like Paris Club, the London Club works to reduce developing countries' immediate debt servicing burdens. • “Membership" is fluid • No formal mandate. • In the London Club, the interests of the creditor banks are represented by a steering committee composed of those banks with the greatest exposure to the debtor country in question.

33. London Club reschedules commercial debts debts The interests of the creditor banks are represented by a steering committee composed of those banks with the greatest exposure to the debtor country in question As a rule, the London Club does not reschedule interest payments, instead, commercial banks provide the country with a "new money" loan as part of the rescheduling package. London Club generally refuses consolidation periods of more than one year London Club may reschedule a debt without requiring the debtor nation to conclude a standby agreement with the International Monetary Fund (IMF). London Club debtors enjoy more flexibility, but incur more expense, than their Paris Club counterparts. The Paris Club reschedules debts owed to official creditors. In the Paris Club, more often than not, the creditors are represented by the most influential among them, regardless of their relative stake in the restructuring in question Paris Club reschedules both principal and interest Whereas the London Club prefers them to exceed two or three years, however, the Paris Club has slowly expanded its consolidation periods Paris Club requires an IMF arrangement London Club Paris Club

34. STEPS INVOLVED IN A LONDON CLUB RESTRUCTURING Seven steps involved in a London Club Restructuring: • First, the debtor declares a moratorium on payments, • Forms a debt management team, and • Drafts an information memorandum. • Simultaneously, the creditors form a steering committee or bank advisory committee (BAC). • The parties convene at the exploratory meeting. • They then negotiate the heads of terms (hot) and, • Document the rescheduling agreements.

35. THE ROLE OF THE IMF AND WORLD BANK • Throughout the 1980s, the multilateral financial institutions became increasingly involved in resolving the debt crisis. • The role of the International Monetary Fund (IMF) is to preserve the financial integrity of the world monetary system and to provide balance of payments assistance to countries experiencing debt service difficulties. • the IMF attempts to hold the appropriate balance between the adjustment effort required from the debtor countries and the commitment of new external finance from the commercial banks and official creditors

36. THE ROLE OF THE IMF • Assist in formulating adjustment programs that incorporate performance criteria from debtor countries' upper credit tranche drawings. • Provide stand-by facility or extended fund facility. • Act as a catalyst in facility or external funds from commercial B banks.

37. THE ROLE OF THE WORLD BANK • World Bank and other regional institutions) provide concessional and non-concessional finance for development purposes. THE ROLE OF THE WORLD BANK • Support debtors' stabilization programs. • Establish structural adjustment lending programs. • Mobilize funds from other sources for future development of debtor countries. • Provide technical assistance in debt management.

38. IMF • Every debt rescheduling exercise, requires a debtor country to have an IMF program or a similar adjustment program in place. • Before creditors enter any serious rescheduling negotiations, the IMF must confirm that the debtor is pursuing an economic program that would set it on the path to recovery. • Creditors adopted this policy in response to their perceived helplessness in monitoring the economy of debtor countries.

39. SUMMARY • Creditors and debtors may view progress in dealing with the debt problem differently. • From the creditors' point of view, the strategy seems to be quite successful. • A disruption of the financial system has been avoided, • debt is being serviced in most cases, • banks have managed to reduce their exposure, and • debtor countries are pursuing sound adjustment programs. • Debtors, however, give a less positive evaluation of the debt strategy.

40. NEW PROPOSALS FOR SOVEREIGN DEBT RESTRUCTURING • Irrespective of the outcome of the debate over whether such borrowing has been useful, it remains a fact that the debt build-up has led to repayment problems and in some cases default. • The current framework for addressing default, bankruptcy and debt restructuring has proven to be inadequate in sorting out these problems. • Several efforts underway to establish a new and more effective restructuring process.

41. NEW PROPOSALS FOR SOVEREIGN DEBT RESTRUCTURING • While the restructuring of official debt and syndicated bank loans involved sometimes dozens of lenders, the use of bonds involves hundreds if not thousands of creditors. • Widespread agreement for the need for a sovereign debt restructuring process, • Disagreement over what the actual process should be. • A framework will need to protect the rights of creditors and debtors, and protect debtors from civil law suits during the structuring process. • Process should prevent rogue vulture hedge funds from delaying or otherwise disrupting the restructuring process and from profiting from others’ efforts to forgive and restructure outstanding debt.

42. Three Basic Approaches • SDRM proposal calls for the creation of an institution to act as an arbiter in a new formalized process which would work along the lines of an international bankruptcy court. • “Collective Action Clauses” to allow a majority of creditors to set the terms of restructuring • Adapts U.S. sovereign bankruptcy law, known as “Chapter 9”, to the needs of developing countries

43. SOVEREIGN DEBT RESTRUCTURING MECHANISM Four “core features”: • Majority rule (as opposed to unanimity) in restructuring decisions, • A legal “stay” against claims by creditors, • Protection of creditor interests, and • Priority financing.

44. Collective Action Clauses • Focuses on the writing of bond and loan contracts to include clauses that would prevent a minority of creditors from blocking negotiations with the debtor. • Decentralized market-oriented approach, as opposed to the centralized non-market approach of SDRM. • Collective Action Clauses (CACs) would bind in a minority (and therefore, any vulture funds) and allow a majority vote (usually a super-majority of 60% to 75%) to determine the outcome of a restructuring agreement. • The principal shortcoming with this approach is that CACs can only be included in future debt, • The enormous amount of currently outstanding debt would not benefit from their inclusion.

45. Holdout Creditors • Further complicating matters is the fact that some creditors might not be willing to relinquish their contractual rights. • These holdout creditors can refuse to participate in the restructuring and/or accept a rescheduling of debt. Rather, they demand payment according to the terms set forth in the original bond. • The situation has been exacerbated by the aggressive legal strategies employed by so-called “vulture funds,” which buy distressed sovereign debt on the secondary market and then sue for contractual interest and principal payments. • The case of Peru’s debt restructuring illustrates the litigious holdout creditor problem to date

46. Issues of Legal Jurisdiction • Even if CACs are employed in all new debt issuances and this effectively creates a new universal legal framework, there will still not necessarily be a uniform interpretation; • It will be up to individual jurisdictions to interpret the clauses, according to their domestic law. • Central to the holdout creditor problem is the question of jurisdiction. The governing law often determines whether or not creditors may vote to alter the payment terms of the bond. • Either English or New York law governs most sovereign bonds

47. English vs. New York Law • Under English law, any provisions, including terms of payment, can be changed via supermajority vote (usually 66⅔% or 75%). • A majority of creditors can impose a restructuring on the holdout creditor, which eliminates the holdout’s ability to disrupt the process. • Bonds governed by New York law, on the other hand, have a unanimity requirement. • Payment terms of the lending agreement cannot be changed unless 100% of bondholders agree to the new arrangement

48. Exit Consents • The desired effect is to provide a disincentive to holdouts. • After the details of the debt restructuring are negotiated, creditors exchange their old bonds for new issues. • As the exchange is taking place, creditors agree to alter certain clauses of the original bonds to make them less attractive. • E.g., The old bonds might be de-listed from the exchange on which they trade, making them illiquid, or have the waiver of sovereign immunity removed. • In the us corporate context, exit consents have successfully “coerced” unwilling creditors to accept an exchange offer.

49. CHAPTER 9 OR FTAP PROPOSAL • Third proposal for a better restructuring framework proposes that Chapter 9 of U.S. bankruptcy law be applied internationally to sovereign debt. • Chapter 9 functions in the U.S. to protect the rights of indebted municipal governments and public agencies in order to protect the rights of taxpayers and public sector employees, and allows for their full participation in, and ability to object to, the outcome of a debt rescheduling process. • Would allow an indebted nation to file for a stay. • As with the SDRM proposal, there will need to be a third party body to be put in place to resolve the conflict between the debtor and creditors. • Unlike the permanent DRF, this body is proposed to be ad hoc, appointed with each petition for a stay, and also is to act as arbitration panel.

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