Monday, July 09, 2007

Debt Swap in Brief

Debt crises of the 80s forced creditor and debtor countries to look for mechanism that can ease the burden of debtor countries. In 1985, Chile became the first country to introduce debt-equity program, i.e. mechanism to swap debt of developing countries that could not pay their foreign debts. In this program, sovereign debtor’s commercial debt from private creditor is bought by investor in secondary debt market and then converted into share investment in debtor country. Debt-equity swap has contributed to reduction of debt and increase of investment in developing countries.

Debt-swap mechanism was also applied in nonprofit sector in the form of debt-for-nature swap in Bolivia in 1987. This was followed by debt-for-developmentswap in other sectors such as child development, education, and health. Although debt-for-development and debt-for-nature swap is being replaced by debt-equity swap as the main means of debt reduction in developing countries, the nominal of their transactions remains significant in financing development.

Since it is considered as a new and innovative product, debt swap has become a standard for debt manager in developing countries for the past 20 years. More or less 50 countries has been implementing debt swap since 1985. In the first decade since its introduction, three-party debt-swap that involved conversion from commercial debt and export credit took the main stage. However, since the addition of debt swap clausal in Paris Club in 1990 bilateral debt has also become eligible for swap.

Debt belonging to multilateral institution is not included in debt swap operation because of the creditor’s status as multilateral institution. In addition, the initiative of Heavily Indebted Poor Country (HIPC) involves multilateral debt conversion de fact because debtor countries have to have a commitment to implement poverty reduction program as a prerquisite for HIPC debt relief.

Bilateral debt conversion may be applied in poor countries as long as it is related to debt conversion program. Paris Club debt swap clausal for debt rescheduling in 1990s regulates the framework of debt conversion bilaterally. The clausul regulates:

-debt reduction program for converting Official Development Assistance (ODA) to become fund for development and environmental projects. Several bilateral aid agencies have bought debt from export credit agent and commercial creditor.

-debt selling programs for converting non-concessional export credit—which is mostly debt-equity swap. In this program, the agent of creditor country—mostly export credit agency/ECA or Ministry of Finance—sells debt to potential investors for debt conversion transaction.

Non-Paris Club bilateral creditor have also sold debts for debt swap transaction, generally through ad-hoc transaction negotiated with investors or through bilateral agreement negotiated directly with the government of debtor country.

From the perspective of debtor countries, the advantages of debt swap program are:

§ Debt reduction. In general, debt conversion can be recognized from the reduction of the number of debt through discount from lower face value or redemption price.

§ Positive impact on payment balance. The positive impact of debt swap on payment balance is the decreasing amount of debt service payment in foreign currency. The implementation of debt-for-export swap can also increase export value and trade balance.

§ Investment encouragement. Debt swap can be formulated to increase investments on prioritized sectors. Debt-equity-swap is an incentive to encourage privatization or facilitate the return of capital that has been moved by its citizen to other countries.

§ Increase of fund for development programs. Mexico and Madagascar have applied debt-for-development and debt-for-nature swap by offering interesting redemption level for non-profit investors.

However, still from the point of view of debtor countries, the disadvantages are:

§ Fiscal cost of debt prepayment. If debt swap requires that payment should be made in local currency, it will take a considerable amount of fund from the budget to finance the prepayment, thus adding extra burden to the budget.

§ Inflation risk. The negative impact of debt swap is large intake of fund in local currency that can increase the level of inflation. To reduce such undesirable impact, the government can stipulate the ceiling of total fund intake in local currency.

§ Transaction cost. Debt swap transaction is complicated and requires a considerable length of time, thus necessitates some resources for negotiating, documenting, and monitoring the entire length of transaction. On certain cases, Governments may need to hire consultants to assist them throughout the process.

§ Investor corruption risk. Debtor countries should instigate close supervision to prevent ‘roundtripping’, i.e. investor transfers local currency obtained from debt conversion to other countries to get illegal profit.

§ Policy conditionality. Debt swap that takes the form of acquisition of local assets by foreign owner may result in resistance from local community due to their sense nationalism since undoubtedly the foreign owner will take full control of the said assets.

§ Investment subsidy. Debtor countries may give investment subsidy because in debt-equity swap, usually the government gives incentive to foreign investor in order to implement privatization.

The forms of debt swap, debts eligible for debt swap and the form of debt conversion are as follows:
Indonesia has also been involved in debt swap. Until recently Indonesia has received offer of debt swap from four creditor countries; Germany, Great Britain, France and Italy. The debt swap schemes offered by the four countries vary. Germany and Italy offer largely similar scheme, i.e. debt repayment through the implementation of agreed development projects. Germany has agreed upon two projects regarding elementary education quality enhancement and is considering another related to environment. Meanwhile, Italy offers development
project especially in the area hit by Tsunami like Aceh and North Sumatera. Great Britain and France offer debt swap that involves third party as investor. Debts offered to be written off are non-ODA debts that are almost similar in nature to commercial debts. The theme offered by the British is employment provision and environment conservation, while the French focuses on increasing foreign investment in Indonesia.

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