SDR Module 3

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    Debt Rescheduling

    Debt Rescheduling - a form of debt re-organization inwhich debtors and creditors negotiate to defer paymentsof principal and/or interest falling, due in a specifiedinterval for repayment on a new schedule.The term Restructuring is used to include therescheduling of interest and principal payments as well asa write-down on the debt principal or interest rate.Conventionally, Debt Restructuring is the process ofrescheduling medium- to long-term debt maturities or

    refinancing short-term debts and/or interests.

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    Historical Perspective

    Debt has been the largest source of capital flows todeveloping countries in the past 50 years.Lending increased drastically starting in the 1970s,

    and today the total external indebtedness ofdeveloping countries is close to $3 trillion representing about 42.5% of their GDP.Long-term foreign debt owed or guaranteed by

    governments is $2.2 trillion or 75% of all long-termdebt.Given their weak economies, developing countrieshave found it difficult to service such debts.

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    International Debt Crises

    Long history of sovereign debt problems and crises.Includes advanced economies.During 1930s Great Depression, both the U.K. andFrance defaulted on their debts.

    During latter 1900s, Latin America became moreassociated with debt payment problems,1914 - Mexico suspended its debt payments.1956 Following Argentina

    s debt problems, agroup of wealthy industrialized nations met in Paristo develop a solution to problems in Argentina - ledto what is now known as the Paris Club .Since the first case involving Argentina in 1956,Paris Club has reached 347 agreements concerning77 debtor nations

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    80s & 90sFollowing huge lending increases in lending in themid-1970s, mainly in the form of syndicated bankloans, debt crises swept through developing world,starting with Mexico in August of 1982.1994 - Tequila Crisis started in Mexico - spreadthrough Latin America and other parts of thedeveloping world.1997/98 - debt crisis in East Asia1998 - Russian default2001 - Turkey2002 - Largest sovereign default in history occurredwhen Argentina defaulted on U$141 billion of publicdebt.

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    MOVE FROM BANK LENDING TO LARGE-SCALE BOND ISSUANCE

    Throughout this debt crisis prone period, therewere many efforts to restructure sovereigndebts,

    Each effort was a problem in itself.This problem became greater with theintroduction of bond lending.Whereas the restructuring of official debt andsyndicated bank loans involved sometimesdozens of lenders, the introduction of bondsexpanded the base to involve hundreds if not

    thousands of creditors.

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    MEDIUM TO LONG-TERM OBJECTIVES OFDEBT RESTRUCTURING

    Avoid a further liquidity crisis.Mitigate and eventually eliminate the crisisatmosphere.Restore a climate in which the sovereign mayoperate normally in the international creditmarkets.

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    What Factors Force States To Reschedule Debts?

    Origins of the CrisisOriginated in the mid-1970s, following oil priceshocks

    High prices for commoditiesOverly optimistic assumptions about economicgrowthDeclining terms of trade

    Inappropriate domestic economic policiesPetro-dollar recyclingExcessive military expenditure contributed to thebuilding crisis

    Corruption

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    What Factors Force States To Reschedule Debts?

    Low interest rates led many countries to contract loanobligations which proved unsustainable whenconditions took turn for worse

    By early 1980s, commodities prices fell sharply As real interest rates rose, many developing countrieshad difficulties in meeting their obligationsGlobal recessionSome countries were successful in responding to theseproblems, others could not adjust quickly enoughDebt crisis erupted in 1982, when Mexico announcedthat it was no longer able to service its foreign debt.

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    EARLY APPROACHES TO THE DEBTCRISIS

    Large middle-income countries owed much oftheir debt to major commercial banks

    At first, there was real concern that a defaultwould undermine the international bankingsystemDebt often exceeded the capital base of

    many of these international banksInternational financial community feared thatthe banking system would collapse

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    Liquidity vs. Solvency Problems

    Initially, it was believed that the debt crisis wasdue to short-term liquidity problems.

    Assumption was that short-term debt relief,such as extended repayment periods,combined with new money and macroeconomicadjustment would return countries to

    creditworthiness and enhance their ability tofinance economic growth

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    EARLY APPROACHES TO THE DEBTCRISIS

    Focus was on re-scheduling large, middle-income countries such asBrazil and Mexico, as they presumably posed the greatest threat tothe world financial systemLater realization of the uniqueness of each debtor country's debtsituation, economy, and debt service capacity, creditor governmentsagreed to manage the debt crisis on a case-by-case basisBecame evident that many debtors' economic problems were morestructural than had been assumed and required a longer-termresponse from debtors and creditors alikeMeanwhile, private capital from within these countries fled abroadseeking greater and more secure rates of return. This Capital flightexacerbated debtors' difficulties.

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    Baker Plan

    In 1985, the Baker Plan embraced a newstrategy for managing the debt of middle-income countries. It analyzed a debtor

    country's adjustment program, then increasedbank lending to support policy efforts whilecontinuing to monitor the results through theIMF.

    Baker Plan made new money available tosustain levels of investment necessary torestore growth and allow the major debtors tooutgrow their debt

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    The Brady Plan

    The Brady Plan acknowledged the need to combinethe objectives of the debt strategy with those ofdevelopment policies.

    First among the Brady Plan's innovative elementswas its explicit recognition of the need forcommercial debt reduction and for reducing debtservice.

    Secondly, the Brady initiative made IMF and WorldBank funds (as well as contributions bygovernments, particularly, that of the Japanese)available to support debt reduction operations.

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    Brady Plan

    In May 1989, IMF Board agreed to guidelinesdefining its role in the new third world debtstrategy.

    Guidelines provided for separate funds to bedevoted by the IMF to debt reduction25% of a country's extended fund facility orstandby loan arrangement to be "set aside" andUp to 40% of a debtor country's quota to bedevoted to interest support

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    Brady Plan

    The Plan recognized the need to loosenlegal, regulatory, tax, and accountingconstraints that limited the possibility ofdebt/debt service reduction.

    required banks to waive provisions such assharing and negative pledge clauses in existingagreementsmandated a review of creditor countries'regulatory, accounting, and tax provisions toeliminate disincentives (or create incentives) fordebt reduction

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    Mexican Brady Plan

    Mexico's debt deal was the first comprehensive deal within the Bradyinitiative. Banks involved in the negotiations had three options.

    First, banks could exchange old loans for new bonds at a discount of35% of their face value, keeping interest rates at market levels(equivalent to LIBOR + 13/16bps)

    Alternately, the banks could exchange old debt for face-value newbonds (called par bonds) bearing fixed interest rates of 6.25%.

    The third option was a provision of new money, equivalent to 25% ofthe banks' medium- and long-term loans.

    (Both of the first two options reduced interest payments.)

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    Mexican Brady Deal

    Both options also provided for 30 year bonds, whose principal wasguaranteed (collateralized) with loans provided by the IMF, WorldBank, Japan, and Mexican reserves used to purchase U.S. Treasuryzero-coupons

    The bonds had 30 year "bullet" maturities - no annual amortizationpayments, and principal was repaid only at the end of 30 years -which also reduced debt service

    Official support also guaranteed interest payments for 18 months(rolling)

    Mexico's bonds also included a novel value recovery clause linkingdebt service payments to oil prices, the country's main source offoreign exchange

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    Mexican Bradys Value Recovery Clause

    From July 1996 onwards, if the oil pricesurpassed the barrier of U.S. $14 dollars perbarrel (adjusted for U.S. inflation), up to 30%

    of the additional revenues would accrue tocreditors.This additional payment, however, could not

    exceed 3% of the nominal value of the debtconverted into new bonds.

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    Debt Conversion Programs

    The Brady Plan proposals recognized that thedebtors had to adopt policies to attract bothdirect and indirect investment and thatdebt/equity swaps could be a usefulcomponent of such a strategy.Several Latin American countries used other

    debt conversion mechanisms, such as debtbuy-back and debt-for-nature swaps.

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    Debt Conversion Programs

    A debt-equity swap converts a developing country'sdebt into equity via foreign investment (direct orportfolio) in a domestic firm.Once the project is approved, the company purchasesthe developing country's foreign debt on the secondarymarket at less than its full face value.Recently, several developing countries have usedextensive conversions of private commercial debt topromote foreign investment, reduce debt, conductprivatization and further other development objectives

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    DEBT CONVERSION PROGRAM RESULTS

    Positive Debt Conversion Results Include:Major reduction in commercial debtInvestment promotion and return of flight capital

    Export promotion and import substitutionPrivatizationStrengthened private sector finance

    Debt conversions can help catalyze FDI flows

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    OTHER DEBT RESTRUCTURING ISSUESWhile some countries have survived the crisis, many others, despite theirefforts, show clear signs that the debt burden is intolerable and its servicingrequirements exorbitant.Obviously, the poorest and most heavily indebted countries have differentneeds than lower-middle-income debtors. The debt problem of the poorerdeveloping countries was qualitatively different from that of the large middle-income countries.Many of the debt-distressed poor countries had a larger debt burden inrelation to their economic size and potential.Moreover, these countries relied heavily on the export earnings of one or twocommodities.

    A significant decline in the terms of trade for these commodities severelydisrupted the countries' capacity to service debt or resume growth.Recent developments combine the goals of debt relief and developmentBecause the commercial debt of the poorest countries is small in absoluteterms, future measures to help these debt-distressed countries mustemphasize grant or highly concessional external finance as well as greaterdebt reduction.Consensus that creditors should afford the poorest debtors even moregenerous terms

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    OTHER DEBT BURDEN ALLEVIATIONPROPOSALS

    Under The "Enhanced Toronto Terms

    Creditors Can Opt To:Cancel 50% of eligible maturities beingconsolidatedHave interest rates on non-concessional debt.Further stretch export credit and concessional

    debt repaymentsCapitalize reduced interest rates to equalizenet present value (NVP) terms with the other

    options.

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    OTHER DEBT BURDEN ALLEVIATION PROPOSALS

    TRINIDAD TERMS SUGGESTED :Rescheduling the entire stock of debt for maturitiesfalling due in 15 to 18 month intervals, instead of re-negotiation tranche by tranche.Increasing the amount of relief provided by debt stockcancellation from 1/3 to 2/3.Capitalizing for 5 years interest payments on theremaining 1/3 of the debt stock and requiring phasedrepayment with steadily increasing payment based onexport and output growth in the debtor economy.Stretching repayment of the remaining 1/3 stock over25 years.

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    OTHER DEBT RESTRUCTURINGS

    During the mid-1980s, larger middle-incomecountries received better terms than most sub-Saharan African countries.

    As a result, many countries "left out" of theBaker initiative have had to seek other forms ofdebt rescheduling and relief.

    E.g., the London Club is one alternative.

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    Role of Paris & London Clubs

    The Paris Club and the London Club are thetwo principal frameworks for restructuring (or,more practically, for rescheduling) sovereign

    debt.Each club has a set of rules and proceduresused for rescheduling operations.

    In general, the Paris Club reschedules debtsowed to official creditors, whereas theLondon Club reschedules debts owed tocommercial banks

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    Paris Club

    The Paris Club is an informal forum wherecountries experiencing difficulties in payingtheir debts to governments and private

    institutions meet with their creditors torestructure these debts. Paris Club is

    not a club,not a formal international organization.has no offices or secretariat,has no charter.ad hoc institution with no legal status.

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    LONDON CLUB A forum for rescheduling credits extended bycommercial banks (without a creditor-governmentguarantee).Negotiations often take place in London,Informal body comprising commercial banks exposed tothird World debt.Like Paris Club, the London Club works to reducedeveloping countries' immediate debt servicing burdens.

    Membership" is fluid

    No formal mandate.In the London Club, the interests of the creditor banksare represented by a steering committee composed ofthose banks with the greatest exposure to the debtorcountry in question.

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    London Club Paris Club

    London Club reschedules commercial debtsdebts

    The interests of the creditor banks are

    represented by a steering committeecomposed of those banks with thegreatest exposure to the debtor countryin question

    As a rule, the London Club does notreschedule interest payments, instead,commercial banks provide the countrywith a "new money" loan as part of therescheduling package.

    London Club generally refuses consolidationperiods of more than one year

    London Club may reschedule a debt withoutrequiring the debtor nation to conclude astandby agreement with the InternationalMonetary Fund (IMF).

    London Club debtors enjoy more flexibility,but incur more expense, than their ParisClub counterparts.

    The Paris Club reschedulesdebts owed to officialcreditors.

    In the Paris Club, more often thannot, the creditors arerepresented by the mostinfluential among them,regardless of their relativestake in the restructuring inquestion

    Paris Club reschedules bothprincipal and interest

    Whereas the London Clubprefers them to exceed two orthree years, however, theParis Club has slowlyexpanded its consolidationperiods

    Paris Club requires an IMFarrangement

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    STEPS INVOLVED IN A LONDON CLUBRESTRUCTURING

    Seven steps involved in a London ClubRestructuring:

    1. First, the debtor declares a moratorium on payments,2. Forms a debt management team, and3. Drafts an information memorandum.4. Simultaneously, the creditors form a steering

    committee or bank advisory committee (BAC).5. The parties convene at the exploratory meeting.6. They then negotiate the heads of terms (hot) and,7. Document the rescheduling agreements.

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    THE ROLE OF THE IMF AND WORLD BANK

    Throughout the 1980s, the multilateral financialinstitutions became increasingly involved in resolvingthe debt crisis.The role of the International Monetary Fund (IMF) isto preserve the financial integrity of the worldmonetary system and to provide balance of paymentsassistance to countries experiencing debt servicedifficulties.the IMF attempts to hold the appropriate balance

    between the adjustment effort required from thedebtor countries and the commitment of new externalfinance from the commercial banks and officialcreditors

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    THE ROLE OF THE IMF

    Assist in formulating adjustment programsthat incorporate performance criteria fromdebtor countries' upper credit tranchedrawings.Provide stand-by facility or extended fund

    facility. Act as a catalyst in facility or external fundsfrom commercial B banks.

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    THE ROLE OF THE WORLD BANK

    World Bank and other regional institutions) provideconcessional and non-concessional finance fordevelopment purposes.

    THE ROLE OF THE WORLD BANKSupport debtors' stabilization programs.Establish structural adjustment lending programs.Mobilize funds from other sources for futuredevelopment of debtor countries.Provide technical assistance in debt management.

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    IMF

    Every debt rescheduling exercise, requires adebtor country to have an IMF program or asimilar adjustment program in place.

    Before creditors enter any serious reschedulingnegotiations, the IMF must confirm that thedebtor is pursuing an economic program that

    would set it on the path to recovery.Creditors adopted this policy in response to theirperceived helplessness in monitoring theeconomy of debtor countries.

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    SUMMARY

    Creditors and debtors may view progress indealing with the debt problem differently.From the creditors' point of view, the strategyseems to be quite successful.

    A disruption of the financial system has beenavoided,debt is being serviced in most cases,banks have managed to reduce their exposure, and

    debtor countries are pursuing sound adjustmentprograms.Debtors, however, give a less positiveevaluation of the debt strategy.

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    NEW PROPOSALS FOR SOVEREIGN DEBTRESTRUCTURING

    Irrespective of the outcome of the debate overwhether such borrowing has been useful, it remainsa fact that the debt build-up has led to repaymentproblems and in some cases default.The current framework for addressing default,bankruptcy and debt restructuring has proven to beinadequate in sorting out these problems.

    Several efforts underway to establish a new andmore effective restructuring process.

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    NEW PROPOSALS FOR SOVEREIGN DEBTRESTRUCTURING

    While the restructuring of official debt and syndicatedbank loans involved sometimes dozens of lenders, theuse of bonds involves hundreds if not thousands ofcreditors.Widespread agreement for the need for a sovereign

    debt restructuring process,Disagreement over what the actual process should be. A framework will need to protect the rights of creditorsand debtors, and protect debtors from civil law suitsduring the structuring process.Process should prevent rogue vulture hedge funds fromdelaying or otherwise disrupting the restructuringprocess and from profiting from others efforts to forgiveand restructure outstanding debt.

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    Three Basic Approaches

    1. SDRM proposal calls for the creation of aninstitution to act as an arbiter in a newformalized process which would work alongthe lines of an international bankruptcy court.

    2. Collective Action Clauses to allow a majorityof creditors to set the terms of restructuring

    3. Adapts U.S. sovereign bankruptcy law, knownas Chapter 9, to the needs of developingcountries

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    SOVEREIGN DEBT RESTRUCTURINGMECHANISM

    Four core features

    : Majority rule (as opposed to unanimity) in

    restructuring decisions, A legal

    stay

    against claims by creditors,Protection of creditor interests, and

    Priority financing.

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    Collective Action Clauses

    Focuses on the writing of bond and loan contracts toinclude clauses that would prevent a minority ofcreditors from blocking negotiations with the debtor.Decentralized market-oriented approach, as opposed

    to the centralized non-market approach of SDRM.Collective Action Clauses (CACs) would bind in aminority (and therefore, any vulture funds) and allow amajority vote (usually a super-majority of 60% to 75%)to determine the outcome of a restructuring agreement.

    The principal shortcoming with this approach is thatCACs can only be included in future debt,The enormous amount of currently outstanding debtwould not benefit from their inclusion.

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    Holdout Creditors

    Further complicating matters is the fact that somecreditors might not be willing to relinquish theircontractual rights.These holdout creditors can refuse to participate in the

    restructuring and/or accept a rescheduling of debt.Rather, they demand payment according to the termsset forth in the original bond.The situation has been exacerbated by the aggressivelegal strategies employed by so-called vulture funds ,

    which buy distressed sovereign debt on the secondarymarket and then sue for contractual interest andprincipal payments.The case of Peru s debt restructuring illustrates thelitigious holdout creditor problem to date

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    Issues of Legal Jurisdiction

    Even if CACs are employed in all new debt issuancesand this effectively creates a new universal legalframework, there will still not necessarily be a uniforminterpretation;It will be up to individual jurisdictions to interpret theclauses, according to their domestic law.Central to the holdout creditor problem is the question of

    jurisdiction. The governing law often determines whetheror not creditors may vote to alter the payment terms of

    the bond.Either English or New York law governs most sovereignbonds

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    English vs. New York Law

    Under English law, any provisions, includingterms of payment, can be changed viasupermajority vote (usually 66 % or 75%).

    A majority of creditors can impose a restructuring onthe holdout creditor, which eliminates the holdout sability to disrupt the process.

    Bonds governed by New York law, on the other

    hand, have a unanimity requirement. Payment terms of the lending agreement cannot bechanged unless 100% of bondholders agree to thenew arrangement

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    Exit Consents

    The desired effect is to provide a disincentive toholdouts.

    After the details of the debt restructuring arenegotiated, creditors exchange their old bonds for newissues.

    As the exchange is taking place, creditors agree to altercertain clauses of the original bonds to make them lessattractive.E.g., The old bonds might be de-listed from theexchange on which they trade, making them illiquid, orhave the waiver of sovereign immunity removed.In the us corporate context, exit consents havesuccessfully

    coerced

    unwilling creditors to accept anexchange offer.

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    CHAPTER 9 OR FTAP PROPOSAL Third proposal for a better restructuring framework proposes thatChapter 9 of U.S. bankruptcy law be applied internationally tosovereign debt.Chapter 9 functions in the U.S. to protect the rights of indebtedmunicipal governments and public agencies in order to protect therights of taxpayers and public sector employees, and allows for their

    full participation in, and ability to object to, the outcome of a debtrescheduling process.Would allow an indebted nation to file for a stay.

    As with the SDRM proposal, there will need to be a third party bodyto be put in place to resolve the conflict between the debtor andcreditors.Unlike the permanent DRF, this body is proposed to be ad hoc ,appointed with each petition for a stay, and also is to act asarbitration panel.