Rescheduling as the groundwork for secondary markets in sovereign debt.

• Author: Buckley, Ross P.

[sections] 1 INTRODUCTION

The secondary market in the debt of less developed countries (LDC), now known as the "emerging markets', has been newsworthy throughout the 1990s because of its explosive growth(2) and the profitability of some investments in these markets,(3) However, few people appreciate how the strategy of repeated reschedulings in the 1980s laid the groundwork for the subsequent rapid development of this market. This little known role of reschedulings is the focus of this article.

The first response of international commercial banks to the debt crisis in 1982 was to reschedule the current debt of LDCs. Fresh loans were extended to permit the payment of interest upon the rescheduled debt.(4) This remained the standard response throughout the 1980s and received the imprimatur of the U.S. government in the Baker Plan.(5)

[sections] 2 A TYPICAL RESCHEDULING PACKAGE

A regular pattern for rescheduling(6) soon formed in 1983.(7) The first step in most reschedulings of commercial bank debt was to establish a steering committee to act as an advisory group and have a liaison with all bank creditors. The members of this committee were usually the major money-centre banks,(8) The steering committees required the debtor to complete, or enter into, a rescheduling of its official debts. The term "official debts" refers to debts to other governments(9) or international institutions such as the World Bank or International Monetary Fund [hereinafter IMF].(10)

The second step of most steering committees was to require the country to implement, or enter into, an economic program designed by the IMF.(11) The IMF conditioned its loans upon reformation of domestic economic policy in a process which became known as "structural adjustment."(12)

In addition to rescheduling official debts and adherence to the structural adjustment program, the other elements of a typical rescheduling included:

(a) new commercial bank loans, usually with a grace period on interest repayments of between two and four years;(13)

(b) new IMF loans for a three year period;(14) and

(c) the rescheduling of existing commercial bank loans over longer maturities and with substantial grace periods on capital repayments,(15)

From the beginning, loans were grouped for rescheduling based on their due dates. For instance, all $4.8 billion of Brazilian loans due in 1983 were rescheduled in one agreement.(16) From 1982 to 1984, debts falling due in the next year were generally rescheduled together,(17) However, these annual reschedulings were burdensome and by 19841985 the trend was to negotiate multi-year rescheduling agreements.(18) Accordingly, all of Mexico's loans due from 1985 to 1990 were rescheduled in one agreement.(19)

New money to facilitate interest payments accompanied most of the reschedulings. The title "new money loans" is misleading since the money never reached the debtors but went directly to their accounts with the lending banks.(20) In reality, the new money was a method of capitalizing interest payments in advance.(21) It was usually less than the forthcoming interest payments and as a result the net transfer of resources was in favor of the banks.(22) Fresh capital to support economic development in the region was virtually non-existent in the 1980s.

In the early debt reschedulings, the banks demanded a substantial premium to compensate for the high risks of such lending. As a result, rescheduling increased the financial burden on the debtors. The average interest rate was the LIBOR(23) plus 2.2 percent(24) and generous fees averaged 1.2 percent of the loan.(25)

As the cycle of reschedulings continued, both the interest rates and fees were progressively reduced. By 1984 the average margin over LIBOR was 1.77 percent and average fees were 0.8 percent.(26) Later still, the Mexican rescheduling of 1987 set a new low standard for interest rates at 13/16 th over LIBOR.(27) Banks had finally learned that higher premiums created higher risks by increasing the burden on debtors.(28)

[sections] 3 THE OVERALL EFFECT OF THE RESCHEDULINGS

From the outset some believed that rescheduling was a placebo that would never solve the debt problem.(29) Most, however, believed that by buying time the debtor nations could trade their way out of their problems.(30) Time did significantly ameliorate the problem for the bank.(31) As the 1980s progressed, the borrowers kept servicing their debts and the banks kept booking the profits from these massive loans.(32) The banks accumulated reserves and increased their primary capitals(33)so that by the end of the decade a default would not have threatened the solvency of most banks. Indeed, one could characterize the entire thrust of the debt restructurings of the 1980s as an attempt to prevent a massive shakeout in the international financial system. As a senior official in the General Accounting Office said in 1989, "we believe that the efforts up until recently -- all the restructurings... were measures to get us from there to here without crashing the banking system."(34)

In contrast, time did nothing but worsen the economic plight of the borrowers,(35) As Carlos Marichal wrote in 1989:

Repayment of the debts has meant enormous sacrifices for the peoples of Latin America. At the urging of the bankers and the officials of the International Monetary Fund, governments have imposed painful austerity programs on their citizens... to extract sufficient revenue for paying foreign debts. These programs have led to... a sharp deterioration in basic living standards. Despite these sacrifices, there has been a steady worsening of the economic situation in most countries... [and] record levels of unemployment intensify the misery and discontent.(36)

Neither did more time help matters. As Duncan Green wrote in 1995:

An investment collapse has left the region burdened with a crumbling infrastructure of potholed roads, electricity blackouts and water shortages which will take decades to make good .... In human terms, the failure has been far more profound.., terrible damage [has been inflicted] on the poor. By 1993, 60 million more Latin Americans had been driven below the poverty line, bringing the total to nearly half of the population.(37)

The debt crisis has been, primarily, a financial problem in the West. In Latin America it has long been a political and social issue to provide sufficient food, adequate shelter and basic healthcare.(38)

[sections] 4 RESCHEDULING AND THE SECONDARY MARKET

However, while the direct effects of rescheduling and the accompanying structural adjustment programs on the debtor nations were adverse in the extreme, the indirect effects of rescheduling were more positive. The rescheduling process facilitated the growth of the secondary market for LDC debt and the secondary market in turn eased the burden on debtor nations. The market benefited the debtors by first permitting formal and informal debt buy-backs(39) which, when secondary market prices were as low as 20 percent of the face value, were a particularly good investment of foreign exchange for debtor nations.(40) Second, the market made necessary(41) and facilitated(42) the Brady Plan which brought with it an element of debt relief.

Growth of the Secondary Market

The rescheduling process supported the growth of the secondary market by: (1) replacing a multiplicity of debtors with one debtor; (2)...