Debt swap is a generic term for an exchange of debt with some other asset. Examples of debt swaps include the convertible bond, in which a debt-equity swap is initiated by the bondholder, and the debt-equity swap pioneered by Salomon Brothers in the USA in the early 1980s, when corporations replaced over US$10 billion of debt with US$7 billion of new equity. The latter, however, disappeared after 1984, probably because the tax-related incentive ceased to exist (Hand, 1989).
The most significant application of debt swaps has been in international finance, particularly as a mechanism for solving the debt-servicing problems of less developed countries (LDCs). The LDC debt crisis exploded in 1982 with Mexico defaulting on its loan payments, followed by other defaults, mostly Latin American. The creditors were generally international (largely US) commercial banks. Among the various solutions proposed, the most popular were market-based strategies like debt buybacks and various debt swaps such as debt for debt and debt for equity.
In a debt for debt swap, the creditor ban k exchanges its outstanding loans for US dollar-denominated bonds issued by the LDC’s central bank. These bonds are known as Brady bonds after the US Treasury Secretary Nicholas Brady, architect of the Brady Plan of 1989 to deal with the debt crisis. The Brady Plan was the first to accept debt reduction as necessary for a permanent solution; therefore, Brady bonds have longer maturities and lower coupons than the original loans. However, they have certain attractive features such as liquidity, collateralization, and rolling guarantees. The liquidity is a result of an active secondary market, with a volume of US$100 billion in mid-1994. Most Brady bonds also have collateralization of principal and immediate coupons, the collateral usually being US Treasury instruments of the appropriate maturity, and paid for partly by World Bank and IMF loans and partly from the LDC’s own reserve s. The interest guarantees are rolled forward continuously. Because of this collateral backing, Brady bonds are normally senior to other LDC loans.
A debt-equity swap is an exchange of outstanding LDC debt for an equity stake in a private corporation in the LDC, as follows: LDC debt is purchased on the secondary market from the bank at the market price, usually at a discount from face value by a multinational corporation (MNC). The MNC then trades the debt claim to the LDC’s central bank for the full face value in the local currency (less the central bank’s cut), which it then invests in a local company, very often a newly privatized corporation. The investment in local equity must be maintained for a minimum number of years.
The advantage for the MNC is that the investment is made at a significant discount, since the discounts prevailing in the market can be quite high. The LDC’s advantage is that the swap reduces external debt with no outflow of foreign currency, and external debt is replaced by foreign direct investment. The swap converts foreign debt into foreign equity; this is equivalent, in a corporate finance setting, to reducing leverage and thereby improving credit rating. Another potential benefit is the increased efficiency resulting from privatization which often accompanies the debt swap. In the USA, the Federal Reserve Bank amended Regulation K in 1986 to allow commercial banks to make investments through debt swaps. This led to many banks taking equity positions in LDCs, and had a significant positive effect on commercial bank stocks (Eyssel et al., 1989).
A disadvantage for the LDC is that its liquidity position might worsen by allowing direct foreign investment through swaps instead of fresh capital inflows. The swaps may be subsidizing foreign investments that would have been carried out anyway, and not generating any additional investment. Furthermore, swap s can actually reduce investment in the LDC through their effect on interest rates, inflation, and other macroeconomic variables. For the creditor banks, there is the usual moral hazard problem; by encouraging swaps, they may be helping reduce the value of the debt by providing incentives to debtor countries to delay repayments.
There is a small theoretical literature on the analysis of debt-equity swaps. The seminal paper is Helpman (1989), which derived conditions under which a swap will not be Pareto improving (strictly preferred by all participant s), and also showed that a swap may actually reduce investment in the LDC. Errunza and Moreau (1989) showed that, with homogeneous expectations, swaps are not Pareto improving even in the presence of informational asymmetries; they might, however, be Pareto improving with heterogeneous expectations. For valuation purposes, it has been demonstrated (Blake and Pradhan, 1991) that a debt swap is equivalent to the conversion of converti ble bonds to equity, with the addition of exchange-rate risk. However, the fact that the equity investment must be maintained for a number of years, significantly reduces the swap value.
Debt-equity swaps have been the most important type of debt reduction instrument, accounting for over US$35 billion (or almost 40 percent of the total volume of debt conversions of all types) from 1985 to 1993. Since the establishment of the first institutionalized debt-equity swap program in Chile in 1985, it has become an integral part of external debt management and reduction. It st arted slowly with conversions worth US$500 million in 1985, and peaked in 1992 with a volume of US$9.2 billion. After 1992, there was a decline in the volume, partly because market discounts on LDC debt were much smaller (Collyns et al., 1992).
How effective was the debt conversion program in resolving the debt crisis? One point of view is that it was very successful, and “Latin American borrowers have recovered from the debt crisis” (World Debt Tables, 1994-95). At the other extreme, some believe that the program has not tackled the root causes of the debt problem. A report by Larrain and Velasco (1990) on Chile, which had the most ambitious swap program, suggests that the contribution of debt-equity swaps to real investment in Chile has been moderate at best. Although it did contribute to the amelioration of Chile’s debt burden, the program came nowhere near offering a permanent solution. Bartolini (1990) has concluded, based on numerical simulations with reasonable parameter values, that a much larger fraction of debt forgiveness is required (about 60 percent, instead of the 3 0 percent envisaged by the Brady Plan) for a sustainable long-term solution.
Although it is true that there has been substantial LDC debt reduction and credit rating improvement, it is too early to make a definitive assessment. The Mexican peso crisis of 1994 indicates that the market remains very volatile and vulnerable to shocks. Defaults do occur, albeit on a smaller scale, such as the Alto Parana corporation of Argentina in 1995. External debt has also risen to dangerous levels in many LDCs, with total debt estimated at US$1,945 billion by end-1994 compared to US$1,369 at end-1987. Debt overhang remains a serious problem for the international banking sector; however, we are likely to be better prepared for the next crisis because banks have become more circumspect in their lending activities.
