metadata: authors: 0: author: Claessens,Constantijn A.
1: author: Diwan, Ishac
2: author: Fernandez-
count: World
docna: 0: docna: Recent experience with commercial bank debt reduction
docty: Policy Research Working Paper
subtopic: Debt Relief and HIPC,Human Rights,Banks & Banking Reform,Capital Markets and Capital Flows,Capital Flows,External Debt,International Trade and Trade Rules,Debt Markets
teratopic: Environment,Finance and Financial Sector Development,Macroeconomics and Economic Growth
abstracts: cdata!: The authors review the case for
            market-based debt reduction and concerted debt reduction.
            They explain the new menu-based approach to debt reduction
            and discuss why it may be preferred to market-based and
            concerted debt reduction.  In a review of the five recent
            debt-reduction agreements, they find that the menu approach
            indeed achieved debt reduction at substantially lower costs
            than a comparable market-based operation.  By one measure,
            the five countries may have saved more than $8 billion.
            Even a menu-based approach to debt reduction, however, is
            unlikely to directly benefit the debtor financially.  They
            find that the debtors suffered financial losses equal to a
            few percent of their GDPs.  Indirect benefits, or efficiency
            gains associated with debt reduction, are necessary to make
            the operation benefit the debtor.
repnme: repnme: Recent experience with commercial bank debt reduction
display_title: Recent experience with commercial
            bank debt reduction
listing_relative_url: /research/1992/10/699551/recent-experience-commercial-bank-debt-reduction
topicv3: Commercial Banking m1326069 1236,Debt Relief m1326505 452,Trade m1326924 698,Capital Markets m1326967 332,Discrimination m1505707 3379
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment,Finance and Financial Sector Development,Macroeconomics and Economic Growth
origu: International Economics Department
no_of_pages: 52
model_extractions: Ir -16 b <!-- Start of picture text --> _ _ Policy Re"aeroh<br>DetadIntemallonal Finance<br><!-- End of picture text --> WPS 995

- This paper a product of the Debt and Intemational Finance Division, Intemational Economics Department- is part of a larger effort in the department to understand the costs and benefits to countries of debt and debt service reduction arrangements. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room S8-042, extension 33722 (October 1992, 48 pages).

Claessens, Diwan, and Fernandez-Arias review the case for market-based debt reduction and concerted debt reduction. They explain the new menu-based approach to debt reduction and discuss why it may be preferred to market-based and concerted debt reduction.

In a review of the five recent debt-reduction agreements, they find that the menu approach indeed achieved debt reduction at substandally lower costs than a comparable market-based operation. By one measure, the five countries may have saved more than $8 billion.

Even a menu-based approach to debt reduction, however, is unlikely to directly benefit the debtor financially. They find that the debtors suffered financial losses equal to a few percent of their GDPs. Indirect benefits, or efficiency gains associated with debt reduction, are necessary to make the operation benefit the debtor.

**IPe** Pohicy Research Working PaperSeriesdisseminatestheiidingsofworkunder way in theBank Anobjectiveofthe senes is to get these findings out quiclcly, even if presentations are less than fully polished. The fndings, iriterpretations, and conclusions in these papers do not necessarily repesent of ficial Bank policy.

Produced by the Policy Research Dissenmination Center
Recent Experience with Commercial Bank Debt Reduction Stijn Claessens, Ishac Diwan and Eduardo Fernandez-Arias1 IECDI, The World Bank 'We would like to thank D.C. Rao, Masood Ahmed, John Underwood and participants in a Bank semitisr for their comments, and Danny Cassimon for his research assistance.
# Table of Contents

|Intro|duction|3|
|---|---|---|
|I.|Efficiency Gains and Benefits of DDSR|6|
||Efficiency Gains of DDSR<br>The Net Benefit of DDSR|7<br>12|
|II.|Financial Cost of Debt Reduction|14|
||Valuation of Country Debt and Financial Costs<br>Minimizing Fmancial Cost: The Case for Menu-based<br>Debt Reduction|14<br>17|
|M1.|<br>Experience of Brady Deals|26|
||The Extent of Debt Reduction<br>Cost Reduction in Menu-based Operations<br>Financial Gains of Commercial Banks<br>Financial Cost to Debtor Countries|26<br>29<br>32<br>34|
|IV.|Concluding Remarks|37|
|Tabl|es|39|
|Refe|rences|45|
|Ann|ex Table|47|
3

# Recent Experience with Commercial Debt Reduction

# INTRODUCTION

Over the years, many proposals have been made to resolve<sup>the commercial debt problems</sup> of middle-income developing countries (see Carmichael<sup>(1989) for an overview). During a</sup> period of time, international policy makers considered market-base **d**<sup>ebt reduction an attractive</sup> means to solve the debt problem. Market-based debt<sup>reduction transactions involve the</sup> repurchase (or conversion into other claims) by the debtor of<sup>its commercial debt at a discount</sup> through an open-market operation. Market-base **d** ebt reduction<sup>transactions increased sharply</sup> after 1985, from about $1 billion in face value of debt retired<sup>to over $17 billion in 1988 (see</sup> the Quarterly Review, World Bank, various issues).<sup>The results were mixed, however, as debt</sup> burdens remained high and economic performance in many of<sup>the indebted countries remained</sup> poor.

Over this period, many proposals involving government intervention were<sup>made, often</sup> centered around an institution involved in buying up commercial<sup>debt at a discount and forgiving</sup> part of it. Most of these proposals involved a concerted<sup>approach to debt reduction, i.e., all</sup> creditors would have to sell their claims to the institution or<sup>be forced to participate in debt</sup> forgiveness in a uniform way. None of these concerted proposals<sup>were implemented to solve</sup> the commercial debt problems.

What did occur was official support for a menu-based approach.<sup>In 1989, officials of</sup> several creditor countries-former Finance Minister Miyazawa of<sup>Japan, President Mitterand of</sup> France, and Secretary Brady of the United States--proposed topromote official support for debt and debt reduction (DDSR). The Brady plan finally adopted<sup>in May of 1989 involves the IMF,</sup>
4 the World Bank, and the Japanese government providing between $30-35 billion in funds to support DDSR operations agreed by debtor countries with their commercial creditors. Since the introduction of the Brady Plan, five countries (Mexico, Philippines, Costa Rica, Venezuela, and Uruguay) have received official support and reached agreements with their commercial creditors on DDSR packages reducing commercial debt obligations and/or converting debts into collateralized bonds and/or domestic assets. At the time of writing, the Philippines (second phase), Brazil, Argentina, Poland, and Ecuador, among others, are negotiating with their creditors agreements along similar lines.<sup>2</sup> The two key features in these agreements are the participation of virtually all commercial banks<sup>3</sup> and the use of a menu of different options, including both debt reduction and new money, from which banks have to choose. This differs from previous, market-based debt reduction transactions in that, like in a concerted operation, aU banks need to agree to some form of restructuring for the agreemen **t** o be concluded. By contrast to a concerted approach, however, this menu-based approach allows banks to freely choose among the menu of options, and therefore does not impose the same treatmen **t** o all banks.

The main purpose of this paper is to evaluate the financial implications of these three approaches, namely market-based, concerted, and menu-based, from the point of view of the debtor and the creditors. After a background discussion on the development impact of DDSR operations and their benefits to aU parties, conducted in section I, we focus on the evaluation of the three approaches. In section II, we discuss the analytical case for market-based debt 2Nigeria concluded an agreement in Febniary 1992. About twenty countries wers initially singled out as potential recipients of Brady treatment 3A partal exception is the Philippines opemtion, where about one fourth of eligible commercial bank debt was not involved in the restnturing.
# S

reduction and concerted debt rducdon, explain how dhe new menubad approach to debt reduction woiks, and discuss tie reasons why it may domnte te odhe two methods of debt reduction. In section m, we nevw the five recent Brady deals and evaluate our dieoretdcal analysis regarding the workdngs of the menu-bod appoch apins acta picce. Finally, in section IV, we conclude by dfawing lsons from he deas.
6

# **_I._ EFCIENCY GAI AND BENEFTS DF** DDSR

The main moti' ation for DDSR is the creation of efficiency gains by unlocking the inefficient arrangement in which some indebted countries and commercial banks are trapped into. At the root of this inefficient arrangement is the lack of enforceability of sovereign contracts, which limits the countries' ability to credibly commi **t** o future payments and, consequently, their ability to attract foreign financing beyond a relatively low ceiling. Once circumstances are such that this ceiling is surpassed, a debt crisis sets in and commercial banks retrench, lending only on a negotiated, involuntary basis. While in these circumstances both banks and countries have a common interest in efficient domestic investment helped by adequate external financing, whose returns they could share in a mutually advantageous way, the implementation of a cooperative arrangement between creditors and debtors would require commercial banks to limit their retrenchment facilitating the countries' investment effort. In practice, coordination failures among banks and the relative inability to credibly commit to cooperate in the future of all the parties involved have precluded the implementation of such cooperative arrangements. Instead, short-sighte **d** ebt rescheduling negotiations have taken place resulting in inefficient outcomes. The inefficient arrangement that DDSR attempts to improve is characterized by disincentives to domestic investment and the lack of external financing, which result in low domestic investment. Efficiency gains from DDSR relate to more and better domestic investment as well as more efficient external financing, both in terms of volumes and risksharing features. DDSR can lead to a new structure of commercial bank debt whose face value is reduced and mostly converted into bonds, where permanent and relatively low ceilings on debt
7 service are established, and where some insurance is provided in th; form of fixed nominal interest rates and recapture clauses.

## **_Efficiency_** _Gains_ **_ofDDSR_**

DDSR operations are carried out in the expectation that these characteristics generate efficiency gains. These efficiency gains of DDSR can be classified in three (partially overlapping) categories: (i) those related to the cashflow implications of the DDSR agreement, the direct benefits; (ii) those reiated to changes in the debtor's economy following DDSR, the domestic indirect benefits; and (iii) those related to changes in the behavior of creditors following DDSR, the external indirect benefits.

# **Ci)** Cashflow implications of the DDSR agreement: direct benefits

The financing of the DDSR operation matters. To the extent that the debtor country is capital-rationed, investment is inefficiently low and cashflow relief can have a positive effect on domestic investment. However, DDSR tend operations expected to be front-loaded because the debtor country has no credible way to commit to future compensation in exchange for upfront debt reduction. The financing of this upfront liquidity need is thus important. When financing comes from domestic sources or from external grants and loans that the debtor would have received anyway, this liquidity leads to inefficient outcomes as investment is reduced.<sup>4</sup> If exte'nal, additional financing is used, this inefficiency can be avoided.

Sro **the extent that part of this financing would have been used for investment purposes and that part of the associated future output would have been used for debt service to the same banks, the banks end up paying part of the DDSR bill. Feemandez-Arias (1992) presents financial savings under different debt-servicing scenarios and the possible implications on investmext.**
8 More generally, changes in cashflows affect liquidity and investment. In section m we show that DDSR operations are financially costly to countries and, therefore, cashfiow savings are negative (in present value). This implies that cashflow savings are not a likely source of efficiency gains (see also Fernandez-Arias (1992)).

# XLi~ Cha in the debtor's economy: the domestic indirect benefits

Debt reduction can lead to indirect benefits in the debtor economy. These indirect benefits depend on the specifics of domestic economic policy, and, in general, are fuzzy and 5 difficult to predict pre deal. A case by case analysis is in general required. The mechanisms that can bring about thuoe gains comprise the following:

- (a) Debtors repay (part of) their debts because a failure to do so would expose them to the various penalties creditors can impose. These penalties will be related to, among others, the country's access to goods and financial markets. For a highly indebted country, this implies that actual repayments will depend on the activity that is subject to the threat of penalties. This can lead to distortions. For example, penalties may be related to trade and an increase in trade will then be associated with larger debt repayments. This implies-at the margin-a disincentive to engage in trade reforms. More generally, the threat of penalties can lead to the ixpectation of a high future "tax" (Sachs, 1990 and Krugman, 1989) and distort incentives to engage in all kind of investments and reform efforts (that are often akin to investments). Depending on the severity of the

'Feandez-Aims _(1992)_ disusses _the ex-post_ evidence on some of _these_ domestic indirect :ienefits.
9 penalties, debt reduction can leads to a reduction of these disincentives;

- (b) A second type of inefficiency is introduced by the increased uncertainty (about future fiscal and foreign exchange developments) associated with a debt overhang. In general, the negotiation and bargaining process is associated with uncertainty (sometimes as a result of posturing) about timing, extent and nature of debt servicing. In the face of this uncertainty, investors will often prefer to postpone their investments (and engage in capital flight). A DDSR agreement can lead to a reduction in uncertainty, which can then lead to increased private investment and a repatriation of flight capital;

(c) A third type of inefficiency may be related to an asymmetry in information between debtors and creditors, where a 'good" debtor is unable to convey to the creditors its true characteristics. To the extent that DDSR is advantageous only to a good debtor--when post deal the economy performs better than expected by the creditors and the repayments do not become a burden to the country--DDSR can be used by the debtor to signal its "true" creditworthiness to investors. Furthermore, a large DDSR deal that is supported by the IFIs (and accompanied by their conditionality) can in this respect also act as a signal and increase market confidence: the IFIs are presumably better informed about the debtor and, by providing some of their own money in the context of a DDSR deal, signal their confidence in the debtor; and (d) A fourth type of inefficiency is related to the internal transfer that the government has to achieve in order to collect the needed revenue to service public external
10 debt. If the internal transfer is achieved by raising taxes from some economic sector (e.g., trade, financial markets), these sectors will be less profitable, and less iavestment will occur. Often this will be accompanied by capital flight. If the inflation tax is used to raise the necessary government revenues, relative prices will likely be distorted and an inefficient allocation of resources can result. Reductions in public debt service can alleviate these distortions and lead to efficiency gains. Possibly more important than the cashflow savings in external debt, discussed in (i) above, is the reduction in domestic interest rates and the public debt premium as a result of uncertainty reduction and the other factors previously discussed.

- (e) Last, are domestic political factors. A DDSR deal may lead to an increased domestic acceptance of austerity as the burden of reforms is now perceived to be shared with extemal creditors. This may make the reform process mc -e viable and ultimately lead to increased output and higher repayments to banks.

# (iii) Effect of DDSR on the creditors: the extemal indirect benefits

To discuss the effects on the creditors, it is useful to recall the definition of a debt overhang. A debt overhang is defined as a situation where the existing debt is unlikely to be serviced in full, leading to a secondary market discount and a cut-off of voluntary credits. This is consistent with profitable investment opportunities in the ^ountry. In principle, the existing creditor group as a whole could gain by providing the debtor with some liquidity to take advantage of existing investment opportunities and in that way increase the country's capacity
11 to repay. Small creditors, however, will try to escape the burden of this concerted lending approach by free-riding on the efforts of the larger creditors. This of course reduces the desire of larger creditors to provide liquidity.

DDSR can now create efficiency gains if it increases the scope for cooperation among creditors by allowing smaller creditors (potential free-riders) to exit. DDSR, if it is deep ennugh, can also create headroom for new types of creditors. When these new creditors (e.g., international financial institutions (IFIs) and foreign direct investors (FDI)) provide additional value (e.g., through their conditionality and monitoring of investments) or technology transfers, whic&' allows them to deal more effectively than commercial banks with the particular problems of the highly indebted countries, additional efficiency gains may be realized (Diwan and Rodrik, 1992).

The exact nature of these inefficiencies--and the gains from removing these inefficiencies through a DDSR operation--will depend most on three factors: the type of penalties the country is exposed to; the instruments used to raise government revenues; and the relationship between the country and its creditors. These factors wiU in general be hard to quantify and a case-bycase analysis will be required. The only general rule that may be developed is that DDSR, by removing some disincentives, can increase the likelihood of success of an existing reform program (or make it more likely that a reform program becomes acceptable for the country), and in that way lead to efficiency gains and increased output. DDSR is thus more likely a profitable possibility when a good program is in place, but unlikely otherwise.

The DDSR experiences are too recent to be fully evaluated (Femandez-Arias (1992) presents some preliminary evidence). Nevertheless, they sugges **t** hat the deals have led to very
12 favorable results in Mexico and in Venezuela, and moderately favorable ones in the other countries. In Mexico the debt deal has been associated with a sharp decline in domestic interest rates<sup>6</sup> , and both in Mexico and Venezuela the stock markets has risen, and a renewed access to the world financial markets has occi.red.7 For the other countries, the impact has been less pronounced. In case of Costa Rica and the Philippines, policy slippages and the impact of adverse internal and extemal shocks (Gulf crisis, earthquake, coup, lower export prices, etc.) initialy diluted or dissipated the possible positive effects of the agreements. In the case of Uruguay, the agreement is too recent to be able to fully evaluate it. In all cases, the policy framework has proven to be the most important factor.

# **_The_** _Net_ **_Beneogt of DDSR_**

To the extent that the operation entails efficiency gains, the debtor country could benefit from it. Note that the country's benefit is a welfare concept, and therefore the benefit is only the additional value of the investment return in excess of that of foregone current consumption. These benefits come at a cost to the country. In order to obtain the net benefit derived by the debtor country, the financial cost of the operation needs to be subtracted. This financial cost comprises the direct cost of debt reduction (e.g., the resources paid to banks in a buy-back operation) and the change in the expected present value of debt service payments on outstanding 1he domic interest rates fell by about 20 percent when the Brady agreement was announced, and by a further 10 percent towards the end of 1990 (see van Wijnbergen (1991a and 1991b)).

'Domestic stock markets increased by 25% percent in Mexico and 116% percent in Venezuela. Foreign capital held abroad by domestic residents has flown back to both Mexico and Venezuela in considerable amounts. Private and public sector entities in these two countries have been able to access voluntarily the private capital markets in significant amounts (see further the World Debt Tables 1991/1992 and Fernandez-Arias (1992)). lbe secondazy market prices for both Mexico and Venezuela (stripped of any enhancement values) have also increased considerably between the date of the agreement and mid-1991, by about 20 percentage points, reflecting further confidence.
13 debt claims.

As discussed in the next section, to a first approximation this financial cost to the country is the mirror image of the financial gains of external creditors. The financial gain of commercial banks is a direct result of the operation. The financial cost to the country may differ from commercial banks' financial gain, however, because other external creditors may also incur financial gains or losses as a result of DDSR operations. The picture that emerges is one where the efficiency gains created by the operation are shared by the debtor country, commercial banksl and, possibly, other external creditors. The country benefits from the portion of efficiency gains which are not diverted to extemal creditors in the form of financial gains.
14

## **II. FINANCIAL** COST OF DEBT **REDUCTION**

In this section, we first analyze the cost of debt reduction and<sup>the possible reasons why</sup> debt may be valued differently by the debtor compared to its creditors. Second,<sup>we review why</sup> market-based debt reduction puts the debtor at a disadvantage relative<sup>to its creditors and</sup> conclude that the menu-based approach minimizes financial costs to the<sup>country when compared</sup> to both market-based and concerted approaches.

# **_Valuation of countra debt and financial costs_**

To analyze the cost of a dollar of face value of commercial debt for<sup>the debtor, we have</sup> to analyze why it repays in the first place. In the absence of a international<sup>bankruptcy court</sup> (or the usage of "gunboats"), the debtor will pay because in that way it<sup>avoids penalties being</sup> imposed. These penalties can be intertemporal (trade sanctions, withdrawal<sup>of trade credits, etc.</sup> see Bulow and Rogoff (1989a)) or intertemporal (exclusion of future access<sup>to capital markets,</sup> see Eaton and Gersovitz (1981)). To avoid these penalties from being imposed<sup>on it, which may</sup> generate little direct benefits to the creditors, the debtor and the creditors<sup>will try to reach an</sup> agreement involving some (partial) payment by the debtor. Since the bargaining<sup>power of the</sup> creditors will depend on the severity of the penalties they can impose,<sup>the agreement reached</sup> with creditors will likely imply that the debtor will pay in relation to the<sup>severity of the penalties</sup> the creditors can successfully impose upon the debtor (see Fernandez-Arias<sup>(1991)).</sup> The secondary market price of a country's debt claims provides<sup>a useful starting point</sup> for gauging the debt servicing prospects of that country as perceived by its<sup>commercial creditors.</sup>
1S As in all relatively efficient asset markets, it is reasonable to presume that the market value of debt represents the consensus market estimate of the expected present value of aU future payments received on account of outstanding debt claims. The market for debt has grown since 1985, and it has become fairly efficient and liquid, at least for the large debtor countries. Transaction volume in 1991 is estimated to have been around $200 billion.

The present value for the debtor of its expected future debt service may be different from the market value of debt. Cashflow payments made by countries may not exactly coincide with the receipts that banks effectively receive in net terms in connection with those payments because of tax and regulatory reasons as well as the expectation of third parties bailing out banks. Banks--especially those in a weak financial position--may expect to receive from official institutions some side-payments, or if necessary, be bailed out by the official sector, if the country is unable to repay. Secondary market prices would then overstate the expected value of payments by the country as they include payments by third parties.<sup>8</sup> While the situation wiUl vary from country to country, it can generaUy be expected that these considerations will lead creditors to value debt relatively more. This of course makes DDSR operations that are beneficial to both the debtor and its creditors more difficult to achieve.

It should be noted that differences in valuation of a given stream of cash flows may arise from the different discount and risk aversion factors used by the debtor and the creditors. The typical indebted country is capital-poor, undiversified, and shut off from the world capital market for lack of creditworthiness. It is thus likely more impatient (have a higher discount 8 Certain aspects of banking regulations may exercise a depressing effect on prices. But on a net basis, it is hard to believe that due to bankdng regulations, the price can be lower than the present value of what the creditors are expected to receive from the debtor. If such a situation arose, non-banks would buy the debt from the banks. However, no such trend had been observed prior to the Brady plan.
16 rate) and more risk-averse han its creditors. Consequently, it may be not in its interest to prepay debt (which entails an efficiency loss resulting from a reduction of liquidity), even at a fair market-value from the creditors' point of view. It should be noted however, that financial costs refer to the expected present value of debt service payments discounted at the riskless market rate and are therefore not dependent on these differences.

It appears that, if anything, to assume that the country's expected future debt service is adequately reflected by market valuations is a conservative assumption regarding the estimation of the financial costs to the country. Making such assumption, the financial costs to the debtor country equal the financial gains to its external creditors. If only commercial banks are financially affected by the operation, we can ignore other creditors. To the extent that other creditors are subjec **t** o country risk, however, they are probably affected. Other private external creditors are likely gainers: they benefit from the rise in value of their claims as a result of debt reduction and improved country's prospects without increasing their exposure. In the case of official creditors, there is the countervailing factor that they generally increase their exposure by providing additional financing. If official claims are risldess, official creditors are not financially affected by definition. If official claims are subject to country risk, however, the financial impact is ambiguous. The total financial cost to the country would then amount to the total financial gains of abe external creditorse, that is financial gains to commercial banks and other private creditors plus the financial gains (or minus the financial'losses) of official creditors. We will estimate in the next section the financial costs to the country as the net payment made in exchange for debt reduction minus the reduction in the market value of outstanding 9And other **foreign** investors if applicable.
17 debt. This reduction in value is determined not only by the amount of debt reduction achieved but also by the method of financing. For example, if new senior loans are used to finance DDSR, the value of commercial bank debt falls for a given amount of debt reduction (see Claessens, Diwan, Froot and Krugman, (1991) for more details). In the remainder of this section we will show that a menu-based approach to debt reduction minimizes this payment and, therefore, the financial cost of a given DDSR operation.

# _Minimizng financial cost: the case_ **_for_** _menu-based debt reduction_

It is useful to think that debt reduction, and DDSR more generally, affects two basic parameters: the size of the economic pie generated by the debtor country (the efficiency gains), and its sharing between the various stakeholders (the interest groups in the debtor country, the banks and the other creditors). For the debtor, benefits from DDSR crucially depend on a larger economic pie. The mechanisms used for DDSR will matter in determining the sharing of the gains. We will show that a pure market-based approach generally favors the creditors at the expense of the debtor. In a menu-based approach, the debtor can retain as much as possible the efficiency gains.

# Market-based DDSR

When considering the costs and benefits of market-based DDSR, it is important to understand the effects that are intrinsic to the market-place. In all asset markets where sellers are atomistic, it is quite difficult for a buyer to internalize a general value increase associated with its purchase of an asset. In the context of country debt, this implies that there are two
18 reasons why market-based DDSR leads to an overpayment by the debtor.

- (a) Market-based DDSR occurs at the average price of debt. However, the financial benefit of DDSR to the country is only the marginal decrease in the value of debt--the marginal price. The marginal price will be lower than the average price since debt service in the bad states of nature is not strictly proportional to the quantity of debt outstanding (Bulow and Rogoff, 1989b and 1991).

(b) The market price of debt rises following DDSR. With less debt around, the remaining debt is more likely serviced. In a rational market, an announced DDSR operation will not occur at the lower, pre deal price but at the higher, post deal price (Dooley, 1989). T-he compounded effect of these two factors is that the market value of debt will be reduced by less than the expenditure the country makes. In fact, the difference between the pre deal and post deal price provides all banks--those that exit as well as those that remain-with a capital gain compared to their status-quo and implicitly the debtor makes transfers to the exiting as well as remaining banks.<sup>10</sup> The case of Bolivia is illustrative of the direct losses that arise in market-based DDSR (see Bulow and Rogoff (1989b)). In 1986, Bolivia began negotiations with both outside donors and its creditors that ultimately led to an extemally financed buyback in March 1988, completely financed by a donation. Bolivia owed its commercial banks $670 million in debt and $300 million in interest arrears. Debt was valued by the market at $40.2 million on the eve of the buyback negotiations in September 1986 (i.e., 6 cents on the dollar). The 1988 buyback retired $335 million of debt (with their arrears) at a price of 11 cents, implying an expense of $36.9

**'**<sup>**0**</sup> **This does not imply that market-based DDSR necessarily hurts the debtor, but that indirect or efficiency gains arising from DDSR have to be large enough to compensate for the direct loss.**
19 million which was funded by the external donation. After the transaction in March 1988, the remaining $335 million of claims were valued at $36.9 million. The operation thus reduced Bolivia's expected payments by only $3.3 million (40.2-36.9), and creditors net gain was $36.9-$3.3=$33.6 million. Clearly, creditors received most, but not all, of the donation. Assuming Bolivia would have received the grant anyhow, it would likely have been better off if it had used the grants for some other purpose.

# Concerted versus Market-based deals

We have argued above that if debt is reduced by the debtor through a market-based operation, then the price that must be paid is the average price of claims after debt reduction because any lender can choose between selling or retaining claims, a reflection of the marketbased character of the operation. Concerted agreements could conceivably be worked out to overcome this coordination problem. Ideally, each creditor bank would sell a specific share of its claims at its marginal price. (An even lower price would imply that banks are hurt, which would not be feasible to the extent that banks' participation is voluntary.) In practice, banks may retain bargaining power and may be able to obtain higher-than-marginal prices even with perfect coordination. Furthermore, perfect coordination may not work because it is difficult to bar individual banks from free-riding. But even a small amount of coordination would still represent an advantage to the country over the simple market-based approach to the extent that less than the ex-post average price is paid.

A more important problem with the concerted approach is, however, the heterogeneity of banks and the imperfect observability of this heterogeneity. If creditors differ in their relative
20 valuation of country debt, a DDSR operation that does not discriminate between banks, and that at the same time hurts no bank, must occur at the reservation price of the bank with the highest valuation. This may prove extremely costly. Attempts to discriminate between banks in a concerted approach require unobservable information and are subject to adverse selection problems.

Experience with concerted approaches brought these problems to the surface. Concerted agreements focusing on new lending characterizec the 1982-88 period. The process, however, broke down over time as the interests of the different banks increasingly diverged. By 1988, the new money process came to a halt--in spite of U.S. Secretary Baker's repeated calls for a strategy of "growth out of debt". The banks that valued the claims the most were inclined to press for a continuation of the concerted new money approach, while those with low exit cost opposed the process, and free rode at an increasing rate (possibly on official creditors in part).

# The case for a menu-based approach to debt reduction

By 1988, investment banks were worldng hard on schemes that would allow the low exit cost banks to leave rather than further veto concerted new money deals. Equipped with its recent experience with informal swaps (that extinguished over $10 billion of private debt in 1988), Brazil innovated by developing the first menu-base **d** eal in 1988. This was followed by the Mexican Morgan deal of 1989. This led the way for the more sophisticated menu-driven deals of the Brady plan. The menu-based approach allows the creditors to self-selt, with only those with low valuations selling out at a particular price and others remaining, while avoiding any free-riding. We will argue below that this menu-based approach retains the coordination
21 features of the concerted approach but is more efficient than it.

Recent agreements (Brazil 1988, Mexico 1989, Philippines 1989, Costa Rica 1989, Venezuela 1990, Uruguay 1991, Nigeria 1992, and some deals under negotiation) have used an approach different from market-based and concerted to reduce external debt. The agreements have included a menu of options from which creditors select. This pre deal agreed-upon menu is thus a contract, that may be partly implicit, establishing a future choice set for the lenders. The menu approach requires that lenders choose from a restricted set of actions post deal, and therefore, like in a concerted approach, cannot free ride. The possible means for enforcing such a choice include creditor country legal and political institutions. In the Brady deals to date, freeriding has been prevented through a variety of mechanisms, including "novation", political pressures and forms of financial engineering. For example, in the Mexico 1989 agreement, existing debt contracts were rewritten such that the previous agreements, both between the debtor and the creditors and among creditors, were no longer binding-the so called novation." In the Venezuela and Uruguay agreements, fully collateralized, short-term notes were used to overcome a restriction on buybacks. Political pressures were particularly strong in the case of Mexico. In addition, the IFIs have at times made it clear that they would condone arrears to commercial creditors (and lend into arrears themselves) if the country had negotiated in good faith but no agreement was reached, thus increasing pressure on all banks to recontract.

"The major implication of this novation was that debt which is exchanged into the new instruments<sup>(including</sup> some of the new money provided) would no longer be subject to the shaaing class and non-participating<sup>creditors</sup> would not be able to share equally in payments made by Mexico on its retructured debt. For<sup>instance, in case</sup> Mexico would pay in full on the new instumments, but would not pay in full on debt which was<sup>not exchanged, the</sup> holders of the non-exchanged debt would not be able to share in the payments the holders<sup>of the new instruments</sup> receive. The "novation clause gave claim holders a greater incentive to accept one of<sup>the three options and</sup> drastically reduced the problem of free-riders.
22 Discrimination can lead to gains for the debtor country. By combining concerted and choice characteristics, the menu-based approach to DDSR retains the advaniages, but not the drawbacks of each of the two mechanisms described above. The options on the menu and their relative pricing are negotiated first; in a second round, each creditor freely chooses his preferred option. By negotiating on a menu pre deal and allowing banks to choose post deal, a better burden sharing among the commercial banks can be achieved without unsurmountable coordination problems, and the debtor country can get a better overall deal. In effect, the menubased approach to DDSR can allow the debtor country to act as a discriminating monopsonist: by judiciously tailoring the relative terms and prices of items on the menu, the debtor extracts more from each creditor.

What have been the tools used to achieve this discrimination? Recent menus have offered banks to swap their old claims for a portfolio of exit instruments--and sometimes for cash (buybacks)--or for a commitment to provide new money, so as to accommodate the needs of the banks that prefer to exit as well as those of the banks that prefer to remain exposed to the country. Buybacks have not been used extensively, and in most deals, DDSR has been accomplished by exchanging old debt for new instruments--exit bonds--with a lower contractual obligation but, also, with a higher security. The latter has been achieved by pledging a secure asset (usually US Treasury bills or bonds) against specific payments of the bond (see further Annex table 1 for a description of the actual instruments used in recent agreements). The contractual reduction in obligations has been offered in several ways to accommodate the regulatory, accounting, and tax practices of the different types of banks and the liquidity needs of the country. In particular, two instruments have been heavily used, a discount bond that
23 reduces the principal obligation, and a par bond that reduces the interest rate.<sup>12</sup> It is clear that exit instruments can be tailored to minimize the cost of debt reduction. But there may be some banks (with very high exit cost) that would only be willing to exit when the value of the exit instruments is very high. To buy out the high exit cost banks using an exit menu option would dramatically increase the cost of debt reduction to the debtor since all banks would tend to choose this more valuable option. On the other hand, allowing the high exit cost banks to remain on the sideline, would imply a breakdown of the whole menu approach.

In the recent menu-based deals, this problem was addressed by requiring any bank that refused to exit at a "reasonable" price to contribute something else. Since non-exiting banks get a capital gain on their existing exposure, they were required to remit (part) of this<sup>capital gain</sup> through a new money "tax". As an illustration of this mechanism, consider the situation where the pre deal price is 40 cents and the post deal price rises to 45 cents, a 5 cents gain. If remaining, non-exiting banks holding $30 billion of claims provide now $2.7 billion in new money, they will have a loss on the new money of (100-45)*$2.7 billion = $1.5 billion. It turns out that they are still equally well off as in the status-quo since the capital gain on their remaining claims, 5*$30 billion = $1.5 billion, will offset exactly the loss on the new<sup>money.</sup> In this way, the overall costs to the debtor of DDSR is not determined by the reservation price of the high exit cost bank.

The importance of banks' heterogeneity deserves a more detailed substantiation. Banks can differ for a number of reasons. The reasons include differences in national regulatory<sup>and</sup> tax framework (Hay and Paul 1991); the extent to which a commercial bank has other business '<sup>2</sup> More recently, par bonds where the interest rate start. at low levels and is stepped up over time have also<sup>beer</sup> introduced (so-called FLIRBs).
24 interests in the debtor country creating an ey ra benefit to lending; differences in expectations (Williamson, 1989); altemative business opportunities; and bank size in the presence of fixed costs associated with recontracting and monitoring the debtor's economy (Fernandez and Ozler, 1991). The existence of a secondary market for sovereign debt suggests that the marginal value of a debt claim **siiould** be the same for all participating banks. In a sense, the market should already neutralize the effects of any bank heterogeneity. If this were the case, the arguments for using a menu would be weak and a simple concerted agreement would be as effective.

But it seems unlikely that the secondary i'iarket is able to fully take away the effects of heterogeneity. This is because banks that sell debt at a discount face exit costs which depends on the particular situation of the exiting bank. For example, accounting practices and capital adequacy rules in the United States discourage bankers with relatively large exposure to participate in debt reduction by requiring a bank that sells part of its loans to a given country to mark down whole or part of its portfolio of loans to that country. For U.S banks with relatively large exposure this would mean wiping out a large portion of reserves. Similarly, banks with large exposure may face higher regulatory costs when buying a claim than banks with small exposures. The existence of exit and entry cost thus creates a wedge between the price at which debt is sold, and the net payout that accrues to the seller, and vice-versa when debt is bought. As a result, debt may not be transacted at all in the secondary market when differences in valuation are smaller than this wedge. And if trading occurs, the secondary market price observed will likely reflect the lower end of banks' valuations.

While heterogeneity may give rise to a secondary market, the market is thus not likely to eliminate the effects of heterogeneity completely. Because of heterogeneity, the menu-based
25 approach allows the debtor therefore to pay less for the same debt reduction, compared to market-based and concerted DDSR, by exploiting the differences among banks arising from the structure of their balance sheet, the regulatory system within which they operate, and their overall business strategies. The menu can create "value" through offering instruments better suited to the systems or situations in which the individual bank operates." For example, a bank that wants to exit, but cannot afford the regulatory cost of a full exit, may prefer a par-bond that allows it to spread the regulatory costs of exit over a number of years. Heterogeneity across lenders also implies that the choices the banks make from a menu will depend on their own characteristics."4 "Although both parties see it as additional value, to the extent that it is obtained through regulatory and tax loopholes there is no true efficiency gains involved, but rather the shifting of risks and losses to creditor countries and their taxpayers. From the debtor country's point of view, the case for using the menu-approach does not rely on the assumption that the financial cost to the country is the mirror image of financial gains to external creditors; it is entirely based on how various negotiation mechanism affect the payment needed to compensate banks in a given DDSR agreement.

'<sup>4</sup> This issue is explored in depth in Demirguc-Kunt and Diwan (1990) who show, using the experience of the Brazil 1988 debt deal, that 80 percent of bank choices between exit and relending options can be explained by measures of financial strength, natiouality, exposure, and long term interest in the country (as proxied by the existence of branch offices in the debtor country). See also Diwan and Spiegel (1991) and Diwan and Kletzer (1991).
26

# III. EXPERIENCE OF BRADY DEALS

We now discuss the five most recent menu-based deals: Mexico,<sup>Philippines, Costa Rica,</sup> Venezuela, and Uruguay. The agreements are described in Annex<sup>table 1 (more detail can be</sup> found in World Bank 1990 and 1991). Negotiations were<sup>relatively slow in Mexico, the</sup> Philippines and Costa Rica. In each of the three cases, the approach<sup>followed was an innovation</sup> relative to previous deals. Mexico's strategy was to spread the needed<sup>debt reduction among a</sup> large group of banks, to develop a simple menu, and to work hard<sup>on contractual issues--such</sup> as the novation clause--in order to produce marketable securities.<sup>The lack of a buyback option</sup> in the Mexico deal was due to the fact that many of the smaller banks had<sup>already exited in</sup> previous deals. The Philippines negotiations proceeded in<sup>parallel, but the approach followed</sup> was rather different. The main goal there seems to have<sup>been the exit of a large fringe of small</sup> banks, with the expectation that a sizable amount of new money<sup>could be extracted from the</sup> remaining large banks who could (for strategic or financial reasons) afford<sup>to take a longer view.</sup> The Costa Rica negotiations were also slowed down by the search for<sup>innovative solutions. The</sup> main problem there was how to treat arrears in the context<sup>of a menu deal. On the other hand,</sup> the negotiations proceeded quite briskly for Venezuela<sup>and Uruguay, where the degree of</sup> innovation was modest.

# _ne extent_ **_of_** _debt reduction_

Table 1 reports for each of the countries the eligible<sup>commercial and total debt before</sup> the exchange. In all cases, non-commercial claims, short<sup>term debt as well as bonds were left</sup> out from the eligible base. While the official sector shared<sup>in the debt relief burden by</sup> providing loans or reschedulings, short term debt and<sup>bonds were not subjected to rescheduiings</sup>
27 or DDSR. The eligible debt as a share of total debt varied from 59 percent in Venezuela to 23 percent for the Philippines.

Since the deals involved various bond exchanges and buybacks, as well as provisions of new money, the net present value (NPV) of DDSR is used as the measure of the extent of contractual debt reduction achieved and the degree of exit involved. Table 1 reports separately as well as combined the NPV of debt reduction and debt service reduction, with the effect of recapture clauses shown separately (see Claessens and van Wijnbergen (forthcoming) for the calculations). This measure of debt reduction, before taldng into account the new money provided by commercial banks, is the Gross DDSR. The largest relative amounts of Gross DDSR were for Costa Rica and Uruguay (71 and 49 percent respectively), where DDSR was to a large extent achieved through buybacks. Mexico, Venezuela, and the Philippines reduced their initial eligible debts by between 20 percent and 30 percent. Net DDSR, that is Gross DDSR minus new money from commercial banks, also shown in Table 1, is of course smaller.

An important feature of most of the deals that needs to be taken into account in arriving at a final measure of the effective debt relief is the impact of collateralization of part of the new debt. The up-front purchase of collateral in the form of secure foreign bonds is essentially a prepayment of the collateralized debt service obligation: the resources needed for payment are already set aside beyond the country's control and are not subject to country risk. Therefore, from the point of view of commercial banks these resources are financially equivalent to cash and, like in an actual prepayment, the corresponding debt obligation is no longer a claim on the country's future resources. Table 1 also reports the prepayment equivalent of both principal and
28

# interest collateral."<sup>5</sup>

The best way to summarize the overall commercial debt relief achieved in these operations is now the "debt reduction equivalent" or DRE. The DRE is defined as the Net DDSR plus the portion of debt that is implicitly prepaid through the provision of suitable collateral. Table 1 presents the DRE for each of the five countries. The DRE ranged from 10 percent of the original face value in the case of the Philippines to over 70 percent in the case of Costa Rica. The shallowness of debt reduction in the case of the Philippines was mainly due to its success in attracting new money, which more than financed the compensation to exiting banks."<sup>6</sup> In the aggregate, for the five countries combined, commercial bank debt was reduced by more one third.

Table 2 reports the financing of the enhancements, in the form of additional and nonadditional (set-aside) loans, new money from the commercial banks and the country's own resources, the latter including the set-asides loans. It is worth noting at the outset the distinction between the additional and non-additional official loans used to finance the enhancements. Additional loans would not have accrued to the country in the absence of the agreement. In practice, the distinction between funds that have already been committed and new funds is often fuzzy. We consider here the IFIs' set-asides as the only non-additional loans. Of the total financing, 44% was from additional, official loans; the remainder was equally divided between commercial banks' new loans and diversion of the country's own resources (including set-

**'We** will **discuss later** the distinction between principal **and interest** collateralization and the **valuation** of the **later,**

"6It should **be noted,** however, that the new money component of **the arangement** came **several** months after the buy-back **and could** be considered a separate agreement. In that case, commercial bank debt reduction in the Philippines would be on the order of 20 percent.
29 asides). Table 2 also reports how the resources were divided over buybacks, principal collateralization and interest support.

On the whole, taldng into account the additional, official loans, the five countries' total external debt was effectively reduced by about one ninth. The reduction ranged from essentially zero in the case of the Philippines to slightly over 20 percent in Costa Rica.

# _Cost reduction in Menu-based erations_

An important issue in evaluating the arrangements is whether the use of the menu approach has allowed the debtor to reduce debt at better than post deal prices. We argued above that a menu approach would allow for debt reduction below the post deal price whereas marketbased debt reduction would occur at the post deal price. For buybacks this can in principle be established by comparing the buyback price with the post deal price. In case of a new money call, the effective value creditors receive is the post deal value of its original deal claims (rescheduled debts-including the capital gain on it-and the new money provided) minus the capital loss on the new money they provide. Its associated effective price can then be compared to the post deal price. In a debt exchange, old debt is swapped for a new instrument which is a combination of uncollateralized (reduced payments) claims and risldess enhancements. For each unit of old debt, the creditors therefore receive some enhancements, which amount to a prepayment--or a partial buyback, and a capital gain on the uncollateralized portion as the debt price increases.

In the context of a debt exchange, the question regarding the concertedness of the agreement is whether the debtor has received sufficient concessions from its creditors in
30 exchange for the capital gain they experience on the uncollateralized portion of the new instruments. If the debt exchange is market-based, the capital gain is not taxed, i.e, the uncollateralized portion of the debt "free-rides". The net result is that the ratio of enhancements (net of new money and valuing the interest collateral appropriately) to the DRE is equal to (or above) the post deal debt price. If the exchange is part of a menu agreement, then banks are asked to also provide concessions in exchange for the capital gain on the uncollateralized portion. In that case, the ratio of net enhancements to the DRE will be below the post deal debt price and the arrangement would be equivalent to a partial buyback below the post deal price.

We can now analyze the behavior of debt prices at the time the agreements were finalized. Since the prices quoted before and after the exchange are prices of different instruments--the deal retires old, non-enhanced claims and replaces them with new instruments which are combinations of country risk and enhancements--we need to extract from the prices of these instruments a post deal debt price that is comparable to the pre deal price. In other words, the raw prices need to be stripped of the values of the principal collateral and the interest guarantee. Except for the interest guarantee--a financial innovation--this is a simple task (see the discussion on the DRE). To obtain an estimate of the value of the interest guarantee, we use the model of Clark (1990) who obtains an estimate of the value as one minus the stripped debt price, times the face value of the interest collateral.'<sup>7</sup> Table 3 reports the post deal prices extracted from the raw prices of enhanced

**"Mhis model has the following desirable property: if the debt price is one, the interest guarantee** does **not provide any additional value, while it provides full additional value if the debt price is zero. Fernandez-Arias (1992) presents the case when the interest guarantee's market value is set at its face value.**
31 instruments immediately after the exchanges took place."8 Table 3 can be used to compare the post deal (stripped) price in each deal with the applicable price of the old claims at the time of the exchange. This price represents the average value per unit of debt the creditors got in the deal (AVC). Table 3 also reports an estimate of the pre deal price (see below).

We can use the AVC as a measure of how market-based the deal was: if the AVC is close to the post deal price, then the deal is not much different from a market-based operation. However, if the AVC is below the post deal price, then the concerted deal is significantly cheaper than a market-based operation. Table 3 shows that the AVCs are below the post deal stripped prices. This is thus direct evidence that the terms at which debt reduction was achieved were better than what would have occurred under a market-based approach. The difference between the AVC and the post deal price is the greatest for Costa Rica and the smallest for the Philippines.

The AVC and the post-deal allows us to compute that the cost of DDSR, if done using the market-based approach, would have costed more than $8 billion over the cost actually incurred using the concerted menu approach."9 Therefore the coordination and efficiency achieved with the menu approach may have saved the countries more than $8 billion. This $8 billion saving may amount to a cost reduction of more than 50% when compared to an estimate of the total financial cost, developed below.

18Arguably a more recent price could be used since there is some evidence of a 'learning curve" in the market for sovereign debt, making the initial post deal price a less useful indicator. It also appears that<sup>the market has</sup> become more efficient. For instance, for a few months after the initial introduction of the Mexican Brady bonds, the stripped prices of the par and discount bond differed considerably from each other (leading to arbitrage opportunities), but this difference vanished in the third month of trading. But more recent price are also dependant on the exogenous shocks that occurred after the exchange.

'<sup>9</sup> This larger market-based approach cost can be constructed as an upper estimate<sup>of the size of the indirect</sup> benefits obtained from DDSR along the lines of the methodology developed in Bulow and Rogoff (1991).
32

# _Fnancial galns of commewM banks_

The AVC gives an a;veae measure of the value retained by each creditor. A closer look at the prices of each of the instruments right after the exchange took place reveals that some of the options on the menu (normalized per unit of old debt) had different post deal values. At the same time, not all banlks chose the same options at the actual exchange. This can only be because of differences in valuation between banks of the various options. If all banks valued the options in the same way, then they all would have picked the option expected to offer post deal the highest value. The clearest example is provided by the Venezuelan agreement (see Table 4). Excluding the new money option (this option was rationed as it was oversubscribed)2', the different exit options ranged in value between 45 and 49 cents. Yet many of the banks chose the least valuable option (the buyback), indicating that because of heterogeneity, options with the same intrinsic market value do not have the same opportunity value to each individual bank.

From the debtor country's perspective, the larger the difference between the AVC and the post deal, the better the deal it obtained. However, a large difference between the AVC and the post deal price is not a sufficient for the deal to be 'good" for the debtor compared to the status quo since the AVC may still be higher than the price that would have prevailed in the absence of a DDSR agreement. Figures 1 to 5 depict for each deal the AVC and the series of prices prevailing from before the announcement of the Brady plan until the date of the exchange. As can be observed, market prices moved in anticipation of the finalization of the agreement, the date of the exchange. Indeed, in the few weeks before the exchange actually took place, debt prices converged smoothly toward the AVC as the uncertainty about whether the exchange would I In te cas of Venezela, oil prices moved up betwee th agreement date and the actusl exchanp (becauw of the Gulf cnisis). As a result, Venezuela's debt became more valuable, and more banks than exper d chose the **Mw** Money optioa which thus had to be restricted.
33 actually take place was reduced.

The status comparison price should thus not be the price right before the exchange but instead be taken when expectations about a deal were sufficiently low. In the absence of exogenous shocks during the interim period, the best the debtor can hope to achieve without hurting the banks is an AVC which is equal to the price prevailing before DDSR was considered a possibility. However, Figures 1-5 make it clear that in most cases, the AVCs were halfway between the post deal prices and the prices prevailing when expectations about a value increasing agreement where still low (say the date right before the Brady speech).21 The overall picture that emerges is that the deals were done at prices halfway between a market-based transaction and a concerted operation that would have left banks at their initial payoff level. On the basis of this analysis, banks would thus appear to have gained substantially.

That commercial banks made financial gains should not be surprising since the operations are voluntary in nature and, therefore, they do no expect to lose. Nevertheless, prices moved because of severl exogenous events, particularly the oil price increase due the Gulf crisis and changes in world interest rates, which makes it difficult to develop a point estimate of the changes in prices due to aU exogenous shocks (see Claessens and van Wijnbergen (1991) for a methodology). Instead one can investigate whether the price at which banks would not have made a gain, the AVC, is likely to have prevailed without exogenous shocks. The use of debt valuation models based on fundamental underlying variables strongly suggests that the applicable pre-deal price, cleaned from expectations, is in general well below the AVC and that, therefore, banks made gains. While secondary market prices have been erratic and do thus not provide 21 Femandez-Airia (1992) obtas redwl **t** hat the average market prices would hae to be 32 cents downward biased to make the aggregate financial cost to the countries zero. Valuing the interest guarantee at one minus the post deal price, this necessay downwad bias become 15 cents.
34 an accurate measure of expected payments, there is no strong reason to expect a systematic and substantial bias.

The gains per unit value can be translated into absolute gains, measured by the difference between the market value of the aggregate portfolio held by the banks after and before the exchange using the average market prices in the month before the Brady plan was announced (March 10, 1989).Y (See Table 5.) On aggregate, the banks increased the value of their loan portfolios by $5.3 billion.' In all cases banks gained from the deal, with the ranking of the relative gains as follows: Costa Rica, Venezuela, the Philippines, and Mexico, followed by Uruguay.

# _Financial cost to debtor counties_

We finally turn to an overall evaluation of these agreements from the debtors' point of view. This is achieved by developing estimates of the direct financial costs of the agreements to the debtor, the counterpart to the gains of the (commercial) creditors, using market information. If no other creditor is subject to country risk, the financial cost to the country is the counterpart to the financial gain of the commercial banks. Otherwise, capital gains on existing debt of other creditors benefiting from commercial bank debt reduction also need to be counted as financial cost. In addition, for the official creditors, additiona **l** ending may entail losses. Non-additional, official loans would have been extended to the country even in the I The value after **the** exchange is the total value of all the new instruments including the new money provided, plus the cash received from buybacks minus the face **value** of new money provided.

"The gains are much larger when evaluated at more recent prces. There are two exogenous reasons for this phenomenon. Clearly, **the** (unexpected) decline in interest rates from about 10% at the time of the Brady-speech to about 6% in 1991 has increased the value of those insttuments **with** fixed interest rates. **In** addition, the Gulf crisis led to increased export eanings for Mexico and Venezuela-and better prospects for their oil industry in general. But there are also indications of some learning, with the market discovering that DDSR agreements **had** a much more positive effect than expected for some countries.
35 absence of a debt agreement. We therefore continue to treat those funds as if they came from the country's own reserves.

When atl other debt is assumed to be riskless, the financial cost of the agreement for the country is the difference between the market value of commercial bank claims before the agreement and just after the exchange of instruments. As reported in Table _5,_ the gains to the banks for all countries were $5.3 billion, which implies that the total loss for the countries is also $5.3 billion.

This assumes that official loans are riskless, i.e., that they are expected to be fully serviced in the future. This assumption may influence the estimate of the direct costs to the extent that existing official claims are impaired and, correspondingly, new, additional loans contain an implicit "grant" element. Since there is no consensus on the precise status and price of official debt, we assume as an alternative that official and commercial loans have the same seniority status (see Bulow, Rogoff and Bevilaqua (1992) for analytical and empirical findings on the relative seniority of official claims). Since we have no prior on the status of other, nonofficial debts, we treat these debts also as if they have the same value as commercial debts. The debtors' financial costs under this scenario is then reduced by the grant element on the additional official loans, which are only valued at the post deal stripped price instead of at one. The cost will be increased, however, because of the capital gain other creditors received as a result of the DDSR deal, i.e., the change in the market value of other debt outstanding, calculated by applying the difference between the pre deal and post deal stripped price to all other debt (inclusive of the set-asides).

The estimated costs under this altemative turn out to be much larger than in the riskless other debt scenario. For the five deals, we get a total direct cost of $18.4 billion (see Table 5). The large loss is due to the large capital gains other creditors make as a result of the DDSR; on
36 average, the post deal price is 18 cents higher than the pre deal price. But, the additional official loans are now only valued at the post deal price instead of at one. Thus, the capital gain of the other creditors is somewhat offset and, on net, a $13.1 billion gain for the other creditors results. This translates into a 40 percent increase when compared to the initial market (value of their claims valued at the pre deal commercial bank price). Tbe commercial banks gain remains _$5.3_ billion, or a 19 percent increase compared to their pre deal market value.
37

# IV. !CONCLUDNG R1EMARKS

Our main analytical conclusions are twofold: a DDSR operation is likely to be financially costly for the debtor country mainly because banks would not voluntarily enter into agreements that reduce their payoff; and this financial cost can be minimized if the deal follows the menubased approach, where the expected rise in debt price for non-exiters is taxed away.

An evaluation of the recent menu driven agreements supports these conclusions. First, debt reduction was achieved at better than market-based terms. Second, the success of the menu-based approach has been relative rather than complete, in the sense that DDSR deals have still provided banks with important gains relative to before the Brady deal was announced.

Therefore, a DDSR agreement is still only beneficial to the debtor country when the DDSR leads to significant efficiency improvements in its economy or in its external financial relations. The Brady agreements are too recent to allow us to quantify exactly the actual impact on the debtors' macroeconomy using economic aggregates. In addition, other factors may have affected those aggregates (most notably the extent of the adjustment effort, the recent changes in world interest rates, and the recent Gulf-crisis). The important policy implication nevertheless is that DDSR agreements--since they always involve costs for the debtor-can only provide gains to the debtor in the context of an adjustment and reform strategy when there are good reasons to believe that the efficiency gains will compensate for the direct financial losses.

Implications of our analysis for actual DDSR-proposals are the following: (i) using the recent experience, identify better how DDSR influences the domestic economy. An improvement in our understanding of the way in which efficiency gains come about can lead to larger future indirect benefits, allowing the debtor to ask for larger current concessions from the banks; (ii) improve the financial engineering in the deals. In particular, agreements could be indexed on any exogenous uncertainty between signing of agreement and actual exchange. This
38 would reduce the occurrences of mispricing of some options and can increase confidence that there is sufficient financing for enhancements; and (iii) to allow the debtor countries to successfully resolve their debt crisis--and not to let the Brady plan increase the payoff of commercial banks, the bargaining power of the debtors needs to be strengthened.
39 Table 1: Debt Face Values and DDSR gmllions of dolars **unless** noted otherwise)

||Total External<br>Debt<br>(1)|Commerci<br>(|al Bank Debt'<br>2)|Debt<br>Reduction<br>(3)|Debt<br>' Service<br>Reductimn|RecGpture<br>Cl&ue4<br> <br>(5)|Gro<br>C6)= (|ssDD<br>3)+(4)|SR<br>-MS)|
|---|---|---|---|---|---|---|---|---|---|
|||S<br>X|<br>of Total||<br>|<br><br>||||
||__<br>|<br> <br>_________<br>_____<br>__________<br>|<br> <br>_________||(4)|B<br>_______|_____|o<br>|f Cmercial<br>~~ ~~~Bank<br>Debt|
|MEXICO<br>|$95.416<br> <br>|<br>$47,170<br> <br>|49X|<br>S7.061|S7.948|S858|S14.151||302|
|PHILIPPINES<br> <br>|<br>S28.468<br>|<br>S6.600|23X|<br>S1,340|S0||S1.340||202|
|COSTA<br>RICA<br> <br>|S4.603<br> <br>|S1 608|351|S1.029|5115||S1144||711|
|VENEWUELA<br>US23.<br>|<br>491<br>|S19O1l<br> <br>|59X|<br>S1.921|$2 67|S186|||243412<br>2|
|URGtUiAY<br>|S3.707<br>|<br>S1,610<br>|43X|<br>S628|S169|S11|S786||49X|
|TOTAL|S164.685|<br>S75,999|46X|<br>S119799|<br>11|055|S21,833||29X|
||_Nc-Non?_<br>(7)|met CO<br>(8)=C6)-|SR<br>(7)|Prepayment<br>Equivalent<br>of<br>Piil|Prepayment<br>Equivalen<br>of Interest<br>ll|Prepayment<br>tEquivalentof<br> <br>Collateral<br>|Debt<br>|Reduc<br>(<br>(12)|tionEquivalent<br>DRE)<br>+M8)+(11)|
|||<br>||rncpa<br>|Coatera<br> <br>|7 (11)=(9)+(1|)|||
|||S<br>X of<br>B|Commercial<br>ank Debt|Collateral<br>(9)|<br>(10)||S||X of Commereial<br>Bank Debt|
|MEXICO<br>|S13027<br> <br>|3124|281|S3.465|<br>S1.787|<br>S55252|<br>S18|376|<br>39X|
|PHILIPPINE<br> <br>|S<br>S690|5650|102|S0|SO|<br>S0|<br>|5650|<br>10X|
|COSTA<br>RICA<br> <br>|-<br>|51144<br>|711|50|522|<br>S22|<br>S1|,166|<br>731|
|VENEZtWE<br>U1.16<br>|6<br>|$3.246|17X|SW89|<br>S363|<br>S1.172|S4|.418|231|
|URUGUAY<br>|589<br> <br>|5697<br>|431|557|$14|<br>571||S768|48X|
|TOTAL|S28972<br>S|18,861|25X|S4,331|S2 16|,517|25|.378|331|

Source: World Debt Tables (1990/91 and 1991/92) nd Quarterly Review of financial Flows (various Issues) 'Eligible commercial bank debt.

2Fmoe value of debt reduced by buybacks and discount bonds.

*Present value of debt service reduction an par **bonds** (102 dIscount rate).

"Expected present value of service under recapture clatus.

"Present value of new maone to be disbursed by comercial banks.

'Face value of principal collateral.

Sfince the interest guarantee Is rolling and would only be drain at sam point uncertain in the future, and since interest on guarantee fund goes to the country, the prepayment equivalent of the interest guarantee is less than its face value. The prepayment equivalent of as its face value *ultiplied by the post-operation stripped discount (see Table 3). -. he interest collateral is estimated
40 Table 2: Usage of Enhancements and Flunchng of Enhancements (Mions of dolbers

|||Usage of En<br>Usage ofEn|thanicements<br>hancements||Fin<br>Offici|ancing Sources f<br>fa<br>Debt|or Enhancemen<br>i|ts<br> <br>|
|---|---|---|---|---|---|---|---|---|
||Buyback|Principal|Interest|Total|<br>Additional'|<br> <br>St Aid<sup>2</sup>|CommercaL<br>|<br>Country<br><sup>4</sup>|
|MEXICO|S0|S3465||<br>||e ses|New Mone9|Liquidity|
|PHILIPPINES<br>||<br>670|,<br>So|$3,717<br>|$7,182<br>|S3,732<br>|S1,847<br>|$1.027|$2,423|
|<br>COSTA RICA|<br>$188|<br>S0|S0<br>|S670<br>|$107<br>|$320|$690|($127)|
|VENEZUELA|<br>$647|<br>$809|$37<br>|$225<br>|$177|S0|S0|$42|
|URUGUAY|<br>$352|<br>$57|S924<br>|S2.380<br>|S687<br>|$1,010|S1.166|<br>$527|
|TOTAL|<br>$1857|<br>$4331|$54<br>|$463<br>|S140<br>|$86|$89|S234|
|Source:<br>World Debt|,<br>Tables(1990/91a|,<br>nd 1991/92)<br>and|$4,732<br>Quarterly<br>Revie|$10,920<br>w<br>of Financia<br>|$4,843<br>l<br>Flows (various<br>i|$3,263<br> <br>ssues)|$2,972|<br>$3,099|

3The NPV of the new 'The face value of the additional 2The face value of non-additional moneys to be disbursed official existing by coamercial debt (including official debt (includirg banks.IMF) disbursed IMF). We consider in the context here the IFIs' of the deal.set-asides as the only non-additional funds. "The usage of the country's own reserves, including set-asides. * Does not add up due to a grant and other external financing.
41 Table 3: Pde.

||<br>"EXICO|Stripped<br>Pre?-<br>Operation<br>0.36|Prices<br>Post<sup>3</sup>-<br>Oeration<br>052|Average<br>Value<br>to Creditors<br>(AVC)'<br>041|
|---|---|---|---|
||PHILIPPINES|<br>0.40|.<br>052|.<br>046|
|COSTA<br>RICA|0.12|.<br>0.39|.<br>024|
|VENEZUELA|0.37|<br>0.61|.<br>050|
|URUGUAY|0.56|<br>074|.<br>060|
|TOTAL|0.37|.<br> <br>055|.<br> <br>044|
|Source:<br>Salomon<br>Br|others<br>and<br>Authors<br>c|.<br>'<br>alculations|<br>.|

> 3 divided stripping enhancements) 'The Average Value to Creditors (AVC) is defined as the post-operation value of the new portfolio. comprising post-operation debt claims operation.2is estimated The post operation price The pre operation by the models.asthe and payments face price market value is the average is of commercial value applicable the price right after the deal has teen finalized and bonds are exchanged, of debt in connection debt price after (column in the the deal 2 with buybacks month in (as also Table before 1) minus used the Brady net of rnw money for the the DRE (coLumn plan AVC) was anncunced minus provided, the 12 in Table prepayment as a fraction (March 2). See expressed as a stripped price. The stripped price equivalent 10, 1989).Lamdany of the face of collaterals and Underwood value of the debt tcolumn (1989) for altenative11 in TabLe (inclusive before 1),the of
42 Tabe 4: Vahle of Individual Instaments (Cents per doUsr. unless otherwise noted)

||___________________<br>||MEXICO<br>||PHIUPPINES<br>VENEZUELA|URUGUAY|
|---|---|---|---|
|Par Bond<br>Di|41.81<br>|NA<br>49.25<br>|56|
|scount Bond<br>Bbk|41.03<br>|NA<br>48.3<br>|NA|
|uyac Price<br>|NA<br>|50<br>45<br>|56|
|FLIRBS<br>|NA<br>|NA<br>49|NA|
|NewNoney VaLue<br>|31.25<br>|46.5<br>53<br>I|68.7|
|Input Prices for New Money:<br>||<br>|<br>_|=|
|Nlew Mone Bonds A<br>|NA<br>|65<br>67<br>|68.5|
|NewMoneyBonds 8<br>Ci|NA<br>|NA<br>63<br>|NA|
|onverson Bonds<br>|NA<br>|NA<br>60<br>|75|
|Rescheduled Claims<br>|45<br>|50<br>NA<br>|NA|
|New Money Call (fraction)|0.25|0.1<br>0.2|0.2|

Source: Salomon Brothers, Anrex Table 1, and Authors' calculations
43 Table 5: Financial Cost to the Country IMilons of dolam)

||Other claims<br>are<br>_risktess'|Other claims<br>are equal<br>in seniority<br>2|
|---|---|---|
|MEXICO|$2.189|<br>$8,368|
|PHILIPPINES|$451|<br>$3,151|
|COSTA<br>RICA|$193|<br>$907|
|**VENEZUELA**|**$2,444**|$5,583|
|URUGUAY|$53|<br>$407|
|**TOTAL**|$5,330|<br>$18,416|

# Source: Authorst calculations

- Costs to the country are the financial gains of the commercial banks, calculated as the post-operation market value of the commercial bank debt portfolio subtracted from the pre-operation market value of the commercial bank debt.

- **2** The costs as in the first cotumn plus the additional costs to the country as the result of the financial gains of other creditors assuming that all of them have the same seniority status as commercial barns. These financial gains of other creditors are calculate as the capital gains on existing debt (the difference between post-operation and pre-operation prices times the face value of other claims) and the financial loss associated with additiona **l** ending (using the post-operation stripped discount).
<!-- Start of picture text --> Secondany Market Prices Before Omeratlon Conduslom ul<br>L Mak o .<br>:- GAL \<br>48<br>44 \ I ED .~~~~~~~~~~~4<br>4*~~~~~~~~~~~~~~~~~4<br>W .. ...... .<br>OPOST-OESO LS A<br>3_S<br>J )'~~~~~~~S<br>a/ Prices ezrssed as cents per dollar of facc value. 'ltst pdceso wn ls the tit quote ln 19S9 (OIAW/9) sad laut plc. shown Ih<br>the las quote before the conclusdon ofthe opeaoi Tlbe vlcel Uiesows the dat of th Dhady amo_nmm (03/10189).<br>Wben tradIb8 on old debt stopped, quote on par bone wre used.<br>Source Sabomon Broheas.<br><!-- End of picture text -->