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Donald R Lessard


February 1989







Donald R Lessard
WP# 192 1-89 February 1989


Donald R. Lessard*

Paper Presented at World Bank Symposium on Dealing with the Debt Crisis:
The Evolution of Developing Country Debt Difficulties and a Range of Policy Options^

Washington, DC. September 22, 1988
Revised February 1989



This paper examines the potential benefits of and obstacles to the inclusion of
alternatives to general obligation finance such as direct investment, portfolio equity
investment, quasi-equity investment, and commodity-price indexed debt in the externa!
financing of LDCs. The advantage and obstacles are first considered for a country starting
with a clean slate, then for a country suffering from a debt overhang in the context of boih
concerted and voluntary exchanges.

*. I am grateful to Jonathan Eaton for comments on an earlier draft.

**. Professor of International Finance and Management, MIT Sloan School of Management,
50 Memorial Drive, Cambridge, MA 02139. (617) 253-6688.


As the debt crises of developing countries continue with no apparent end in
sight, the structure of these countries' obligations as well as their aggregate amount
are receiving increasing attention. It is increasingly acknowledged that a structure
of obligations dominated by general-obligation, floating rate borrowing is far from
ideal (Lessard and Williamson [1985], Krugman [1988]) and that it has contributed to
the severity of the crisis. The potential role of alternatives in resolving the crisis is
receiving even greater attention, but with much less agreement. On the one hand,
debt-equity swaps and other variants that combine debt buybacks with alternative
forms of finance, typically in the context of voluntary exchanges, are held out as the
leading way out of the crisis by institutional observers, bankers, private sector
groups in LDCs, and a few academics (see for example Ganitsky and Lema [1988] and
Regling [1988]). On the other hand, such exchanges are typically depicted as
inconsequential or even damaging to the interests of LDCs by many academic
economists and LDC officials (see e.g. Bulow and Rogoff [1988], Dombusch [1987],
Froot 1988], and Krugman [1988]).

Much of this debate rests on the false premise that one must choose between
debt conversion and debt reduction. It is true that the champions of conversion
programs include banks that are seeking to maintain the value of their claims and
that much of the opposition to such programs comes from LDCs and others who
believe that substantial debt reduction in order (see e.g. Sachs [1989]). However,
there is no logical or institutional reason that a reduction in debt should not be
accompanied by an improvement in the efficiency of the claims structure or that
conversion somehow precludes reduction. While the conversion of Idc general
obligations into alternative forms can take place through voluntary debt
conversions, it also can take place through negotiated exchanges involving all
lenders as well as through separate new money packages. Therefore, it is
inappropriate to associate the potential shortcomings and abuses of voluntary
exchanges with alternative forms of finance in general.

This chapter, therefore, focuses on the potential role of alternatives to
general obligation finance in the inevitable restructuring of Latin American
countries' obligations, whether or not this restructuring includes significant debt


What is "Alternative" Finance?

Commercial alternatives to general obligation finance are defined here as
modes of finance that involve ex ante sharing of risks inherent in particular
projects or enterprises or in the borrowing country's overall portfolio of activities
and, in many cases, a corresponding sharing of responsibility and control. While
this is a broad definition that includes modes of finance ranging from non-recourse
project lending to direct foreign investment, it is narrower than commercial finance
that includes all modes of finance that bear commercial terms (i.e. everything but
concessional finance) or that involve a private lender, a private borrower, or both.

Our definition, for example, excludes many types of financing that may be
provided by private lenders on commercial terms. These include most forms of
general obligation financing, including traditional libor-linked floating rate debt as
well as fixed interest rate bonds, note issuance facilities, etc, whose service does not
depend in any direct way on outcomes within the borrowing country. On the other
hand, it does include contingent general obligations whose terms that are indexed to
factors that influence the borrowing country's ability to pay, such as commodity
prices or indices of external economic activity, e.g. total trade among OECD countries
or industrial production in industrialized countries, as well as "share of export" and
other modes of financing that are linked directly to some measure of the borrowing
country's overall ability to pay.

A key element in the analysis is the emphasis on those alternatives that
provide the possibility of gains to creditors as well as debtors, in contrast to those that
simply shift the burden from one group to the other. In technical terms, this implies
an emphasis on completing markets that currently function poorly or not at all.
However, this also requires an assessment of why markets currently are not complete
along the relevant dimensions, in particular the political and institutional obstacles
to various alternative financing modes.

Why Consider Alternative Finance?

The usual reason for seeking alternatives to general obligation borrowing
from official and commercial sources is the perception that the supply of these
resources simply will not be sufficient to meet LDCs' needs. While undoubtedly

correct, this perspective misses the point. LDCs' financial problems are not the result
of limitations on the aggregate supply of international finance. Rather, they reflect
the limited ability of particular LDCs to contract credibly for sufficient external
finance to meet their needs, especially given the already substantial debt overhang
faced by many of them.i

The financing requirements of developing countries are small relative to the
size of world capital markets. Even an ambitious figure of $20 billion a year is less
than 10 percent of the current net debt financing provided by OECD markets and
institutions. Individual countries face a virtually elastic supply on the condition that
they are able to make credible commitments to meet the terms of their obligations. 2
Therefore, tapping new sources of funds should not be expected to increase greatly
the potential supply of funds to a particular country. A given country, however, may
increase its actual supply of funds (or reduce the degree of debt relief required to put
it back on a current basis) by recontracting in a way that shifts the pattern of
promised payments across future circumstances and thus expands the range of
commitments it can back with credibility. Our focus, therefore, is not on the size of
external financial markets or of these markets' potential appetite for LDC assets;
rather it is on how commercial alternatives to general obligation finance can
increase the actual supply of funds to these countries, reduce the burden imposed by
external financing, and improve the performance of the assets financed.

We take it as given that the overriding goal of a restructuring a country's
obligations and recapitalizing its economy is to restore an acceptable level of growth
in the short run and provide the basis for dynamic long-run development involving
domestic as well as foreign private interests. The primary reasons for changing not
only the amount but also the structure of financing are to:

(1) reduce the "overhang" of senior obligations (official and commercial bank
debt) that distort public and private economic incentives within the country and

вАҐThis is not to deny that many LDCs, including the poorest countries in Latin America,
face an debt relief and aid crisis in that, regardless of how restructured, their obligations
outweigh their ability to repay and voluntary external finance will not provide them with a
tolerable level of growth.

2This result is obtained in theoretical models, see for example Eaton, Gersovitz, and
Stiglitz [1986], and is borne out by the fact that newly industrialized countries (NICs) have been
able to achieve very rapid growth in external financing in line with the growth of their economies.


preclude the issuance of new, junior claims (project financing, direct investment,
local equity investment) and to limit the explicit and implicit costs to debtors of
current or potential future noncompliance;

(2) more closely match countries' obligations their ability to pay over time and
across circumstances (e.g. commodity prices and interest rates), thereby
simultaneously increasing the potential value of their obligations and reducing
potential costs of noncompliance; and

(3) rearrange the allocation of risks, rewards, and responsibilities among
agents in order to increase the benefits of diversification and participation.

This chapter is organized in five pans. The first classifies alternative
financing modes in terms of the extent to which they involve risk sharing and
managerial control and illustrates these general dimensions with several specific
alternatives. Part II examines the potential benefits of alternative forms of external
commercial finance for LDCs without an existing debt overhang. Part III suggests
why these alternatives have not played an important role in LDCs' financing to date,
even prior to the onset of their debt crises, in order to identify the political and
institutional preconditions for their implementation. Part IV examines the
implications of a debt overhang for the attractiveness and feasibility of these
alternatives in the context of concerted as well as voluntary exchanges, emphasizing
those conditions where linking debt buybacks and the issuance of new obligations is
superior to separate transactions. Part V summarizes the discussion of and identifies
a series of steps that can and should be taken by countries, their external creditors,
and the key international institutions to support the implementation of these
alternative financing arrangements.

I. Commercial Financing Alternatives

There are a large number of alternatives to general obligation borrowing for
obtaining external finance. It is useful to classify them along three dimensions:
1) expected cost, 2) degree of risk sharing or hedging and, 3) degree of managerial
participation in the project or enterprise financed.

The expected cost is comprised of three components: the required expected
return to investors, which may be substantially less than the promised rate in the
case of risky obligations; the deadweight cost or penalty in the case of

nonperformance; and the monitoring and control costs associated with particular
forms of finance. We assume that the required expected return to investors is

given by a stylized international capital asset pricing model in which the risk
premium is an increasing function of the covariance of this cost or return with
aggregate world consumption, i.e. a world consumption beta. 3 Therefore, short-term
floating-rate obligations or price-level indexed obligations whose returns are
largely independent of variations in aggregate output will command minimal
investor risk premiums, while, for example, copper-linked bonds which have a
significant positive covariance with aggregate output will require a substantial risk
premium.'* A broadly diversified portfolio of local equities, though, will command
only a slightly higher cost than floating rate debt since empirical analyses show that
the are close to zero-beta assets with respect to external factors.

The enforceability of sovereign credit, in general, depends on the ability to
lenders to impose penalties in the case of nonperformance, see e.g. Eaton, Gersovitz,
and Stiglitz[1986]. These penalties generally result in deadweight costs, since their
cost to borrowers is not offset by a corresponding gain to lenders. However, there is
no similar generally accepted model of deadweight costs associated with
nonperformance nor are there any estimates of its magnitude. 5 We assume that
expected deadweight costs depend on two factors: the expected incidence of
nonperformance and the ability of lenders to distinguish between bad luck and bad
faith on the part of borrowers with respect to meeting their commitments on
particular claims. Therefore, we expect that these deadweight costs will be highest

3 Stulz [1988] derives an explicit international Capital Asset Pricing Model that links
returns to assets' consumption betas.

"^Risk premia are defined here as in the financial economics literature as increments in
the expected return on an asset relative to the expected return on a zero-beta asset, not as
adjustments in promised rates to reflect anticipated defaults as is common in the Idc debt

5There is a great deal of uncertainty over what penalties a counu-y will face when it does
not meet its obligations. Most formal models assume that it will be relegated to financial and
commercial autarchy for at least some period. Many observers, though, argue that these penalties
are much smaller, see e.g. Kaletsky [1985]. Eichengreen and Portes [1988] infer from data from
the 20's through the 50's that differential impact of default on subsequent access to credit is
small, but this inference is questionable since in the subsequent period all LDCs effectively went
into commercial and financial autarchy because of the world depression and the associated
collapse of the international commercial and financial system.

for noncontingent general obligations, especially floating rate obligations that
enhance the probability of default through adverse interest rate movements.

Monitoring costs depend on the amount and frequency of information and
influence required for the enforcement of particular claims. At this stage we assume
only that they are equal for all forms of general obligations, and are higher for
claims that penetrate the economy and hence may require information and
influence at the level of firms or projects.

Risk sharing refers to the extent to which the contractual obligation is linked
explicitly to some aspect of the borrower's economic situation and hence shifts risks
inherent in the domestic economy to other participants in the world economy.
Equity investment, for example, entitles the investor to a pro rata share of the profits
of a particular firm, while commodity-linked bonds or export participation notes
perform the same role at the level of the economy as a whole. This attribute is most
valuable to a borrower when the risks that are shifted contribute significantly to the
variability of income or the availability of foreign exchange or both, in other words,
those risks that are systematic at a local level. The outstanding examples are coun-
tries whose exports are dominated by one or two primary products, such as Chile
(copper), Malaysia (tin, palm oil) or Mexico, Nigeria, and Venezuela (oil). Whether a
particular contingent obligation provides risk sharing at a national level depends on
its covariance with national aggregate consumption or overall net foreign exchange
transfers. 6

Hedging is accomplished when financing terms are selected to minimize the
borrower's exposure to adverse fluctuations in the cost of finance resulting from
shifts in external economic variables, such as interest rates and exchange rates.
Hedging can be accomplished through the purchase of options or through entry into
swap contracts. Using either of these instruments, the borrower can manage risk
independently of the supply of capital.

Managerial participation or control refers to the extent that private agents
participate in the selection of investments and/or their management over time. With
the exception of the World Bank, this participation is virtually nil for general

6A country's "utility" will be a function of the level and variability of its overall
consumption, assuming away distributional considerations. The impact of a particular obligation
on this utility with depend on its contribution to the level and variability of net foreign transfers
which influence the level of consumption.


obligation lenders. It will be greatest in the case of claims that are contingent or^ the
outcomes of particular projects or firms such as equities, quasi-equities, commercial
bonds, or project loans.

The positions along these dimensions of various alternatives, including
general obligation financing, direct foreign investment, portfolio equity investment
(both in individual shares and in national funds), quasi-equity, and project lending
are shown in Figure 1.

Figure 1 here

General obligation financing, at the origin, provides the benchmark. On an
ex ante basis, it offers the lowest cost, but it also involves no ex ante risk sharing or
managerial involvement. Direct foreign investment typically has a higher expected
cost, but it also combines risk sharing with managerial control of investments and,
often, a substantial international integration of operations. Other alternatives
typically are more focused in the dimensions that they provide. Commodity bonds,
for example, provide risk sharing but no managerial involvement, while portfolio
equity and quasi-equity investment - where the lender is entitled to an income
stream that depends in some well-defined way on the success of the project but with a
narrow claim to participate in ownership or control. - share risks and responsib-
ilities, but over a narrower range of outcomes than direct investment.


Alternative Finance Modes

Direct investment, the traditional alternative to sovereign borrowing, entitles
the investor to a pro rata share of the distributed profits of the firm. It typically is
motivated by the return the parent expects to be able to earn by making use of its
existing knowhow in a local operation and/or by incorporating the local operation
in its global production and marketing network. Thus it responds largely to firm
specific, microeconomic factors as well as to macroeconomic prospects in the host
country. In some cases, however, direct investment also serves to overcome limits to

the enforceability of other cross-border claims posed by country risk or the absence
of the necessary local institutions.

Portfolio investment in equities quoted on public stock markets, like direct
investment, entitles the investor to a share in the profits of private enterprise.
Unlike the direct investor, however, the equity investor typically is seeking only a
share of profits, and not the responsibilities of control. Indeed, many equity
investors deliberately restrict their holdings to a small percentage of the total stock
(less than 5 percent), in order to maintain liquidity and avoid being forced to take
responsibility for saving the firm if they lose confidence in its management.

Portfolio equity investment can involve varying degrees of penetration of the
domestic economy. The least penetrating mode, popular in many LDCs, is the offshore
investment trust (closed end fund) that invests in a broadly diversified portfolio of
domestic shares. Other more penetrating modes involve investments in individual
shares, either through offshore listings of LDC firms or local purchases of locally
listed shares. While portfolio investment is typically defined as involving little or no
managerial control, this too can vary substantially. A national index fund may or
may not participate in the governance of the firms in which it invests. If it does,
though, the general practice is to separate the nationality of ownership and control
by appointing a local investment management firm that represents shareholder
interests on boards, etc.

Quasi-Equity Investments break open the package of risk sharing and
managerial control that direct investment has typically constituted. These new

forms of international investment include joint ventures, licensing agreements,
franchising, management contracts, turnkey contracts, production sharing, and
international subcontracting. ^ They permit the host country to single out the
particular features controlled by the foreign enterprise that cannot economically be
obtained elsewhere, and to contract for those without allowing foreign control of the
domestic operation.

Non-recourse Project or Stand-Alone Finance provides another way to shift
risks and responsibility to foreign investors by linking borrowing to particular
enterprises or projects without a general guarantee. In such cases, the lender is
exposed to the downside risks of the undertakings being financed, but in contrast to

''For a description of these insu-uments, see Lessard and Williamson [1985] and Oman


equity or quasi-equity claims, does not share in the upside potential. From the ,
perspective of the borrower, such financing can be thought of as borrowing at a rate
that is independent of the project's success and purchasing insurance to service the
debt in case the project fails. It may also involve the earmarking of project revenues
for servicing the project borrowing. Clearly, therefore, the lender would require a
higher promised interest rate on such loans than on general obligations. ^

Just as equities or quasi-equities linked to particular projects or firms transfer
some or all of the risks of those undertakings to investors, contingent general
obligations do the same for the country as a whole. A country that is heavily
dependent on, say, oil or copper revenues could issue commodity-linked bonds. With
such bonds, debt service would remain a sovereign obligation with the implied
enforcement leverage, but the amount of the debt service under any set of
circumstances would be determined by the price of the commodity.


II. Potential Benefits of Alternative Finance

Given that most alternative modes of finance involve somewhat higher
expected costs than floating-rate, general obligation borrowing, why should
borrowers ever prefer them? The key reasons, which we develop below, are that
these alternatives often are more attractive in terms of their distribution of costs
over time and across circumstances and in terms of their incentive effects and
interactions with local financial markets. In contrast to expected cost, which by
definition is a zero-sum game between lenders and borrowers, these dimensions can
give rise to positive sum combinations. 9

8 The exception would be a case where the lender is shielded from transfer risk by escrow
arrangements that provide for debt-service payments out of export proceeds before they are
remitted to the host country.

'The exception would be the case where a reduction in current interest rates, by reducing
the probability of default, would increase the present value of lenders' claims.


Time Profile of Debt Service ^

Other things equal, a borrowing country will prefer financing whose time
profile of repayment obligations matches the profile of resources available for debt
service. The usual rule of thumb is that long-term projects should be financed by
loans with equivalent maturities, while current trade activities can be financed with
short-term obligations. However, at the country level the matching should be in
terms of ability to pay at the aggregate level, which has little to do with the maturity
of the assets being financed. In practice, time matching requires spreading debt
service as equally as possible over future periods where foreign-exchange surpluses,
ready access to new financing, or both are anticipated and, in particular, avoiding
the bunching of maturities. Debt rescheduling has effectively transformed the
obligations of most LDCs into perpetuities, leaving little room for further gains on
this dimension. The time matching of LDCs' obligations could still be improved by
recontracting on a price-level indexed basis, thus transforming a nominal annuity

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Online LibraryDonald R LessardBeyond the debt crisis : alternative forms of financing growth → online text (page 1 of 3)